FINANCIAL ACCOUNTING.pdf

Department of Distance and Continuing Education University of Delhi nwjLFk ,oa lrr~ f'k{kk foHkkx fnYyh fo'ofo|ky; B.Com. (Programme) / B.Com. (Hons.) Semester-I Course Credit - 4...

Department of Distance and Continuing Education University of Delhi nwjLFk ,oa lrr~ f'k{kk foHkkx fnYyh fo'ofo|ky; B.Com. (Programme) / B.Com. (Hons.) Semester-I Course Credit - 4 DSC-3 FINANCIAL ACCOUNTING (Department of Commerce) As per the UGCF - 2022 and National Education Policy 2020 Financial Accounting Editorial Board Sh. K.B.Gupta, Dr. Sneh Chawla, Dr. Rutika Saini Content Writers Ms. Sumita Jain (Unit II, IV & V) Academic Coordinator Deekshant Awasthi © Department of Distance and Continuing Education ISBN : 978-93-95774-46-8 Ist edition: 2022 E-mail: [email protected] [email protected] Published by: Department of Distance and Continuing Education under the aegis of Campus of Open Learning/School of Open Learning, University of Delhi, Delhi-110 007 Printed by: School of Open Learning, University of Delhi © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com.(Programme)/B.Com.(Hons.) Unit I-V are edited versions of study material prepared for the courses under Annual & CBCS Mode. Corrections/Modifications/Suggestions proposed by Statutory Body, DU/Stakeholder/s in the Self Learning Material (SLM) will be incorporated in the next edition. However, these corrections/modifications/suggestions will be uploaded on the website https://sol.du.ac.in. Any feedback or suggestions can be sent to the email- [email protected] © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Financial Accounting TABLE OF CONTENTS UNIT I : 1. Accounting: Its Concepts and Conventions 2. Accounting Standards 3. Accounting Process UNIT II : 4. Business Income, AS-10 & Inventory Ms. Sumita Jain 5. Inventory Management UNIT III : 6. Accounts from Incomplete Records: Single Entry System 7. Final Accounts of Non-for-Profit Organizations UNIT IV : 8. Accounting for Branches and Departments Ms. Sumita Jain 9. Lease Transactions: Concept & Classification UNIT V : 10. Computerized Accounting System Ms. Sumita Jain 11. Groups and Ledgers 12. Trial Balance, Cash Flow Statement and Reports © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Financial Accounting UNIT I LESSON 1 ACCOUNTING: ITS CONCEPTS AND CONVENTIONS STRUCTURE 1.1 Learning Objectives 1.2 Introduction 1.3 Accounting as an Information System 1.3.1 Functions of Accounting 1.3.2 Advantages of Accounting 1.3.3 Limitations of Accounting 1.3.4 The Users of Accounting Information 1.3.5 Role of AI and Data analytics in accounting 1.4 Branches of Accounting 1.5 Basis of Accounting 1.6 Accounting Concepts 1.7 Essentials Features of Accounting Principles 1.8 Accounting Conventions 1.9 Summary 1.10 Glossary 1.11 Answers to In-text Questions 1.12 Self-Assessment Questions 1.13 References 1.14 Suggested Readings 1.1 LEARNING OBJECTIVES To know the basic concepts of accounting To identify the role of accounting as an information system 1|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) To know the role of AI in accounting To explain the functions of accounting To identify the various branches of accounting To apprise the accounting concepts and conventions. 1.2 INTRODUCTION Definition of Accounting: Before attempting to define accounting, it may be added that there is no among unanimity accountants as to its precise definition. However, some of the definitions are as given below. According to L.C. Copper, "Book-keeping may be described as the science of recording transactions in money or money's worth in such a manner that, at any subsequent date, their nature and effect may be clearly understood, and that, when required, a combined statement of their result may be prepared". R.N. Carter defines Book-keeping as "Book-keeping is the science and art of correctly recording in books of account all those business transactions that result in the transfer of money or money's worth" Yet another definition is given A.H. Rosenkampff. According to him, "Book-keeping is the art of recording business transactions in a systematic manner" Out of the above and many more others, the most acceptable one is that given by American Institute of Certified Public Accountants (AICPA) Committee on Terminology. According to AICPA "Accounting is the art of recording, classifying and summarising 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 results thereof". Book-keeping is a subject of profound importance to all kinds of business enterprises. It is of great importance, for example, to manufacturing concerns, trading concerns, banks, transport companies and insurance companies. They have to follow a proper accounting system if they want to know as to whether they are earning, profits or incurring losses and how much; whether or not all the transactions have been recorded fully and accurately; the amount they owe to their creditors as well as the amount owed to them by their debtors. Thus, the objects of accounting are to enable the businessman to ascertain accurately and easily. 2|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting 1. The amount of gain or loss during a particular period, and 2. The amount of his assets and liabilities and capital in the firm at a particular point of time. Double Entry Principle: In the present era double entry system of book-keeping is considered to be the best, common and universal system, because it is modem, scientific, and complete. It fulfils all the objects of a businessman. It originated in western countries and so it is also called western system of accounting. It is also called mercantile system of accounting because according to this system cash and credit transactions can be recorded. Double entry system has been defined differently by different authorities. Some of which are as follows: - According to Carter, "The modern system of Accounting in use is known as Double Entry. Double Entry is a system of Book-keeping by means of both personal and impersonal accounts." M.J. Keller defines Double Entry