NCERT Class XI Accountancy: Chapter 2 – Theory Base of Accounting
National Council of Educational Research and Training (NCERT) Book for Class XI
Chapter: Chapter 2 – Theory Base of Accounting
Class XI NCERT Accountancy Text Book Chapter 2 Theory Base of Accounting is given below.
As discussed in the previous chapter, accountingis concerned with the recording, classifying andsummarising of financial transactions and eventsand interpreting the results thereof. It aims atproviding information about the financialperformance of a firm to its various users such asowners, managers employees, investors, creditors,suppliers of goods and services and tax authoritiesand help them in taking important decisions. Theinvestors, for example, may be interested inknowing the extent of profit or loss earned by thefirm during a given period and compare it with theperformance of other similar enterprises. Thesuppliers of credit, say a banker, may, in addition,be interested in liquidity position of the enterprise.All these people look forward to accounting forappropriate, useful and reliable information.
For making the accounting informationmeaningful to its internal and external users, it isimportant that such information is reliable as wellas comparable. The comparability of information isrequired both to make inter-firm comparisons, i.e.to see how a firm has performed as compared tothe other firms, as well as to make inter-periodcomparison, i.e. how it has performed as comparedto the previous years. This becomes possible onlyif the information provided by the financialstatements is based on consistent accountingpolicies, principles and practices. Such consistencyis required throughout the process of identifying the events and transactions to be accounted for, measuring them,communicating them in the book of accounts, summarising the results thereofand reporting them to the interested parties. This calls for developing a proper theory base of accounting.
The importance of accounting theory need not be over-emphasised as nodiscipline can develop without a sound theoretical base. The theory base ofaccounting consists of principles, concepts, rules and guidelines developedover a period of time to bring uniformity and consistency to the process ofaccounting and enhance its utility to different users of accounting information.Apart from these, the Institute of Chartered Accountants of India, (ICAI), whichis the regulatory body for standardisation of accounting policies in the countryhas issued Accounting Standards which are expected to be uniformly adheredto, in order to bring consistency in the accounting practices. These arediscussed in the sections to follow.
2.1 Generally Accepted Accounting Principles (GAAP)
In order to maintain uniformity and consistency in accounting records, certainrules or principles have been developed which are generally accepted by theaccounting profession. These rules are called by different names such asprinciples, concepts, conventions, postulates, assumptions and modifyingprinciples.
The term ‘principle’ has been defined by AICPA as ‘A general law or ruleadopted or professed as a guide to action, a settled ground or basis of conductor practice’. The word ‘generally’ means ‘in a general manner’, i.e. pertainingto many persons or cases or occasions. Thus, Generally Accepted AccountingPrinciples (GAAP) refers to the rules or guidelines adopted for recording andreporting of business transactions, in order to bring uniformity in thepreparation and the presentation of financial statements. For example, one ofthe important rule is to record all transactions on the basis of historical cost,which is verifiable from the documents such as cash receipt for the moneypaid. This brings in objectivity in the process of recording and makes theaccounting statements more acceptable to various users.
The Generally Accepted Accounting Principles have evolved over a longperiod of time on the basis of past experiences, usages or customs, statementsby individuals and professional bodies and regulations by government agenciesand have general acceptability among most accounting professionals. However,the principles of accounting are not static in nature. These are constantlyinfluenced by changes in the legal, social and economic environment as wellas the needs of the users.
These principles are also referred as concepts and conventions. The termconcept refers to the necessary assumptions and ideas which are fundamentalto accounting practice, and the term convention connotes customs or traditionsas a guide to the preparation of accounting statements. In practice, the samerules or guidelines have been described by one author as a concept, by anotheras a postulate and still by another as convention. This at times becomesconfusing to the learners. Instead of going into the semantics of these terms,it is important to concentrate on the practicability of their usage. From thepracticability view point, it is observed that the various terms such asprinciples, postulates, conventions, modifying principles, assumptions, etc.have been used inter-changeably and are referred to as Basic AccountingConcepts in the present chapter.
