INTRODUCTION TO FINANCIAL ACCOUNTING

Financial accounting is the branch of accounting that focuses on recording,

classifying, summarizing, and reporting the financial transactions and activities
of a business or organization. It is a fundamental aspect of the broader field of
accounting, essential for providing a clear and accurate picture of a company's
financial performance and position. Accounting has universal application for
recording transactions and events and presenting suitable information to aid
decision-making regarding any type of economic activity ranging from a family
function to functions of the national government.
The aim of accounting is to meet the information needs of the rational and
sound decision- makers, and thus, called the language of business.
Accounting may be defined as the process of recording, classifying,
summarising, analysing and interpreting the financial transactions and
communicating the results thereof to the persons interested in such
information.
1. Recording – This is the basic function of accounting. All business
transactions of a financial character, as evidenced by some documents such as
sales bill, pass book, salary slip etc. are recorded in the books of account.
Recording is done in a book called “Journal.” This book may further be divided
into several subsidiary books according to the nature and size of the business.
2. Classifying – Classification is concerned with the systematic analysis of
the recorded data, with a view to group transactions or entries of one nature at
one place so as to put information in compact and usable form. The book
containing classified information is called “Ledger”. This book contains on
different pages, individual account heads under which, all financial transactions
of similar nature are collected. For example, there may be separate account
heads for Salaries, Rent, Printing and Stationeries, Advertisement etc. All
expenses under these heads, after being recorded in the Journal, will be
classified under separate heads in the Ledger. This will help in finding out the
total expenditure incurred under each of the above heads.
3. Summarising – It is concerned with the preparation and presentation of
the classified data in a manner useful to the internal as well as the external
users of financial statements. This process leads to the preparation of the
financial statements.
4. Analysing – The term ‘Analysis’ means methodical classification of the
data given in the financial statements. The figures given in the financial
statements will not help anyone unless they are in a simplified form. For
example, all items relating to fixed assets are put at one place while all items
relating to current assets are put at another place. It is concerned with the
establishment of relationship between the items of the Profit and Loss Account
and Balance Sheet i.e. it provides the basis for interpretation.
5. Interpreting – This is the final function of accounting. It is concerned
with explaining the meaning and significance of the relationship as established
by the analysis of accounting data. The recorded financial data is analysed and
interpreted in a manner that will enable the end-users to make a meaningful
judgement about the financial condition and profitability of the business
operations. The financial statement should explain not only what had
happened but also why it happened and what is likely to happen under
specified conditions.
6. Communicating – It is concerned with the transmission of summarised,
analysed and interpreted information to the end-users to enable them to make
rational decisions. This is done through preparation and distribution of
accounting reports, which include besides the usual profit and loss account and
the balance sheet, additional information in the form of accounting ratios,
graphs, diagrams, fund flow statements etc.
The first two procedural stages of the process of generating financial
information along with the preparation of trial balance are covered under
book-keeping while the preparation of financial statements and its analysis,
interpretation and also its communication to the various users are considered
as accounting stages.
 ACCOUNTING SYSTEM

An accounting system is a structured process or set of procedures used by

businesses and organizations to record, analyse, summarize, and report
financial transactions and information. It is an essential tool for managing and
understanding the financial health of a company. The primary objective of an
accounting system is to provide accurate and reliable financial data that can be
used for decision-making, financial analysis, and regulatory compliance.

Key components of an accounting system typically include:

Chart of Accounts: A list of all the accounts used to classify and record financial
transactions, such as assets, liabilities, equity, revenue, and expenses. Each
account is assigned a unique account number for easy identification.

General Ledger: The central repository that contains all the individual
transactions recorded in the various accounts. It serves as the foundation for
preparing financial statements and generating reports.

Recording Transactions: The system should allow the recording of various

financial transactions, such as sales, purchases, payments, receipts, and other
financial events. This can be done manually or, more commonly, through
automated processes integrated with other business systems.

