Chapter 2

Concepts & Convention of Accounting

 Accounting Period Concept
• Income is measured for a specified interval of time—
accounting period

A period of 12 months

Financial year

Calendar year

Diwali year.

– Makes comparison easier.

– Takes seasonal fluctuations in consideration.

 Example

• X Limited reported profit of Rs. 14 crores

whereas P Limited net profit of Rs.20 crores.
Which company has performed better?
X Limited prepares its accounts for 7 months
whereas, P Limited prepares its accounts for 13
months.
 Money Measurement
Concept

• Only those transactions that can be

expressed in terms of money are the subject
matter of accounting.
Money is the common unit of measurement
Each accounting transaction must be converted
into the `reporting currency’ of the entity.
 Examples

• There is a lockout in the factory of Y limited for 2 months.

How do you record this in accounts?
• Z Limited has 2 plants, 7 cars, 8 computers, 11 tables and 6
chairs as its assets. What are the total assets?
• Q Limited has sales of Rs. 1.20 crores in domestic market and
$10 million of exports. What is the total income of Q
Limited?
 The Entity Concept

• Business is a separate accounting entity for

which accounts are kept
Business and the businessman are separate
entities

Transactions recording depends upon the

`accounting entity’ chosen.
 Examples

• Shyam bought goods for Rs. 10 lakhs and sold them in Rs.
10.50 lakhs. What is the profit?
Out of the good bought, he consumed goods worth Rs. 1
lakh for personal purposes?

• A Limited is a captive BPO of B Limited, a UK entity. The costs

incurred by A during 2011 are of worth Rs. 20 crores and the
revenue is nil, as all the services were provided to B Limited
which owns A Limited. What is the profit of A Limited?
 Accrual Concept

• Cash basis of accounting versus accrual basis of accounting.

• Timing when income or expenses should be recorded.

• Income and expenses are recorded when ‘accrued’, and not

when received or paid.

Income recorded when earned

Expenses recorded when incurred

 Examples

• D Limited sold goods on 28 February 2012 for Rs. 10 lakhs

and allowed 3 months credit to its customer. The amount
was collected on 28 May 2012. Should the sale be recorded
in the year 2011–12 or 2012–13?

• E Limited has the practice of paying monthly salary on the

7th of next month. Salary for the month of March 2012 was
paid on 7th April 2012. Should it recognized as the expense
of 2011–12 or 2012–13?
 The Matching Concept

• Expenses should be matched against the

revenue generated to ascertain profit
Profit = (Sales/Income – Cost of goods sold)

Cost of goods sold = Opening Stock + Purchases +

Expenses incurred – Closing stock
 Examples

• Total purchase for the year 2011–12 are Rs.

120 lakhs whereas, the sales are 175 lakhs.
What is the profit?
What is the profit if goods worth Rs. 20 lakhs are
still unsold?
What is the profit if goods worth Rs. 35 lakhs
bought during 2010–11 were unsold during that
year?
 Operating versus Capital Expenditure

• Revenue expenses / Operating expenses

(OPEX)
OPEX for day-to-day operations
OPEX is charged to P&L account when incurred.
• Capital expenditure (CAPEX)
CAPEX for long-term benefits
CAPEX is appropriated over the useful life of the
asset by way of depreciation.
 The Going Concern Concept

• The business will continue to operate

indefinitely
Unless there are reasons to believe otherwise

The business neither has the intention nor the

necessity to discontinue operations.
 Historical Cost Concept

• Assets are recorded in the accounts at its

historical cost
Subsequent changes in the value are normally not
recorded in the accounts

Cost is however systematically apportioned over

the useful life of the asset.
 Examples

• A Limited bought a piece of land for Rs. 120 lakhs

during 2001–02. The current market price for the
same is Rs. 1,000 lakhs. At what value, should it
appear in the balance sheet?