2.2 Basic Accounting Concepts
The basic accounting concepts are referred to as the fundamental ideas orbasic assumptions underlying the theory and practice of financial accountingand are broad working rules for all accounting activities and developed by theaccounting profession. The important concepts have been listed as below:
- Business entity;
- Money measurement;
- Going concern;
- Accounting period;
- Dual aspect (or Duality);
- Revenue recognition (Realisation);
- Full disclosure;
- Conservatism (Prudence);
2.2.1 Business Entity Concept
The concept of business entity assumes that business has a distinct andseparate 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. Keepingthis 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 anotherdistinct entity (business unit). Similarly, when the owner withdraws any moneyfrom the business for his personal expenses(drawings), it is treated as reductionof the owner’s capital and consequently a reduction in the liabilities of thebusiness.
The accounting records are made in the book of accounts from the point ofview of the business unit and not that of the owner. The personal assets and liabilities of the owner are, therefore, not considered while recording andreporting the assets and liabilities of the business. Similarly, personaltransactions of the owner are not recorded in the books of the business, unlessit involves inflow or outflow of business funds.
2.2.2 Money Measurement Concept
The concept of money measurement states that only those transactions andhappenings in an organisation which can be expressed in terms of moneysuch as sale of goods or payment of expenses or receipt of income, etc. are tobe recorded in the book of accounts. All such transactions or happeningswhich can not be expressed in monetary terms, for example, the appointmentof a manager, capabilities of its human resources or creativity of its researchdepartment or image of the organisation among people in general do not finda place in the accounting records of a firm.
Another important aspect of the concept of money measurement is thatthe records of the transactions are to be kept not in the physical units but inthe monetary unit. For example, an organisation may, on a particular day,have a factory on a piece of land measuring 2 acres, office building containing10 rooms, 30 personal computers, 30 office chairs and tables, a bank balanceof Rs.5 lakh, raw material weighing 20-tons, and 100 cartons of finished goods.These assets are expressed in different units, so can not be added to give anymeaningful information about the total worth of business. For accountingpurposes, therefore, these are shown in money terms and recorded in rupeesand paise. In this case, the cost of factory land may be say Rs. 2 crore; officebuilding Rs. 1 crore; computers Rs.15 lakh; office chairs and tables Rs. 2lakh; raw material Rs. 33 lakh and finished goods Rs. 4 lakh. Thus, the totalassets of the enterprise are valued at Rs. 3 crore and 59 lakh. Similarly, alltransactions are recorded in rupees and paise as and when they take place.The money measurement assumption is not free from limitations. Due tothe changes in prices, the value of money does not remain the same over aperiod of time. The value of rupee today on account of rise in prices is muchless than what it was, say ten years back. Therefore, in the balance sheet,when we add different assets bought at different points of time, say buildingpurchased in 1995 for Rs. 2 crore, and plant purchased in 2005 for Rs. 1crore, we are in fact adding heterogeneous values, which can not be clubbedtogether. As the change in the value of money is not reflected in the book ofaccounts, the accounting data does not reflect the true and fair view of theaffairs of an enterprise.
2.2.3 Going Concern Concept
The concept of going concern assumes that a business firm would continue tocarry out its operations indefinitely, i.e. for a fairly long period of time andwould not be liquidated in the foreseeable future. This is an importantassumption of accounting as it provides the very basis for showing the valueof assets in the balance sheet.
An asset may be defined as a bundle of services. When we purchase anasset, for example, a personal computer, for a sum of Rs. 50,000, what we arebuying really is the services of the computer that we shall be getting over itsestimated life span, say 5 years. It will not be fair to charge the whole amountof Rs. 50,000, from the revenue of the year in which the asset is purchased.Instead, that part of the asset which has been consumed or used during aperiod should be charged from the revenue of that period. The assumptionregarding continuity of business allows us to charge from the revenues of aperiod only that part of the asset which has been consumed or used to earnthat revenue in that period and carry forward the remaining amount to thenext years, over the estimated life of the asset. Thus, we may chargeRs. 10,000 every year for 5 years from the profit and loss account. In case thecontinuity assumption is not there, the whole cost (Rs. 50,000 in the presentexample) will need to be charged from the revenue of the year in which theasset was purchased.