System as follows: "The most common system of accounting data for an enterprise is the Double Entry System. As the name implies, the entry made for each transaction is composed of two parts, a 'Debit' and a 'Credit." Each business transaction that results in transfer of money or money's worth involves a twofold aspect, (a) the yielding or giving of a benefit, and (b) the receiving of that benefit. In other words, every business transaction involves exchange of value for value, or inter-change of money or money's worth or every business transaction involves receiving something having value and giving something, which has value. According to Double Entry System, both these aspects of the transaction, the receiving aspect and the giving aspect, are recorded. Thus, if Building is bought from Mukesh, Building Account receives and Mukesh's Account gives. There must, therefore, be double entry to have a complete record of each transaction. For a clear understanding of the principles of double entry system, it is necessary to first carefully bear in mind that certain transactions are common to almost every business. These common transactions are as follows: 1. The businessman enters into business dealings with a number of persons or firms. 2. He must have some assets or properties in which or with the help of which he carries on the business; and 3. He must incur certain expenses such as office rent, salaries, advertising, etc. for carrying on the business, and that he must have some sources from which the income of the 3|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) business is derived. It follows, therefore, that in order to keep a complete record of all the business transactions, it will be necessary to keep the following accounts (i) The account of each person or firm with whom the firm has to deal. (ii) The account of each asset or property in the business; and (iii) The account of each head of expense or source of income. The accounts which come under first group are called Personal Accounts, those which come under second group are called Real Accounts, and those coming under the third group are called Nominal accounts. Since words 'debit and credit', and 'Account' have been used in the above definitions and discussion, it will be better if we first understand the meaning of these words and then proceed to discuss the rules of double entry system. The double entry system divides the page into two equal halves. The left-hand side of each page is called the debit side, while the right-hand side is called the credit side. There was no rational reason in the way in which the sides were chosen to represent different items, and the credit side could have easily been the left-hand side and the debit the right-hand side. The Venetian merchants who were the 'first known businessmen to use double entry just happened to select the left hand or debit side for the assets and opposite side to represent capital and liabilities, and so it has remained ever since. An Account is a classified and chronological record in which the money values (sometimes also the quantities or the money values and quantities together) of all the benefits given or received by a particular party (which may be a human being or a personified object) are arranged in two separate columns on the right and left sides respectively of each sheet of paper or each page or folio of the book in which it is written. There will be a debit side as well as credit side to every account. This is indicated by writing "Dr" and "Cr" on the left-hand side and right-hand side margin respectively of the account. All entries in the Dr. side are preceded by the word 'To', meaning that the account of which the record is being prepared is a debtor to the account the name of which appears in the entry. On the other hand, all entries in the credit side are preceded by the word by', so that each entry may mean that the account of which the record is being prepared is credited by the account the name of which appears in the entry. The title of the account is written across the top of the account at the centre. 4|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting The account of the party that gives a benefit is called a "Creditor" and that of the party that receives it is called a "Debtor". As a general rule the value of each benefit received by an account is entered on the left-hand column of the account and the account is said to have been 'debited' with such value; on the other hand, the value of each benefit given by an account is entered on the right- hand column of the account and the account is said to have been 'credited' with such value. These are called debit and credit entries respectively. Having understood the meaning of the words "Debit and Credit", and "Account", let us now proceed with the explanation of rules of double entry system. Rules of Double Entry System: For debiting or crediting a particular account, we have first to see which class of account are affected by the transaction which is entered into by the businessman. After ascertaining that, the following rules of debit and credit will have to be followed: (1) Personal Accounts: In the case of personal accounts, we debit the. person or the firm with the benefits received by him or by the firm and credit the person or the firm with the benefits imparted by the person or the firm. In short, we can say that- Debit the Receiver (of benefits): and Credit the Giver (imparting the benefits) (2) Real Accounts: Real accounts are debited with the incomings and are credited with the outgoings or, Debit what, comes in the business; and Credit what goes out (of the business) (3) Nominal Accounts: All amounts expended or lost are debited and all amounts gained are credited to nominal accounts In other words: Debit all expenses and losses, and Credit all incomes and gains. It should be kept in mind that these rules never vary and will have to be rigidly followed under all conceivable conditions. It should also be noted that the above-mentioned phenomena like 'giver' and 'receiver', 'coming in' and 'going out' etc. are to be judged not from the proprietor's point of view but from the point of view of the business. In addition to the above rules of double entry system, there are certain basic concepts and conventions of accounting which must be known before actual book-keeping and accounting work is started. These concepts are discussed here-in-after. 