Application of Accountancy concepts, principles, and conventions

Aditya Vegad (IPM05170)

Aryan Sethia (IPM05015)

Keshav Sahu (IPM05035)

Kshitij Jingar (IPM05039)

Mrinali Roy (IPM05042)

Nishant Ingle (IPM05032)

Devadevan R Saji (IPM05021)

Shrish Bhattacharya (IPM05059)

Integrated Programme In Management, IIM Rohtak

TERM III – ACCOUNTANCY

Dr. Samta Jain

Apr 19, 2024

 Introduction

Financial statements provide insight into a company's health, but the way that picture
is created is determined by the accounting concepts, principles, and conventions used. These
concepts, like revenue recognition and going concern, act as a common language for
businesses to tell their financial story. But this language must be used strategically.
Companies can use these concepts to demonstrate a stronger financial position, which can
help them attract investors and obtain loans. However, there is an opposite side. Misuse of
these concepts might distort the financial picture and even mislead stakeholders. Let's take a
closer look at how these accounting concepts can benefit and hurt businesses.

Revenue Recognition

Definition

According to the principle of revenue recognition revenue is recognized when it is

earned not when the cash is received. According to the accrual accounting revenue
recognition concept, revenues must be recorded when they are earned and realized, not when
money is received (Times et al., n.d.).

Example

Air India has purchased 470 aircraft from Airbus and Boeing which is worth $70
billion, so this $70 billion which is revenue for Airbus and Boeing, would be recorded on the
date at which Air India purchased the aircraft, no matter when these companies would be
giving the delivery of the aircraft to Air India.

Benefits

1) By following revenue recognition companies’ true financial position is reflected.

2) Following the revenue recognition approach guarantees adherence to accounting

guidelines like International Financial Reporting Standards (IFRS) or Generally Accepted
Accounting Principles (GAAP).

Limitations

1) By following this principle, companies sometimes manipulate financial

performance by showing excess revenue or expense.
2) This principle mainly focuses on the revenue earned so it is not aligned with the cash flow
statement, leading to discrepancies in cash flow reporting.

Business Entity

Definition

A business entity is an officially recognized organization created to engage in

commercial, industrial, or professional endeavors. These entities are established to make
profits or offer goods and services, and they function within defined legal frameworks.

Example

Imagine a bakery called "Sweet Delights." Instead of the bakery owner being
personally responsible for everything, the business itself (Sweet Delights) takes on its own
legal responsibilities and can enter contracts, own equipment, and pay taxes separately from
the owner. This separation helps protect the owner's personal assets if the business runs into
trouble.

Benefits

1) Legal Safeguard: Business entities offer legal protection to proprietors by

segregating personal assets from business debts, hence mitigating personal liability risks.

2) Capital Accessibility: Specific business structures, such as corporations, enjoy enhanced

access to funds through avenues like stock and bond issuance.

Limitations

1. Complexity in Establishment: Creating and managing specific business structures,

like corporations, can entail intricate legal protocols and administrative tasks.

2. Regulatory Compliance Expenses: Business entities must adhere to various regulations,

resulting in expenses for registration, reporting, and tax compliance.

Materiality

Definition

Materiality is an accounting convention that concerns the relevancy of information. It

suggests that in financial reporting, only significant information should be disclosed. In
simpler terms, if omitting or manipulating a piece of financial information could change the
decisions of the people using the financial statements, then that information is considered
should be disclosed. Moreover, there is an aspect where we consider only financially
important information relevant to the enterprise rather than considering non monetary aspects
such as employee discontent, hierarchical deliberations and so on, which is also reflected
through another concept known as the money measurement concept.

Example

Let us suppose that a large multinational company in India purchases occasional use
items like matchsticks for miscellaneous office purposes. However, these purchases are
insignificant compared to its overall economic activities(as the cost and quantity of
matchsticks are minimal). Thus, such transactions are immaterial and don't require disclosure
in financial statements, as their omission doesn't influence investor or stakeholder
decision-making. Another example for another facet would be that the multinational
company would also have to face several internal employee conflicts as well as be influenced
by the leadership style of the hierarchy, which would be difficult to take into account as they
cannot be measured in financial terms.

Benefits

Companies should only be concerned with disclosing relevant financial information

that can impact decision-making and thus avoid burdening users of financial information
with unnecessary details. This enables stakeholders to efficiently analyze and interpret
financial information for effective decision-making (making it more user-friendly).