2.2.4 Accounting Period Concept
Accounting period refers to the span of time at the end of which the financialstatements of an enterprise are prepared, to know whether it has earned profits orincurred losses during that period and what exactly is the position of its assets andliabilities at the end of that period. Such information is required by different usersat regular interval for various purposes, as no firm can wait for long to know itsfinancial results as various decisions are to be taken at regular intervals on thebasis of such information. The financial statements are, therefore, prepared atregular interval, normally after a period of one year, so that timely information ismade available to the users. This interval of time is called accounting period.The Companies Act 1956 and the Income Tax Act require that the incomestatements should be prepared annually. However, in case of certainsituations, preparation of interim financial statements become necessary.For example, at the time of retirement of a partner, the accounting periodcan be different from twelve months period. Apart from these companieswhose shares are listed on the stock exchange, are required to publishquarterly results to ascertain the profitability and financial position at theend of every three months period.
Test Your Understanding – IChoose the Correct Answer
1. During the life-time of an entity accounting produce financial statements inaccordance with which basic accounting concept:
(c) Accounting period
(d) None of the above
2. When information about two different enterprises have been prepared presentedin a similar manner the information exhibits the characteristic of:
(d) None of the above
3. A concept that a business enterprise will not be sold or liquidated in the nearfuture is known as :
(a) Going concern
(b) Economic entity
(c) Monetary unit
(d) None of the above
4. The primary qualities that make accounting information useful for decision-makingare :
(a) Relevance and freedom from bias
(b) Reliability and comparability
(c) Comparability and consistency
(d) None of the above
2.2.5 Cost Concept
The cost concept requires that all assets are recorded in the book of accountsat their purchase price, which includes cost of acquisition, transportation,installation and making the asset ready to use. To illustrate, on June 2005,an old plant was purchased for Rs. 50 lakh by Shiva Enterprise, which is intothe business of manufacturing detergent powder. An amount ofRs. 10,000 was spent on transporting the plant to the factory site. In addition,Rs. 15,000 was spent on repairs for bringing the plant into running positionand Rs. 25,000 on its installation. The total amount at which the plant will berecorded in the books of account would be the sum of all these, i.e.Rs. 50,50,000.
The concept of cost is historical in nature as it is something, which hasbeen paid on the date of acquisition and does not change year after year. Forexample, if a building has been purchased by a firm for Rs. 2.5 crore, the purchase price will remain the same for all years to come, though its marketvalue may change. Adoption of historical cost brings in objectivity in recordingas the cost of acquisition is easily verifiable from the purchase documents.The market value basis, on the other hand, is not reliable as the value of anasset may change from time to time, making the comparisons between oneperiod to another rather difficult.
However, an important limitation of the historical cost basis is that it doesnot show the true worth of the business and may lead to hidden profits. Duringthe period of rising prices, the market value or the cost at (which the assetscan be replaced are higher than the value at which these are shown in thebook of accounts) leading to hidden profits.
2.2.6 Dual Aspect Concept
Dual aspect is the foundation or basic principle of accounting. It provides thevery basis for recording business transactions into the book of accounts. Thisconcept states that every transaction has a dual or two-fold effect and shouldtherefore be recorded at two places. In other words, at least two accounts willbe involved in recording a transaction. This can be explained with the help ofan example. Ram started business by investing in a sum of Rs. 50,00,000 Theamount 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 orcapital will also increase by an equal amount. It may be seen that the twoitems that got affected by this transaction are cash and capital account.Let us take another example to understand this point further. Supposethe firm purchase goods worth Rs. 10,00,000 on cash. This will increase anasset (stock of goods) on the one hand and reduce another asset (cash) on theother. Similarly, if the firm purchases a machine worth Rs. 30,00,000 oncredit from Reliable Industries. This will increase an asset (machinery) on theone hand and a liability (creditor) on the other. This type of dual effect takesplace in case of all business transactions and is also known as duality principle.The duality principle is commonly expressed in terms of fundamentalAccounting Equation, which is as follows :
In other words, the equation states that the assets of a business are alwaysequal to the claims of owners and the outsiders. The claims also called equityof owners is termed as Capital(owners’ equity) and that of outsiders, as
Liabilities(creditors equity). The two-fold effect of each transaction affects insuch a manner that the equality of both sides of equation is maintained.The two-fold effect in respect of all transactions must be duly recorded inthe book of accounts of the business. In fact, this concept forms the core ofDouble Entry System of accounting, which has been dealt in detail, inchapter 3.
