Accounting Principal
Accounting Principal are the rules adopted by accountants universally while recording accounting transaction. They are the norms or rules which are followed in accounting of various items of assets, liabilities, expenses, income, etc. for example, Inventory (stock) is valued at lower of its cost or net realisable value. Fixed assets should be depreciated over their expected useful life.
According to American Institute of Certified Public Accountants
“Principles of Accounting are the general law or rule adopted or proposed as a guide to action, a settled ground or basis of conduct or practice”.
Basic Accounting Concepts
- Business Entity Concept – According to the Business Entity Principle, business is considered to be separate from its owners. Business transactions are recorded in the books of account from the business point of view and not from that of the owners. Owners being regarded as separate from business are considered as creditors of the business to the extent of their capital. Business entity principle is applicable to all forms of business organisations, whether they are sole proprietorship, partnership or companies.
- Going Concern Concept – The Concept of going assumes that a business firm would continue carry out its operations indefinitely, i.e. for a fairly long period of time and would not be liquidated in the foreseeable future. This is an important assumption of accounting as it provides the very basis for showing the value of assets in the balance sheet.
- Money Measurement – According to the money Measurement Principle, transactions and events that can be measured in money terms are recorded in the book of account of the enterprise. Money is the common denominator in recording and reporting transactions.
- Accounting Period – According to the Accounting Period Principle, life of an enterprise is broken into smaller periods so that its performance is measured at regular intervals. The accounts of an enterprise are maintained following the Going Concern concepts, meaning the enterprise shall continue its activities for a foreseeable future.
- Full Disclosure– According to the principle of Full Disclosure, “There should be complete and understandable reporting on the financial statement of all significant information relating to the economic affairs of the entity.” Apart from legal requirements, good accounting practice requires all material and significant information to be disclosed. Disclosure of material information will result in better understanding. For example, the reasons for law turnover should be disclosed.
- Consistency Concept – the accounting information provided by the financial statements would be useful in drawing conclusions regarding the working of an enterprise only when it allows comparisons over a period of time as well as with the working of other enterprises. Thus, both inter-firm and inter-period comparisons are required to be made. This can be possible only when accounting policies and practices followed by enterprises are uniform and are consistent over the period of time.
- Materiality – Materiality Principle refers to relative importance of an item or an event. Means that it is a matter of exercising judgement to decide which item is material and which is not. And only those items should be disclosed that have significant effect or are relevant to the user. An item may be material for one enterprise but may not be material for another. For example, amount spent on repairs of building, say 2, 5000, is material for an enterprise having a turnover of say 10, 00,000 but it is not material for an enterprise having a turnover of say 15,00,00,000.
- Prudence or Conservatism – It takes into consideration all prospective losses but not the prospective profits. The application of this concept ensures that the financial statements do not paint a better picture than what it actually is. For example, closing stock is valued at lower of cost or market value or making the provision for doubtful debts and discount on debtors in anticipation of bad debts and discount. Prudence or Conservatism Principle prescribes that anticipated expenses and losses should be accounted.
- Cost– According to the cost concept, an asset is recorded in the books of account at the price paid to acquire it and the cost is the basis for all subsequent accounting of the asset. Assets is recorded at cost at the time of its purchase but is systematically reduce be charging depreciation. For example, an asset is purchased for 5, 00,000 and if at the time of preparing the final accounts, even if its market value is say 4, 00,000 or 7, 00,000, yet the asset shall continue to be shown at its purchase price of 5, 00,000.
- Matching– An important objective of business is to determine profit periodically. It is necessary to match ‘revenues’ of the period with the ‘expenses’ of that period to determine correct profit (or loss) for the accounting period. Profit earned by the business during a period can be correctly measured only when the revenue earned during the period is matched with the expenditure incurred to earn that revenue.
- Dual Aspect or Duality – According to the Dual Aspect Concept, every transaction entered into by an enterprise has two aspects, a debit and a credit of equal amount. Simply stated, for every debit there is a credit of equal amount in one or more accounts. It is also true vice versa. For example, Nitin starts a business with a capital of 1, 00,000. There are two aspects to the transaction. On one hand, the business has an asset of 1, 00,000 (cash) while on other hand; it has a liability towards Nitin of 1, 00,000 (capital of Nitin).