Double-Entry Bookkeeping: The accounting system follows the principles of

double-entry bookkeeping, ensuring that every transaction has an equal and
opposite effect on at least two accounts. This maintains the accounting
equation (Assets = Liabilities + Equity) and ensures the accuracy of financial
records.

Financial Statements: The system should be able to generate financial

statements such as the income statement, balance sheet, and cash flow
statement. These statements provide a comprehensive view of the financial
performance and position of the business.

Financial Reporting and Analysis: The system should allow for the generation of
various financial reports and performance analysis to aid in decision-making
and budgeting.

Audit Trail and Security: Maintaining a clear audit trail of all transactions is
essential for internal control and external audits. The system should also have
appropriate access controls to prevent unauthorized access to financial data.

Tax Compliance: The accounting system should support compliance with tax
regulations by generating reports and calculations necessary for tax filing.

Accounting systems can vary in complexity and can be manual or computerized

(accounting software). With advancements in technology, most businesses now
use computerized accounting software, which streamlines processes, reduces
errors, and provides real-time financial insights.

Popular accounting software options include QuickBooks, Xero, Sage, and SAP,
Tally among others. When choosing an accounting system, businesses consider
factors such as their size, complexity, budget, and specific accounting needs.
It's essential to select a system that aligns well with the organization's
requirements and can adapt to its future growth.
 LIMITATIONS OF FINANCIAL ACCOUNTING

There are certain misconceptions regarding financial statements. A common

man presumes that an income statement shows the correct income or loss of
the enterprise and that a balance sheet depicts a perfectly true and fair picture
of financial standing of that enterprise. It must be recognised that the
accounting as a language has its own limitations. The figures of profit or loss
generated by the accounting process are subject to various constraints within
which the accounting works. The assumptions and conventions, on which the
accounting is based, become the limitations of accounting. The financial
statements are never free from subjectivity factor as these are largely the
outcome of personal judgement of the accountant with regard to the adoption
of the accounting policies. Following are certain instances:
1. The factors which may be relevant in assessing the worth of the
enterprise don’t find place in the accounts as they cannot be measured in
terms of money. The Balance sheet cannot reflect the value of certain factors
like loyalty and skill of the personnel which may be the most valuable asset of
an enterprise these days.
2. Balance Sheet shows the position of the business on the day of its
preparation and not on the future date while the users of the accounts are
interested in knowing the position of the business in the near future and also in
long run and not for the past date.
3. Accounting ignores changes in some money factors like inflation etc.
Accounting records past financial transactions and events. While this historical
information is crucial for decision-making, it may not always reflect the current
economic reality or predict future financial performance accurately.
4. There are occasions when accounting principles conflict with each other.
5. Certain accounting estimates depend on the sheer personal judgement
of the accountant, e.g., provision for doubtful debts, method of depreciation
adopted, recording certain expenditure as revenue expenditure or capital
expenditure, selection of method of valuation of inventories and the list is
quite long.
6. Financial statements consider those assets which can be expressed in
monetary terms. Human resources although the very important asset of the
enterprise are not shown in the balance sheet. There is no generally accepted
formula for the valuation of human resources in money terms.
Not Designed for Managerial Decision-making: Financial accounting is
primarily meant to serve external stakeholders, such as investors, creditors,
and regulators. While it provides a historical overview of the company's
performance, it may not offer the detailed information required for day-to-day
managerial decision-making.
In nutshell, it can be said that the language of accounting has certain practical
limitations and, therefore, the financial statements should be interpreted
carefully keeping in mind all various factors influencing the true picture.
USERS OF ACCOUNTING INFORMATION
Users of accounting information refer to individuals or groups who rely on
financial data and reports generated by the accounting system of an
organization. The information provided by accounting is essential for making
informed decisions, assessing financial performance, and understanding the
overall financial health of a company. Some of the key users of accounting
information include:

Management: Internal users, such as managers and executives, use accounting

information to make strategic decisions, set financial goals, and monitor the
performance of various departments within the organization. They rely on
financial statements like income statements, balance sheets, and cash flow
statements to assess profitability, liquidity, and overall financial stability.