2.2.7 Revenue Recognition (Realisation) Concept
The concept of revenue recognition requires that the revenue for a businesstransaction should be included in the accounting records only when it isrealised. Here arises two questions in mind. First, is termed as revenue andthe other, when the revenue is realised. Let us take the first one first. Revenueis the gross inflow of cash arising from (i) the sale of goods and services by anenterprise; and (ii) use by others of the enterprise’s resources yielding interest,royalties and dividends. Secondly, revenue is assumed to be realised when alegal right to receive it arises, i.e. the point of time when goods have been soldor service has been rendered. Thus, credit sales are treated as revenue on theday sales are made and not when money is received from the buyer. As for theincome such as rent, commission, interest, etc. these are recongnised on atime basis. For example, rent for the month of March 2005, even if received inApril 2005, will be taken into the profit and loss account of the financial yearending 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, itwill be taken to the profit and loss account of the financial year endingMarch 2006.
There are some exceptions to this general rule of revenue recognition. Incase of contracts like construction work, which take long time, say 2-3 yearsto complete, proportionate amount of revenue, based on the part of contractcompleted by the end of the period is treated as realised. Similarly, whengoods are sold on hire purchase, the amount collected in installments is treatedas realised.
2.2.8 Matching Concept
The process of ascertaining the amount of profit earned or the loss incurredduring a particular period involves deduction of related expenses from therevenue earned during that period. The matching concept emphasises exactlyon this aspect. It states that expenses incurred in an accounting period shouldbe matched with revenues during that period. It follows from this that the revenue and expenses incurred to earn these revenues must belong to thesame accounting period.
As already stated, revenue is recognised when a sale is complete or serviceis rendered rather when cash is received. Similarly, an expense is recognisednot when cash is paid but when an asset or service has been used to generaterevenue. For example, expenses such as salaries, rent, insurance arerecognised on the basis of period to which they relate and not when these arepaid. Similarly, costs like depreciation of fixed asset is divided over the periodsduring which the asset is used.
Let us also understand how cost of goods are matched with their salesrevenue. While ascertaining the profit or loss of an accounting year, we shouldnot take the cost of all the goods produced or purchased during that periodbut consider only the cost of goods that have been sold during that year. Forthis purpose, the cost of unsold goods should be deducted from the cost ofthe goods produced or purchased. You will learn about this aspect in detail inthe chapter on financial statement.
The matching concept, thus, implies that all revenues earned during anaccounting year, whether received during that year, or not and all costsincurred, whether paid during the year, or not should be taken into accountwhile ascertaining profit or loss for that year.
2.2.9 Full Disclosure Concept
Information provided by financial statements are used by different groups ofpeople such as investors, lenders, suppliers and others in taking variousfinancial decisions. In the corporate form of organisation, there is a distinctionbetween those managing the affairs of the enterprise and those owning it.Financial statements, however, are the only or basic means of communicatingfinancial information to all interested parties. It becomes all the more important,therefore, that the financial statements makes a full, fair and adequatedisclosure of all information which is relevant for taking financial decisions.The principle of full disclosure requires that all material and relevant factsconcerning financial performance of an enterprise must be fully and completelydisclosed in the financial statements and their accompanying footnotes. Thisis to enable the users to make correct assessment about the profitability andfinancial soundness of the enterprise and help them to take informed decisions.To ensure proper disclosure of material accounting information, the IndianCompanies Act 1956 has provided a format for the preparation of profit andloss account and balance sheet of a company, which needs to be compulsorilyadhered to, for the preparation of these statements. The regulatory bodies
like SEBI, also mandates complete disclosures to be made by the companies,to give a true and fair view of profitability and the state of affairs.
2.2.10 Consistency Concept
The accounting information provided by the financial statements would beuseful in drawing conclusions regarding the working of an enterprise onlywhen it allows comparisons over a period of time as well as with the workingof other enterprises. Thus, both inter-firm and inter-period comparisons arerequired to be made. This can be possible only when accounting policies andpractices followed by enterprises are uniform and are consistent over theperiod of time.
