yr vane Chapter 2 (A) Basic Accounting Concepts and Conventions Need for Accounting Concepts and Conventions : As History gives visible shape to the past of human race, accounting provides & systematic visible shape to business transactions, It records, classifies ang summarises all the financial transactions taking place in a business, Itcommunicates the results of the transactions in the form of financial statements to the internal and external users who are in need of the data, The acco Teports have to be prepared by the accountants and understood by the u: the same sense, If different firms follow their compiling and finalising accounts, uniformity analysis would be impossible, There will be utter confusion in the world of trade and commerce. Different accounting principles, Postulates or concepts and conventions were developed over the years which act as ‘the basic Points of agreement’ on which Financial Accounting theory and practice are founded, ing Concepts and Conventions The generally accepted principles were e accountants, historical unting ers in own principles and practices in will be absent and comparative 2. Objectivity The principles are supported They are not based on subjective 3. Feasibility . The principles are practicable since they can be applied without excessive cost and effort. and supplemented by facts and documents. Views of individual accountants,Basic Accounting Concepts and Conventions 22 Characteristics of Accounting Concepts and Conventions % 1, The accounting principles are developed for practical Purposes. They cannot be validated or proved like the principles of Mathematics, Physics and Chemistry, They are the best possible suggestions based on practical experience, reasoning and observation of the professional accountants, 2. The principles are for common usage to ensure uniformity and understanding. They are not rigid. They can be adapted to the changing needs and circumstances of business units. They enhance the usefulness of the data relating to the activities of a firm. 3. They are not specifically made or legislated by any government or legal authority, They are not legally enforceable. 4, They are in the process of evolution and are likely to change as per the dictates of changing circumstances and technology. Meaning and Classification of Accounting Concepts and Conventions The Generally Accepted Accounting Principles (GAAP) are all termed Concepts by some experts. Some others call all of them Conventions. However, an overwhelming majority of authors on accounting distinguish between concepts and conventions. Recounks , jonap bS> Accounting concepts, are the aosulnpatsns or postulates of ideas which are essential to the practice of Accounting and preparation of financial statements. The following is a generally accepted list of basic Accounting Concepts:- ; ae (1) The entity concept (2) The money measurement concept @) Going concern concept (4) Dual aspect concept (©) Accounting period concept (6) Cost concept (7) Revenue Recognition concept or Realisation concept. (8) Matching concept 9) Accrual concept (10) Objective evidence concept. Accounting conventions are the established traditions, customs, methods and practices which usually act as guidelines for preparation and presentation of accounts. Accounting community has accepted their utility and importance in ° making the financial statements more realistic, reliable and useful to the end users. The following are the generally accepted accounting conventions:- (1) Convention of full disclosure (2) Convention of consistency. (3) Convention of materiality (4 Convention of conservatism. Accounting concepts are subdivided into fundamental concepts and non fundamental concepts, based on their importance. 1. Fundamental Concepts There are two fundamental concepts — The entity concept and the money Measurement concept. ‘The entity concept states that financial accounting information relates to the oat ies of a business entity only and not to the activities of owners of the usiness.Financial Aco, 23 t limits recognition of activities to ment concept F & tt The gon eae in terms of money. The alteration of either op he which can be express i ounts. e ire nature of financial acc i ¢ the entire nat concepts will chang al Concepts | i 2.Non See are important for recording nd finals accounts, Buy rt nce) i: A s reine hen do not affect the basic ae of nancial account The tale all other concepts except the entity and money 2 concep mh nting concepts are also classified on the basis of the aspects ar cour s i i useful. ecounting