5|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) 1.3 ACCOUNTING AS AN INFORMATION SYSTEM Accounting is often referred to as the language of business. The primary aim of a language is to serve as a means of communication. Accounting is used to communicate financial and other information to people, organizations, Governments etc., about various aspects of business and no business entities. Accounting information is used when Mr. A applies for a loan at a bank or when A submits his income-tax returns. Business enterprises use accounting for their day-to-day activities and to report the result of these activities to their owners, creditors, employees and Governmental agencies. The accounting is, therefore, also an information system. In today's society, many persons and agencies outside the accounting information; (ii) Accountant may supervise the work of book-keeper's recording work but the bookkeeper has no role in accountant's work of interpretation; (iii) the work of bookkeeper is routine and clerical in nature and is increasingly being done by computers. But the work of accountant is technical in nature and requires higher level of knowledge, conceptual understanding and analytical skill; (iv) Book-keeping is done in accordance with basic concepts and conventions for all types of organisations. But the methods and procedures adopted by accountants in the analysis and interpretation of financial reports may not be same for all the firms. 1.3.1 Functions of Accounting: Financial accounting performs the following major functions: (i) Maintaining systematic records: Business transactions are properly recorded, classified under appropriate accounts and summarised into financial statements-income statement and the balance sheet. (ii) Communicating the financial results: Accounting is used to communicate financial information in respect of net profits (or loss), assets, liabilities etc., to the interested parties. (iii) Meeting legal needs: The provisions of various laws such as Companies Act, Income Tax and Sales Tax Acts require the submission of various statements, i.e., annual accounts, income tax returns, returns for sales tax purposes and so on. (iv) Protecting business assets: Accounting maintains proper records of various assets and thus enables the management to exercise proper control over them with the help of following information regarding them: (a) How much is the balance of cash in hand and cash at bank? (b) What is the position of inventories? (c) How much money is owed by the customers? (d) How much money is owing to the creditors? (e) What is the position of various fixed assets and how these are being used? 6|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting (v) Accounting assists the management in the task of planning, control and coordination of business activities. (vi) Stewardship: In the case of limited companies, the management is entrusted with the resources of the enterprise. The managers are expected to act true trustees of the funds and the accounting helps them to achieve the same. (vii) Fixing responsibility: Accounting helps in the computation of the profits of different departments of an enterprise. This would help in fixing the responsibility of departmental heads. 1.3.2 Advantages of Accounting (i) Assistance to management: The accounting information helps the management to plan its future activities by preparing budgets in respect of sales, production, expenses, cash, etc. Accounting helps in coordination of various activities in different departments by providing financial details of each department. The managerial control is achieved by analyzing in money terms the departures from the planned activities and by taking corrective measures to improve the situation in future. (ii) Records rather than memory: It is not possible at all to do any business by just remembering the business transactions which have grown in size and complexity. Transactions, therefore, must be recorded early in the books of accounts so that necessary information about them is available in time and free from bias. (iii) Intra-period comparisons: Accounting information when recorded properly can be used to compare the results of one year with those of previous year(s). (iv) Aid in legal matters: Systematically recorded accounting information can be produced as evidence in a court of law. (v) Help in taxation matters: Income Tax and Sales Tax authorities could be convinced about the taxable income or actual turnover (sales), as the case may be, with the help of written records. (vi) Sale of a business: In case, a sole trader or a partnership firm or even a company wants to sell its business, the accounting information can be utilized to determine proper purchase price. 1.3.3 Limitations of Accounting (i) Accounting information is expressed in terms of money. Non-monetary events or transactions, however important they may be, are completely omitted. (ii) Fixed assets are recorded in the accounting records at the original cost, that is, the actual amount spent on them plus, of course, an incidental charge. In this way the effect of inflation (or deflation) is not taken into consideration. The direct result of this practice is that balance sheet does not represent the true financial position of the 7|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) business. (iii) Accounting information is sometimes based on estimates; estimates are often inaccurate. For example, it is not possible to predict with any degree of accuracy the actual useful life of an asset for the purpose of depreciation expense. (iv) Accounting information cannot be used as only test of managerial