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Accounting Concepts

Introduction and Meaning Generally accepted accounting principles (GAAP) comprise a set of rules, concepts and guidelines used in preparing financial accounting reports. To make the accounting language convey the same meaning to all people, as far as practicable, and to make it meaningful, accountants have agreed on a number of concepts which are followed in the preparation of financial statements. Following is the list of accounting concepts agreed to by accountants: 1. Business entity Concept According to this concept, business is treated as a unit or entity apart from its owners, creditors, managers and others. In other words, the proprietor of an enterprise is always considered to be separate and distinct from the business which he controls. All the transactions of the business are recorded in the books of the business from the point of view of the business. Even the proprietor is treated as a creditor to the extent of his capital*. Upon investment of money in the business by the proprietor, it is deemed that the proprietor has given money and the business has received money. In brief, i. ii. iii. Only the business transactions are recorded and reported and not the personal transactions of the proprietor; and The personal assets of the owners or shareholders are not considered while recording and reporting the assets of the business entity. Income is the property of the business unless distributed to the owners.

2. Dual aspect Concept Dual aspect is a basic principle of accounting. It is the basis or foundation of accounting. According to this principle, every transaction as a dual aspect, i.e, two-fold effect. Every receiver is also a giver and every giver is also a receiver. Suppose Mr. A purchases furniture for cash Rs. 10,000, he receives furniture on the one hand and pays Rs. 10,000 cash on the other. Thus, two-fold effect is (i) increase in one asset, i.e. Furniture, and (ii) decrease in other asset, i.e. cash. Thus, receiving and giving aspects are the two aspects of every business transaction. This principle is called double entry system of book keeping. It is the core of accountancy. As per dual aspect, total assets and total liabilities must be equal. This equality is called Balance Sheet equation or Accounting equation. It can be stated as: Liabilities = Assets Or Capital + Liabilities (outside) = Assets Or Capital = Assets Liabilities 3. Going Concern Concept According to Kohlers Dictionary for Accountants, a going concern concept is defined as any enterprise which is expected to continue operating indefinitely in the future. This concept assumes that a business entity will continue to operate indefinitely and that it will not be liquidated in the immediate future. Indefinite existence means that the business enterprise will not be wound up within the foreseeable future and therefore would be able to meet its contractual obligations and use its resources according to the plans and predetermined goals. This concept forms the basis for depreciation. The cost of a fixed asset is allocated over its useful life. Fixed assets are depreciated over their useful life rather than over a shorter period on the expectation of early liquidation. If a machine is purchased and its useful life is expected to be 5 year, then the total cost of the machine is allocated over the period of 5 years on some suitable basis for ascertaining and measuring the income of each year. The full purchase cost will not be considered as the expense of the current year only. Assets are recorded at historical cost basis, i.e. at the acquisition cost and not at market values, because market values are useful only in the event of liquidation. In those cases where a joint venture business is undertaken for a limited period only, say, for construction of a cinema building, then the accountant will keep in mind the fact that joint venture arrangement will last for a limited period. Here indefinite existence would not be assumed. The accounting records will be

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made accordingly. The total cost of the machine or equipment would be wholly charged to the cost of business although the machine or equipment could be utilized physically over a number of years. 4. Accounting Period Concept The net income of any business can only be measured by comparing the assets of the business existing at the time of its commencement with those existing at the time of its liquidation. But life of business is assumed to be indefinite (going concern assumption) and the measurement of income, according to the above assumption, is not possible due to very long period. The proprietor of the business cannot wait for such a long periods for the determination of income at the end of the life of business because it will be too late to take corrective steps at that time if it is disclosed that the business had all the time been running at a loss on account of certain reasons or business had not been using its full capacity to make more profits. Thus, he has to know at frequent intervals how things are going. Therefore, accountants choose some shorter and convenient time for the measurement of income. Twelve-month period is normally adopted for this purpose which can be Calendar Year or Financial Year. Calendar Year begins from Ist January and ends on 31st December whereas Financial Year starts from 1st April and ends on 31st March. Under the Income Tax Provisions, Companies Act and Banking Companies Act accounts are to be prepared for a Financial Year. 5 Money Measurement Concept The money measurement concept underlines the fact that in accounting every worth recording event, happening or transaction is recorded in terms of money. In other words, a fact or a happening which cannot be expressed in terms of money is not recorded in the account books. General health condition of the chairman of the company, working conditions in which a worker has to work, sales policy pursued by the enterprise, quality of products introduced by the enterprises, etc, cannot be expressed in money terms and thus are not recorded in the books. In view of the above condition this concept puts a serious handicap on the usefulness of accounting records for management decisions. In spite of the limitations of money measurement assumption, it remains indispensable. This assumption increases the understanding of the state of affairs of the business. For example, if a business has a cash balance of Rs. 7,000, a building containing 20 rooms, a piece of land of 2,000 meters, 40 tables, 20 fans, 2 machines and so on then in the absence of money measurement concept these different types of assets cannot be added to give useful information. But if they are expressed in monetary terms- Rs. 7,000 cash, Rs. 50,000 of building, Rs. 2,00,000 of land, Rs. 8,000 of tables, Rs. 6,000 of fans, Rs.1, 60,000 of machines- it is possible to add them and use them for comparison or any other purpose. 6 Cost Concept According to this concept fixed assets are recorded at the price at which they are acquired. This price is termed as Cost. In balance sheet, these assets appear not at cost price every year, but depreciation is deducted and they appear at the amount which is cost less depreciation. This value is called book value. Under cost concept all such events are ignored which affect the business but have no cost for example the most active, important director dies, then the earning capacity and position of the business will be affected, but this event has no cost hence it will not be recorded in account books. The underlying idea of cost assumption is that: (i) (ii) asset is recorded at the price paid to acquire it - that is at cost price; and This concept is mainly for fixed assets, current assets are not affected by it. They appear in balance sheet at cost or market price whichever is lower, though they two are acquired at cost price.

