Financial and Management Accounting Unit 2

Unit 2 Accounting Concepts, Principles,

Bases and Policies
Structure:
2.1 Introduction
2.2 Accounting concepts, principles, bases and policies – meaning
2.3 Types of accounting concepts
2.3.1 Business Separate entity concept
2.3.2 Going concern concept
2.3.3 Money measurement concept
2.3.4 Periodicity concept
2.3.5 Accrual concept
2.4 Basic Principles
2.4.1 Principle of Income recognition
2.4.2 Principle of expense
2.4.3 Principle of matching cost and revenue
2.4.4 Principle of Historical costs
2.4.5 Principle of full disclosure
2.4.6 Double aspect principle
2.4.7 Modifying Principle
2.4.8 Principle of materiality
2.4.9 Principle of consistency
2.4.10 Principle of conservatism or prudence
Short Answer Questions

2.1 Introduction
Any subject for that matter, is based on certain postulates, concepts and
policies. Before understanding the subject, one has to go through the basic
assumptions on which the subject is built upon. Accounting is a reflection of
all business transactions expressed in terms of money relating to a definite
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period of time and the object of accounting being finding out profit or loss
arising out of transactions and finally to judge the financial position of the
business organization. In this Unit, the concepts, the basic principles and
policies of accounting are briefly described.

Learning Objectives:
After reading this unit, you should be able to understand the following:
1. To know the meaning of concepts, principles and policies basing on
which Accounting science has emerged.
2. To expose the students to different concepts of accounting.
3. To have an insight into the basic principles of accounting.

2.2 Accounting concepts, principles, bases and policies-meaning

As we have understood in the Unit 1, accounting is the language of
business and it is concerned with measurement of financial performance of
a business by recording, analyzing and reporting the business results for the
sake of stakeholders. Since all stakeholders should understand the
accounting language in the same sense, certain principles, concepts and
policies of accounting have been laid down. Principles are basically the
rules of action adopted by the accountants universally while recording
accounting transactions. The principles are doctrines associated with theory
and procedures and current practices of accounting. These principles may
be classified as concepts and conventions. While concepts are in the form
of assumptions or conditions, conventions are those customs and traditions
which guide the accountants while preparing accounting statements. For
instance business is started with an assumption that it shall be continued for
a long period of time and no body promotes a business organization to close
it down within a short period. Basing on this assumption, business man
purchases fixed assets, uses them and values them from time to time. This
is a strong assumption that any businessman approaches with. Such
assumption is called a concept. To give an example for convention,

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inventory (stock) in a business is valued at the end of an accounting period,

at cost or market price which ever is lower. This is an accepted convention
or a practice or a principle in accounting. On the other hand, an accounting
policy is one which is adopted by management, relevant to the situations.
For example, every asset should be depreciated (this is a concept) at the
end of an accounting period. The practice is to adopt fixed installment or
diminishing balance method or any other method of depreciation.(this is a
convention). The policy of the management may be to adhere to fixed
installment method of depreciation and it is their choice. Therefore no
management can exercise discretion regarding fundamental presumptions
of accounting. But every management has a choice of making an
accounting policy.

It is not out of place to mention that in order to bring uniformity in

terminology, accounting concepts, conventions, and assumptions, the
Institute of Chartered Accountants of India (ICAI) established Accounting
Standards Board (ASB) in 1977. The principal objective of ASB is to
formulate accounting standards so that such standards will be established
by the council of ICAI. While formulating the accounting standards, ASB will
give due consideration to the International Accounting Standards and try to
integrate them to the extent possible. It also considers the customs,
practices, laws and usages prevailing in Indian business. There are
altogether 30 accounting standards issued by ASB which have to be
adopted by management of different enterprises to improve the quality of
presentation of financial statements in our country.

Self Assessment Questions 1:

1. Accounting principles are _______ , associated with theory and practice
of accountings.
2. Principles are classified as ________ and ________.

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3. Assets may be depreciated on fixed installment method or reducing

balance method. Is this a concept or convention?
4. A business is started with an assumption of making profit. Is this
assumption, a concept or convention?
5. The purpose of establishing ICAI and ASB is to ________.
6. How many accounting standards are issued by ASB so far?

2.3 Types of Accounting concepts

As said earlier, concepts are the basic assumptions or conditions upon
which the science of accounting is based. There are five basic concepts of
accounting, namely – business entity concept, which is also termed as
separate entity concept, going concern concept, money measurement
concept, periodicity concept and accrual concept. Each concept is
discussed below.