for which they are ; a .) Concepts related to income measurement and preparation of financial a) statements, (i) Going concern concept (ii) Accounting period Concept (iii) Matching concept. , b) Concepts relating to identification, measurement and recording of financial transactions. . (i) Entity concept (ii) Dual aspect concept (ii) Money measurement concept (iv) Cost concept (v) Objective evidence concept (vi) Realisation concept (vii) Accrual concept. Classification of the accounting concepts reveals their relative impo) and their practical use in the accounting process. The various accounting concepts and conventions are explaingd below in detail. ACCOUNTING Co (1) Business Entity Concept A business entity is an organisati, i : s 'ganisation of persons to accomplish an economic goal. According to the entity Concept, the 7 i ‘i eo entity that represents the association of = is onsiered distinct and separate from the owners, managers and 5 « enterprise. The account, i careers it itself (sole Proprietorship, partn Cunting entity may be the business uni societies or a department), or an amalgamation of related depending on the User’s need; per ; S. It can b -busi i ED wth am le gts in economiesegem een Broup like # The entity o limi ty concept de-limits te area to be covered by accounting records and reports. It determines What ii Sto i the books of accounts, A. Separate st eee eet accounting entity. The Personal transactions oes pau painted cor are not connected to the business unit are exclud eae ond are ounts: All business transactions of financial nature, cia ud ook ear the owmers are recorded in the books ofthe bust For exanaphe fa cole rade ‘PTS businesses (ie. a holding company),Basic Accounting Concepts and Conventions 24 withdraws money from the business for personal use, it is recorded as drawings by the owner. If he buys a car with the money withdrawn, it is ignored in the books of the business. All the financial transactions are recorded from the point of view of the entity itself and not from the point of view of the other parties such as customers, suppliers, partners, owners ete, For example, when a firm sells goods to a customer it is recorded as ‘sale’ by the firm and not as ‘purchases’ by the customer. Similarly, when dividend is paid to the shareholders of the company, it is dividend paid by the company and not dividend received by the shareholders. The entity concept underlines the accounting concept of profit in which a sharp distinction is made between the operating expenses of the business and payment to owners. All payments to owners are recorded as repayment of capital or drawings or loan or distribution of profits. They are not treated as expenses o* the business. The owners are entitled for the capital invested by them and als: for the profits earned by the business entity. From legal point of view, a joint stock company is recognised as separate legal entity from the shareholders. Partnership firms and sole trading businesses do not have legal entity, but they have business entity for accounting purposes. The business entity concept implies that accounting has to maintain financial records of the business, record incomes and expenses of the business, ascertain profit or loss made by the business entity and show its financial position periodically. The owners of the business entity have to be treated like financiers but eligible for profits and responsible for losses. (2) Going Concern Concept According to International Accounting Standard —1 (IAS-1) “The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation”. This concept assumes that a business entity has continuity of life. It will continue for an indefinite period of time. It has no need or intention to close down. . This concept is important for valuation of assets and liabilities. It recognises the value of assets and liabilities of the business enterprise on the basis of their productivity and not on the basis of their current realisable value. Many assets derive their value from employment in the firm. If the firm ceases to operate, their realisable values may be a fraction of their book values or their value to the firm In generation of income. For example, approach roads laid to connect a factory with a highway will be worthless when the factory is closed down. ee values of assets are ignored. They are valued at cost less ‘ion for the purpose of balance sheet.S| Be Financial Accoun, istorical cost of the fixed-assets is recovered throt ighout their usefgy life = Way of charging depreciation: This i based on the