Shareholders/Owners: Shareholders and owners of a company use accounting

information to evaluate the financial performance and value of their
investments. They are interested in financial statements and reports that show
the company's profitability, assets, liabilities, and equity.

Investors: Investors, both individual and institutional, use accounting

information to assess the financial health and potential of a company before
making investment decisions. They analyse financial statements, including
historical and projected data, to determine the company's growth prospects
and financial stability.

Creditors: Creditors, such as banks and other lending institutions, use

accounting information to evaluate the creditworthiness of a company when
considering extending loans or credit. They assess the company's ability to
repay debt and its overall financial risk.
Employees: Employees may be interested in accounting information, especially
if the financial health of the company directly affects their job security,
compensation, or benefits. They might also be interested in financial reports to
understand the company's overall performance and stability.

Government Agencies: Various government agencies use accounting

information to monitor compliance with financial regulations, tax assessment,
and overall economic analysis. They may require companies to provide audited
financial statements and other reports for regulatory purposes.

Suppliers and Vendors: Suppliers and vendors use accounting information to

assess the financial stability of a company they plan to do business with. It
helps them determine if the company can meet its payment obligations
promptly.

Customers: Customers may indirectly be interested in a company's financial

health as it can impact product quality, service levels, and overall sustainability.
Customers may also rely on accounting information to assess the stability of a
supplier they are considering doing business with.

General Public and Media: The general public, including media outlets, may
have an interest in the accounting information of large corporations, especially
publicly traded companies. They use this information to assess economic
trends, understand the financial performance of prominent companies, and
form opinions on various economic matters.

Overall, accounting information plays a crucial role in facilitating transparency,

accountability, and informed decision-making for all stakeholders connected to
a business entity.
 TYPES OF ACCOUNTING
Accounting can be broadly categorized into several types, each serving specific
purposes and catering to different stakeholders. Here are some of the main
types of accounting:

Financial Accounting: This type of accounting focuses on recording,

summarizing, and reporting financial transactions of a business to external
parties, such as investors, creditors, regulators, and the general public. It
follows generally accepted accounting principles (GAAP) or international
financial reporting standards (IFRS).

Managerial Accounting: Also known as cost accounting, managerial accounting

provides information to internal management for planning, decision-making,
and control purposes. It involves the analysis of costs, budgets, variances, and
other data to help managers make informed business decisions.

Tax Accounting: Tax accountants focus on complying with tax laws and
regulations. They prepare and file tax returns, calculate tax liabilities, identify
tax deductions, and ensure that the organization or individual pays the correct
amount of taxes.

Forensic Accounting: Forensic accountants use accounting principles and

investigative techniques to detect and investigate financial fraud,
embezzlement, and other financial crimes. Their work often involves legal
proceedings and may serve as evidence in court cases.

Government Accounting: This type of accounting is specific to government

entities and institutions. It follows specialized accounting principles and
guidelines for the proper management and reporting of public funds and
resources.
Nonprofit Accounting: Nonprofit organizations have unique accounting
requirements to track and report on their financial activities, donations, and
grants, while demonstrating accountability and transparency to donors and
stakeholders.

International Accounting: This encompasses accounting practices that deal

with multinational companies or transactions involving multiple countries. It
considers different accounting standards and regulations across various
jurisdictions.

These types of accounting often overlap, and accountants may specialize in one
or more of these areas based on their career goals and the needs of the
organizations they serve.
 FINANCIAL STATEMENT

A financial statement is a formal record of the financial activities and position

of a business, organization, or individual. It provides a summary of financial
transactions and information over a specific period of time, typically one year
or a quarter.