7. Periodic Matching of Cost and Revenue Concept (or Matching Concept) It is widely recognized that desire of making profit is the most important provocation to keep the proprietor engaged in the business activities. Due to this reason a major share of attention of the accountant is absorbed in evolving techniques of measuring income. To compare profit or loss of an accounting period, it is necessary to match or compare all expenses incurred in an accounting year with the revenues earned during that year. For this, we have to recognize the revenues or inflows during an accounting period and the expenses incurred in securing of the

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expenses from the sum of the revenues. The formula is: Net income = Revenues Expenses. For this, the following important point must be noted: (i) Revenue realization: In accounting, the amounts received or receivable for the sale of output are called revenues. Revenues are flow of funds which have resulted from the trading activities of the business as distinct from capital invested by the proprietor or loans made by creditors and others. Revenue is recognized in the period in which it is earned or realized. Determination of the period in which revenue is to be realized is the first step in the application of this principle. The various bases used for determining the period in which revenue is realized are: (i) the sales basis, (ii) the cash basis, and (iii) the production basis. a. b. c. Sales basis considers the revenue as realized when sale is completed and sale is completed when assets such as cash or a promise to pay cash are transferred from the buyer to the seller in exchange for title to goods or service. Cash basis considers the revenue as realized when amount is ultimately collected from sales. This basis is adopted when there is a doubt about the collection of the amount from a sale. This basis is often used in accounting for hire-purchase sales. Production basis considers the revenue as realized on the basis of production. This basis is adopted when sales basis fails even approximately to realize revenue in the periods in which it is earned. For example, a contractor engaged in the construction job often finds the typical project required two more years for completion. In such cases a contractor may elect to take up revenue and earnings on his project on a percentage of completion bases.

Time of various transactions rather than cash inflow is most significant. In case of sale of goods or services, revenue is regarded as realized when sale actually take place and not when cash is received. Credit sales are treated as revenue although cash is received from debtors later on. Incomes such as commission, rent, and interest are recognized on time basis. (ii) Expenses: Expenses are the using or consuming of goods and services in the process of generating revenues. All expenses such as salaries, rent, and interest, insurance are recognized on time basis. They are recorded in the year in which service is obtained or the expense is incurred, whether paid immediately or payable at a later date. They should be recognized in the period in which the related revenue is recognized. Expenses are generally recognized when an entitys economic benefits are used up in delivering or producing goods or rendering services. Thus, according to this principle: (i) (ii) Cost of goods sold should be matched or compared with sales revenue during an accounting period, Only those costs or expenses should be considered which relate to the same accounting period as the revenues. In preparing profit and loss account for the year 2009, all incomes and expenses earned or incurred during 2009 must alone be considered. Any income or expenses pertaining to 2008 or 2010 must be excluded and not considered.

(iii) All expenses incurred during and accounting period (whether paid or not) and all revenues earned during that year (whether received or not) must be considered while determining net income or loss. (iv) Losses from fire and storm, from sale of capital assets, from all other causes even though not related to ordinary business operations, must be deducted from revenue before calculation of the net income of the business. 8 Verifiable Objective Evidence Concept This concept states that accounting records should be prepared in such a manner that all transactions recorded in the books of accounts should be verifiable objectively. Such transactions and entries relating to them should be supported by-evidence such as invoices, cash memos, vouchers, etc. Likewise information given in financial statements should be objectively verifiable. Personal bias has no place in preparation and presentation of financial records whether they are books of accounts or financial statements.