assumption that the ising te continues for the foreseeable future, The depreciation is an allocation Of fut, cost and is not based on valuation of ass: Going concern concept is the basis for several business transac Outsiders enter into contracts and dealings with a firm. Financial insti lend money to a business unit. Creditors supply goods on credit and Customers buy goods on credit, All such transactions are based on the treatment ofa business unit asa going concem, Similarly, prepaid expenses and accrued incomes are treated as assets on the presumption of continuation of business, Going concem concept influences accounting practices in relation to valuation of assets and liabilities, depreciation of the fixed assets, treatment of outstanding and prepaid expenses and incomes, 3) Moncy Measurement Concept All business transactions are measured, expressed and recorded in terms of money. ‘Money’ provides a common denominator or unit of measurement by means of which heterogeneous facts about a business can be expressed in terms of quantities which can be added or subtracted and summarised. Money, as 4 diverse range of data to enable tions, tutions legal tender used as the medium of exchange. The money measurement concey events which cannot be measure value of skilled labour force, working conditions, etc., cannot be recorded in accounts in Spite of thei The concept is invaluable in summarising busii pt excludes all business transactions and ‘d in terms of money, Thus, quality of the products, production policies, disputes ir importance to the business, ness operations, assets and meaningful and c: usage of monetary denomination, . 3S n : tL money measurement concept impose certain limitations on a business unit. Important events, specific strengthsBasic Accounting Concepts and Conventions 26 g (9) Accrual Concept ‘This concept makes a distinction between receipt of cash and the i, ety . to receive cash and payment of cash and the legal obligation to Pay cash in Telation to revenues and expenses respectively. Revenues and costs are accrueg ; . recognised as they are eamed or incurred and not as ao is ae OF paig, The accrual concept is the basis for mercantile system of accounting, Accounts maintained on cash basis ignore the accrual aspect and use paying and Teceivin of cash as the criteria for recording expenses and incomes. While finalising accounts, all expenses and losses pertaining to the accounting period must bg listed out. Any outstanding expenses and prepaid expenses must be recorded, Similarly, all incomes associated with the period should be included. Any accrue incomes and incomes received in advance must be appropriately recorded, The accrual concept ensures that the profit or loss shown is on the basis of full facts relating to all expenses and incomes. (10) Objective Evidence Concept All accounting entries must be based on objective evidence. ‘Objective’ refers to verifiability, reliability and absence of bias. No transaction must be recorded in the books of accounts without verifiable documentary evidence, Examples are cash receipts for payment made, bank paying-in counterfoils or bank statements for deposits in bank, invoice copies for purchases ete. The confidence of users of financial statements can be achieved through systematic adherence to this concept. Objective evidence concept facilitates auditing of accounts and eliminates unauthorised entries in the books of accounts, improving their reliability. Management decisions based on such accounts are likely to be more successful Accounting achieves authenticity, accuracy and reliability by following the concept of objective evidence. ACCOUNTING CONVENTIONS (1) Convention of Full Disclosure According to this convention, all accounting Statements should be prepared honestly. Thisshould be evident through the transparency of the statements. The statement should disclose fully all the significant information. Facts, figures and the details which are of material interest to the owners, invest ; credits etc., must be clearly presented in the financial Statements, This of disclosure needs proper classification, summarisation, aggregation i type of d Pe numerous business transactions, and explanation o! The convention of disclosure is gainin, im os growth of business organisations. Modern ieiceana 2 a sui an stock companies where ownership is Completely separated from a eo The Companies Act 1956, has made several provisions for ne ay om of essential information by companies. Detailed form ang schedules are prescribe |Basic Accounting Concepts and