PRINCIPLES OF ACCOUNTING

INTRODUCTION- PRINCIPLES OF ACCOUNTING

“Accounting principles are a body of doctrines commonly associated with the theory and
procedures of accounting serving as an explanation of current practices and as a guide for
selection of conventions or procedures where alternatives exist.”

The basic fundamental truth of accounting or rules of conduct or procedures which are
universally accepted & followed by accountants everywhere, without unreasonable likes or
dislikes, to record business transactions & prepare accounts are called accounting principles.
These accounting principles gradually developed over a long period of time through its
usage, necessity & experience.

Classification of accounting principles:

Accounting principles

(A) (B) (C)

Accounting Concepts Accounting Conventions Accounting Assumptions

1 Business entity 1 .Disclosure 1. Going concern

2 Cost 2. Materiality 2. Consistency

3 Dual aspects 3. Conservative approach 3. Accrual

4 Accounting period 4. Money Measurement

5 Realizations

6 Matching cost

A. Accounting concepts:

Concepts mean a general idea which conveys certain meaning. Accordingly, accounting
concepts imply general notions or abstract ideas on which accounting are based. In order to
communicate, information exactly at the same meaning to all interested parties of the
business, accountants have discovered a number of accounting concepts. The different
accounting concepts are explained below:

1. Business entity:

The business entity concept suggests that business has a separate entity & has an
independent legal existence distinct from the ownership. Although a business has no

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body, soul, life & existence still law recognize it as a legal person. This accounting
concept enables accountants to record the transaction of the proprietor separately from
the transaction of the business.

CASE STUDY

Mr. XYZ owner of Reliance Ltd died after 6 months from the commencement of business
but the business of Reliance Ltd will be continued till today as a separate business
entity.

2. Cost concept:

The cost concept suggests that the fixed assets of the business are recorded in the
books of accounts at their respective cost & not at current market value. The price paid
to acquire or produce the assets is called cost. This accounting concept enables
accountants to depreciate the assets correctly & show them at their correct value in the
books of accounts.

CASE STUDY

An asset purchased for Rs.100000 it recorded in the books at Rs 100000, even its
market value at the time of preparation is Rs 150000 it would be not considered.

3. Dual aspect concept:

The dual aspects accounting concept explain that every a business transaction has two
aspects via, (1). Acquisition or increase in the assets of the business & (2)Creation or
increase in the claims against business, e.g. capital received in cash by the business
from the proprietor has dual aspects viz.(1).proprietor has a claim against the business
entity . This concept suggests that assets are always equal to liabilities.

CASE STUDY

Purchase of stock in cash will result in increase in stock & decrease in cash.

4. Accounting period concept:

This accounting concept suggest that although business entity has an everlasting
existence, but for the convenience the life span of business entity is split up into smaller
intervals of 12 months to measure & compare the result & progress of the business.
According to the provisions of the companies act, 1956 & the banking regulation act,
the accounting period for every business entity should consist of 12 months. The
financial year in India now corresponds to the financial year which starts on 1st April of
one year & ends on 31st march of the next year.

CASE STUDY

M/S Z Ltd operates its books of a/c from 1st April 2009 to 31st March 2010 or for the
year ended.

5. Realization concept:

This accounting concept explains as those sales which are supposed to be completed
when the title & possession of goods are passed from the seller to the buyer & payment
in that exchange is received by the seller from the buyer. Revenue or income is
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considered to be earned on the date on which its actual payment is received. Since
accounting is the historical records of the business transactions, it records what is
actually received & paid. In the case of installment sales or hire purchase, the sales are
treated to have been completed only to the extent to which installments are
received.similary, in the case of contract account profit is calculated on the basis of work
certified.

CASE STUDY

Sale of Rs. 2.5 Lacs to Mr. A on credit, out which he paid Rs.2.00 Lacs paid after a week
and for the balance bill for 5 months credit is provided which may or may not be
received in future.

6. Matching cost and revenue concept:

This accounting concept suggest that while determining exact or accurate profit or
income, we have to compare or match the revenue of the business with the cost
incurred for one and the same accounting period. In the other words, only relevant cost
or expenses of the period are required to be deducted from the relevant revenue of that
period.

