Accounting Principles

By Dilshad D. Jalnawalla

 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. These assumptions are rules of the game and they have been developed from common accounting practices.

generally accepted set of rules can provide uniformity in the accounting system, the accounting procedure and presentation of accounting results. These assumptions help accounting statements to become comparable, leading to better analysis and comparison of performances.

ACCOUNTING CONCEPTS

 The term concepts includes those basic assumptions or conditions upon which the science of accounting is based.
1. Business Entity Concept 2. Going Concern Concept 3. Cost Concept

4. Money Measurement Concept

5. Duality Concept 6. Accounting Period Concept

7. Matching Concept
8. Realisation Concept

Business Entity Concept

A business entity is an organization of persons
to accomplish an economic goal. An entity is defined as those undertakings under the control of a single management. This may include a sole-proprietor, a partnership firm, a company or a non- profit making organization. This business entity is considered separate and distinct from the owners of the enterprise.

 For Example:- When an owner Mr.X starts

a business, styled X & Co., he brings capital into the business, the business in turn is deemed to owe the capital to the owner. This means the accounts are to be prepared only from the point of view of X & Co.- as if it was a different person from the owner.

This concept is applied to all forms of business organizations for the following reasons

a) Its a solution to the problem of separating the b)

business transactions from the personal transactions of the owner. To ascertain the return on capital employed enabling us to record how successful or otherwise the business has been. To ensure proper use of funds provided by the owner. To hold title to property in the name of the firm. To enter into transactions with outsiders in the name of the firm.

c)
d) e)

Going Concern Concept

Accounting is based on the concept that a
business unit will be operating for long. The accounting system provides a continuous record of the performance of the business throughout its existence. This concept assumes that the business unit will continue operating under the same economic conditions and in the same general environment.

This concept relates to the future which is, by definition, uncertain. Therefore, many factors can be used to determine whether a business unit is a going concern. They include the following: a) Liquidity: Should have sufficient liquid assets to pay its

liabilities. Various ratios can be applied to ascertain the liquidity of the business unit.

b) Capital Structure: It must have a sound capital structure to

overcome any short-term or long term difficulties. Capital Structure of a business unit is influenced by several factors such as cost of various sources of capital, dividend policy, the risk of insolvency, stability of earnings, and the like. in and/or the services it supplies.

c) Market: Should have continuing demand for the goods it deals d) Management Ability: Should be managed efficiently and
effectively to produce a competitive product and to see that the objectives of the enterprise are achieved.

 Going Concern Concept presumes that

the enterprise will continue in operation long enough to charge against income, the costs which have been deferred under the accrual concept, to pay liabilities when they become due and to meet the contractual commitments.

Cost Concept
Historical cost refers to the cost at the time
of acquisition. In accounting all transactions are generally recorded at cost and not at market value, this cost becomes the basis for subsequent accounting for that asset. This is because, this figure can normally be ascertained beyond doubt.

 For Example: If a business buys a plot of

land for Rs.2 lakh, the asset would be recorded in the books at Rs.2 lakh even if its market value at that time happens to be Rs.2.5 lakhs. It would continue to be shown in the balance sheet at Rs.2 lakh, even if later the market value of the land rises to say Rs.5 lakhs.

 In absence of this concept the figures would

have depended on the subjective views of a person. But on account of continued inflationary tendencies the preparation of financial statements on the basis of historical costs has become largely irrelevant for judging the financial position of the business. But pragmatic consideration of the possibilities has always found historical cost, in spite of its acknowledged limitations, to be superior.

Money Measurement Concept

Money provides a uniform way to measure
the value of goods and services. All business transactions are recorded in terms of money because money is a useful way of converting accounting data into a common unit. Only those transactions which can be measured in terms of money are to be recorded in the books of account.

 For Example: Purchase of an Asset can

be measured in rupee term so it is to be recorded. But retirement/ death of a Chairman, cannot be measured in monetary terms so it cannot be recorded in accounts.

