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Chapter - 2 Accounting Concepts and Standards

    1. Chapter Introduction

2. Basic Accounting Concepts

3. Basic Accounting Concepts: Details

4. Accounting Concepts: Income Measurement

5. Accounting Standards

 

 

 

1. Chapter Introduction:

                        In this chapter, we will discuss the rules & conventions of accounting. 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.

 

2. 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.

 

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

 

3. Basic Accounting Concepts: Details

 

 Q. Explain the following Basic accounting concepts:

  • Entity Concept (Dec. 02)
  • Money Measurement Concept
  • Going Concern Concept (June 02, Dec. 01)
  • Cost Concept
  • Dual Aspect Concept
  • Full Disclosure Concept
  • Objectivity Concept
  • Accrual Concept (Dec.00, June 01)

 

Entity Concept (Dec. 02):

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:

  1. Money does not have a constant value. The value of money changes because of inflation or deflation in the country.
  2. 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 (June 02, Dec. 01):

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 (Dec.00, June 01)

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.

 

4. Accounting Concepts: Income Measurement

                            One important objective of accounting is to ascertain the results of operations of an organisation for a period of time. In case of profit oriented organisation, the income statement summarises the results of its operations for a given period of time, generally a year. The going concern concept of accounting assumes that the life of a business is perpetual. Such being the case, owners, management and other interested parties cannot wait indefinitely to know how much income has been earned by the business. They would like to know at least on a periodical basis the results of operations of the business. This brings into play certain concepts, which are related to income measurement. These are discussed below:

 

The Time Period Concept (Periodicity Concept)

This concept indicates that the profitability of a business is to be measured periodically. The period for which income is measured is called the accounting period. For the purpose of external reporting, the accounting period is generally one year. Thus, accounting profit is the result of completed transactions during the accounting period. For income tax purposes, a business has compulsorily to adopt financial year beginning on 1st April in any calendar year and ending on 31st March in the next calendar year as its accounting year. However, for internal reporting the profitability report can be prepared monthly, quarterly or half yearly depending on the nature of project to facilitate better control and evaluation of performance.

 

The Revenue Recognition (Realisation) Concept

According to this concept, revenue is considered as being earned on the date on which it is realised. Revenue is thus recognised in the Profit and Loss Account of an enterprise when a sale is made or service is rendered to customers. According to Accounting Standard-9 (AS-9) in case of sale of goods, revenue will be recognised when the seller of goods has transferred to the buyer the property in goods and no significant uncertainty exists regarding the sales price. In a transaction involving the rendering of services, revenue should be recognised when services have been rendered to the satisfaction of the customer and when no significant uncertainty exists regarding the amount of consideration. According to Anthony and Reece, "The conservatism concept suggests the period when revenue should be recognised. Another concept, the realisation concept indicates the amount of revenue that should be recognised from a given sale".

 

The Matching Concept (Jan. 01, June 03)

Deducting expenses from revenues arrives at accounting profit. However, accountants carry forward expenses until they can be identified with the revenue of particular accounting year and carry forward receipts until they can be regarded as revenue of the particular year. Thus, this principle is very important for correct determination of profit, which is also a measure of performance. All expenses that generate revenue in the current accounting period are recognised as expenses of the current period. Cost of goods sold and operating expenses incurred during the current period are recognised as expenses of the current period and will be matched with the revenue of the current period. Incomes received in advance or relating to earlier periods must not be taken into account. Similarly, expenses paid in advance are also to be ignored while computing the income of current accounting period.

 

The Materiality Concept

According to this concept, financial statements should disclose all material items, i.e., items the knowledge of which might influence the decisions of the user of the financial statements. What is material may, however, differ from concern to concern and year to year. Kohler has defined materiality as 'the characteristic attaching to a statement, fact or item whereby its disclosure or the method of giving it expression would be likely to influence the judgement of a reasonable person.' Thus when the event is material, it should be disclosed. But if the item or event is immaterial, it may not be disclosed. It is on the basis of materiality concept that items of stationery are considered to have been used up either at the time of purchase or at the time of their issue from stores.

 

The Consistency Concept

The Generally Accepted Accounting Principles (GAAP) permit more than one method of describing identical operating situations. For example, a firm may have different methods of providing depreciation on fixed assets or inventory valuation or making provision for likely bad debts, which are permissible under the GAAP. As a result, the firm will report different amounts of income in different years for the same accounting transactions. Inconsistency will make the two financial statements incomparable. It is for this reason that the consistency principle requires that the basis of income measurement and preparation of financial statements should remain consistent for intra-firm and inter-firm comparison. Accounting Standard-I (AS-I) also states that it is assumed that accounting policies are consistent from one period to another. Thus, a firm should follow same accounting methods and procedures from year to year. However, it is permitted to change them if it has a sound reason to do so. But the effect of such a change must be disclosed in the financial statements of the year in which change took place to enable the users to be aware of the lack of consistency.

The Conservatism (Prudence) Concept

As the term suggests its traditional approach of playing safe or being cautious in recognising all the possible losses but ignoring all probable profits. This is also known as prudence concept implying the common and accepted behaviour of accounting or providing for future losses. Though this approach leads to creation of secret reserves and understatement of income; it also of safeguards the interest of outsiders by preventing the management from recognising unrealised, profits and providing for all future losses. There are few instances, which illustrate the acceptance and adherence of this concept.

  1. Inventories are valued at lower of cost or market price.
  2. Providing for doubtful debts and discount allowed to debtors but ignoring the probable discount received from creditor till the time final payments are made.
  3. All the fixed assets are valued on historical costs irrespective of their market price except in the case of revaluation of business.
  4. Preference of written down value method over straight-line method of depreciation, since the earlier one, provides for more depreciation in the initial years of use.
  5. Valuing Joint Life Insurance Policy at its surrender value irrespective of amount of instalments paid.
 

5. 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:

  • 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.
The Accounting Standard Board has so far issued twenty-two definite standards. They are listed below:
  • AS-1 Disclosure of Accounting Policies
  • AS-2 (Revised) Valuation of Inventories
  • AS-3 (Revised) Changes in Financial Position
  • AS-4 (Revised) Contingencies and Events Occurring After the Balance Sheet.
  • AS-5 (Revised) Prior Period and Extraordinary Items and Changes in Accounting Policies
  • AS-6 (Revised) Depreciation Accounting
  • AS-7 Accounting for Constructions Costs
  • AS-8 Accounting for Research & Development
  • AS-9 Revenue Recognition
  • AS-10 Accounting for Fixed Costs
  • AS-11 (Revised) Accounting for the effect of Changes in Foreign Exchange Rates
  • AS-12 Accounting for Government Grants
  • AS-13 Accounting for Investments
  • AS-14 Accounting for Amalgamation
  • AS-15 Accounting for Retirement benefits in the Financial Statements of Employers
  • AS-16 Borrowers Costs
  • AS-17 Segment Reporting
  • AS-18 Related Party Disclosures
  • AS-19 Leases
  • AS-20 Earnings per share
  • AS-21 Consolidated Financial Statements
  • AS-22 Accounting for Taxes on Income
 



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