Self Assessment Questions 2:

1. What are the different types of accounting concepts?
2.3.1 Business Separate Entity Concept
The essence of this concept is that business is a separate entity and it is
different from the owner or the proprietor. This is true in the case all forms of
organization. If X starts business, he should not mix up his personal
properties with that of the business. When he invests his funds into the
business, it is regarded as capital to the business and capital is a liability
from the business point of view. If X withdraws any money from the
business, it is deductable from the capital and to that extent the liability of
the business towards the owner is reduced. On the other hand, if the
proprietor withdraws money from the business for business purposes, then it
is treated as expenditure to the business.This legal separation between
business and ownership is kept in mind while recording the transactions in
the books of business.

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Self Assessment Questions 3:

1. Business entity concept is also termed as __________.
2. Business and its owner are _______________ entities .
3. Can personal properties of owner be mixed with the properties of
business properties?
4. Capital brought in by proprietor to the business is _______ to the
business.
5. Profits earned in business form an addition to _____________ of the
owner.

2.3.2 Going concern concept

The fundamental assumption is that the business entity will continue fairly
for a long time to come. There is no reason why an enterprise should be
promoted for a short period only to liquidate the business in the foreseeable
future. This assumption is called “going concern concept”. For this reason
accountants value fixed assets on historical cost method. Had the business
been set up to last for a short period, fixed assets should have been valued
at a market price. Besides, going concern concept provides for amortization
of the cost of fixed assets over the life time of the assets. For example, an
entrepreneur purchases a plant for Rs. One crore and it has a life of 10
years. During this period, he sets aside every year certain funds from the
income of the business so that it would help him for replacement of the
asset at the end of ten years. This process of amortization presupposes
that the enterprise will continue to do business fairly for long time.

Self Assessment Questions 4:

1. Can a company be promoted to last only for a month?
2. A business concern continues to function for ________. This is the
essence of going concern concept.

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3. Do you purchase a building for your business to last for a short period or
long period?
4. What is the underlying intention in making a provision every year when
an asset is purchased?

2.3.3 Money Measurement Concept

All transactions of a business are recorded in terms of money. An event or a
transaction that can not be expressed in money terms, can not find place in
the books of account. The honesty of the employees, dynamism of the
selling agents, promptness and integrity of the cashier, even though
influence the business results, can not be brought to the books of accounts.
Besides it makes no sense if a business has 10 tons of raw material, five
vehicles, one premises and a few items of furniture, unless all these assets
are expressed in terms of some monetary value. If it is said that the value of
these assets is Rs. two crores, it makes a lot of sense. Money is the
common denominator in which the business transactions should be
expressed.

Self Assessment Questions 5:

1. Can honesty of an employee be expressed in terms of money?
2. Transactions should be stated in terms of _______________.
3. We have in a business 5 chairs, one godown, 2 tons of cement. What
does it mean?
4. Money is common _______ in which the business transactions should
be expressed.

2.3.4 Periodicity Concept

The time interval for which accounts are prepared is an important factor,
even though we assume long life for a business. The time interval is usually
one year and this period is called accounting year. Often the accounting
period could be half year or even a quarter. The financial statements should

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be prepared at the end of each accounting period so that income statement

shows profit or loss for the accounting period. So also a balance sheet is
prepared to depict the financial position of the business.

Self Assessment Questions 6:

1. The time interval for which accounts are prepared is called
____________.
2. What is the usual accounting period?
3. The expenses of a business are Rs.500000. Why does this statement
not make any sense?

2.3.5 Accrual Concept

Profit earned or loss suffered for an accounting period is the result of both
cash and credit transactions. It is possible that certain incomes are earned
but not received and similarly expenses incurred but not yet paid during an
accounting period. But it is relevant to consider them while computing the
financial results just because they are related to the specific accounting
period. For example, interest receivable on Fixed deposit for the year ending
31-12-2006 is Rs. 12000 but it is actually credited to the bank account only
in February 2007. For calculating the income from interest, the amount
Rs.12000 is considered even though it is not received before 31-12-2006.
This amount is called accrued interest. Similarly the expenses which are
incurred for the accounting period, might be paid only after the accounting
period. Such accrued expenses are deducted while calculating the profit for
the accounting period. This is the accrual concept.

