By Asok Nadhani

Accounting Principles, Concepts & Conventions

2.1 Accounting Principles

Accounting principle is a general law or rule adopted or professed as a guide for action. It is a basis of conduct or practice.

2.2 Generally Accepted Accounting Principles (GAAP)

Accounting principles satisfying the following criterion and accepted by accountants all over the world are known as Generally Accepted Accounting principles (GAAP).

(i)        Usefulness: The Accounting principle should increase the usefulness of accounting records by making accounting information more meaningful.

(ii)       Objectivity: The accounting principle should be reliable, trustworthy and supported by facts, and should not be influenced by personal bias.

(iii)      Feasibility: Accounting principle should be practical, so that it can be implemented without any difficulty.

2.3 Accounting Concept

Accounting concept is based on following basic assumptions or conditions:

2.3.1 Separate Entity Concept: Business is treated as a separate entity from its owners. All transactions are recorded in the books of the business. Proprietor’s capital appeared as a liability in the business as he is treated as a creditor. This concept makes a distinction between personal transaction and business transaction.

Example: Mr. A started a business with Rs.5, 00,000. As per the concept, it means the enterprise owes to Mr. A

Rs.5, 00,000. The proprietor of a business is treated as a creditor for capital. If he spends Rs.6, 000 to meet his family expenses it will be treated as drawing, not as business expenses and would be charged to his Capital A/c. Likewise Shareholders are treated as creditors for the amount they subscribed to share capital.

2.3.2 Going Concern Concept: This term is based on the concept that a business will continue an indefinite long economical life. All outstanding, prepaid expenses and incomes are taken into account while preparing final accounts.

Example:

                                                             Balance Sheet of Mr. A as on…

Liabilities	Rs.	Assets	Rs.
Capital	5,00,000	Plant & Machinery	3,00,000
		Cash in hand	2,00,000
	5,00,000		5,00,000

Now let us assume Mr. A wants to sell the machinery. The market value of the machinery may be different than book value. As per going concept, the increase or decrease in value of the asset in the short-run is ignored because the asset is used for generating future benefit and not for immediate sale. Current change in fixed asset market value should not be counted for this valuation.

2.3.3 Money Measurement Concept: Under this concept, only cash transactions are recorded in the books of the accounts. Here money is accepted as a unit of account. Transactions, which can not be expressed in monetary values, are not entered in business.

Example: The value of a worker can not be expressed in terms of money, though they are integrated part of production. So their values are not taken in accounts books.

2.3.4 Accounting Period Concept: Accounting period is a segmentation of business life for studying the results shown by business in each segment (normally one year). Under this concept, the life of a business is divided into appropriate period to get correct financial position of the business related to each such segmented period. This concept helps to segregate and compare the earnings and status for each segment period of the business.

2.3.5 Matching Concept: Under this concept, accounting record is made in such a manner that cost may be compared with revenue. This enables comparison of revenue and cost.

Example: Rs.10,000 is earned and for that Rs.3,000 is paid and Rs.2,000 remains to be paid. Under this concept the net profit would be 10,000-(3,000 + 2,000) = Rs.5,000.

2.3.6 Accrual Concept: Under this system, revenues and expenses are recognized as they are earned or incurred, irrespective of the date of receipt or payment. It may be considered as a consequence of periodicity concept.

Both Accrual Accounting & Matching Period Concept work together for measurement and recognisation of Income, assets and liabilities. The profit of an accounting period is the revenues less expenses incurred for those revenues.

Example: Mr. A borrows Rs.1, 50,000. The rate of interest is 10%.At the end of the year he will pay Rs.15,000 as interest. If it is not paid within the accounting period, and  will be taken as liability. It  will be taken into accounting for that year.

2.3.7 Cost Concept: This concept is similar as going concern concept. Under this concept, assets are shown in cost price (i.e. in acquisition price). The cost price is systematically reduced by charging depreciation to reflect its reduction in value over time.

Example: A building has been acquired paying Rs.5, 00,000. The building  would be recorded as Rs.5,00,000 in the books, whatever be the market price because this concept states that the assets are shown in cost price i.e. in acquisition price. If after one year, its market value comes down to Rs.4, 00,000, there will not be any change in acquisition cost books of account. However a charging depreciation of Rs.50, 000, (@ 10% p.a.) the assets would be shown at Rs.4, 50,000 at the end of the year.

