Professional Documents
Culture Documents
By R. Venkata Subramani
Copyright © 2009 John Wiley & Sons (Asia) Pte. Ltd.
APPENDIX
A
Basics of Accounting Theory
BASIC ASSUMPTIONS
Basic assumptions def ne the basic objectives of accounting practice. They provide
ground rules, which are essential characteristics of a traditional accounting model.
BASIC CONCEPTS
Basic concepts indicate which events will be accounted for and in what manner. They
form the underlying principles of f nancial accounting practices.
Matching Concept
This concept states that expenses are recognized in the same period as their related
revenues. While revenue is recognized according to the realization concept, the
matching concept requires that all expenses incurred in generating the same revenue
be recognized at the same time.
Objectivity Concept
According to this concept, each business transaction requires proper evidence to
support it. For example, the historical cost of a land is highly verif able. The cost of the
land can be traced back to the time when it was purchased.
Materiality Principle
Any information that will have an effect on its decision makers is known as material
information. Materiality is mainly dependent on the relative amount of money involved
in the transaction. It also depends on the nature of the item. The context of materiality
is left to the judgment of the company that prepares the f nancial statement.
Consistency Principle
The f nancial statements provided by the company should be consistent year after
year. Each rule, concept, and principle that is used by the company must be observed
and applied every year. Comparison of f nancial statement between different
accounting periods will be signif cant only if the practices followed by the company
are consistent.
Prudence Principle
The principle of conservatism or principle of prudence requires that the company
make prudent accounting choices and estimates for the future. It is always better to
understate assets and overstate liabilities. For example, a part of the accounts receivable
may not be collected, and this is known as bad debts. So the accountant would have to
make provisions for such a situation.
ACCOUNTING MODEL
Financial Position
The balance sheet or statement of f nancial position shows the assets, liabilities, and
shareholders’ equity at a specif c point in time. It gives a snapshot of the company’s
f nancial position in a particular time period. This provides a wealth of information to
external decision makers.
One of the important features of a balance sheet is that it helps the decision makers
to assess what resources are available to generate future cash f ows. It also provides
information about liquidity and long-term solvency.
606 Accounting for Investments
Assets are the resources of a company. The company’s obligations are known as
liabilities. Owners’ equity refers to the assets that are available after all obligations have
been satisf ed.
Results of Operation
The record of the amount of net income earned by a company during a period of time
is known as the income statement or results of operation. It represents the measurement
of economic performance of a company. It is in effect a summarization of revenues
generated and the costs incurred to generate the revenues. Net income or net loss is
derived from the difference between revenues and expenses. Net income is used to
evaluate the health and performance of a business.
Revenues refer to the inf ow of resources when goods are sold or services are
performed. It represents an increase in total assets. The outf ow of resources to generate
such revenue is referred to as expenses.
Intangible assets are those that do not have a physical existence and cannot be touched
or felt. They include such things as goodwill, patents, copyrights, and so on.
Liabilities
Liabilities are amounts that the company owes, such as accounts payable, loans, and so
on. Liabilities are also classif ed into three categories:
1. Long-term.
2. Current.
3. Contingent.
Debt or other obligations that will not be paid off within one year are known as long-
term liabilities. Liabilities that are repayable within one year are known as current liabilities.
A liability that can be anticipated to arise in the future is known as contingent liability.
FASB Concepts Statement 6, Elements of Financial Statements, describes the
characteristics of assets and liabilities as follows:
An asset has three essential characteristics:
(a) it embodies a probable future benef t that involves a capacity, singly or in
combination with other assets, to contribute directly or indirectly to future net
cash inf ows,
(b) a particular entity can obtain the benef t and control others’ access to it; and
(c) the transaction or other event giving rise to the entity’s right to or control of the
benef t has already occurred.
A liability has three essential characteristics:
(a) it embodies a present duty or responsibility to one or more other entities that
entails settlement by probable future transfer or use of assets at a specif ed or
determinable date, on occurrence of a specif ed event, or on demand,
(b) the duty or responsibility obligates a particular entity, leaving it little or no
discretion to avoid the future sacrif ce; and
(c) the transaction or other event obligating the entity has already happened.
Owners’ Equity
Owners’ equity equals total assets minus total liabilities. To start a business, investors
put in the money initially in return for part ownership. Ownership restricted to a single
person is known as sole proprietorship; ownership by a small group is a partnership;
and ownership that is represented by transferable shares is known as a corporation.
Equity increases through investments made by owners. Such investment involves
a transfer of resources by the investor to the company in exchange for ownership
rights. For example, a person becomes a shareholder of a company by the exchange of
resources for the issuance of stock by the company. Owners’ equity increases also when
prof ts are generated by the business and retained for the business’s use. The amount of
prof t that is not distributed to the investors is known as retained earnings.
A decrease in equity is a result of distributions to owners. In other words, owners’
equity decreases when investors take back part of their investment. In the case of a
corporation, distribution to owners is in the form of dividends. Owners’ equity is also
decreased when the company generates a loss instead of a prof t.
608 Accounting for Investments
Income
Revenue or income refers to the inf ow of resources when goods are sold or services are
performed. It represents an increase in total assets. Assets are increased by borrowing
or through money invested by people. Similarly, assets also increase when the company
provides a product or service for which customers pay. But these assets are not tied
to any liability obligation; hence the assets belong to the company and result in an
increase in owners’ equity. Companies also earn revenue by charging interest or by col-
lecting rent. For the good sold or services performed, income is in the form of cash or
accounts receivable.
Expenses
The outf ow of resources to generate revenue is referred to as expenses. This means the
amount of assets used to conduct business operations—for example, payment of salary
to employees.
One important feature of expenses is that they represent outf ows of resources
incurred in the process of generating revenues. Expenses are paid for by cash or as a
credit, wherein cash payment is to be made at a later date.
Off-balance-sheet Items
These are items that are not reported as part of the balance sheet, but are reported
in the footnotes to the f nancial statements. There must be certain legitimate reasons
to report an item as off-balance-sheet. The items most commonly reported are lease
agreements, pension assets and liabilities, investment in joint ventures, and securitiza-
tion of assets.
In the case of lease agreements, if the contract does not have a buyout option at the
end of the lease, then it cannot become a personal asset. So at the end of the lease the
item must be returned and hence it cannot become an asset of your own.
The assets of pensions are put into a trust or invested in a f nancial vehicle. These
assets belong to the employees, so it is not right for the companies to claim them as
their own.