CASE STUDY

Product x is purchased at Rs. 100 & 20 numbers of units have been purchased.
Therefore total expenses are Rs 2000 out of these 5 units have been sold at Rs. 250
each, so the total revenue is Rs.1250

Now Expenses are Rs 500 & the revenue are 1250, profit should be Rs. 750 (total
revenue – total Expenses)

B.ACCOUNTING CONVENTIONS:

Conventions mean accepted rules or usages. They are the general agreement or
customary practice. Accounting conventions means and include those customs or
traditions which accountants to prepared accounting statement. In other words, customs
convention they are the rules which have a common acceptance and are called
accounting conventions. They are the rules which have a common acceptance and
agreement in accountancy. They are the rules of practice adopted by general agreement
and custom and followed years together to prepare accounts of the business enterprises.
At the end of every financial year, every business entity draws up the financial
statement and positional statement according to the following conventions.

Convention of disclosure:

According to the convention of full disclosure, accounting statement must disclose all the
material facts and information so that interested parties after reading such accounting
statement gets a clear view of the state of affairs of the business. This accounting
convention is more revenant to a joint stock where there is separation between ownership
and management must disclose true and fair view of the state of affairs of the company.
true and fair view means.

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1. All the material items are disclosed.

2. Financial position of a company is neither overstated nor understated.

3. Final accounts are compiled with requirements of law.

4. Final statements are made according to recognized accounting principles and

standards laid down by professional bodies.

5. Convention of materiality:

According to the materiality, accountants must disclose all material facts and
information which highlight the financial position and profitability of the business
organization.

CASE STUDY

An amount of Rs. 1 Lac in total sale of Rs 100 Lacs is immaterial but amount of Rs 10
Lacs in total sale of Rs. 100 Lacs is material.

6. Convention of conservatism:

This accounting convention suggests that while preparing accounting statement,

planning, policies, strategies and budgets, all possible or anticipated losses must be
taken into consideration while unrealized, prospective or anticipated profit should be
ignored. This is also known as “the policy of playing safe game.” It is also called
“principle of prudence.” Accounting this accounting convention, closing stock is
valued at the market value or at the cost whichever is lower. Similarly provision for
bad and doubtful debts is also permitted and made every year.

CASE STUDY

Making provision for doubtful debts & discount for debts & discount on debtors but
not provide on creditors

Accounting principles must satisfy the following conditions;

1. They should be based on real assumptions;

2. They must be simple, understandable and explanatory;
3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.

C. Accounting Assumptions:

1. Going Concern :

According to this concept, it is assumed that the business will be carried out
indefinitely for a long period of time in future & accordingly business transactions are
undertaken recorded. Fixed assets like plant & machinery, furniture & fixture, land &
building, motor vehicles, etc.are purchased on the assumption that a business is
going concern.

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If the company’s operations were suspended and its case was referred to BIFR, it is
an indication that the fundamental accounting assumption of going concern may not
be appropriate.

CASE STUDY

M/S VIP Ltd Purchase fixed assets for Rs. 50 Lacs which can be in use for indefinite
period and will be accounted over the life period assets.

The BIFR had sanctioned the modified rehabitation scheme for the company on 29th
September 1999 and amended on 22nd February 2002 which is being implemented by
the company. In the light of revival package the accounts for the year have been
prepared on the assumption of going concern and due consideration has been given
to rehabilitation package in the preparing financial statements.

2. Accrual concept:

This accounting concept stated that revenue is recognized when they are earned and
not when they are received. Similarly, costs are recognized as soon as they are
incurred and not when they are paid. This accounting concept enables the
accountants to measure the income for a particular period by calculating the
difference between the revenue recognized in that period and expenses incurred to
earn that revenue. Accrual accounting is a basic accounting concept used in the
preparation of the trading account and profit and loss account and balance sheet

CASE STUDY

Mrs. Nitu an employee received salary of Rs. 35000 p.m. of March 2010 in April
2010 will be booked in financial year 2009-10 not in 2010-2011 on basis of accrual
accounting as she earned this salary in financial year 2009-10 even though received
in 2010-2011.

XYZ Company ltd closes its books of accounts on 31st March every year but as on 31st
march 2010 Interest on fixed deposits amounting Rs 30 lacs are not accrued because
it is not shown in their bank statement hence it will not show the correct accounting
position because that interest is earned before closing of financial year 2009-10
hence need to be booked on accrual basis.

3. Consistency:

This accounting convention stated that once a particular accounting policy, practice,
or method is adopted to preparation of financial statements then same should be
followed for future years also unless it is required by law or management. For
example company is using straight line method of depreciation for machinery in one
year then it has to follow the same method in succeeding years also it cannot switch
to written down value method.

