3 Accounting Concepts & Standard 23.10.08

The rules and conventions of accounting are commonly referred to as the conceptual framework of accounting. As with any discipline or body of knowledge, some underlying theoretical structure is required if a logical and useful set of practices and procedures are to be developed for reaching the goals of the profession and for expanding knowledge in that field. Such a body of principles is needed to help answer new questions that arise. Accounting theory may be defined as logical reasoning in the form of a set of broad principles that • • •

Provide a general frame of reference by which accounting practice can be evaluated. Guide the development of new practices & procedures. Provide a coherent set of logical principles that form the general frame of reference for the evaluation and development of sound accounting practices.

Q. What do you mean by basic accounting concepts? Accounting has come to present status after a period of several hundred years. During this period certain accounting assumptions, concepts and conventions have emerged. Accountants universally in the recording, classification, summarization and reporting of the transactions follow these. Accounting assumptions, concepts and conventions are called Generally Accepted Accounting Principles (GAAP) since they have been commonly accepted by professional accounting world as general guidelines for preparing financial statements and reports. Thus accounting principles are rules of action adopted by accountants. Accounting principles are man-made. Unlike the principles of physical and natural sciences, accounting principles are not eternal truths. They have been evolved over the years keeping in view their relevance, objectivity and feasibility. Accounting Standard Board (ASB) of the Institute of Chartered Accountants of India makes accounting rules in India. Knowledge of accounting concepts facilitates the learning of accounting, the

language of business, by users of accounting information. The users of accounting information include shareholders, investors, lenders, suppliers of goods and services (creditors), customers, employees, government and its agencies and public at large. Q. List the basic accounting concepts. The Institute of Chartered Accountants of India in its Accounting Standard-I (AS-I) has stated that going concern, accrual and consistency are fundamental accounting assumptions. For the sake of convenience all accounting concepts are discussed under two headings: • •

Basic accounting concepts Accounting concepts related to income measurement

Basic Accounting Concepts are: • • • • • • • •

Entity Concept Money Measurement Concept Going Concern Concept Cost Concept Dual Aspect Concept Full Disclosure Concept Objectivity Concept Accrual Concept

Accounting concepts related to income measurement are: • • • • • •

The The The The The The

Time Period Concept (Periodicity Concept) Revenue Recognition (Realisation) Concept Matching Concept Materiality Concept Consistency Concept Conservatism (Prudence) Concept

Q. Explain the following Basic accounting concepts:

• • • • • • • •

Entity Concept Money Measurement Concept Going Concern Concept Cost Concept Dual Aspect Concept Full Disclosure Concept Objectivity Concept Accrual Concept

Entity Concept In accounting, the entity of business is considered separate from the existence of its owners. Accounts are kept for the entity as distinct from owners. Thus, money invested by the proprietor by way of capital is considered to be the liability of the business to the proprietor. If proprietor withdraws some cash or goods, they are treated as drawings but not as business expense. Capital is reduced by the amount of drawings. The principle of separate entity is quite visible in the case of corporate bodies since a company is a legal entity separate from the shareholders who own it. In case of a corporate body the liability of the shareholders is limited to the extent of the value of shares held by them. But in case of non-corporate bodies the owners or partners remain legally liable for the debts of the business even after its closure. Their private property can be sold to discharge the liability of the firm. Money Measurement Concept In accounting, a record is made only of those facts or transactions that can be expressed in monetary terms. It provides a common yardstick, i.e., money for measuring, recording and summarizing the transaction. Events, which cannot be expressed in money terms, do not find a place in account books. For example, salary paid to manager is recorded in account books but his competence, which cannot be expressed in monetary terms, is not recorded in the books. The application of

money measurement concept makes accounting data and information relevant, simple, understandable, homogeneous and comparable. The main advantage of money measurement concept is that even a layman is able to understand and appreciate the things stated in terms of money. However, the concept suffers from the following flaws: a. Money does not have a constant value. The value of money changes because of inflation or deflation in the country. All business assets cannot be measured in money terms. It is very difficult to calculate the value of goodwill or measure the competency or morale of employees. Going Concern Concept This concept assumes that the business will exist for certain foreseeable future with the specified goal or for specified duration. Thus recording and valuation of long-term assets and liabilities are based on this assumption. Fixed assets are recorded on historical costs and written down over the expected life of the assets. Similarly long-term liabilities, i.e., debentures, preference shares, long-term loans are raised and their terms of repayment are settled on this assumption. The going concern concept is the backbone of accounting and is based on the following assumptions: • • •

Business has an indefinite life. Assets are depreciated on the basis of their expected life without caring for their current values. In case of innovations or new inventions, their effect is measured in financial terms and assets are depreciated to allow for such innovations or inventions.