Conventions 2.10 by the Act. The basis for valuation of investments and inventories has to: be specifically stated. Contingent liabilities have to be listed out. The scope for concealment of information by joint stock companies is very limited, The footnotes, comments, descriptive captions, supplementary schedules etc., in the accounting reports are an invaluable aid for full disclosure. For example, market value of investments may be given as a foot note. Revaluation reserves included in the reserves and surpluses may be indicated through a separate caption. The full disclosure does not imply providing any information required by anybody or revealing trade secrets and strategies. But the legitimate demands for information of the interested parties like shareholders and creditors should be fully satisfied. (2) Convention of Consistency The basic aim of the doctrine of consistency is to preserve the comparability and reliability of financial statements. According to this convention, the rules, practices and concepts used in accounting should be continuously observed and applied year after year. Comparisons of results among different accounting periods can be significant and meaningful only when consistent practices were followed in ascertaining them. Valuation of stock can be done in different acceptable ways like average price method or cost price method. It can also beon the basis of cost or market price whichever is lesser. Similarly, depreciation can be provided under different methods; investments can be valued in several ways. Whichever method or practice is followed, it should be followed regularly. If any change is implemented it must be clearly indicated with reasons for the change. According to E.L. Kohler, consistency can be at three levels — vertical, horizontal and dimensional. Vertical consistency refers to consistency in the various aspects of financial statements in the same year in a firm. Horizontal consistency refers to consistency of practices between different years ina firm. Dimensional consistency refers to consistent accounting practices in the financial statements of different firms in the same industry. Consistency serves the purpose of eliminating personal bias, whims and fancies of the accountants. They will have to follow consistent rules, practices and methods. The convention of consistency makes the financial statements more reliable and comparable for the needs of the end users. (3) Convention of Materiality Materiality means ‘relative importance’. All important items and facts should be disclosed in accounting statements. Unimportant and immaterial details need not be separately given. Otherwise, the accountant becomes over burdened with unnecessary details. For example, a plastic container for drinking water co™ be clubbed with general expenses instead of separately being disclosed as an asset.Financial Account. ssociation (AAA) “An item shoe believe that knowledge’of it Would ied ate : ‘According to the American He be regarded as material if there is rea Se nanos i invest i decision of informed inves i edures. ee 2 ts, (i) information (ii) amounts (iti) proce | information and toon se sto directors and employees can be materia! and shou} ( Loans to direct anking Companies Regulation Act, i Bi arately disclosed, as per Z DA Gi) Epis ans to the nearest Rupees based on materiality of amounts. Gil) Disclosing pro: i jality of procedures. 7 faa The ia Ray is subjective, amenable for interpretation of individual accountants, Similarly, what is material in one firm may be immaterial for another firm, What is material in one dccounting year may not be so in the subsequent years. In spite of these limitations, maximum possible material details should be provided in the financial statements. (4) Convention of Conservatism Conservatism is a policy of caution or ‘playing safe’. It demands taking a ‘gloomy’ view of a situation. Conservatism is the defensive accounting mechanism against ‘uncertainty’. According to Kohler, “Conservatism is a guideline which chooses between acceptable accounting alternatives for recording events and transactions so that the least favourable immediate effect on assets, income and owner’s equity is reported”. | Uncertainty isunavoidable in the estimation of useful life of assets, contingent epi realtion ees etc, The convention of conservatism demands ¢ least favourable situati i ‘ali i atid b anew ea ion to the firm will materialise and precautions , When stocks are valued, the usual principle followed is “cost or market price whichever is lower’. If market