CASE STUDY

JET AIR WAYS follows straight line method of providing depreciation on fixed assets
& it is expected that the company follows the same method of depreciation
consistently.

4. Money measurement concept:

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The money, measurement concept suggests that accountants record only those
transactions which are financial in nature & capable of being expressed in monetary
term. The qualitative & quantitative aspects which cannot be, measured in terms of
money are not recorded in the books of accounts, e.g. change in economic policy of
the government.

CASE STUDY

Death of partner, resignation of an executive or appointment of new manager is the

event which is important but cannot be expressed in money and should not be
accounted.

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2.5 CONSIDERATIONS IN THE SELECTION OF ACCOUNTING POLICIES

The main consideration in selection of accounting policies is the presentation of true and fair
picture. The financial picture presented by Balance Sheet and the net result shown by Profit
& Loss Account should be true and fair. To ensure the true and fair consideration this
statement issues following guidelines:

Prudence: As defined in the statement, prudence means recognising all losses immediately
but ignoring anticipated profits. Business environment is highly dynamic, therefore,
enterprises has to keep anticipate the future and take managerial decisions accordingly.
This statement suggests that accounting policies should be such that no profit is recognised
on the basis of anticipation but all anticipated losses are provided for.

For Example: If valuation of stock is always done at cost, consider a situation where
market price of the relevant goods has reduced below the cost price, then valuing stock at
cost price means ignoring anticipated losses. Similarly if stock is always valued at market
price, then take a situation where cost price is below market price, indirectly we are
recognising the anticipated gross profit on stock in the books. Therefore, accounting policy
should be cost price or market price whichever is less, in this case we are ignoring
anticipated profits (if any) but any anticipated losses would be taken care of.

Substance over form: While recording a transaction one should look into the substance of
the transaction and not only the legal form of it.

For Example: The ownership of an asset purchased on hire purchase is not transferred till
the payment of the last instalment is made but the asset is shown in the books of the hire
purchaser. Similarly, in the case of the amalgamation, the entry for amalgamation in the
books of the amalgamated company is recorded on the basis of the status of the
shareholders of amalgamating company after amalgamation i.e. if all or almost all the
shareholders of the amalgamated company has become shareholder of the amalgamating
company by virtue of amalgamation, we record all the transactions as Amalgamation in
nature of Merger otherwise it is recorded as Amalgamation in nature of Purchase.

Materiality: All the items which are material should be recorded. The materiality of an item
is decided on the basis that whether non-disclosure of the item will effect the decision
making of the user of accounts. If the answer is positive then the item is material and
should be disclosed, in case answer is negative, item is immaterial. By this statement does
not mean that immaterial item should not be disclosed, disclosure or non-disclosure of an
immaterial item is left at the discretion of the accountant but disclosure of material item is
been made mandatory.

All of the above are used in the preparation of an Income Statement and a Balance Sheet. An
Income Statement essentially summarises the income and expenses and is used to calculate
profit or loss.

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A balance Sheet is a statement of assets and liabilities of a business on a given date.

If you made your personal income statement, it would be the excess of spending over the
money available to you (isn’t that always the case?)

If a salaried individual sets out to make his Income Statement, it would consist of his salary on
the income side and all expenses incurred for the month on the expense side.

A balance Sheet would consist of his house,car and all other belongings on the one side(assets)
and loans on the other(liabilities).

The Balance Sheet of a business would look as follows:

Liabilities Assets
Funds Brought in for Business(Equity) Plant,Equipment
Loans(Debt) Motor Vehicles
Loans(Short term-Working Capital) Investment
Cash in Hand
Inventory, Accounts Receivable

Exercise 1

Just google into a few businesses you like and check out their Balance Sheets. See how
they are presented and whether different businesses have different ways of presenting
the Financial Statements..

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ILLUSTRATIONS
Illustration 1
A Ltd.has sold its building for Rs. 50 lakhs to B Ltd. and has also given the possession to B
ltd. The book value of the building is Rs. 30 Lakhs. As on 31st March, 2006, the
documentation and legal formalities are pending. The company has not recorded the sale
and has shown the amount received as advance. Do you agree with this treatment?

Solution

The economic reality and substance of the transaction is that the rights and beneficial
interest in the property has been transferred although legal title has not been transferred. A
Ltd. Accounting Standards and Guidance Notes 1.13 should record the sale and recognize
the profit of Rs. 20 lakhs in its profit and loss account. The building should be eliminated
from the balance sheet.