- Revenue Recognition (Realisation) Concept – According to the Revenue Recognition Concept, revenue is considered to have been realised when a transaction has been entered into and the obligation to receive the amount is established. It is to be noted that recognising revenue and receipt of an amount are two separate aspects.
- Objective Concept – The Verifiable Objective Concept holds that accounting should be free from personal bias. Measurements that are based on verifiable evidences are regarded as objective. It means all accounting transactions should be evidenced and supported by business documents. These supporting documents are cash memo, invoices, sales bills, etc.
Systems of Accounting
The systems of recording transactions in the book of accounts are generally classified into two types, viz. Double entry system and Single entry system. Double entry system is based on the principle of “Dual Aspect” which states that every transaction has two effects, viz. receiving of a benefit and giving of a benefit.
Double Entry:- Double entry system is a complete system as both the aspects of a transaction are 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 by checked by preparing the trial balance. The system of double entry can be implemented by big as well as small organisations.
Single entry:- Single entry system is not a complete system of maintaining records of financial transactions. It does not record two-fold effect of each and every transaction. Instead of maintaining all the accounts, only personal accounts and cash book are maintained under this system.
Basis of Accounting
From the point of view the timing or recognition of revenue and costs, there can be two broad approaches to accounting. These are:
- Cash basis; and
- Accrual basis.
Under the cash basis, entries in the book of accounts are made when cash is received or paid and not when the receipt or payment becomes due. Let us say for example, if office rent for the month of December 2014, is paid in January 2015, it would be recorded in the book of account only in January 2015.
Accounting Standards
Accounting Standards are a set of guidelines, i.e., generally accepted Accounting Principles, that are followed for preparation and presentation of Financial Statements. They are accounting rules and procedures relating to measurement, recognition, Treatment, presentation and disclosure of accounting transactions in the financial statements issued by the council of the Institute of Chartered Accountants of India.
Need for Accounting Standards
Accounting extends information to various users of information. Accounting information can serve the interest of different users only if it possesses uniformity and full disclosure of relevant information. There can be alternate accounting treatment and valuation norms which may be used by any business entity. Accounting standard facilitate the scope of those alternatives which fulfil the basic qualitative characteristics of true and fair financial statement.
Benefits of Accounting Standards
- Accounting standard helps in eliminating variations in accounting treatment to prepare financial statements.
- Accounting standard may call for disclosures of certain information which may not be required by law, but such information might be useful for general public, investors and creditors.
- Accounting standard facilitate comparability between financial statements of inter and intra companies.
Limitations of Accounting Standards
- Accounting standard makes choice between different alternate accounting treatments difficult to apply.
- It is rigidly followed and fails to extend flexibility in applying accounting standards.
- Accounting standard cannot override the statue. The standards are required to be farmed within the ambit of prevailing status.
Goods and Services Tax
(One County One Tax)
GST is a destination based tax on consumption of goods and services. It is proposed to be levied at all stages right form manufacture up to final consumption with credit of taxes paid at previous stages available as setoff. In a nutshell, only value addition will be taxed and burden of tax is to be borne by the final consumer. The concept of destination based tax on consumption implies has the tax would accrue to the taxing authority which has jurisdiction over the place of consumption which is also termed as place of supply.
GST has a dual aspect with the Centre and States simultaneously levying on a common tax base. There are three main components of GST which are CGST, SGST and IGST.
CGST means Central goods and Services Tax. Taxes collected under CGST will constitute the revenues of the Central Government.
SGST means State Good and Services Tax. A collection of SGST is the revenue of the State government. With GST all state taxes like VAT , entertainment tax, luxury tax entry tax etc. will be merged with GST.
IGST means integrated Goods and Services Tax. Revenue collected under IGST is divided between Central and State Government as per the rates specified by the government. IGST is charged on transfer of goods and services from one state to another. Import of goods and services are also covered under IGST.
Characteristics of Goods and Services Tax
- GST is a common law and procedure throughout the country under single administration.
- GST is a destination based tax and levied at a single point at the time of consumption of goods and services by the end consumer.
- GST is a comprehensive levy and collection on both goods and services at the same rate with benefit of input tax credit or subtraction of value.