• R Limited, a pharmaceutical company, bought 10,000

shares of S Limited as a strategic investment at Rs.
250 per share. The current market price of S Limited
is Rs. 150 per share? At what value this investment
should appear in the books of R Limited?
 Dual Aspect Concept

• Each accounting transaction affects at-least

two accounts in such a way that
Assets = Liabilities + Owner’s equity

• This system of accounting is called double-

entry bookkeeping system.
 Qualitative Characteristics that make
Accounting information useful-
Conventions of Accounting
Conservatism

• Anticipate no profit but anticipate all losses

Recognize gains only when they are reasonably certain
Recognize losses even if they are reasonably probable.
• It is prudent to `understate profits’ rather than
`overstate’.
 Examples

• Pee Ltd. bought 1,000 shares of RIL @ Rs. 1,000 per share on 1 October
2011 for trading. The market price per share on 31 March 2012 is Rs. 800. At
what value, the short-term investment appear in the balance sheet of Pee
Ltd? How do we treat Rs. 200 fall in value per share?
What would be your answer if the market price per share on 31 March
2012 is Rs. 1,200?

• MD Limited sells goods on credit basis. On 31 March 2012, it has a total

outstanding of Rs. 1,200 lakhs from its customers. The past experience says
that about 5 per cent of the customers invariably default. How do we
account for this anticipated loss?
 Materiality
– Insignificant details should be avoided but all
important information must be disclosed.
Any information that may influence the decision of
the user of the financial statement
The level of details to be maintained.
 Examples

– S Limited bought a calculator for Rs. 200. It has an estimated useful life of
5 years.
Is it a CAPEX or OPEX?
Should it be depreciated over its useful life?

– In the profit and loss a/c of Tee Ltd. about 60 per cent of the expenses
have been clubbed under the heading `Miscellaneous Expenses’ where as
Cee Limited has reported all heads of expenses separately including
about 100 different types of expenses which together constitute only 10
per cent of the total expenses in rupee terms. What are your views?
 Consistency
• Accounting methods once chosen must be
applied consistently, period after period
unless there are strong reasons to change.
Makes inter-period comparison possible
If there is a change, the same must be disclosed
separately
The impact of the change in accounting policy
must be quantified and reported separately.
 Example

• Dee Limited wants to change its accounting

policy in respect of depreciation method.
Is it allowed to do it?
What is the impact of change in accounting policy?
What disclosure would you suggest?
 Substance Over Form

• The accounting treatment and presentation

in financial statements of transactions and

events should be governed by their substance

and not merely by the legal form.

 Example

• X Limited sold some investments to Y Limited for Rs. 100

lakhs with an agreement to repurchase them after one
month at Rs. 101 lakhs.

How should this transaction be recorded in the books of X

Limited?

How to treat the gain of Rs.1 lakh?

 Quiz

1. Satnam & Company, a proprietorship firm paid an

annual rent of 600,000 for the premises. The premises
is used 2/3rd for official purposes and 1/3rdfor the
residence of the proprietor. The entire amount paid is
recoded as business expense. Which accounting
concept is violated?
Separate Legal Entity

25
2.Inventories are valued at `lower of cost or
realizable value’. Which accounting principle in
applicable here?
Conservatism

26
3. Which concept facilitates the comparison of
performance of the business from one period to
another?
Consistency

27
4. Store XYZ sold a television to its customers,
Mr. L for Rs.50,000 on 15th Dec. Mr. L pays
Store XYZ on 9th Jan. Store XYZ records the sale
on 15th Dec not on 9th Jan when the cash is
received. Which accounting concept is being
applied here?
• Accrual

28
5. A non current asset with a cost of Rs.50 lacs is
depreciated over its useful life of 7 years rather
than expensing the entire amount when it is
purchased. Which accounting concept is being
applied here?
• Matching

29
6. A large company purchases a chair Rs.4500
and expenses it immediately instead of
recording it as an asset and depreciating it over
useful life. This practice may be acceptable
because of which principle?
• Materiality

30
7. Once a particular financial period is adopted
by a business, it is not changed from one period
to the next period?
• Consistency

31
8. A company borrowed $100,000 in December
and will make its only payment for interest when
the note comes due six months later. The total
interest for the six months will be $3,600. On
the December income statement the accountant
reported Interest Expense of $600. This action
was the result of which accounting
principle/guideline?
Matching
32