Limitations

Determining which information is relevant can vary depending on the perspectives of

different stakeholders, leading to inconsistencies in financial reporting. This subjectivity can
impact the reliability and comparability of financial statements.

Conservatism

Definition

In accounting, the convention of conservatism, sometimes known as the concept of

prudence, is a policy that anticipates potential future losses but not future rewards. It states
that when deciding between two alternatives, choose the one with the lowest likelihood of
overstating assets and income. To avoid overstating assets or income, apply the principle of
caution.

Example

Conservatism suggests that when uncertainties exist, or when alternative accounting

methods are equally valid, a cautious

Case Study: XYZ Ltd. - Provision for Bad Debts

XYZ Ltd. is a manufacturing company in India that sells its products to various customers on
credit terms. As part of its accounting practices, XYZ Ltd. follows the principle of prudence
to ensure that its financial statements reflect a conservative estimate of its financial position.

XYZ Ltd. follows the principle of prudence by recognizing revenue only when it is
realized or realizable. To adhere to the principle of prudence, XYZ Ltd. makes a provision
for bad debts based on historical data, current economic conditions, and individual customer
assessments. The company also discloses the amount of the provision for bad debts and any
significant assumptions or uncertainties associated with this estimate.

By applying the principle of prudence, XYZ Ltd. presents financial statements that
reflect a conservative estimate of its financial position. The provision for bad debts ensures
that the company's accounts receivable are stated at a more realistic value, considering the
potential risk of customer defaults. Stakeholders, including investors, creditors, and
regulators, can have confidence in the reliability and conservatism of XYZ Ltd.'s financial
reporting.

Benefits

Risk Mitigation: It encourages companies to anticipate future contingencies and make

provisions for them, reducing the likelihood of unexpected financial setbacks.

Enhanced Financial Stability: The prudence principle promotes the presentation of

financial statements that reflect a more realistic and conservative view of a company's
financial position.

Limitations
 Understated Financial Performance: The prudence principle may lead to an
understatement of a company's financial performance by requiring conservative estimates
and provisions.

Subjectivity and Bias: The application of the prudence principle involves subjective
judgment and estimation, which can introduce bias into financial reporting.

Matching Principle

Definition

The matching principle in accounting is the practice of matching a company's

expenses with its corresponding revenues within the same accounting period. This ensures
accurate financial reporting and compliance with widely accepted accounting rules.

Example

For example, suppose Frozen Cloud offers a license for $5000 that costs $1000 to
develop. The cost of products sold is $1,000, which should be recognized in the same time as
the income, in accordance with the matching principle.

Benefits

The matching principle in accounting aligns expenses and revenues, preventing

misrepresentation of financial results. It improves accuracy in reflecting a company's
financial status, providing a reliable representation of its financial position, and assisting
stakeholders in making decisions. The matching principle also allows the cost of an asset to
be spread out across its useful life by allocating a percentage of its cost to each period during
which it generates revenue.

Limitations

Forecasting and allocating expenses to revenues can be difficult, especially when

dealing with indirect costs and complicated transactions. Determining whether to record
expenses can be subjective, resulting in variations in financial reporting. Transactions that
span many accounting periods complicate the application of the Matching Principle,
necessitating careful allocation of expenses and revenues between periods.
 Historical Cost

Definition

According to this concept, all the assets of a firm are kept on the balance sheet at the
original cost/purchase price paid for buying the asset and is not updated according to market
conditions

Example

ExxonMobil, one of the biggest publicly traded oil and gas companies purchases a
new oil refinery for a cost price of 1 billion Dollars, records the asset on its balance sheet
with the original cost price, and maintains this historical cost price in the following and
upcoming years.

Benefits

1) Simplicity and Objectivity: This method allows ExxonMobil a direct and objective
method for valuing its assets. It has simplified the accounting process and reduced the need
for subjective asset value assessment.