Income Statement (Profit and Loss Statement): This statement shows the
revenue earned and expenses incurred over a specific period. The main
components of an income statement include:

Revenues or Sales: The total income generated from selling goods or services.
Cost of Goods Sold (COGS) or Cost of Sales: The direct costs associated with
producing goods or providing services.
Gross Profit: Calculated by subtracting COGS from revenues.
Operating Expenses: Indirect costs related to the day-to-day operations of the
business, such as salaries, rent, utilities, etc.
Operating Income: Obtained by subtracting operating expenses from gross
profit.
Other Income and Expenses: Additional income and expenses not directly
related to the core business operations.
Net Income (or Net Loss): The final result after accounting for all revenues,
expenses, and taxes. If revenues exceed expenses, it's a net income; otherwise,
it's a net loss.
Balance Sheet (Statement of Financial Position): This statement provides a
snapshot of a company's assets, liabilities, and shareholders' equity at a
specific point in time. The primary components of a balance sheet include:

Assets: Resources owned or controlled by the company, such as cash,

inventory, property, equipment, etc.
Liabilities: Debts or obligations owed by the company, such as loans, accounts
payable, etc.
Shareholders' Equity: The residual interest in the assets after deducting
liabilities. It represents the company's net worth.
Cash Flow Statement: This statement presents the inflows and outflows of cash
and cash equivalents during a specific period. It is divided into three main
categories:

Operating Activities: Cash flows generated or used by the company's core

operations.
Investing Activities: Cash flows related to the purchase or sale of long-term
assets, such as property, equipment, or investments.
Financing Activities: Cash flows from transactions with the company's owners
and creditors, such as issuing stocks, taking out loans, or paying dividends.
Financial statements are essential for assessing the financial health,
performance, and stability of a business. They are also used by investors,
creditors, analysts, and other stakeholders to make informed decisions and
evaluate the company's overall financial position. These statements are
typically prepared in accordance with accounting standards and regulations
specific to the region or country where the company operates.
BASIC ACCOUNTING CONCEPTS AND TERMINOLOGY

Basic accounting concepts and terminology form the foundation of

understanding financial information and managing business transactions. Here
are some key concepts and terms in accounting:

Accounting: Accounting is the process of recording, classifying, summarizing,

and interpreting financial transactions of a business or organization.

Transaction: Any financial event or activity that affects the financial position of
a business, such as sales, purchases, investments, or borrowings.

Double-Entry Accounting: The fundamental principle in accounting where

every transaction has two aspects: a debit and a credit. Debits and credits must
balance, ensuring that the accounting equation (Assets = Liabilities + Equity)
remains in equilibrium.

Account: A specific record or location in the accounting system used to track

changes in a particular financial item, such as cash, inventory, accounts
payable, or accounts receivable.

Balance Sheet: A financial statement that shows the assets, liabilities, and
equity of a business at a specific point in time. It provides a snapshot of the
financial position of the business.

Income Statement (Profit and Loss Statement): A financial statement that

summarizes the revenues, expenses, and profits or losses generated by a
business over a specific period, usually a quarter or a year.
Cash Flow Statement: A financial statement that shows the inflows and
outflows of cash and cash equivalents during a given period. It helps to analyze
the liquidity and cash position of the business.

Assets: Economic resources owned or controlled by a business that provide

expected future benefits. Assets can be tangible (e.g., cash, inventory,
equipment) or intangible (e.g., patents, trademarks).

Liabilities: Debts or obligations owed by a business to external parties, such as

loans, accounts payable, or bonds.

Equity: The residual interest in the assets of a business after deducting

liabilities. It represents the ownership interest of the business owners or
shareholders.

Revenues (Income): The income generated from the primary activities of the
business, such as sales revenue.

Expenses: The costs incurred by a business to generate revenue, such as

salaries, rent, utilities, and other operating expenses.

Net Income (Net Profit): The difference between total revenues and total
expenses. If revenues exceed expenses, it results in a net profit; otherwise, if
expenses exceed revenues, it leads to a net loss.

Accrual Basis Accounting: An accounting method where transactions are

recorded when they occur, regardless of when the actual cash is exchanged. It
ensures a more accurate representation of a company's financial position.
Cash Basis Accounting: An accounting method where transactions are recorded
only when cash is received or paid. It is simpler but may not provide an
accurate representation of a company's financial position.