performance on the basis of more profits. Profit of a period of one year can readily be manipulated by omitting such cost of advertisement, research and development, depreciation and soon. (v) Accounting information is not neutral or unbiased. Accountants calculate income as excess of revenues over expenses. But they consider only selected revenues and expenses. They do not, for example, include cost of such items as water or air pollution, employee's injuries etc. (vi) Accounting like any other discipline has to follow certain principles which in certain cases are contradictory. For example, current assets (e.g., stock of goods) are valued on the basis of cost or market price whichever is less following the principle of conservatism. Accordingly, the current assets may be valued on cost basis in some year and at market price in another year. In this manner, the rule of consistency is not followed regularly. 1.3.4 The Users of Accounting Information Financial accounting is primarily concerned with preparation of accounting information for the outsiders who do not have direct access to the accounting records. They obtain accounting information of business enterprises from their annual reports, data published by Government departments and information published in financial newspapers, e.g., the Economic Times, Financial Express etc., or business magazines e.g., Business India, Business World. The Economist, etc. In the following paragraphs, the users of accounting information have been grouped into a number of major headings and the requirements for each considered therein: Creditors and short-term lenders: Creditors include suppliers of goods and services on credit. Short-term lenders such as commercial banks supply money for short periods to business organisations. Bankers and suppliers inspect the accounting information before making loans or granting credit. They want to know whether or not the enterprise will be able to meet its financial repayment obligations in time. Their specific interest lies in solvency, liquidity and profitability positions of the business enterprise. Accounting serves their purpose by disclosing true and fair view of current assets in the balance sheet and profitability position in the income statement so as to assure the creditors and lenders that their debts would be paid in time. Investors: Under this category are included the existing shareholders and future shareholders. Basically, they will be interested in the dividends that are paid. They are also 8|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting interested about future prosperity of their enterprise. But the income statement and the balance sheet of one year will not be helpful to guide the investors about the future prospects. So, the accounting information must provide the details of the profits and financial position of business so that the investors can find out the progress of the past few years and it may be assumed that this progress will be maintained in future as well. At present such information is generally given in the published accounts. The statement of the chairman in the annual reports also provides some indication about the future progress. Long-term lenders: This category of users includes debenture holders and those providing long-term loans, say, industrial banks, financial institutions, etc. They are interested in knowing that they will get the interest due to them and that the same will be paid when it is due and payable. They will also see to it that their principal amount is also paid on due date. So, their main interest is in the profitability for interest payments and liquidity for the repayment of the loan amount. The availability of cash flow statements in addition to income statement and balance sheet has considerably helped users to evaluate the liquidity position of a business enterprise. Management: The owners are not the only persons within the business enterprise who are interested in various aspects of the operations of a business. With are interested in various aspects of the operations of a business. With the separation of management and ownership (particularly in a limited company), the managers are responsible for carrying on the operations of the business enterprises. The type of accounting information needed by managers may vary with the size of the enterprise. The manager of a small business may need relatively little accounting information. As the business enterprise grows in size, the manager loses direct contact with daily operations. As a result, information about various aspects of the business enterprise must be supplied by accounting. Some of their needs for accounting information relate to : (i) setting objectives or targets for future periods and devising methods to attain those objectives (ii) observing and measuring the performance of the various departments of the business as also the enterprise as a whole; (iii) evaluating the performance in relation to the targets set up; highlighting the deviations from the planned targets; and (iv) taking such corrective action as may be necessary to overcome the shortfalls. Employees (Labour unions): In this category are included both individual employees and groups of them represented by labour unions. Employees want more salary and other benefits such as overtime payments, bonus, housing, medical facilities and so on. The bargaining power of the unions is increased if workers' demands are based on facts and figures. In addition, some companies regularly issue certain reports containing financial information about the employers for a better understanding of the business by the employees. These reports highlight what the companies are doing for the welfare of their employees and what they intend to do in future. Government and regulatory agencies: In recent years, the government has become one of the most important users of accounting information. The central, state and local governments 9|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) have the responsibility of allocating the