Self Assessment Questions 7:

1. Interest earned but not received within an accounting period is called
_______.
2. Salary payable for December, 2004 but paid in January, 2005 is known
as _________________ for 2004.

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3. Accrued items should be _________ to compute profit or los for the said
period.
4. Accrual concept considers not only cash transactions but also ______
transactions.

2.4 Basic principles

As stated above basic principles are the rules basing on which accounting
takes place and these rules are universally accepted. There are ten such
basic principles, namely principle of income recognition, principle of
expense, principle of matching cost and revenue, historical cost principle,
principle of full disclosure, double aspect principle, modifying principle,
principle of materiality, principle of consistency and principle of
conservatism. A brief description is in the following paragraphs.

Self Assessment Questions 8:

1. Basic principles of Accountancy are _____________ accepted.
2. How many basic principles of accountancy are there?

2.4.1 Principle of Income Recognition

According to this concept, revenue is considered as being earned on the
date on which it is realized., i.e., the date on which goods and services are
transferred to customers for cash or for promise. It should further be noted
that it is the amount which the customers are expected to pay which shall be
recorded. In effect, only revenue which is actually realized should be taken
to profit and loss account. Unreaslised revenue should not be taken into
consideration for determining the profit. For example, a sale is considered to
be made when the property in goods (ownership) is transferred from the
seller to buyer. Similarly, when a businessman receives an order for the sale
of such products, yet to be manufactured, then revenue is said to have been
generated when the products are ready and physically present in deliverable

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state and payment is received or promised to be received but not when the
order is received.

Self Assessment Questions 9:

1. Income is considered as earned only when it is ____________.
2. Income is realized whether it is actually received in cash or promised to
be received . Is it True or False?
3. Income realized is different from cash received. Is it true or false?
4. A sale is made on credit. Does it constitute income realization?
5. An order is received for sale of goods. Is it realisation of income?
6. An order is received with an advance of Rs.100000 cash. Can this be
called income?

2.4.2 Principle of Expense

Expenses are different from payments. A payment becomes expenditure or
an expense only when such payment is revenue in nature and made for
consideration. Salaries are paid for having received the services of the
employees and so it is an expense. If furniture is bought, it is not
expenditure because it is a capital payment. Therefore all revenue expenses
are transferred to profit and loss account to ascertain profit or loss of the
business undertaking. In other words, there are revenue expenses and
capital expenses. While revenue expenses are charged against profit,
capital expenses are shown in the balance sheet as assets.

Self Assessment Questions 10:

1. A cash payment may be a revenue payment or capital payment. Is it true
or false?
2. A payment which is revenue in nature is expenditure. Is it true or false?
3. Plant is purchased and payment is made. Is it an expenditure or
acquisition of asset?
4. All revenue expenses are charged against ––––––––––––– .

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5. Capital payments resulting in acquisition of assets appear in the balance

sheet. True or False?

2.4.3 Principle of Matching Cost and Revenue

Revenue earned during a period is compared with the expenditure incurred
to earn that income, whether the expenditure is paid during that period or
not. This is matching cost and revenue principle, which is important to find
out the profit earned for that period. Here costs are reported as expenses in
the accounting period in which the revenue associated with those costs is
reported. For example, sales revenue reported in 2005 is Rs 50 lakh. The
expenses to earn this revenue, comprising purchases, wages, salaries,
sales commission and so on amount to Rs. 30 Lakh. It is possible that some
of these costs might be payable actually in 2006. Even then, they are
considered only for the period 2005, when the sales revenue was earned.
Adjustments are made for outstanding and prepaid expenses as well as
outstanding and pre received incomes while preparing the final accounts for
the accounting period.

Self Assessment Questions 11:

1. Matching concept of accounting considers only revenue incomes and
expenses relating to a particular accounting period. True or False?
2. Incomes and expenses for an accounting period are considered to
compute _____ .
3. Expenditure paid or payable and revenue earned whether realised or not
in cash are taken into account to find out profit or loss. True or False?

4. For the actual revenue received, outstanding incomes are ________

and pre-received incomes are_________________ to find out the
revenue income for the given period.

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5. For the actual revenue expenses (costs) paid during the accounting
period, outstanding expenses are _____ and prepaid expenses are
_____ to find out expenses for the accounting period.