Depreciation: The systematic allocation of the cost of tangible assets over their
useful lives as an expense in the income statement.

Amortization: The process of spreading the cost of intangible assets (such as

patents or copyrights) over their useful lives as an expense in the income
statement.

Trial Balance: A list of all accounts and their balances at a specific point in time
to ensure that debits equal credits.

General Ledger: A complete record of all financial transactions of a business,

organized by accounts.

Fiscal Year: The annual accounting period adopted by a business for financial
reporting purposes. It may or may not align with the calendar year.

These concepts and terms provide a basic understanding of accounting

principles and serve as the building blocks for more complex accounting
practices and financial analysis.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Generally Accepted Accounting Principles (GAAP) refer to a set of accounting

standards, principles, and procedures that are widely accepted and used in the
United States for financial reporting. These principles provide a standard
framework for how companies prepare and present their financial statements,
making it easier for investors, creditors, and other stakeholders to compare and
analyze financial information across different businesses.

Key characteristics of GAAP include:

Relevance: Information presented in financial statements should be relevant to

users for making informed decisions about the company's financial position
and performance.

Reliability: Financial information should be reliable and free from bias, ensuring
that it can be trusted by users.

Consistency: Companies are encouraged to apply consistent accounting

methods and principles from one period to another for better comparability.

Comparability: Financial statements should be structured in a way that allows

for meaningful comparisons between different companies within the same
industry.

Understandability: Information should be presented in a clear and

understandable manner for users without an accounting background.

Materiality: Companies are required to report material information that could

influence the decisions of users.
The Financial Accounting Standards Board (FASB) is the primary standard-
setting body responsible for developing and updating GAAP in the United
States. Over time, GAAP has evolved and been refined to address changing
business practices, industries, and economic environments.

It is essential to note that GAAP might differ from country to country. Other
countries have their own generally accepted accounting principles, such as
International Financial Reporting Standards (IFRS), which are widely used in
many parts of the world. The goal of these standards, whether GAAP or IFRS, is
to promote transparency, consistency, and comparability in financial reporting.

Ind AS

Ind AS stands for "Indian Accounting Standards." It is the accounting standard

adopted in India for the preparation and presentation of financial statements.
Ind AS is largely converged with the International Financial Reporting Standards
(IFRS) to ensure that financial reporting in India is in line with global accounting
practices, making it easier to attract foreign investment and enhance
transparency in financial reporting.

The adoption of Ind AS in India began in phases, primarily for listed companies
and certain other large entities. The Ministry of Corporate Affairs (MCA) in
India, under the Companies Act, is responsible for the implementation and
enforcement of Ind AS.

Some key features and benefits of Ind AS include:

Convergence with IFRS: Ind AS is closely aligned with IFRS, which facilitates
easier comparison of financial statements of Indian companies with their
international counterparts.

Enhanced Transparency: Ind AS improves the transparency and quality of

financial reporting by requiring companies to provide more detailed and
relevant information in their financial statements.

Consistency: The use of standardized accounting principles ensures consistent

reporting across different companies, industries, and sectors in India.

Investor Confidence: Adoption of globally accepted accounting standards like

Ind AS can enhance investor confidence, as it provides a better understanding
of a company's financial health.

Improved Decision-Making: The availability of reliable and comparable financial

information helps stakeholders make better-informed decisions.

Disclosure Requirements: Ind AS mandates comprehensive disclosures to

ensure that all relevant financial information is presented to users of financial
statements.

It's worth noting that while Ind AS is convergent with IFRS, there might be
some specific differences due to unique regulatory requirements or the
economic environment in India. The adoption of Ind AS brings Indian
accounting practices closer to international standards and promotes better
financial reporting practices in the country.
List of Indian Accounting Standards (Ind AS) that were in effect in India.