To illustrate, an investor wants to know the financial performance of anenterprise in the current year as compared to that in the previous year. Hemay compare this year’s net profit with that in the last year. But, if theaccounting policies adopted, say with respect to depreciation in the two yearsare different, the profit figures will not be comparable. Because the methodadopted for the valuation of stock in the past two years is inconsistent. It is,therefore, important that the concept of consistency is followed in preparationof financial statements so that the results of two accounting periods arecomparable. Consistency eliminates personal bias and helps in achievingresults that are comparable.
Also the comparison between the financial results of two enterprises wouldbe meaningful only if same kind of accounting methods and policies are adoptedin the preparation of financial statements.
However, consistency does not prohibit change in accounting policies.Necessary required changes are fully disclosed by presenting them in thefinancial statements indicating their probable effects on the financial resultsof business.
2.2.11 Conservatism Concept
The concept of conservatism (also called ‘prudence’) provides guidance forrecording transactions in the book of accounts and is based on the policy ofplaying safe. The concept states that a conscious approach should be adoptedin ascertaining income so that profits of the enterprise are not overstated. If theprofits ascertained are more than the actual, it may lead to distribution ofdividend out of capital, which is not fair as it will lead to reduction in the capitalof the enterprise.
The concept of conservatism requires that profits should not to be recordeduntil realised but all losses, even those which may have a remote possibility, are to be provided for in the books of account. To illustrate, valuing closingstock at cost or market value whichever is lower; creating provision for doubtfuldebts, discount on debtors; writing of intangible assets like goodwill, patents,etc. from the book of accounts are some of the examples of the application ofthe principle of conservatism. Thus, if market value of the goods purchasedhas fallen down, the stock will be shown at cost price in the books but if themarket value has gone up, the gain is not to be recorded until the stock issold. This approach of providing for the losses but not recognising the gainsuntil realised is called conservatism approach. This may be reflecting agenerally pessimist attitude adopted by the accountants but is an importantway of dealing with uncertainty and protecting the interests of creditors againstan unwanted distribution of firm’s assets. However, deliberate attempt tounderestimate the value of assets should be discouraged as it will lead tohidden profits, called secret reserves.
2.2.12 Materiality Concept
The concept of materiality requires that accounting should focus on materialfacts. Efforts should not be wasted in recording and presenting facts, whichare immaterial in the determination of income. The question that arises hereis what is a material fact. The materiality of a fact depends on its nature andthe amount involved. Any fact would be considered as material if it is reasonablybelieved that its knowledge would influence the decision of informed user offinancial statements. For example, money spent on creation of additionalcapacity of a theatre would be a material fact as it is going to increase thefuture earning capacity of the enterprise. Similarly, information about anychange in the method of depreciation adopted or any liability which is likely toarise in the near future would be significant information. All such informationabout material facts should be disclosed through the financial statementsand the accompanying notes so that users can take informed decisions. Incertain cases, when the amount involved is very small, strict adherence toaccounting principles is not required. For example, stock of erasers, pencils,scales, etc. are not shown as assets, whatever amount of stationery is boughtin an accounting period is treated as the expense of that period, whetherconsumed or not. The amount spent is treated as revenue expenditure andtaken to the profit and loss account of the year in which the expenditureis incurred.
2.2.13 Objectivity Concept
The concept of objectivity requires that accounting transaction should berecorded in an objective manner, free from the bias of accountants and others.
This can be possible when each of the transaction is supported by verifiabledocuments or vouchers. For example, the transaction for the purchase ofmaterials may be supported by the cash receipt for the money paid, if thesame is purchased on cash or copy of invoice and delivery challan, if the sameis purchased on credit. Similarly, receipt for the amount paid for purchase ofa machine becomes the documentary evidence for the cost of machine andprovides an objective basis for verifying this transaction. One of the reasonsfor the adoption of ‘Historical Cost’ as the basis of recording accountingtransaction is that adherence to the principle of objectivity is made possibleby it. As stated above, the cost actually paid for an asset can be verified fromthe documents but it is very difficult to ascertain the market value of an assetuntil it is actually sold. Not only that, the market value may vary from personto person and from place to place, and so ‘objectivity’ cannot be maintained ifsuch value is adopted for accounting purposes.
Test Your Understanding – IIFill in the correct word:
1. Recognition of expenses in the same period as associated revenues is called _______________concept.
2. The accounting concept that refers to the tendency of accountants to resolveuncertainty and doubt in favour of understating assets and revenues andoverstating liabilities and expenses is known as _______________.