2.3.8 Dual Aspect Concept: Under this concept, every transaction is recorded under double entry system. The concept can be expressed as ASSETS = LIABILITIES + CAPITAL.

This concept helps to detect errors and indicates true position of the business.

Example 1: Both aspect of a transaction can be covered in different way. Followings are some examples:

i.    One asset increases and another asset decreases.

New machinery purchased for Rs.25, 000. The effect is- Machinery will be increased and cash will be decreased by

Rs.25, 000.

ii.   Asset increases along with increase in liability.

Suppose the same machinery is purchased on credit. The effect is- Machinery will be increased and creditor will be increased also.

iii.  Both asset and liabilities decrease.

Cash paid to repay Bank o/d of Rs.50, 000. The effect is- Bank o/d and cash both will be decreased by

Rs.50, 000.

iv.  One liability increases and another decrease.

Loan was taken to repay another loan of Rs.1, 00,000. The effect is- A new loan account will be created (liability increases) another will be paid off (liability decreases).

Example 2: The outside liabilities of a business are Rs.30, 000. The proprietor’s capital is Rs.40, 000. Total assets of the firm are = (Liability + Capital) i.e. Rs. (30,000 + 40,000) = Rs.70, 000.

2.3.9 Realization Concepts: Under this concept, revenue is recorded only when it is realized (except Hire Purchase and some Long-term Contract). A lawyer may treat his income only when it is realized.

Example: An asset is recorded at its historical cost of Rs. 3,00,000 and its  cost at current market price is Rs. 7,00,000. In this case, such change is considered if it is to materialize (i.e. the asset is going to be sold at Rs.7,00,000) certainly.

2.3.10 Proprietary Concept: The concept stresses the importance of the proprietors (owners) of a business, rather than the business itself. The basic accounting equation is ASSETS – LIABILITIES = PROPRIETORSHIP. Here the proprietor is the centre of accounting system. The proprietary concept is followed in sole proprietorship and in partnership business where the owners are involved in all decision making. In these types of organization, the owners enjoy all the profits of the business. Legally all of the firm’s debts and liabilities are borne by the proprietors.

2.3.11 Fund Concept: According to the fund concept, each fund is aimed to fulfill some purpose, and the services embodied in the assets are the primary means to achieve that purpose. Fund concept has not gained general acceptance in financial accounting, it has been found useful for government and non profit organizations, where capital expenditure is quite substantial compared to the revenue expenses.

2.4 Accounting Convention

The term ‘convention’ denotes following customs or traditions which the accountant pursue, while preparing the accounting statement.

−  Conservatism: It provides for future losses but anticipates no profit. For example, provisions for bad debts are shown in accounts, while window dressing, secret reserve are not permitted.

−  Consistency: It implies continuance of accounting practices uniformly. For example, a company can adopt any method for valuation of stock, out of several acceptable methods. If change becomes necessary, it should be stated clearly along with its impact on the financial result.

−  Materiality: All material facts, i.e. the items, the knowledge of which might influence the decisions of the user of the financial statements, are recorded.

−  Disclosure: All material information, the knowledge of which might influence the decisions of the user of the financial statements must be disclosed.

Example: A company has switched over to weighted average formula for ascertaining cost of inventory, from the earlier practice of using FIFO. The closing inventory by FIFO is Rs.2 lakh and that by weighted average formula is Rs.1.5 lakh. -

The fact that changes in accounting policy pulls down profit and value of inventory by Rs.50, 000, is to be disclosed, as per AS- 1.

−  Prudence: Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates under conditions of uncertainty, to recognize unrealized profits, Creation of excess provisions, hidden reserve, is not permitted.

2.5 Financial Statement

Financial statements are a way of public communication in the hands of the management of the enterprise (e.g. Profit and Loss A/c. Balance sheet, Cash flow & Fund flow statement etc.)

Characteristics of financial statement:

−  Understandable: Easily understood by the user.

−  Relevant: The information contained should be relevant in comparing and analyzing past & present and is forecasting the future.

−  Reliable: Reliable and contain most objective information.

−  Standard: Comparable and formulated as per standards.

−  Neutral: Free from any bias.

−  Adequate disclosure: The information should be complete, full and fair, with adequate disclosures.