Basic Accounting Concepts


9 Realization Concept

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According to this concept revenue is recognised to have been earned as soon as the sale of goods or rendering of service is complete. It is immaterial whether the price or reward is received immediately or will be received in future. Accounting Standard 9 (AS9)* states that in case of sale of goods, revenue is recognised when the seller of goods has transferred property (ownership) in the goods to the buyer and no significant uncertainty about the sale price exists. Similarly in transactions which involve rendering of services, revenue is recognised as soon as the services are rendered to the satisfaction of the other party and no significant uncertainty exists regarding the amount of consideration to be received. In other words, revenue is recognised as soon as it becomes due irrespective of when it is received. Exception to this rule:    In certain cases, revenue is recognised even much before sale actually takes place, i.e., in gold, diamond mining since these things have definite value. In case of fixed price specific contract of construction, revenue is recognised much before the contracts are actually completed. In case of hire purchase transaction where revenue is recognised after the sale.

10 Accrual Concept Accrual concept is very important and central part of mercantile system of accounting. According to this concept, all expenses and revenues are recorded on the basis of their occurrence and receipts and not on the basis of actual cash paid or received. The result of business transactions, i.e., profit or loss can be truly found out only when all the expenses and revenues related to a particular period of time are recorded. When the revenue exceeds the expenses relating to a period of time, it indicates profit and capital of the businessman increases. If expenses exceed revenue, it indicates loss and the capital decreases. Hence, this concept is very important to know the real working results of the business. 11. Disclosure Concept This concept or principle stipulates that financial statements and accompanying notes should contain full disclosure of all significant financial information. Disclosure should be full and fair & adequate and make the financial statements useful and not misleading. The financial statements are prepared for the benefit of inside and outside users like owners, investors, creditors, bankers, etc., and should, therefore, be made honestly and all material information be given for their use. For example, while reporting sales during the year; sales return should be shown separately and deducted from the amount of sales, rather than showing the net sales for the year. According to Accounting Standard-1 on Disclosure of Accounting policies, to ensure proper understanding of financial statements, it is necessary that all significant accounting policies adopted in the preparation and presentation of financial statements should be disclosed. Any change in an accounting policy which has a material effect should be disclosed, e.g., change in the adoption of Depreciation Method. The practice of appending notes relative to various facts or items which do not find place in accounting statements is in pursuance to the concept of full disclosure of material facts. Examples are: (a) (b) Contingent liabilities appearing as a note. Market value of investments appearing as a note.

12. Materiality Concept The role of this assumption cannot be over-emphasized in as much as accounting will be unnecessarily overburdened with minute details in cash and accountant is not able to make an objective distinction between material and immaterial matters. American Accounting Association (AAA) defines the term materiality as under: An item should be regarded a material if there is reason to believe that knowledge of it would influence the decision of informed investor. For instance, in the case of the profit and loss account, if the amount of profit or loss has been affected due to a change in the basis of accounting e.g, depreciation methods,

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basis of valuation of stock, the amount must be disclosed, it is material in relation to the total amount charged and the amount of profit or loss. 13. Consistency Concept In order to enable the management to draw important conclusions regarding the working of a company over a number of years, it is essential that accounting practices and methods remain unchanged from one accounting period to another. The comparison of one accounting period with that in the past is possible only when the concept of consistency is adhered to. But the idea of consistency does not imply nonflexibility as not to permit the introduction of improved technique of accounting. The principle of consistency plays its role particularly when alternative accenting method is equally acceptable. For example, in applying the principle that fixed asset is depreciated over its useful life a company may adopt any one of the several methods of depredation. But in keeping with the concept of consistency, it is expected that the company would consistently follow the method of depreciation which is once chosen. Any change from one method to another would result in inconsistency. In the following cases, however there is no inconsistency although apparently they may look inconsistent. (a) The application of principle for stock valuation at cost or market price whichever is lower; will result in the valuation of stock sometimes at cost price and sometimes at market price. But there is no inconsistency here because the shift from the cost to market is only the application of the principle. Similarly, if investments are valued at cost or market price whichever is lower, it is only an application of the principle.

(b)

14. Conservatism Concept or Prudence Concept The convention of conservatism, also known as prudence, is based on the policy of 'playing safe'. Accordingly, all anticipated profits should be ignored but all anticipated losses should be accounted for. The convention requires that profits in anticipation should not be recorded but losses in anticipation should immediately be recorded even if there is a very remote possibility of occurrence of such losses. This convention is based on the rule that "anticipate no profits but provide for all possible losses." Thus, a cautious approach should be adopted in ascertaining the income of the business entity with the objective that profits of the enterprise in no case be overstated. The overstatement of profits may lead to distribution of excess dividend, resultant reduction in capital of the business enterprise. According to this concept, business entities are required to: a. value stock at cost or realizable value whichever is lower; b. create provision for doubtful debts; c. create provision for discount on debtors;

d. ignore the provision for discount on creditors; e. create investment fluctuation reserve; f. show the joint life policy at its surrender value on the asset side of the balance sheet;

g. write off intangible assets like goodwill, trademark, patents as early as possible.