3. Revenue is generally recongnised at the point of sale denotes the conceptof _______________.
4. The _______________concept requires that the same accounting method shouldbe used from one accounting period to the next.
5. The_______________concept requires that accounting transaction should be freefrom the bias of accountants and others.
2.3 Systems of Accounting
The systems of recording transactions in the book of accounts are generallyclassified into two types, viz. Double entry system and Single entry system.Double entry system is based on the principle of “Dual Aspect” which statesthat every transaction has two effects, viz. receiving of a benefit and giving ofa benefit. Each transaction, therefore, involves two or more accounts and isrecorded at different places in the ledger. The basic principle followed is thatevery debit must have a corresponding credit. Thus, one account is debitedand the other is credited.
Double entry system is a complete system as both the aspects of a transactionare recorded in the book of accounts. The system is accurate and more reliable as the possibilities of frauds and mis-appropriations are minimised.The arithmetic inaccuracies in records can mostly be checked by preparing thetrial balance. The system of double entry can be implemented by big as well as small organisations.
Single entry system is not a complete system of maintaining records offinancial transactions. It does not record two-fold effect of each and everytransaction. Instead of maintaining all the accounts, only personal accountsand cash book are maintained under this system. In fact, this is not a systembut a lack of system as no uniformity is maintained in the recording oftransactions. For some transactions, only one aspect is recorded, for others,both the aspects are recorded. The accounts maintained under this systemare incomplete and unsystematic and therefore, not reliable. The system is,however, followed by small business firms as it is very simple and flexible (youwill study about them in detail later in this book).
2.4 Basis of Accounting
From the point of view the timing of recognition of revenue and costs, therecan be two broad approaches to accounting. These are:
(i) Cash basis; and
(ii) Accrual basis.
Under the cash basis, entries in the book of accounts are made when cash isreceived or paid and not when the receipt or payment becomes due. Let us say,for example, if office rent for the month of December 2005, is paid in January2006, it would be recorded in the book of account only in January 2006.Similarly sale of goods on credit in the month of January 2006 would notbe recorded in January but say in April, when the payment for the same isreceived. Thus this system is incompatible with the matching principle, whichstates that the revenue of a period is matched with the cost of the same period.Though simple, this method is inappropriate for most organisations as profitis calculated as a difference between the receipts and disbursement of moneyfor the given period rather than on happening of the transactions.Under the accrual basis, however, revenues and costs are recognised inthe period in which they occur rather when they are paid. A distinction ismade between the receipt of cash and the right to receive cash and paymentof cash and legal obligation to pay cash. Thus, under this system, the monitoryeffect of a transaction is taken into account in the period in which they areearned rather than in the period in which cash is actually received or paid bythe enterprise. This is a more appropriate basis for the calculation of profitsas expenses are matched against revenue earned in relation thereto. Forexample, raw material consumed are matched against the cost of goods sold.
2.5 Accounting Standards
As discussed in the preceding section, the Generally Accepted AccountingPrinciples in the form of Basic Accounting Concept have been accepted by theaccounting profession to achieve uniformity and comparability in the financialstatement. This is aimed at increasing the utility of these statement to varioususers of the accounting information. But the difficulty is that GAAP permit avariety of alternative treatments for the same item. For example, variousmethods of calculation of cost of inventory are permissible which may befollowed by different enterprises. This may cause problem to the externalusers of information, which becomes inconsistent and incomparable. Thisnecessitates brining in uniformity and consistency in the reporting ofaccounting information.
Recognising this need, the Institute of Charted Accountants of India (ICAI)constituted an Accounting Standards Board (ASB) in April, 1977 for developingAccounting Standards. The main function of ASB is to identify areas in whichuniformity in standards is required and develop draft standards after widediscussion with representative of the Government, public sector undertakings,industry and other organisations. ASB gives due consideration to theInternational Accounting Standards as India is a member of InternationalAccount Setting Body. ASB submits the draft of the standards to the Councilof the ICAI, which finalises them and notifies them for use in the presentationof the financial statements. ASB also makes a periodic review of the accountingstandards.