Ind AS 101 - First-time Adoption of Indian Accounting Standards

Ind AS 102 - Share-based Payment
Ind AS 103 - Business Combinations
Ind AS 104 - Insurance Contracts
Ind AS 105 - Non-current Assets Held for Sale and Discontinued Operations
Ind AS 106 - Exploration for and Evaluation of Mineral Resources
Ind AS 107 - Financial Instruments: Disclosures
Ind AS 108 - Operating Segments
Ind AS 109 - Financial Instruments
Ind AS 110 - Consolidated Financial Statements
Ind AS 111 - Joint Arrangements
Ind AS 112 - Disclosure of Interests in Other Entities
Ind AS 113 - Fair Value Measurement
Ind AS 114 - Regulatory Deferral Accounts
Ind AS 115 - Revenue from Contracts with Customers
Ind AS 116 - Leases
Ind AS 1 - Presentation of Financial Statements
Ind AS 2 - Inventories
Ind AS 7 - Statement of Cash Flows
Ind AS 8 - Accounting Policies, Changes in Accounting Estimates, and Errors
Ind AS 10 - Events after the Reporting Period
Ind AS 12 - Income Taxes
Ind AS 16 - Property, Plant and Equipment
Ind AS 17 - Leases (Superseded by Ind AS 116)
Ind AS 19 - Employee Benefits
Ind AS 20 - Accounting for Government Grants and Disclosure of Government
Assistance
Ind AS 21 - The Effects of Changes in Foreign Exchange Rates
Ind AS 23 - Borrowing Costs
Ind AS 24 - Related Party Disclosures
Ind AS 27 - Separate Financial Statements
Ind AS 28 - Investments in Associates and Joint Ventures
Ind AS 29 - Financial Reporting in Hyperinflationary Economies
Ind AS 32 - Financial Instruments: Presentation
Ind AS 33 - Earnings Per Share
Ind AS 34 - Interim Financial Reporting
Ind AS 36 - Impairment of Assets
Ind AS 37 - Provisions, Contingent Liabilities, and Contingent Assets
Ind AS 38 - Intangible Assets
Ind AS 40 - Investment Property
Ind AS 41 - Agriculture
 ACCOUNTING CONCEPTS AND CONVENTIONS

The following are the widely accepted accounting concepts:

(a) Entity concept: Entity concept states that business enterprise is a
separate identity apart from its owner. Accountants should treat a business as
distinct from its owner. Business transactions are recorded in the business
books of accounts and owner’s transactions in his personal books of accounts.

(b) Money measurement concept: As per this concept, only those

transactions, which can be measured in terms of money are recorded. Since
money is the medium of exchange and the standard of economic value, this
concept requires that those transactions alone that are capable of being
measured in terms of money be only to be recorded in the books of accounts.
Transactions, even if, they affect the results of the business materially, are not
recorded if they are not convertible in monetary terms.
Transactions and events that cannot be expressed in terms of money are not
recorded in the business books. For example; employees of the organization
are, no doubt, the assets of the organizations but their measurement in
monetary terms is not possible therefore, not included in the books of account
of the organization. Measuring unit for money is taken as the currency of the
ruling country i.e., the ruling currency of a country provides a common
denomination for the value of material objects.

(c) Periodicity concept: This is also called the concept of definite accounting
period. As per going concern’ concept an indefinite life of the entity is
assumed. For a business entity it causes inconvenience to measure
performance achieved by the entity in the ordinary course of business.

If a textile mill lasts for 100 years, it is not desirable to measure its performance
as well as financial position only at the end of its life.
So, a small but workable fraction of time is chosen out of infinite life cycle of
the business entity for measuring performance and looking at the financial
position. Generally, one year period is taken up for performance measurement
and appraisal of financial position. However, it may also be 6 months or 9
months or 15 months.
According to this concept accounts should be prepared after every period &
not at the end of the life of the entity. Usually, this period is one calendar year.
We generally follow from 1st April of a year to 31st March of the immediately
following year.
(d) Accrual concept: Under accrual concept, the effects of transactions and
other events are recognised on mercantile basis i.e., when they occur (and not
as cash or a cash equivalent is received or paid) and they are recorded in the
accounting records and reported in the financial statements of the periods to
which they relate. Financial statements prepared on the accrual basis inform
users not only of past events involving the payment and receipt of cash but also
of obligations to pay cash in the future and of resources that represent cash to
be received in the future.
For example, (1) Mr. X started a cloth merchandising. He invested
` 50,000, bought merchandise worth ` 50,000. He sold such merchandise for `
60,000. Customers paid him ` 50,000 cash and assure him to pay ` 10,000
shortly. His revenueis ` 60,000. It arose in the ordinary course of cloth business;
Mr. X received ` 50,000 in cash and ` 10,000 by way of receivables.