price is more th i All provisions like provision lan Cost, stock is shown at cost only. Provision for doubtful debts, Provision for discount on debtors, provision for contingenci * PON igencies are based on i" . Conservatism may result i the ee es, sets and income an cedural changes in valuation of inventories is based on of full disclosure. Conservatism, wisn, : m, within limit not be taken to extremes where it can dintott thee position of a business unit. © o) ACCOUNTING 5 Dual aspect concept is the basis for Double entry system of book keeping, Ag auseful purpose. It should erating results and financial QUATION contng: Cebit and credit used in the transaction recorded in accounts has two aspects Ant Concept, every business of benefit. The former is the credit aspect and the ete of benefit and sco ies er, le debit aspect. Both theBasic Accounting Concepts and Conventions 212 aspects have to be recorded in accounts appropriately. American accountants have derived the rules of debit and credit through a ‘novel’ medium i.e., accounting equation. The equation is as follo The basis for the equation is the principle of ‘Rights’. Accounting deals with property and rights to property, The total of the properties owned by a business js equal to the total of the ‘Rights’ to the propertics. The properties owned by a business are called assets. The rights to properties are called equities. Equities can be sub-divided into equity of the owners which is known as capital and equity of creditors who represent the debts of the business known as liabilities. These equities may also be called internal equity and external equity. Internal equity represents the owners’ equity in the assets and external equity represents the outsiders’ interest in the assets. Based on the bifurcation of equity, the accounting equation can be restated as follows: . Assets = Liabilities + Capital Oran Capital = Assets ~ Liabilities. When a business is started, entire resources needed may be supplied by the owner or owners. Later on, additional funds may be mobilised through credit purchases and loans. For example, Gokul starts a business with a capital of Rs. 10,000, the accounting equation will be Gokul’s Capital Rs. 10,000 = Cash Rs. 10,000. The Balance Sheet on that date appears as follows: Balance Sheet of Gokul as on . | Amount (Rs.) | Property & Assets | Amount (Rs.) _|_ 10 __ |__ 10,000 __The balance sheet of a business is an expression of the accounting equation. Ttis also called balance sheet equation. It shows the relationship between assets of the business and capital-and-iabitities Rules for Accounting Equation | Gokul’seapital | 10,000 Cash The following ‘rules’ help in understanding the accounting equation clearly. (1) Capital: When capital is increased, itis credited, when capital is withdrawn, itis debited, , (2) Outsiders" liabilities: When liabilities i . nar abilities increase, outsiders? ts are credited. When liabiliti aecounts an 3) Ren ies decrease, their accounts are debited. eae Income: Owner’s equity is increased by the amount of revenue ense: Owner’s equity ii expenses, equity is decreased by the amount of revenue If is i : . If there ig ere Is Increase in assets, the assets, accounts are debited. ctease in assets, the assets’ accounts are credited. zz, _ea between assets and liabilities and their ° Equations ; : lecreases and another asset ine s ° Salen Por satis when debtors are collected, debtors ia a and eash incense. This es a secountng uation iabilit creases and another liability in ie 0 a transact. Q Sy caine are paid through bank overdraft, Creditors q . and bank overdraft increases, This transaction also does Ot alter the total figures in the accounting equation. a ; (©) Assets may increase and correspondingly liabilities May increase, duety some transactions, For example, loan taken from bank INCreases cash, on the assets side and bank loan on the liabilities side. This transaction alters the total figures in the accounting equation. @)_ Assets decrease and liabilities also : Some transactions. For example, creditors paid in cash decre; on liabilities side and cash on the assets side, Conclusion Accounting equation is a and capital and liabilities, accounting equation, balance sheet itself c decrease Correspondingly due to, 'ASES Creditors formula which in: Recording of all Balance Sheet is the e1 ‘onforms to ac dicates the ‘equivalence? of assets business transactions is based on nd result of, accounting process, The ‘counting equation, Mlustration 1 Give Accounting equation for the following transactions of