Accounting standards are written statements of uniform accounting rulesand guidelines or practices for preparing the uniform and consistent financialstatements and for other disclosures affecting the user of accountinginformation. However, the accounting standards cannot override the provisionof applicable laws, customs, usages and business environment in the country.The Institute tries to persuade the accounting profession for adopting theaccounting standards, so that uniformity can be achieved in the presentationof financial statements. In the initial years the standards are of recommendatoryin nature. Once an awareness is created about the requirements of a standard,steps are taken to enforce its compliance by making them mandatory for allcompanies to comply with. In case of non-compliance, the companies arerequired to disclose the reasons for deviations and the financial effect, if any,arising due to such deviation.
The list of accounting standards is given in the appendix to this chapter.
Key Terms Introduced in the Chapter
- Full discloser
- Generally accepted
- Revenue Relisation
- Operating guidelines
- Accounting period
- Dual aspect
- Money measurement
- Accounting concept
- Going concern
- Accounting Principles (GAAP)
Summary with Reference to Learning Objectives
1. Generally Accepted Accounting Principles (GAAP) : Generally Accepted Accounting principles refer to the rules or guidelines adopted for recording and reporting of business transactions in order to bring uniformity in the preparation and presentation of financial statements. These principles are also referred to as concepts and conventions. From the practicality view point, the various terms such as principles, postulates, conventions modifying principles, assumptions, etc. have been used interchangeably and are referred to as basic accounting concepts, in the present book.
2. Basic Accounting Concepts : The basic accounting concepts are referred to as the fundamental ideas or basic assumptions underlying the theory and practice of financial accounting and are broad working rules of accounting activities.
3. Business Entity : This concept assumes that business has distinct and
separate entity from its owners. Thus, for the purpose of accounting, business
and its owners are to be treated as two separate entities.
4. Money Measurement : The concept of money measurement states that only thosetransactions and happenings in an organisation, which can be expressed in termsof money are to be recorded in the book of accounts. Also, the records of thetransactions are to be kept not in the physical units but in the monetary units.
5. Going Concern : The concept of going concern assumes that a business firmwould continue to carry out its operations indefinitely (for a fairly long periodof time) and would not be liquidated in the near future.
6. Accounting Period : Accounting period refers to the span of time at the end ofwhich the financial statements of an enterprise are prepared to know whetherit has earned profits or incurred losses during that period and what exactlyis the position of its assets and liabilities, at the end of that period.
7. Cost Concept : The cost concept requires that all assets are recorded in thebook of accounts at their cost price, which includes cost of acquisition,transportation, installation and making the asset ready for the use.
8. Dual Aspect : This concept states that every transaction has a dual or twofoldeffect on various accounts and should therefore be recorded at two places.The duality principle is commonly expressed in terms of fundamentalaccounting equation, which is :
Assets = Liabilities + Capital
9. Revenue Recognition : Revenue is the gross in-flow of cash arising from thesale of goods and services by an enterprise and use by others of the enterpriseresources yielding interest royalities and divididends. The concept of revenuerecognition requires that the revenue for a business transaction should beconsidered realised when a legal right to receive it arises.
10. Matching : The concept of matching emphasises that expenses incurred in an accounting period should be matched with revenues during that period. It follows from this that the revenue and expenses incurred to earn these revenue must belong to the same accounting period.
11. Full Disclosure : This concept requires that all material and relevant facts concrning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes.
12. Consistency : This concepts states that accounting policies and practices followed by enterprises should be uniform and consistent one the period of time so that results are composable. Comparability results when the same accounting principles are consistently being applied by different enterprises for the period under comparison, or the same firm for a number of periods.
13. Conservatism : This concept requires that business transactions should be recorded in such a manner that profits are not overstated. All anticipated losses should be accounted for but all unrealised gains should be ignored.
14. Materiality : This concept states that accounting should focus on material facts. If the item is likely to influence the decision of a reasonably prudent investor or creditor, it should be regarded as material, and shown in the financial statements.
15. Objectivity : According to this concept, accounting transactions should be recorded in the manner so that it is free from the bias of accountants and others.
16. Systems of Accounting : There are two systems of recording business transactions, viz. double entry system and single entry system. Under double entry system every transaction has two-fold effects where as single entry system is known as incomplete records.