(e) Matching concept: In this concept, all expenses matched with the
revenue of that period should only be taken into consideration. In the financial
statements of the organization if any revenue is recognized then expenses
related to earn that revenue should also be recognized.
This concept is based on accrual concept as it considers the occurrence of
expenses and income and do not concentrate on actual inflow or outflow of
cash.
It should be defined as: Periodic Profit = Periodic Revenue – Matched Expenses
(f) Going Concern concept: The financial statements are normally prepared
on the assumption that an enterprise is a going concern and will continue in
operation for the foreseeable future. Hence, it is assumed that the enterprise
has neither the intention nor the need to liquidate or curtail materially the
scale of its operations; if such an intention or need exists, the financial
statements may have to be prepared on a different basis and, if so, the basis
used needs to be disclosed.
The valuation of assets of a business entity is dependent on this assumption.
Traditionally, accountants follow historical cost in majority of the cases.
(g) Cost concept: By this concept, the value of an asset is to be determined
on the basis of historical cost, in other words, acquisition cost. Although there
are various measurement bases, accountants traditionally prefer this concept
in the interests of objectivity. When a machine is acquired by paying ` 5,00,000,
following cost concept the value of the machine is taken as ` 5,00,000. It is
highly objective and free from all bias. Other measurement bases are not so
objective. Current cost of an asset is not easily determinable. If the asset is
purchased on 1.1.1995 and such model is not available inthe market, it
becomes difficult to determine which model is the appropriate equivalent to
the existing one. Similarly, unless the machine is actually sold, realisable value
will give only a hypothetical figure. Lastly, present value base is highly
subjective because to know the value of the asset one has to chase the
uncertain future.
However, the cost concept creates a lot of distortion too as outlined below:
(a) In an inflationary situation when prices of all commodities go up on an
average, acquisition cost loses its relevance. For example, a piece of land
purchased on 1.1.1995 for ` 2,000 may cost ` 1,00,000 as on 1.1.2022. So if the
accountant makes valuation of asset at historical cost, the accounts will not
reflect the true position.
(b) Historical cost-based accounts may lose comparability. Mr. X invested `
1,00,000 in a machine on 1.1.1995 which produces ` 50,000 cash inflow during
the year 2022, while Mr. Y invested ` 5,00,000 in a machine on 1.1.2005 which
produced
` 50,000 cash inflows during the year. Mr. X earned at the rate 50% while Mr. Y
earned at the rate 10%. Who is more efficient? Since the assets are recorded at
the historical cost, the results are not comparable. Obviously, it is a corollary to
(a).
(h) Realisation concept: It closely follows the cost concept. Any change in
value of an asset is to be recorded only when the business realises it. When an
asset is recorded at its historical cost of ` 5,00,000 and even if its current cost is
` 15,00,000 such change is not counted unless there is certainty that such
change will materialize.
However, accountants follow a more conservative path. They try to cover all
probable losses but do not count any probable gain. That is to say, if
accountants anticipate decrease in value they count it, but if there is increase
in value they ignore it until it is realised. Economists are highly critical about
the realisation concept. According to them, this concept creates value
distortion and makes accounting meaningless.