2) Stability in Financial Reporting: ExxonMobil’s Financial statement will portray

stable and consistent values over the years. These stable values can help ExxonMobil attract
investors looking for a stable investment and help them compare prices with previous records

3) Compliance with accounting standards: This concept follows the Generally

Accepted Accounting Principles (GAAP) and International Financial Reporting Standards
(IFRS), ensuring that ExxonMobil faces no problem with regulatory requirements

Limitations

1) Distorted Asset prices: Over time, the historical cost concept can cause asset
values to significantly differ from their current market values, leading to the understating of
ExxonMobil’s Balance sheet

2) Inefficient Decision making: Investors and other stakeholders relying solely on the
financial statements of ExxonMobil may make decisions based on old asset values(investors
may underestimate/overestimate ExxonMobil’s Financial Health
 Going Concern

Definition

Going concerned implies that a company will keep operating continuously and will
not need to stop or dissolve soon. This means that the organization will continue to function
for the foreseeable future, typically at least the next 12 months or longer, without plans or
requirements for closure or major interruptions to its activities.

Example

Large companies like Coca-Cola and Microsoft are recognized as going concerns
based on their lengthy track record, dominant market presence, and stable performance.
Similarly, a prosperous independent restaurant running profitably for a while is usually seen
as a going concern. Likewise, emerging startups with promising business strategies and
sufficient financial backing are considered ongoing concerns despite their recent
establishment.

Benefits

Business Planning: By assuming the business will continue operating, companies can
confidently plan for the future, making long-term investments and commitments.

Stakeholder Confidence: Investors, lenders, and other stakeholders are more likely to
support a business if it is seen as a going concern, demonstrating stability and reliability.
Employee

Security: Employee security increases when the company is viewed as a going

concern, leading to lower turnover rates and stronger loyalty.

Limitations

Economic uncertainty Economic downturns, industry disruptions, or unexpected

events like pandemics can question the assumption that a company can continue its
operations. Financial distress arising from significant financial difficulties or liquidity issues
could also raise doubts about a company's ability to operate as a going concern. Regulatory
issues may further exacerbate these challenges. Financial distress can bring into question a
company's ability to survive in the long term.
 Duality

Definition

‘Dual aspect’ or ‘duality’ states that every transaction conducted by a business entity
affects two accounts and has a double impact (Duality, n.d.).

Example

For instance, the Adani Group will currently invest more than 124 billion rupees
($1.49 billion) in Telangana as a part of its seven trillion-rupee expenditure plan for the next
decade. One could say that it is a loss-making move. But there are two reasons why it’s not,
the first being the debit nature of investment accounts that are assets and have increased. And
second is the shareholder equity/owner’s equity that increases on the firm’s side. This
situation is like a win-win, where the impact of one transaction can have two effects.

Benefits

Accuracy: The duality principle ensures that every transaction is recorded twice, once
as a debit and once as a credit, ensuring that the books remain balanced. This accuracy helps
in detecting errors and fraud.

Completeness: By recording both the debit and credit aspects of transactions, the
duality principle ensures that all financial transactions are fully accounted for, leaving no
gaps in the financial records.

Financial Reporting: It facilitates the preparation of financial statements like the

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

Limitations

Complexity: While the duality principle ensures accuracy and completeness, it also
introduces complexity into the accounting process.

Errors in Recording: Despite the duality principle's aim to prevent errors, mistakes can still
occur in recording transactions.

Subjectivity: The interpretation and classification of transactions into debit and credit
categories can sometimes be subjective.

Conclusion
 This paper emphasizes the importance of accounting concepts, principles, and
conventions in creating financial reporting procedures and, ultimately, decision-making
processes. From revenue recognition to the duality principle, each concept offers advantages
and downsides that should be carefully considered by businesses and stakeholders.
Understanding and applying these concepts responsibly enables firms to present a more
accurate and cautious image of their financial status, fostering trust and confidence among
investors, creditors, and regulators alike. However, it is vital to highlight the complexities
and subjectivities inherent in these accounting frameworks, underlining the need for ongoing
examination and openness in financial reporting processes.
 References

Duality. (n.d.). VEDANTU.

https://www.vedantu.com/maths/duality

Materiality Concept in Accounting. (n.d.). BYJUS. Retrieved September 3, 2021, from

https://byjus.com/commerce/materiality-concept-in-accounting/

Times, F. B. F. L. F. T. D. L. is a journalist with over 10 years of experience working with

publications such as the F., Independent, T., finance, I. C. H. received his masters in

journalism from the L. C. of C. D. is an expert in corporate, Podcast, E. I. as W. as, &

Liberto, video production L. about our editorial policies D. (n.d.). Accounting

Convention. Investopedia.

https://www.investopedia.com/terms/a/accounting-convention.asp#:~:text=There%20

are%20four%20main%20accounting%20conventions%20designed%20to