resources for different uses. Naturally they are interested in the activities of business enterprises such as sales, profits, dividend policies, investments, etc. Moreover, the Government activities are financed through the collection of tax. Thus, the accounting information about business activities is very helpful in the collection of income tax, excise duties, customs duties, sales tax, etc. Each tax requires a special tax return based on necessary accounting information of various business enterprises. Any distortion in the accounting information needed by the Government agencies would adversely affect the welfare policies of the various types of governments. Similarly, a number of regulatory agencies like Securities and Exchange Board of India (SEBI), the Insurance Regulatory Authority, the Reserve Bank of India etc. need accounting information for the efficient operation of capital markets. Individuals and society: People are affected by the operations of a business enterprise in their localities. They want to know through the accounting information the trends in the prosperity of the enterprise and also the range of activities. This would enable them to assess the employment opportunities in their local areas. Society as a whole is concerned with the environment pollution. The accounting information would disclose how much money has been allocated to control such pollution. This has come to be known as social responsibility accounting. 1.3.5 Role of AI and Data Analytics in Accounting We are living in the world of Artificial Intelligence. The organizations have realised that the AI can make their financial and accounting system much stronger and easier. The main reason behind the exponential growth of AI in accounting and finance is the data generation and computation. This automation has the power to save 80-90% of the time usually taken by the workforce in data recording and analysing. This saved time can be put into many other relevant tasks and increase the productivity and output. The AI also helps the accounting team to forecast the needs related to various resources. Artificial intelligence helps the team to process the documents in the real time and generate the reports automatically. These AI generated reports are more reliable and can help in the strategic decision making. Following section talks about some of the key areas where AI can facilitate the accounting. Invoice Processing: The generation and processing of invoice usually takes a lot of time when done manually. The AI based invoice management system can reduce the time taken and increase the volume. Inbound Logistics: The AI can help the organization to contact their suppliers in no time and send the requisitions automatically. A well-established AI system can help in good inventory management. 10 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Financial Accounting Procurement: The AI system can help the organization to centralise its procurement activities by reducing the paperwork. Auditability: the data analytics help organization to keep a track on every transaction and makes the audit process easy. The cognitive computing and predictive analytics facilitate the forecasting process. Cash-flow management: The Artificial intelligence offer many tools which can help the enterprise to record the cash transactions conveniently. The AI based applications can also predict the cash requirements of future based upon the current expenses and inflation. Chatbot- a new way of customer care: Today is the era of chatbots. The AI driven chatbots are able to solve the customers query in a speedy manner. The chatbots work on the basis of some predefined vocabulary and presents options accordingly. The chatbots have reduced the burden on the customer care staff drastically. IN-TEXT QUESTIONS 1. Accounting is used to communicate ____________ information to people, organizations, Governments etc. 2. The accounting information helps the management to plan its future activities by preparing __________in respect of sales, production, expenses, cash, etc. 3. _____________ include suppliers of goods and services on credit. 4. The _____________ are responsible for carrying on the operations of the business enterprises. 5. Accounting has to follow certain principles which in certain cases are contradictory. True/False 1.4 BRANCHES OF ACCOUNTING Accountants tend to specialise in various types of accounting work, and this has resulted in the development of different branches of accounting. Some of these divisions of accounting are given as: (i) Financial Accounting: Accounting designed for outsiders (persons other than owners and managers) is known as financial accounting. It is concerned with the 11 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) recording of business transactions and the periodic preparation of balance sheet and income statement from such records. In this manner, the financial accounting is useful for ascertaining profit or loss made during a given period and financial position at the end of the period. (ii) Management accounting: It is concerned with the interpretation of accounting information to guide the management for future planning, decision-making, control, etc., Management accounting, therefore, serves the information needs of the insiders, e.g., owners, managers and employees. (iii) Cost accounting: It has been developed to ascertain the costs incurred for carrying out various business activities and to help the management to exercise strict cost control. (iv) Tax accounting: This branch of accounting has grown in response to the difficult tax laws such as relating to income tax. sales tax, excise duties, custom duties, etc. An accountant is required to be fully aware of various tax legislations. (v) Social accounting: This branch of accounting is also known as social reporting or social responsibility accounting. It discloses the social benefits created and the costs incurred by the enterprise. Social benefits include such facilities as medical, housing, education, canteen, provident