Tuesday, September 30, 2014

Accounting Principles : Accounting Basics Day 5

Introduction

The accounting principles are accounting rules used to prepare, present, and report financial statements for a wide variety of entities, including publicly-traded and privately-held companies, non-profit organizations, and governments. In this chapter we are going to learn about these accounting procedures which form the guidelines to prepare the financial statements.


Learning Objectives

By the time you finish Day 3 you would have learnt about

  • Basic accounting conventions. 
  • Concepts. 
  • Assumption

Why Accounting Principles?


Imagine that you are a business owner, and you take copies of your financial records to six different accountants. You ask each one to calculate your profit for the year. A fortnight later they each provide you with their answers. There are six different profit figures, with very wide variations between them. What impression do you now have of the accounting profession?
To avoid this kind of situation arising various rules, or accepted ways of going about things have evolved. These rules are known as 'concepts' and 'conventions' To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently.


Assumptions

The basic assumptions of accounting are like the foundation pillars on which the structure of accounting is based. The four basic assumptions are as follows:

Business Entity Assumption

The concept of business entity assumes that business has a distinct and separate entity from its owners. It means that for the purposes of accounting, the business and its owners are to be treated as two separate entities. Keeping this in view, when a person brings in some money as capital into his business, in accounting records, it is treated as liability of the business to the owner. Here, one separate entity (owner) is assumed to be giving money to another distinct entity (business unit). Similarly, when the owner withdraws any money from the business for his personal expenses (drawings), it is treated as reduction of the owner’s capital and consequently a reduction in the liabilities of the business.

Money Measurement Assumption

The concept of money measurement states that only those transactions and happenings in an organization which can be expressed in terms of money such as sale of goods or payment of expenses or receipt of income, etc. are to be recorded in the book of accounts. All such transactions or happenings which cannot be expressed in monetary terms, for example, the appointment of a manager, capabilities of its human resources or creativity of its research department or image of the organization among people in general do not find a place in the accounting records of a firm.

Accounting Period Assumption

The users of financial statements need periodical reports to know the operational result and the financial position of the business concern. Hence it becomes necessary to close the accounts at regular intervals. Usually a period 52 weeks or 1 year is considered as the accounting period.

Going Concern Assumption

As per this assumption, the business is assumed to continue for a never ending period and therefore transactions are recorded from this point of view. There is neither the intention nor the necessity to wind up the business in the foreseeable future.

Basic Concepts of Accounting

These concepts guide how business transactions are reported. On the basis of the above four assumptions the following concepts (principles) of accounting have been developed.

Dual Aspect Concept

Dual aspect is the foundation or basic principle of accounting. It provides the very basis for recording business transactions into the book of accounts. This concept states that every transaction has a dual or two-fold effect and should therefore be recorded at two places. In other words, at least two accounts will be involved in recording a transaction. This can be explained with the help of an example. Ram started business by investing in a sum of Rs. 50, 00,000 the amount of money brought in by Ram will result in an increase in the assets (cash) of business by Rs. 50, 00,000. At the same time, the owner’s equity or capital will also increase by an equal amount. It may be seen that the two items that got affected by this transaction are cash and capital account.All business transactions recorded in accounts have two aspects - receiving benefit and giving benefit. For example, when a business acquires an asset (receiving of benefit) it must pay cash (giving of benefit).

Realization Concept

The concept of revenue recognition requires that the revenue for a business transaction should be included in the accounting records only when it is realized. Here arise two questions in mind. First, is termed as revenue and the other, when the revenue is realized. Let us take the first one first. Revenue is the gross inflow of cash arising from (i) the sale of goods and services by an enterprise; and (ii) use by others of the enterprise’s resources yielding interest, royalties and dividends. Secondly, revenue is assumed to be realized when a legal right to receive it arises, i.e. the point of time when goods have been sold or service has been rendered. Thus, credit sales are treated as revenue on the day sales are made and not when money is received from the buyer. As for the income such as rent, commission, interest, etc. these are recognized on a time basis. For example, rent for the month of March 2005, even if received in April 2005, will be taken into the profit and loss account of the financial year ending March 31, 2005 and not into financial year beginning with April 2005. Similarly, if interest for April 2005 is received in advance in March 2005, it will be taken to the profit and loss account of the financial year ending March 2006.

Historical Cost Concept

Under this concept, assets are recorded at the price paid to acquire them, which includes cost of acquisition, transportation, installation and making the asset ready to use . For example, if a piece of land is purchased for Rs.50,00,000 and its market value is Rs.70,00,000 at the time of preparing final accounts the land value is recorded only for Rs.50,00,000. Thus, the balance sheet does not indicate the price at which the asset could be sold for.

Matching Concept

The earnings and expenses shown in an income statement must both refer to the same goods transferred or services rendered during the accounting period. The matching concept requires that expenses should be matched to the revenues of the appropriate accounting period.
Profit is an excess of revenue over expenditure therefore it becomes necessary to bring together all revenues and expenses relating to the period under review so we must determine the revenue earned during a particular accounting period and the expenses incurred to earn these revenues

Verifiable and Objective Evidence Concept

The concept of objectivity requires that accounting transaction should be recorded in an objective manner, free from the bias of accountants and others. This can be possible when each of the transaction is supported by verifiable documents or vouchers. For example, the transaction for the purchase of materials may be supported by the cash receipt for the money paid, if the same is purchased on cash or copy of invoice and delivery challan, if the same is purchased on credit. Similarly, receipt for the amount paid for purchase of a machine becomes the documentary evidence for the cost of machine and provides an objective basis for verifying this transaction.

Conventions

To make the accounting information useful to various interested parties, the basic assumptions and concepts discussed earlier have been modified. These modifying principles are as under.

Convention of Full Disclosure

The principle of full disclosure requires that all material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes. This is to enable the users to make correct assessment about the profitability and financial soundness of the enterprise and help them to take informed decisions.

Convention of Materiality

The materiality principle requires all relatively relevant information should be disclosed in the financial statements. Unimportant and immaterial information are either left out or merged with other items.
For example, money spent on creation of additional capacity of a theatre would be a material fact as it is going to increase the future earning capacity of the enterprise. Similarly, information about any change in the method of depreciation adopted or any liability which is likely to arise in the near future would be significant information. All such information about material facts should be disclosed through the financial statements and the accompanying notes so that users can take informed decisions.

Convention of Consistency

The aim of consistency principle is to preserve the comparability of financial statements. The rules, practices, concepts and principles used in accounting should be continuously observed and applied year after year. Comparisons of financial results of the business among different accounting period can be significant and meaningful only when consistent practices were followed in ascertaining them.
To illustrate, an investor wants to know the financial performance of an enterprise in the current year as compared to that in the previous year. He may compare this year’s net profit with that in the last year. But, if the accounting policies adopted, say with respect to depreciation in the two years are different, the profit figures will not be comparable. Because the method adopted for the valuation of stock in the past two years is inconsistent. It is, therefore, important that the concept of consistency is followed in preparation of financial statements so that the results of two accounting periods are comparable.

Convention of Conservatism

The concept of conservatism requires that profits should not to be recorded until realized but all losses, even those which may have a remote possibility, are to be provided for in the books of account. This principle takes into consideration all prospective losses but leaves all prospective profits. The essence of this principle is “anticipate no profit and provide for all possible losses”. For example, while valuing stock in trade, market price or cost price whichever is less is considered.


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