There are two problems with this concept;

1. The concept assumes stability in the value of money. 2. Many factors which are of vital importance to the
business are outside the purview of accounting. (Like Quality of management, growth of competition, changes in the nature of demand etc.)

Inspite of these limitations this concept is accepted as it is not possible to employ a better measurement scale that can be easily understood by the users of accounting information.

Duality or Double Entry Concept

This concept states that for every
transaction, there will be two aspects. This concept is build around the fact that every time something is given, someone else receives it. Assets = Owners equity + Outside liability

 For Example:
When an equipment is purchased for cash, the new asset comes in (use of fund), and the cash will decrease (source of fund).

Accounting Period Concept

This concept arises from Going concern
concept. To be able to prepare the income statement for a business, the period for which it is to be prepared must be specified. An accounting period may be a calendar year or a financial year.

Advantages
Uniformity and consistency in accounting
treatment for profit ascertainment and asset valuations. Proper matching of periodic revenues and expenses to achieve the objectives of accounting. Comparability of financial statements of different period is facilitated.

Matching Concept
This concept results from the accounting period
concept. In order to determine the profits or losses accrued in an accounting period, the expenses must relate to the goods or services sold during the period. The expenses incurred in the production should be matched with the revenues realized from the sales of the goods and services.

 This concept requires proper allocation of

costs into different accounting periods so that relevant incomes and expenses are matched. The profit of an accounting period is the revenue less expenses incurred in producing those revenues.

 Example: If a salesman is paid commission in

January, 2008 for sales made by him in December, 2007, the commission paid to the salesman in January, 2008 should be taken as the cost for sales made by him in December. This means revenues of December, 2007 should be matched with the cost incurred for earning that revenue in December, 2007. Adjustments are made for all outstanding expenses, accrued incomes, prepaid expenses and unearned incomes, etc, while preparing the final accounts at the end of the accounting period.

Realization Concept
Revenues are recognized only when the
goods and services have been delivered and there is certainty that the revenue will be realized. In determining profits, credit sales are also taken into account. If from the past experience it is realized that revenue will be 95% of sales, a provision of 5% can be created for doubtful debts.

 Example: A places an order with B for

supply of certain goods yet to be manufactured. On receipt of the order, B purchased raw material, employs workers, produces the goods and delivers them to A. A makes the payment on receipt of goods. In this case the sale will be presumed to have been made not at the time of receipt of the order but at the time when goods are delivered to A.

 Exceptions 1. Hire Purchase: Ownership passes when last

installment is paid, but sales are presumed to the extent of installments received and installments outstanding. 2. Contracts Account: Contractor is liable to pay only when the whole contract is completed as per the terms of the contract, the profit is calculated on the basis of work certified.

ACCOUNTING CONVENTIONS

 The term conventions includes those customs 1. 2. 3. 4. 5.

and traditions which guide the accountants while preparing the accounting statements. Convention of Conservatism Convention of Full Disclosure Convention of Consistency Convention of Materiality Convention of Objectivity

Conservatism
In the initial stages of accounting, certain
anticipated profits which were recorded, did not materialize. This resulted in less acceptability of accounting figures by the end-users. This concept emphasizes that revenues are recognized only when they are reasonably certain and expenses are to be recognized as soon as possible. Recognise all losses and anticipate no gains

 For example: Only after a deal is finalized

and items are delivered to the client the payment for items become due from the client. But if we come to know that a customer has lost his assets, we should immediately either make provision for such loss or write them off.

Full Disclosure
All financial events which occur during a
particular financial period should fairly and completely be reported in the financial statements. Full disclosure is required when alternative policies are available, principles peculiar to particular industry and unusual or innovative application of accounting principles.

 Eg.: The firm changes its recording or

reporting procedures. The user may misinterpret the information if recording or reporting system is modified and not fully disclosed.

Consistency
Accounting principles are not static or
unchanging. It is possible to adopt a variety of principles and procedures for business transactions. Once an entity has decided on one method, it will treat all subsequent events of the same character in the same fashion unless it has a sound reason to change.

