Financial and Management Accounting

Unit 2

Unit 2

Accounting Concepts, Principles, Bases and Policies

Structure 2.1 2.2 2.3 Introductions Objectives Accounting concepts, principles, bases and policies meaning Self Assessment Questions 1 Types of accounting concepts Self Assessment Questions 2 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 2.4 Business entity concept Self Assessment Questions 3 Going concern concept Self Assessment Questions 4 Money measurement concept Self Assessment Questions 5 Periodicity concept Self Assessment Questions 6 Accrual concept Self Assessment Questions 7 Basic Principles Self Assessment Questions 8 2.4.1 2.4.2 2.4.3 2.4.4 2.4.5 2.4.6 Principle of Income recognition Self Assessment Questions 9 Principle of expense Self Assessment Questions 10 Principle of matching cost and revenue Self Assessment Questions 11 Principle of Historical cost Self Assessment Questions 12 Principle of full disclosure Self Assessment Questions 13 Double aspect principle Self Assessment Questions 14
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2.4.7

Modifying Principle Self Assessment Questions 15

2.4.8 2.4.9

Principle of materiality Self Assessment Questions 16 Principle of consistency Self Assessment Questions 17

2.4.10 Principle of conservatism or prudence Self Assessment Questions 18 Terminal Questions Answer to SAQs and TQs

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

2.2 Accounting concepts, principles, bases and policies

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

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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, 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 ________. 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?

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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 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. 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
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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. 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

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should 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. 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.

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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 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?

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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 . 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. 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

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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? 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

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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. 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 tax purposes, the amount can be rounded off to the nearest ten. And fraction does not matter. When we send statement to a

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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 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?

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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 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.

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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. 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

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Self Assessment Questions 11: 1. True 2. Profit or loss 3. True 4. Added, Deducted 5. Added, Deducted 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

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Self Assessment Questions 17: 1. Comparison 2. True 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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