Module 1
Accounting Principles and Concepts
Definition of Accounting:
The American Accounting Association defines accounting as "the process of
identifying, measuring and communicating economic information to permit informed
judgements and decisions by the users of the information."
According to AICPA, Accounting is "the art of recording, classifying and summarizing
in a significant manner and in terms of money, transactions and events which are in
part at least of a financial character and interpreting the result thereof."
Steps in Accounting:
The following are the important steps to be adopted in the accounting process:
1) Recording: Recording all the transactions in subsidiary books for purpose of
future record or reference. It is referred to as "Journal."
2) Classifying: All recorded transactions in subsidiary books are classified and
posted to the main book of accounts. It is known as "Ledger."
3) Summarizing: All recorded transactions in main books will be summarized for
the preparation Statement of Profit and Loss and Balance Sheet.
4) Interpreting: Interpreting refers to the explanation of the meaning and
significance of the result of final accounts and balance sheet so that parties
concerned with business can determine the future earnings, ability to pay
interest, liquidity and profitability and a sound dividend policy.
Functions of Accounting:
From the definition and analysis of the above the main functions of accounting can
be summarized as follows.
(1) Keeping systematic record of business transactions.
(2) Protecting properties of the business.
(3) Communicating the results to various parties interested in or connected with
the business concerned and
(4) Meeting legal requirements for under companies act or income tax act or any
other act required by government.
Objectives of Accounting:
The Main objectives or aims of accounting are enlisted as follows.
A. Providing suitable information with an aim of safeguarding the interest of the
business and its proprietors and others connected with it.
B. Ascertainment and exhibition of profits earned or losses incurred in the
business.
C. Ascertainment of the financial position of the business as a whole.
D. To ensure accounts are prepared according to some accepted accounting
concepts and conventions or generally accepted accounting principles, and E.
To comply with the requirements of the Companies Act, Income Tax Act, etc.
Limitations of Accounting:
The major limitations of accounting are pointed out as follows.
➢ Accounting is based on accounting concepts and conventions like on going
concern or conservatism and financial statements do not disclose true income
and financial position.
➢ Accounting provides only limited information because it reveals the profitability
of the concern as a whole not unit or branch level. It is also incomplete and
inexact in nature
➢ Accounting considers only those transactions which can be measured in
terms of money or quantitatively expressed. Qualitative information is not
taken into account.
➢ Accounting information are based on personal judgement of accountant or the
prepares. So, it is subject in nature that means influence by personal
judgement.
➢ Accounting is only historical in nature. It provides only a post mortem of
records of the business transactions.
Branches of Accounting:
The main function of accounting is to provide the required information for different
parties who are interested in the welfare of that enterprise concerned. In order to
serve the needs of management and outsiders various new branches of accounting
have been developed. The following are the main branches of accounting:
1. Financial Accounting
2. Cost Accounting
3. Management Accounting
Financial Accounting:
Financial Accounting helps to prepare financial statements for external reporting
purposes. Income statement determines the profitability and balance sheet financial
position of the business firm for a specific period of time.
Cost Accounting:
Cost Accounting is the formal accounting system setup for recording costs. It is a
systematic procedure for determining the unit cost of output produced or service
rendered.
Management Accounting:
Management Accounting is concerned with presentation of accounting information
to the management for effective decision making and control.
Accounting Principles:
Different accounting systems and techniques are designed to meet the needs of
information management. The information should be recorded and presented in
such a way that management is able to arrive at right conclusions. The ultimate
aim of the management is to increase profitability and minimize the losses of the
business. In order to achieve the objectives of the concern as a whole, it is essential
to prepare the accounting statements in accordance with the generally accepted
principles and procedures.
The term principle refers to the rule of action or conduct to be applied in accounting.
Accounting principles may be defined as "those rules of conduct or procedure which
are adopted by the accountants universally, while recording the accounting
transactions." The accounting principles can be classified into two categories (I)
Accounting Concepts and (II) Accounting Conventions.
I. Accounting Concepts:
Accounting concepts mean and include necessary assumptions or postulates or ideas
which are used to accounting practice and preparation of financial statements. The
following are the important accounting concepts:
1. Entity Concept:
Separate Entity concept implies that business unit or a company is a body corporate
and having a separate legal entity and status distinct from its proprietors. The
owners or members are not liable for the acts of the company. But in the case of the
partnership business or sole trading business, no separate legal entity from its
proprietors. Here proprietors or members are liable for the acts of the firm. As per
the separate entity concept of accounting it applies to all forms of business to
determine the scope of what is to be recorded or what is to be excluded from the
business books.
For example, if the proprietor of the business invests Rs.50,000 in his business, it is
deemed that the proprietor has given that much amount to the business as loan
which will be shown as a liability for the business. On withdrawal of any amount it
will be debited in cash account and credited in proprietor's capital account. In
conclusion, this separate entity concept applies much larger in body corporate
sectors than sole traders and partnership firms.
2. Dual Aspect Concept:
According to this concept, every business transaction involves two aspects, namely,
for every benefit received there is a corresponding given benefit. The dual aspect
concept is the basis of the double entry book keeping. Thus, for every debit there is
an equal and corresponding credit. The accounting equation of the dual aspect
concept is:
Capital + Liabilities = Assets (or)
Assets = Equities (Capital)
The term Capital refers to funds provide by the proprietor of the business concern.
On the other hand, the term liability denotes the funds provided by the creditors and
debenture holders against the assets of the business. The term assets represent the
resources owned by the business.