Naresh for the Year ended 31.12.94, )) started busines: i) paid rent in advance Rs. 800 iti) Purchased goods for cash Rs, 10, iv) sold goods Or cash Rs, 8,000 V) rent paid Rs. 2,000 and rent out; 's with cash Rs, 36,000 ,000, and on credit Rs, 4,000 (costing Rs, 4,800) standing Rs, 409 vill) paid tocreditors Rs, 1 2200 x) depreciation of €quipment Rs. 50 %) business expenses Rs, 809‘Basie Accounting Concepts and Conventions 214 © Solution: Sh. Equities J Assets No} Rent [Creditor | Capital | Cash | Rentpatd | Stock of | Equipment outstanding inadvance| goods Rs. Rs. Rs, Rs. Rs, Rs. Rs. 1 - - 36,000 | 36,000 - - - : ~ : = 800} +800 : - 2 - - 36,000} 35,200 800 - - | : + 4,000 -__|=10,000/ - + 14,000 - 3. - 4,000 | 36,000} 25,200 800 | 14,000 - : - +3,200| +8,000/ —- = 4,800 : f 4 - | 4,000 | 39,200) 33,200 800 9,200 - | +400 - ~2,400| -2,000) - : : 5. 400 4,000 36,800) 31,200 800 9,200 | a i a bd — 16,000 | - 16,000 i = 2 6.) 400 4,000 | 20,800} 15,200 800 | 9,200 - Le : - =1,000} - - + 1,000 z| 400 | 4,000 | 20,8001 14,200] 800 9,200 1,000 ieaae =1,200 | + 1,200] - : : 8.| 400 2,800 | 20,800/ 13,000] 800 | 9,200 1,000 Lt - - 50} - : - _-50 19.) 400 2,800 | 20,750/ 13,000/ g00 | 9,200 950 L - . =800/ -800) - : | 10.; 400 2,800 | 19,950] 12,200] 800 | 9,200 | __950 Rs. 23,150 Rs. 23,150215 Financial Accounting Theory Questions (A) Short Answer Questions : L ‘What do you understand by basic accounting principles, postulates, concepts and conventions? ; ‘What are the characteristics of Accounting concepts and conventions? . Give a list of different Accounting concepts and conventions. ; / Write short notes on (a) Business Entity concept (b) Convention of materiality, ;. Explain the importance of ‘Money measurement concept’. . Why is it important to assume that a business firm is a ‘going concern’? |. Write short notes on (a) Cost concept (b) Accounting period concept. . Write short notes on (a) Accrual concept (b) Objective evidence concept. . Explain briefly the conventions of consistancy, full disclosure and materiality, |. What do you understand by the convention of ‘Full disclosure? How is it important? . What is Accounting Equation? . Assets = Equities. Explain. (B) Long Answer Questions : eH 3. 4. 5. . What are accounting concepts and conventions? How are they evolved? . How do you classify accounting concepts? . Explain various accounting concepts briefly? ‘What are accounting conventions? Explain them, “The entity concept and money measurement: ‘concept are the Fundamental concepts”. Explain. .. What is Accounting Equation? Explain the ‘rules? wi , : hich help in understanding accounting equation. - Explain ‘Accounting Equation’ with examples,Basit Accounting Concepts and Conventions Exercises 2.16 1. Show Accounting Equation on the basis ofthe following : (a) Ramanujm started business with Rs. 25,000, (b) Purchased goods on credit from Shyam : Rs, 10,000 (©) Solds goods to Soman costing Rs. 1,500 for Rs. 1,800 on credit. Madras, B.Com. Oct. 2002] ssets + Rs, 35,300; Liabilities : Rs. 10,000; Capital : Rs. 25,300] [An 2. Prepare accounting equation on the basis of the following: (i) Rama started business with Rs. 1,00,000 ii) Me purchased furniture for cash Rs, 40,000' i) He paid rent Rs, 500 (iv) He purchased goods on credit Rs.10,000 (W)_ He sold goods (cost price Rs.4,000) Rs. 7,000 for cash. [Ans: Assets Rs. 1,12,50 bilities Rs. 10,000; Capital Rs. 1,02,500) 3. Develop the accounting equation from the following transactions: () \Kumar started business with cash Rs. 50,000 ~ Gi) goods purchased for cash Rs. 13,000 Gi) goods purchased on credit Rs. 12,000 (iv) goods sold (costing Rs, 10,000) for Rs. 12.000. @ (v) furniture purchased on credit Rs. 2.000%, ) cash paid to a creditor Rs. 5,000, tk (vii) Rent outstanding Rs. 1,000 [Ans: Assets Rs. 61,000; Liabilities Rs.10,000; Capital Rs, 51,000} 4. Ramesh had the following transactions. Use accounting equation to show their effect on his assets, liabilities and capital, (i) Ramesh brought Rs.1,35,000 in cash to start business, (ii) purchased securities for cash Rs. 67,500 Gi) purchased an office building for Rs, 135,000 paying Rs. 45,000 in cash and the balance through a loan arranged. (v) sold securities costing Rs.9,000 for Rs. 13,500 ) purchased machinery for cash Rs. 25,200 (Wi) “rent received in cash Rs. 32,400 (Wii) paid cash Rs, 4,500 for loan and Rs.2,700 for interest. (ai) office building expenses paid in eash Rs 2,700 () dividend on securities received in cash Re, 1,800. [Ans: Assets Rs. 2,54,500; Liabilities Rs. 85,500; Capital Rs. 1,69,000] aa