- Minimum number of rates or tax does not exceed two.
- There is no scope for levy of cess, resale tax, additional tax, turnover tax etc.
- There is no multiple levy of tax on goods and services, such as sales tax, entry tax, octroi, entertainment tax or luxury tax etc.
Advantages
- Introduction of GST has resulted in the abolition of multiple types of taxes in goods and services.
- GST widens the tax base and increased revenue to Centre and State thereby reducing administrative cost for the Government.
- GST has reduced compliance cost and increases voluntary compliance.
- GST has affected rates of tax to the maximum of two floor rates.
- GST has removed the cascading effect on taxation.
- GST would help to extend competitive edge in international market for goods and services produced in the country leading to increased exports.
Short Answers
- Why is necessary for accountants to assume that business entity will remain a going concern?
Answer:- Going Concern Concept assumes that the business entity will continue its operation for an indefinite period of time. It is necessary to assume so, as it helps to bifurcate revenue expenditure (i.e. expenditure related to current year), and capital expenditure (i.e. expenditure whose benefits accrue over a period of time). For example, a machinery that costs Rs 1,00,000, having an expected life of 10 years, will be treated as a capital expenditure, as its benefit can be availed for more than one year; whereas, the per year depreciation of the machinery, say Rs.10,000, will be regarded as a revenue expenditure.
2. When should revenue be recognized? Are there exceptions to the general rule?
Answer:- Revenue should be recognised when sales take place either in cash or credit and/or right to receive income from any source is established. Revenue is not recognised, in case, if the income or payment is received in advance or the payment is actually received from the debtors. In a nutshell, revenue will be recognised when the right to receive income is established. For example, Mr. A sold goods in January and received payment in February; then revenue is considered to be recognised in the month of January and not in February. However, if Mr A received cash in advance, i.e. in December and goods are sold in January, then the revenue is recognised in January and not in December.
The exceptions to this rule are given below.
1) Hire purchase– When goods are sold on hire-purchase system, the amount received in instalments is treated as revenue.
2) Long term construction contract– The long term projects like construction of dams, highways, etc. have long gestation period. Income is recognised on proportionate basis of work certified and not on the completion of contract.
3. What is the basic accounting equation?
Answer:-
The basic accounting equation is,
Assets = Liabilities + Capital
It means that all the monetary value of assets of a firm are equal to the total claims, viz. owners and outsiders.
4. The realisation concept determines when goods sent on credit to customers are to be included in the sales figure for the purpose of computing the profit or loss for the accounting period. This of the following tends to be used in practice to determine when to include a transaction in the sales figure for the period. When the goods have been:
- Dispatched b) invoiced c) delivered d) paid for
Give reasons for your answer.
Answer:- According to the realisation concept, revenue is recognised when an obligation to receive the amount arises. When the goods are invoiced, it is treated as the transfer of ownership of goods from the seller to the buyer and hence the revenue is recognised.
5. Complete the following worksheet:
i. If a firm believes that some of its debtors may ‘default’, it should act on this 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 the sales figure owing to the ——.
vii. The management of a firm is remarkably incompetent, but the firms accountants cannot take this into account while preparing book of accounts because of ——- concept.
Answer:-
i) If a firm believes that some of its debtors may ”²default”², it should act on this by making sure that all possible losses are recorded in the books. This is an example of the conservatism concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the business entity concept.
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the dual aspect concept.
(iv) The consistency 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 conservatism.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the revenue recognition.
(vii) The management of a firm is remarkably incompetent, but the firm’s accountants cannot take this into account while preparing book of accounts because of money measurement concept.
Long Answers
- “The accounting concepts and accounting standards are generally referred to as the essence of financial accounting’. Comment.
Answer:- Financial accounting is concerned with the preparation of the financial statements and provides financial information to various accounting users. It is performed according to the basic accounting concepts like Business Entity, Money Measurement, Consistency, Conservatism, etc. These concepts allow various alternatives to treat the same transaction. For example, there are a number of methods available for calculating stock and depreciation, which can be followed by various firms. This leads to wrong interpretation of financial results by external users due to the problem of inconsistency and incomparability of financial results among different business entities. In order to mitigate inconsistency and incomparability and to bring uniformity in preparation of the financial statements, accounting standards are being issued in India by the Institute of Chartered Accountant of India. Accounting standards help in removing ambiguities and inconsistencies. Hence, accounting standards and accounting concepts are referred as the essence of financial accounting.