2.4.4 Principle of Historical Costs

This is called „cost‟ principle. All assets are recoded at the cost of acquisition
and this cost is the basis for all subsequent accounting for the assets. The
expenses and the goods purchased are all shown at the value at which
they are incurred. The assets are constantly reduced in their value by
charging depreciation against their cost to present their book value in the
balance sheet. For example, land bought for Rs.5,00,000 will be shown at
that price only and market value will not be considered. In financial
statements, historical cost is considered but not market value for the
purpose of consistency. However, on account of inflationary situations, this
cost concept does not portray correct picture of the business and so inflation
accounting has emerged.

Self Assessment Questions 12:

1. All assets are shown at historical cost in balance sheet. True or False?
2. Depreciation is charged against the historical cost of assets. True or
False?
3. Historical cost is the cost at which an asset is actually purchased. True
or False?
4. A machinery is bought for Rs.200000 and its market value is Rs.80000.
Which of these values, do you consider reasonable to mention in the
balance sheet?
5. Inflation accounting has emerged as a result of limitation of historical
cost concept. True or False?

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2.4.5 Principle of Full Disclosure

The business enterprise should disclose relevant information to all the
parties concerned with the organization. It means that any information of
substance or of interest to the average investors will have to be disclosed in
the financial statements. For example, the liabilities of the business should
be stated along with assets. If only assets are exhibited without disclosing
liabilities, it amounts to fraud. The Companies Act, 1956 requires that
income statement and balance sheet of a company must give a fair and true
view of the state of affairs of the company.

Self Assessment Questions 13:

1. The principle of full disclosure implies that information which is of
___________ should be stated in financial statements.
2. The material information that is disclosed should be of great interest to
the average investors. True or False?
3. Non-disclosure of material information amounts to ___________.
4. Disclosing about assets without disclosing about liabilities is against to
the principle of full disclosure. True or False?

2.4.6 Double Aspect Principle

This concept is the most fundamental one for accounting. A business entity
is an independent unit and it receives benefits from some and gives benefits
to some other. Benefit received and benefit given should always match and
balance. For instance capital, say Rs.20000 provided by the proprietor is a
liability to the business and it is used for purchasing goods Rs.10000, kept
in bank account of the business Rs.8000 and the balance held in
cash.Rs.2000. The goods, cash at bank and cash in hand (10000 + 8000 +
2000) are regarded as assets. The total liabilities balance with total of
assets. This is dual aspect of accounting. The established principle of
accounting is that for every debit there is an equivalent credit and this is
called double entry principle of accounting.

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Self Assessment Questions 14:

1. Under dual aspect principle, total benefits received by business should
match with total benefits given. True or False?
2. Total liabilities should be equal to ___________ as per dual aspect
principle.
3. For every debit, there should be an equivalent credit. This is called
_________ of accounting.

2.4.7 Modifying Principle

The modifying principle states that the cost of applying a principle should not
be more than the benefit derived from. If the cost is more than the benefit,
then that principle should be modified. This is called cost-benefit principle.
There should be flexibility in adopting a principle and the advantage out of
the principle should over weigh the cost of implementing the principle.

Self Assessment Questions 15:

1. Modifying principle is also known as _____________.

2. The advantage out of the Principle should over weigh the cost of
implementing the principle itself. True or False?
3. If the establishment of costing department is too high that the cost of the
products produced in the organisation is going to overshoot by50%., far
more than the market price. Is it advisable to have cost-department?

2.4.8 Principle of Materiality

While important details of financial status must be informed to all relevant
parties, insignificant facts, which do not influence any decisions of the
investors or any interested group, need not be communicated. Such less
significant facts are not regarded as material facts. What is material and
what is not material depends upon the nature of information and the party to
whom the information is provided. While income has to be shown for income

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tax purposes, the amount can be rounded off to the nearest ten. And
fraction does not matter. When we send statement to a debtor, all details
have to be presented. The same information about the debtors need not be
given in great detail, while sending the information to the Registrar of
companies.

Self Assessment Questions 16:

1. Principle of materiality states that relevant information should be given
to relevant parties. True or False?
2. Details of debtors should be given to creditors. True or False?
3. What is material information to one party may not be so for another
party. True or False?
4. The method of depreciation adopted should be disclosed to Income Tax
Authorities. True or False?

2.4.9 Principle of Consistency

Consistency is required to help comparison of financial data from one period
to another. Once a method of accounting is adopted, it should not be
changed. For instance, stock is valued under FIFO method in an year and it
should not be valued under LIFO method in another year. If assets are
depreciated under diminishing balance method, it should be continued for
ever. It should not be changed.