Illustration 2

ABC Ltd. was making provision for non-moving stocks based on no issues for the last 12
months up to 31.3.2005. The company wants to provide during the year ending 31.3.2006
based on technical evaluation:

Total value of stock Rs. 100 lakhs

Provision required based on 12 months issue Rs. 3.5 lakhs

Provision required based on technical evaluation Rs. 2.5 lakhs

Does this amount to change in Accounting Policy? Can the company change the method of
provision?

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Solution

The decision of making provision for non-moving stocks on the basis of technical evaluation
does not amount to change in accounting policy. Accounting policy of a company may
require that provision for non-moving stocks should be made. The method of estimating the
amount of provision may be changed in case a more prudent estimate can be made.

In the given case, considering the total value of stock, the change in the amount of required
provision of non-moving stock from Rs.3.5 lakhs to Rs.2.5 lakhs is also not material. The
disclosure can be made for such change in the following lines by way of notes to the
accounts in the annual accounts of ABC Ltd. for the year 2005-06:

“The company has provided for non-moving stocks on the basis of technical evaluation
unlike preceding years. Had the same method been followed as in the previous year, the
profit for the year and the corresponding effect on the year end net assets would have been
higher by Rs.1 lakh.”

Illustration 3

Jagannath Ltd. had made a rights issue of shares in 2004. In the offer document to its
members, it had projected a surplus of Rs. 40 crores during the accounting year to end on
31st March, 2006. The draft results for the year, prepared on the hitherto followed
accounting policies and presented for perusal of the board of directors showed a deficit of
Rs. 10 crores. The board in consultation with the managing director, decided on the
following :

(i) Value year-end inventory at works cost (Rs. 50 crores) instead of the hitherto method of
valuation of inventory at prime cost (Rs. 30 crores).

(ii) Provide depreciation for the year on straight line basis on account of substantial
additions in gross block during the year, instead of on the reducing balance method, which
was hitherto adopted. As a consequence, the charge for depreciation at Rs. 27 crores is
lower than the amount of Rs. 45 crores which would have been provided had the old
method been followed, by Rs. 18 cores.

(iii) Not to provide for “after sales expenses” during the warranty period. Till the last year,
provision at 2% of sales used to be made under the concept of “matching of costs against
revenue” and actual expenses used to be charged against the provision. The board now
decided to account for expenses as and when actually incurred. Sales during the year total
to Rs. 600 crores.

(iv) Provide for permanent fall in the value of investments - which fall had taken place over
the past five years - the provision being Rs. 10 crores. As chief accountant of the company,
you are asked by the managing director to draft the notes on accounts for inclusion in the
annual report for 2005-2006.

Solution

As per AS 1 “Any change in the accounting policies which has a material effect in the
current period or which is reasonably expected to have a material effect in later periods
should be disclosed. In the case of a change in accounting policies which has a material
effect in the current period, the amount by which any item in the financial statements is
affected by such change should also be disclosed to the extent ascertainable. Where such

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amount is not ascertainable, wholly or in part, the fact should be indicated. Accordingly, the
notes on accounts should properly disclose the change and its effect.

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GOLDEN RULES OF ACCOUNTING

All the above classified accounts have two rules each, one related to debit and one related
to credit for recording the transactions which are termed as golden rules of accounting, as
transactions are recorded on the basis of double entry system.

1. Personal account is governed by the following two rules:

Debit the receiver

Credit the giver

Eg: Kishor A/c, Bank of Baroda A/c, and Club of India A/c M/s Raja Stores A/c

Ram Loan A/c, Shiva A/c, Debtors A/c,

2. Real account is governed by the following two rules:

Debit what comes in

Credit what goes out

Eg: Cash A/c, Good A/c, Furniture A/c, Bill Receivable A/c, Motor Vehicles A/c

Live Stock A/c, Debentures A/c, Goodwill A/c, Stock of Stationery A/c, Building A/c

3. Nominal account is governed by the following two rules:

Debit all expenses and losses

Credit all incomes and gains.

Eg: Rent A/c, Interest A/c, Discount A/c, Commission A/c, Audit fees A/c, Royalty
A/c

Wages A/c, Interest Receivable A/c, Repairs A/c, Bad Debts A/c, Loss by fire A/c

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