2. Why is it important to adopt a consistent basis for the preparation of financial statements? Explain.
Answer:-
Financial statements are drawn to provide information about growth or decline of business activities over a period of time or comparison of the results, i.e. intra-firm (comparison within the same organisation) or inter-firm comparisons (comparison between different firms). Comparisons can be performed only when the accounting policies are uniform and consistent.
According to the Consistency Principle, accounting practices once selected should be continued over a period of time (i.e. years after years) and should not be changed very frequently. These help in a better understanding of the financial statements and thus make comparisons easy. For example, if a firm is following FIFO method for recording stock, and switches over to the weighted average method, then the results of this year cannot be compared to that of the previous years. Although consistency does not prevent change in the accounting policies, but if change in the policies is essential for better presentation and better understanding of the financial results, then the firm must undertake change in its accounting policies and must fully disclose all the relevant information, reasons and effects of those changes in the financial statements.
3. Discuss the concept-based on the premise ‘do not anticipate profits but provide for all losses’.
Answer:- According to the Conservatism Principle, profits should not be anticipated; however, all losses should be accounted (irrespective whether they occurred or not). It states that profits should not be recorded until they get recognised; however, all possible losses even though they may happen rarely, should be provided. For example, stock is valued at cost or market price, whichever is lower. If the market price is lower than the cost price, loss should be accounted; whereas, if the former is more than the latter, then this profit should not be recorded until unless the stock is sold. There are numerous provisions that are maintained based on the conservatism principle like, provision for discount to debtors, provision for doubtful bad debts, etc. This principle is based on the common sense and depicts pessimism. This also helps the business to deal uncertainty and unforeseen conditions.
4. What is matching concept? Why should a business concern follow this concept? Discuss.
Answer:- Matching Concept states that all expenses incurred during the year, whether paid or not, and all revenues earned during the year, whether received or not, should be taken into account while determining the profit of that year. In other words, expenses incurred in a period should be set off against its revenues earned in the same accounting period for ascertaining profit or loss. For example, insurance premium paid for a year is Rs1200 on July 01 and if accounts are closed on March 31, every year, then the insurance premium of the current year will be ascertained for nine months (i.e. from July to March) and will be calculated as,
Rs.1200–Rs.900=Rs.300
Thus, according to the matching concept, the expense of Rs.900 will be taken into account and not Rs.1200 for determining profit, as the benefit of only Rs.900 is availed in the current accounting period.
The business entities follow this concept mainly to ascertain the true profit or loss during an accounting period. It is possible that in the same accounting period, the business may either pay or receive payments that may or may not belong to the same accounting period. This leads to either overcasting or under casting of the profit or loss, which may not reveal the true efficiency of the business and its activities in the concerned accounting period. Similarly, there may be various expenditures like, purchase of machinery, buildings, etc. These expenditures are capital in nature and their benefits can be availed over a period of time. In such cases, only the depreciation of such assets is treated as an expense and should be taken into account for calculating profit or loss of the concerned year. Thus, it is very necessary for any business entity to follow the matching concept.
5. What is the money measurement concept? Which one factor can make it difficult to compare the monetary values of one year with the monetary values of another year?
Answer:- Money Measurement Concept states that only those events that can be expressed in monetary terms are recorded in the books of accounts. For example, 12 television sets of Rs10,000 each are purchased and this event is recorded in the books with a total amount of Rs.1,20,000. Money acts a common denomination for all the transactions and helps in expressing different measurement units into a common unit, for example rupees. Thus, money measurement concept enables consistency in maintaining accounting records. But on the other hand, the adherence to the money measurement concept makes it difficult to compare the monetary values of one period with that of another. It is because of the fact that the money measurement concept ignores the changes in the purchasing power of the money, i.e. only the nominal value of money is concerned with and not the real value. What Rs.1 could buy 10 years back cannot buy today; hence, the nominal value of money makes comparison difficult. In fact, the real value of money would be a more appropriate measure as it considers the price level (inflation), which depicts the changes in profits, expenses, incomes, assets and liabilities of the business.