Example: Mr. X purchased a piece of land on 1.1.1995 paying ` 2,000. Its

current market value is ` 1,02,000 on 31.12.2022. Should the accountant show
the land at
` 2,000 following cost concept and ignoring `1,00,000 value increase since it is
not realised
Now-a-days the revaluation of assets has become a widely accepted practice
when the change in value is of permanent nature. Accountants adjust such
value change through creation of revaluation (capital) reserve.
Thus, the going concern, cost concept and realization concept gives the
valuation criteria.
(i) Dual aspect concept: This concept is the core of double entry book-
keeping. Every transaction or event has two aspects:
(1) It increases one Asset and decreases other Asset;
(2) It increases an Asset and simultaneously increases Liability;
(3) It decreases one Asset, increases another Asset;
(4) It decreases one Asset, decreases a Liability. Alternatively:
(5) It increases one Liability, decreases other Liability;
(6) It increases a Liability, increases an Asset;
(7) It decreases Liability, increases other Liability;
(8) It decreases Liability, decreases an Asset.
Equity + Liabilities = Assets
(j) Conservatism: Conservatism states that the accountant should not
anticipate any future income however they should provide for all possible
losses. When there are many alternative values of an asset, an accountant
should choose the method which leads to the lesser value. Later on, we shall
see that the golden rule of current assets valuation - ‘cost or market price
whichever is lower’ originated from this concept.
The Realisation Concept also states that no change should be counted unless it
has materialised. The Conservatism Concept puts a further brake on it. It is not
prudent to count unrealised gain but it is desirable to guard against all possible
losses.

For this concept there should be at least three qualitative characteristics of

financial statements, namely,
(i) Prudence, i.e., judgement about the possible future losses which are to
be guarded, as well as gains which are uncertain.
(ii) Neutrality, i.e., unbiased outlook is required to identify and record such
possible losses, as well as to exclude uncertain gains,
(k) Consistency: In order to achieve comparability of the financial
statements of an enterprise through time, the accounting policies are followed
consistently from one period to another; a change in an accounting policy is
made only in certain exceptional circumstances.
The concept of consistency is applied particularly when alternative methods of
accounting are equally acceptable. For example, a company may adopt any of
several methods of depreciation such as written-down-value method, straight-
line method, etc. Likewise, there are many methods for valuation of
inventories. But following the principle of consistency it is advisable that the
company should follow consistently over years the same method of
depreciation or the same method of valuation of Inventories which is chosen.
However, in some cases though there is no inconsistency, they may seem to be
inconsistent apparently. In case of valuation of Inventories if the company
applies the principle ‘at cost or market price whichever is lower’ and if this
principle accordingly results in the valuation of Inventories in one year at cost
price and the market price in the other year, there is no inconsistency here. It is
only an application of the principle.
But the concept of consistency does not imply non-flexibility as not to allow the
introduction of improved method of accounting.
An enterprise should change its accounting policy in any of the following
circumstances only:
a. To bring the books of accounts in accordance with the issued Accounting
Standards.
b. To comply with the provision of law.
c. When under changed circumstances, it is felt that new method will
reflect a true and fair picture in the financial statement.
(l) Materiality: Materiality principle permits other concepts to be ignored, if
the effect is not considered material. This principle is an exception to full
disclosure principle. According to materiality principle, all the items having
significant economic effect on the business of the enterprise should be
disclosed in the financial statements and any insignificant item which will only
increase the work of the accountant but will not be relevant to the users’ need
should not be disclosed in the financial statements.
The term materiality is the subjective term. It is on the judgement, common
sense and discretion of the accountant that which item is material and which is
not. For example, stationary purchased by the organization though not used
fully in the accounting year purchased still shown as an expense of that year
because of the materiality concept. Similarly, depreciation on small items like
books, calculators etc. is taken as 100% in the year of purchase though used by
the entity for more than a year. This is because the amount for books or
calculator is very small to be shown in the balance sheet though it is the asset
of the company.
The materiality depends not only upon the amount of the item but also upon
the size of the business, nature and level of information, level of the person
making the decision etc. Moreover, an item material to one person may be
immaterial to another person. What is important is that omission of any
information should not impair the decision-making of various users.