Self Assessment Questions 17 :

1. The purpose of principle of consistency is to help for ______ from one
period to another period.
2. Consistency principle helps for proper assessment of profit or loss. True
or False?

2.4.10 Principle of Conservatism or Prudence

Accountant follow the rule “anticipate no profit but provide for all anticipated
losses “Whenever risk is expected, provision should be made. The value of

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investments is normally taken at cost, even if the market value is higher than
the cost. If the market value expected is lower than the cost, then provision
should be made by charging profit and creating investment fluctuation fund.
This is the principle of conservatism and it does not mean that the income or
the value of assets should be intentionally under stated.

Self Assessment Questions 18:

1. Provision should be made whenever _____________ is expected.
2. The underlying spirit of principle of conservatism is __________ .
3. The prices of shares in which the business has invested are going up.
Do you consider advisable to provide any provision for that?

Terminal Questions:
1. What are the basic principles of Accountancy?
2. The salaries paid in 2004 Rs.500000; Salaries outstanding Rs.20000;
Salaries paid in advance for 2005 Rs.30000; What is the actual salary
expenditure for 2004? What is the accounting principle involved in this?
3. What is wrong if assets like buildings are shown at market value in the
balance sheet?
4. A business receives capital of Rs.100000 and a loan is raised for
Rs.50000. This is represented by cash Rs.15000; Machinery Rs.85000;
Furniture Rs.20000 and goods Rs30000. Find the total debits and
credits from business point of view. What principle of accounting is
underlying in this case?

Answer for Self Assessment Questions

Self Assessment Questions 1:
1. Doctrines
2. Concepts, conventions
3. Convention

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4. Concept
5. Bringing uniformity in accounting terminology and principles
6. 30

Self Assessment Questions 2:

1. Business entity concept, Going concept, Money measurement concept,
Periodicity concept, and Accrual concept.

Self Assessment Questions 3:

1. Separate entity concept
2. separate
3. No
4. Liability
5. capital

Self Assessment Questions 4:

1. No
2. Long time
3. Long period
4. To replace it after a certain period.

Self Assessment Questions 5:

1. No
2. Money value
3. It makes no sense unless expressed in terms of money value
4. Denominator

Self Assessment Questions 6:

1. Accounting period
2. Year
3. It is because it does not indicate for what period the expenditure is.

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Self Assessment Questions 7:

1. Accrued interest
2. Accrued salary
3. Added
4. Credit

Self Assessment Questions 8:

1. Universally
2. Ten

Self Assessment Questions 9:

1. Realised
2. True
3. True
4. Yes
5. No
6. No

Self Assessment Questions 10:

1. True
2. True
3. Asset Acquisition
4. Profit
5. True

Self Assessment Questions 11:

1. True
2. Profit or loss
3. True
4. Added, Deducted
5. Added, Deducted

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Self Assessment Questions 12:

1. True
2. True
3. True
4. Rs.200000
5. True

Self Assessment Questions 13:

1. Substance
2. True
3. Fraud
4. True

Self Assessment Questions 14:

1. True
2. b) Total Assets
3. c) Double entry principle

Self Assessment Questions 15:

1. Cost-benefit principle
2. True
3. No

Self Assessment Questions 16:

1. True
2. False
3. True
4. True

Self Assessment Questions 17:

1. Comparison
2. True

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Self Assessment Questions 18:

1. Risk
2. Anticipate no profit but provide for all anticipated losses
3. No.

Answers for Terminal Question:

1. Income recognition, principle of expense, matching of cost and revenue,
historical cost principle, full disclosure principle, double aspect principle,
modifying principle, materiality principle, consistency principle and
conservatism principle.

2. Rs.490000 (500000 + 20000 – 30000); Matching cost and revenue

principle.

3. If assets like building are shown at market value instead of historical

cost in the balance sheet, the profit or loss arising out of such valuation
is against to the principle of income recognition. The profit or loss is said
to arise only when the asset is sold or revalued for a specific purpose.
The day when the assets are valued, the market value may be high and
later the prices may fall. Therefore it is wrong to consider the unrealized
or anticipated profit. Hence the assets should be shown at historical cost
in the balance sheet.

4. Benefits received Rs.150000 (Capital Rs.100000 + Loan Rs.50000);

Benefit given Rs.150000 (Cash Rs.15000 + Machinery Rs.85000 +
Furniture Rs.20000 + Goods Rs.30000). It is as per double aspect
principle.

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