17. Basis of Accounting : The two broad approach of accounting are cash basisand accrual basis. Under cash basis transactions are recorded only whencash are received or paid. Whereas under accrual basis, revenues or costsare recognises when they occur rather than when they are paid.
18. Accounting Standards : Accounting standards are written statements of uniform accounting rules and guidelines in practice for preparing the uniformand consistent financial statements. These standards cannot over ride theprovisions of applicable laws, customs, usages and business environment inthe country.
Questions for Practice
1. Why is it necessary for accountants to assume that business entity will remain a going concern?
2. When should revenue be recognised? Are there exceptions to the general rule?
3. What is the basic accounting equation?
4. The realisation concept determines when goods sent on credit to customersare to be included in the sales figure for the purpose of computing the profitor loss for the accounting period. Which of the following tends to be used inpractice to determine when to include a transaction in the sales figure forthe period. When the goods have been:
d. paid for
Give reasons for your answer.
5. Complete the following work sheet:
(i) If a firm believes that some of its debtors may ‘default’, it should act onthis by making sure that all possible losses are recorded in the books.This is an example of the ___________ concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the ___________ concept.
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the ___________ concept.
(iv) The ___________ concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.
(v) A firm may hold stock which is heavily in demand. Consequently, the market value of this stock may be increased. Normal accounting procedure is to ignore this because of the ___________.
(vi) If a firm receives an order for goods, it would not be included in thesales figure owing to the ___________.
(vii) The management of a firm is remarkably incompetent, but the firmsaccountants can not take this into account while preparing book ofaccounts because of ___________ concept.
1. ‘The accounting concepts and accounting standards are generally referredto as the essence of financial accounting’. Comment.
2. Why is it important to adopt a consistent basis for the preparation of financialstatements? Explain.
3. Discuss the concept-based on the premise ‘do not anticipate profits butprovide for all losses’.
4. What is matching concept? Why should a business concern follow thisconcept? Discuss.
5. What is the money measurement concept? Which one factor can make itdifficult to compare the monetary values of one year with the monetary valuesof another year?
Ruchica’s father is the sole proprietor of ‘Friends Gifts’, a firm engaged in the saleof gift items. In the process of preparing financial statements, the accountant ofthe firm Mr. Goyal fell ill and had to proceed on leave. Ruchica’s father was urgentlyin need of the statements as these had to be submitted to the bank, in pursuanceof a loan of Rs. 5 lakh applied for the expansion of the business of the firm.Ruchica who is studying Accounting in her school, volunteered to complete thework. On scrutinising the accounts, the banker found that the value of buildingbought a few years back for Rs. 7 lakh has been shown in the books at Rs. 20lakh, which is its present market value. Similarly, as compared to the last year,the method of valuation of stock was changed, resulting in value of goods to beabout 15 per cent higher. Also, the whole amount of Rs. 70,000 spent on purchaseof personal computer (expected life 5 years) during the year had been charged tothe profits of the current year. The banker did not rely on the financial dataprovided by Ruchica. Advise Ruchica for the mistakes committed by her in thepreparation of financial statements in the context of basic concepts in accounting.
A customer has filed a suit against a trader who has supplied poor quality goodsto him. It is known that the court judgment will be in favour of the customer andthe trader will be required to pay the damages. However, the amount of legal damages is not known with certainity. The accounting year has already been ended and the books are now finalised to ascertain true profit or loss. The accountant of the trader has advised him not to consider the expected loss on account of payment of legal damages because the amount is not certain and the final judgment of the court is not yet out. Do you think the accountant is right in his approach.
Checklist to Test Your Understanding
Test Your Understanding – I
1. (c) 2. (d) 3. (a) 4. (b)
Test Your Understanding – II
3. Revenue Realisation
Accounting Standards (AS)
The ICAI has issued the following standards:
AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring after the Balance Sheet Date
AS 5 Net Profit or Loss for the Period, Prior Period items and Changes inAccounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts
AS 8 Accounting for Research and Development
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Accounting for Retirement Benefits in the Financial Statements of Employers (recently revised and titled as ‘Employee Benefits’)
AS 16 Borrowing Costs
AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income
AS 23 Accounting for Investments in associates in Consolidated FinancialStatements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Join Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent Liabilities and Contingent Assets
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