For example, Mr. Thomas starts business with cash of Rs.1,00,000 and building of
Rs.5,00,000, then this fact is recorded at two places; Assets Accounts and Capital
Account. In other words, the business acquires assets of Rs.6,00,000 which is equal
to the proprietor's capital in the form of cash of Rs.1,00,000 and building worth of
Rs.5,00,000. No external liabilities arise on account of the above transaction. Thus,
liability is zero. The above relationship can be shown in the form of accounting
equation:
Capital + Liabilities = Assets (₹1,00,000
+ ₹ 5,00,000) + ₹ 0 = ₹ 6,00,000
3. Accounting Period Concept:
According to this concept, income or loss of a business can be analysed and
determined on the basis of suitable accounting period instead of wait for a long
period, until it is liquidated. Being a business in continuous affairs for an indefinite
period of time, the proprietors, the shareholders and outsiders want to know the
financial position of the concern, periodically. Thus, the accounting period is
normally adopted for one year. At the end of each accounting period an income
statement and balance sheet are prepared. This concept is simply intended for a
periodical ascertainment and reporting the true and fair financial position of the
concern as a whole.
4. Going Concern Concept:
It is otherwise known as Continue of Activity Concept. This concept assumes that
business concern will continue for a long period to exit. In other words, under this
assumption, the business enterprise is normally viewed as a going concern and it is
not likely to be liquidated in the near future. This assumption implies that while
valuing the assets of the business on the basis of productivity and not on the basis
of their realizable value or the present market value, at cost less depreciation till date
for the purpose of balance sheet. It is useful in valuation of assets and liabilities,
depreciation of fixed assets and treatment of prepaid expenses.
5. Cost Concept:
This concept is based on "Going Concern Concept." Cost Concept implies that assets
acquired are recorded in the accounting books at the cost or price paid to acquire it.
And this cost is the basis for subsequent accounting for the assets. For accounting
purposes, the market value of assets is not taken into account either for valuation
or charging depreciation of such assets. Cost concept has the advantage of bringing
objectivity in the preparation and presentation of financial statements. In the
absence of cost concept, figures shown in accounting records would be subjective
(based on personal judgment) and questionable. But due to inflationary tendencies,
the preparation of financial statements on the basis of cost concept has become
irrelevant for judging the true financial position of the business.
6. Money Measurement Concept:
According to this concept, accounting transactions are measured, expressed and
recorded in terms of money. This concept excludes those transactions or events
which cannot be expressed in terms of money. For example, factors such as the skill
of the supervisor, product policies, planning, employer-employee relationship cannot
be recorded in accounts in spite of their paramount importance to the business. This
makes the financial statements incomplete.
7. Matching Concept:
Matching Concept is closely related to accounting period concept. The main aim of
the accounting is to ascertain the profit periodically. To measure the profit for a
particular period it is essential to match accurately the costs associated with the
revenue. Thus, matching of costs and revenues related to a particular period while
preparing Profit and Loss statement is called as Matching Concept.
8. Realization Concept:
Realization Concept is otherwise known as Revenue Recognition Concept. According
to this concept, revenue is the gross inflow of cash, receivables or other
considerations arising in the course of an enterprise from the sale of goods or
rendering of services from the holding of assets. If no sale takes place, no revenue is
considered. However, there are certain exceptions to this concept. Examples, Hire
Purchase or Sale, Contract Accounts etc.
9. Accrual Concept:
Accrual Concept is closely related to Matching Concept. According to this concept,
revenue recognition depends on its realization and not accrual receipt. Likewise,
costs are recognized when they are incurred and not when paid. The accrual concept
ensures that the profit or loss shown is on the basis of full fact relating to all expenses
and incomes.
10. Rupee Value Concept:
This concept assumes that the value of rupee is constant. In fact, due to inflationary
pressures, the value of rupee will be declining. Under this situation financial
statements are prepared on the basis of historical costs not considering the declining
value of rupee. Similarly, depreciation is also charged on the basis of cost price. Thus,
this concept results in underestimation of depreciation and overestimation of assets
in the balance sheet and hence will not reflect the true position of the business.
II. Accounting Conventions:
Accounting Convention implies that those customs, methods and practices to be
followed as a guideline for preparation of accounting statements. The accounting
conventions can be classified as follows:
1. Convention of Disclosure:
The disclosure of all material information is one of the important accounting
conventions. According to this convention all accounting statements should be
honestly prepared and all facts and figures must be disclosed therein. The disclosure
of financial information is required for different parties who are interested in the
welfare of that enterprise. The Companies Act lays down the forms of Profit and Loss
Account and Balance Sheet. Thus, convention of disclosure is required to be kept as
per the requirements of the Companies Act and Income Tax Act.
2. Convention of Conservatism:
This convention is closely related to the policy of playing safe. This principle is" often
described as "anticipate no profit, and provide for all possible losses. "This concept
is also known as prudence concept. Thus, this convention emphasises that
uncertainties and risks inherent in business transactions should be given proper
consideration. For example, under this convention inventory is valued at cost price
or market price whichever is lower. Similarly, bad and doubtful debts is made in the
books before ascertaining the profit.
3. Convention of Consistency:
The Convention of Consistency implies that accounting policies, procedures and
methods should remain unchanged for preparation of financial statements from one
period to another. Under this convention alternative improved accounting policies
are also equally acceptable. In order to measure the operational efficiency of a
concern, this convention allows a meaningful comparison in the performance of
different period.
4. Convention of Materiality:
Materiality may be defined as "the characteristic attaching to a statement of facts, or
item whereby its disclosure or method of giving it expression would be likely to
influence the judgment of a reasonable person." According to this convention
consideration is given to all material events, insignificant details are ignored while
preparing the profit and loss account and balance sheet. The evaluation and decision
of material or immaterial depends upon the circumstances and lies at the discretion
of the Accountant.