 For example: If a concern is charging

depreciation on fixed assets according to diminishing balance method (one method) it is expected to follow the same method in the subsequent years also.

 This is necessary for the purpose of

comparison. Consistency does not mean inflexibility. However, if adoption of such a technique results in inflating or deflating the figures of profit as compared to the previous period, a note to that effect should be given in the financial statements.

Materiality
A brand new pencil is an asset to the
business unit. Whenever the pencil is used, a part of the asset is consumed. Although the pencil is still in use at the end of the year, its original cost is so insignificant that it would be a waste of time to evaluate and include it in closing stock. Instead, it is written off as expense in the period it was purchased.

 All financial transactions need to be

recorded in the books of accounts. However there may be transactions which may be insignificant and are not shown separately. They are usually clubbed with others. There is no agreement as to the exact line separating material events from immaterial events.

 Eg.: While sending each debtor a statement of

his account, complete details have to be given. However, when a statement of outstanding debtors is prepared for sending to top management, figures may be rounded to the nearest ten or hundred. The companies Act also permits ignoring of paise while preparing financial statements. For Tax purposes, the income has to be rounded to nearest ten.

Objectivity
The economic data supplied by financial
statements should be based on verifiable evidence and should not be biased. Each transaction should be recorded which is substantiated with objectives and verifiable source documentation. The principal ensures that capricious (unpredictable) or unsubstantiated (unconfirmed) judgments do not enter into the financial records of the company.

 Many accounting measures are partially

subjective because of the items being measured. Eg. Ascertainment of estimated useful life and scrap value of a fixed asset for calculating depreciation. Objectivity, therefore, cannot be fully achieved in accounting.

Forms of Business Organisation

Form of organisation Sole Proprietorship Typical Size Small Single Owner Small to medium Min 2; max 20 partners Decision Making Completely flexible Government Regulation None Suitability Small Business

Partnership

Largely flexible but partners may disagree

Virtually none

Small, medium business Professional practices

Limited Company A. Private Small to medium Min 2; max 50 shareholders Largely flexible but directors may disagree Companies Small, medium Act applies business, often but is mild because of legal requirement or to get bank loan

Forms of Business Organisation

Form of organisation Typical Size Medium to Large. Min 7 shareholde rs; no max limit Large to very large Min 7 shareholde rs; no max limit Decision Making Very Rigid Directors may disagree Government Regulation Companies Act applies and is rigorous Extensive filing of documents, public disclosures. Companies Act applies and is rigorous SEBI Act applies and is very rigorous Extensive filing of documents, public disclosures. Suitability B. Public Limited Company i. Not Listed Medium to large business

ii. Listed

Very Rigid Directors may disagree

Large to very large business which require huge public capital.

Omission of paise and showing round figures in financial statements is based on ----a. b. c. d. e.
Conservatism concept Consistency concept Materiality concept Realization concept Cost concept

Under which of the following concepts are shareholders treated as creditors for the amount they paid on the shares they subscribed to?

a. b. c. d. e.

Cost Concept Duality concept Business Entity Concept Going concern concept Since the shareholders own the business, they are not treated as creditors.

Which of the following events is/are not recorded in the books of a business?
a. Significant monetary events after the
balance sheet date b. Death of a chief executive of the business c. Government investigations into the pricing policies of the business d. Both (b) and (c) above

Recording of fixed assets at cost ensures adherence of

a. b. c. d. e.
Conservatism Concept Going Concern Concept Cost Concept Both (a) and (b) above Both (b) and (c) above

Sales are recognized as income:

1. At the point of sale or at the performance
of a service. 2. After the expiry of the credit period allowed to debtors. 3. After the money collected from the debtors.

Matching principle results from the

1. Accounting period principle 2. Duality principle 3. Historical cost principle

Accounts produced objectively will be unbiased and hence tend to be more

1. Relevant 2. Comparable 3. Reliable