However, if it is certain that a particular venture will exist only for a limited period, the accounting records will be kept accordingly. Further, if in the long run a business decides to revalue the assets and transfer the surplus or deficit to capital reserve, it will not be

taken as violation of the going concern concept. Here revaluation is on a permanent basis to reflect current values of assets. Accounting Standard (AS)-l states "the enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of operations." Continuity of activity is to be true of all types of business enterprises. The assumption does not imply the permanent existence of an enterprise. It simply assumes stability and continuity for a period of time long enough to carry out present plans, contracts and commitments. Cost Concept According to this concept, all transactions and events are recorded in the book" of account at the actual price involved. This price is called cost. All assets are carried in the books of accounts from year to year at their acquisition cost (also called historical cost) irrespective of any change in their market value. Acquisition cost is considered highly objective, reliable, definite and free from bias. Thus when a machine is purchased for Rs. 5 lakhs, transportation expenses are Rs. 20,000, installation expenses are Rs. 10,000, the machine is valued at Rs. 5,30,000. This is the historical cost of machine. However, the cost concept creates difficulties in its application in the following situations: (a) When due to price rise, the prices of all commodities go up substantially, the financial position of a firm depicted on cost concept basis does not reflect true picture. (b) Financial statements of two or more firms set up at different points of time prepared on historical cost basis are not comparable due to changes in prices. (c) Depreciation is computed on historical cost. This understates depreciation when current value of an asset is very high. So it becomes necessary to revalue the assets. (d) This concept implies recording of all assets for which costs have been incurred but the assets like managerial competence,

reputation or goodwill of the firm acquired over a period of time are not recorded. (e) The exception to this concept of valuing assets at cost irrespective of its market value is the valuation of inventories. According to AS-2, inventories should be valued at cost or market price whichever is lower. In spite of the limitations, cost concept is still considered highly objective and free from bias. Dual Aspect Concept Every transaction entered into by a firm has two aspects, viz., debit and credit. Debit represents creation of or addition to an asset or an expense or the reduction or elimination of a liability. Credit means reduction or elimination of an asset or an expense or the creation of or addition of a liability. Therefore, according to dual aspect concept, at any time, the total assets of a business are equal to its total liabilities. In the equation form: Assets = Capital + Liabilities Assets denote the resources owned by a business while the term liability refers to external claim. And capital is the claim of the owners against the assets of the business. The system of accounting, which records both the aspects of a transaction ever, is based on Double Entry System of bookkeeping. Full Disclosure Concept Accounting records are meant for the use of owners, investors, lenders, creditors, bankers, employees and Government for various purposes. They must be prepared honestly and all material information should be disclosed for the benefit of its users. An attempt should be made to make the information revealed more meaningful to all those who are entitled to receive it. In case of a holding company, accounts of subsidiary companies should be attached with those of the holding company. Sufficient annexures should follow the income statement and the

balance sheet to make the full disclosure. The Companies Act 1956 has taken sufficient precautions in this regard. This is in keeping with the latest trend of financial statements as a means of conveying and not concealing information. The Accounting Standard-l (AS-I) issued by the Institute of Chartered Accountants of India mentions about 'Disclosure of Accounting Policies' in paragraph 24-27 as follows: 24. All significant accounting policies adopted in the preparation and presentation of financial statements should be disclosed. 25. The disclosure of the significant accounting policies as such should form part of the financial statements and the significant accounting policies should normally be disclosed at one place. 26. Any change in the accounting policies which has a material effect in the current period which is reasonably expected to have a material effect in later period should be disclosed. In the case of a change in accounting policies which has a material effect in the current period, the amount by which any item in the financial statements is affected by each change should also be disclosed to the extent ascertainable. Where such account is not ascertainable, wholly or in part, the fact should be indicated. 27. If the fundamental accounting assumptions, viz., going concern, consistency and accrual, are followed in financial statements, specific disclosure is not required. If a fundamental accounting assumption is not followed, the fact should be disclosed. Objectivity Concept This concept implies that all accounting records should be supported by proper documents, e.g., invoices, cash memos, correspondence, agreements etc. These documents supply the information on the basis of which entries are made in the books of account. The accounting entries are based on objectively verifiable evidence. Accrual Concept

This assumption is core of mercantile system of accounting. According to this concept revenue and costs are recognized as they are earned or incurred (and not as money is received or paid), The accrual concept result in the recognition and recording of revenue transaction when the right to receive revenue arises which can be in cash or in kind, e.g., the credit sales of Rs. 50,000 will be included in the sales but goods sent on approval for sale will not be treated as sales, because of the uncertainty involved in the transaction. Similarly, while ascertaining the profit or loss, not only those expenses, which have been paid in cash, should be considered, but also expenses that have accrued but not paid should be taken into account. The application of accrual concept helps in depiction of time financial position of the enterprise as the costs and revenue is recognized when they are incurred. Q. Discuss the importance of setting accounting standards. The information revealed by the published financial statements is of considerable importance to shareholders, creditors, and other interested parties. Hence, it is the responsibility of the accounting profession to ensure that the required information is properly presented. Therefore it is necessary that certain standards should be followed for drawing up the financial statements so that there is the minimum possible ambiguity and uncertainty about the information contained in them. The International Accounting Standards Committee (IASC) has undertaken this task of drawing up the standards (i) The Growth in International Investment: Investors in international capital markets make decision based on published accounting which are based on accounting policies and which again vary from country to country The International Accounting Statements will help investors to make more efficient decisions. (ii) The Increasing Prominence of Multinational Enterprises: Such enterprises render accounts for the countries

in which their shareholders reside and in local country in which they operate. Accounting standards will help to avoid confusion (iii) The Growth in the Number of Accounting Standard Setting Bodies: It is hoped that the IASC can harmonies these separate rule making efforts. The objective of the IASC is to formulate and publish in the public interest standards to be observed in the presentation of audited financial statements and to promote their world-wide acceptance and observance. Following is the importance of accounting standards: •

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Standards reduce or eliminate all together confusing variations in the accounting treatment used to prepare financial statements. With different companies following same standards, comparison of their financial policies and financial results becomes easier. Accounting standards take care of valuing inventories, contingencies, construction contracts, fixed costs, etc. They cover all aspects of financial activities of company. The standards help the investors for taking decision on investment. Setting standards is useful to both the company & and the investor.