fund and so on while the social costs may include such matters as extra hours worked by employees without payment, environment pollution, unreasonable terminations, etc. (vi) Human resource accounting: It is concerned with the human resources of an enterprise. Accounting methods are applied to identify human resources and its evaluation is done in money terms so that the society might judge the total work of the business enterprises including its nonhuman net assets. It is, therefore, an accounting for the people of the organisation. Unfortunately, no objectively verifiable measure has been developed for universal application. (vii) National accounting means the accounting for the nation as a whole. It is generally not concerned with the accounting of individual business entities and is not based on generally accepted accounting principles. It has been developed by the economists and the statisticians. 1.5 BASIS OF ACCOUNTING The business enterprises use accounting to calculate the profit from the business activities at the end of given period. There are two bases of calculating the profit, namely, the cash basis and the accrual basis. (i) Cash basis of accounting: In this basis of accounting, the income is calculated as the 12 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting excess of actual cash receipts in respect of sale of goods, services, properties, etc. over actual cash payments regarding purchase of goods, expenses on rent, electricity, salaries, etc. Credit transactions are not considered at all including adjustments for outstanding expenses and accrued income items. This method is useful for professional people like doctors, engineers, advocates, chartered accountants, brokers and small traders. It is simple to adopt because there are not adjustment entries. But this basis does not disclose the true profits because it does not consider the income and expense items which relate to the accounting period but not paid in cash. Moreover, this method is not applicable where the number of transactions is very large and expenditure on fixed assets is high. The income or profit is calculated with the help of receipts and payments account. Accrual basis of accounting: Under this method the items of income (revenue) are recognised when they are earned and not when the money is actually received later on. Similarly, expense items are recognised when incurred and not when actual payments are made for them. It means revenue and expenses are taken into consideration for the purpose of income determination on the basis of the accounting period to which they relate. The accrual basis makes a distinction between actual receipts of cash and the right to receive cash for revenues and the actual payments of cash and legal obligations to pay expenses. It means that income accrued in the current year becomes the income of the current year whether the cash for that item of income is received in the current year or it was received in the previous year, or it will be received in the next year. The same is true of expense items. Expense item is recorded if it becomes payable in the current year whether it is paid in the current year, or it was paid in the previous year, or it will be paid in the next year. The advantages of this system are: (a) it is based on all business transactions of the year and, therefore, discloses the correct profit or loss; (b) the method is used in all types of business units; (c) it is more scientific and rational in application; (d) it is most suitable for the application of matching principle. The disadvantages are: (a) it is not simple one and requires the use of estimates and personal judgement; (b) it fails to disclose the actual cash flows. Mixed or hybrid basis of accounting: Under this method revenues (items of income) are recognised on cash basis while the expenses are recorded on accrual basis. The purpose is to remain cautious, safe and hundred per cent certain for revenues items and make adequate provisions for expenses. 1.6 ACCOUNTING CONCEPTS Accounting in the past was mainly used to (1) keep control over property and assets of the business concerned and (2) ascertain and report about the profit or loss and the financial position relating to the various periods. But not a day’s accounting is used not only for the above-mentioned purposes but also for collecting, analysing and reporting of information to the management and others at the required points of time to facilities rational decision making. 13 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) Moreover, the accounts in the past were prepared mainly for the use of the proprietor. Today financial statements are required by the proprietors, creditors, potential investors, Government and many others. The proprietors study the financial statements to know about the profitability of their business. Creditors study them to ascertain the solvency of the business. Prospective investors are interested in them for the ascertainment of the correct earing potential of the business. Government makes use of these statements for finding out the net contribution that a business can make to the economic well being of the country. To satisfy the diverse and complex needs of those who use accounting, one needs something more than the clerical procedures, journalising, posting, taking out trial balance and closing the books etc. The accountant should have 'guides to action' or 'principles' for completing his work of a wide dimensions. The usefulness of accounting will be maximised only if there exist some generally accepted concepts regarding the nature and measurement of liabilities, assets, revenues and expenses. There must also be some widely supported standards of disclosure and reporting. There will be widespread understanding of and reliance on accounting statements only if they are prepared in conformity with generally accepted accounting principles. If there is no common agreement on accounting matters, then complete chaotic conditions would prevail as in that case every businessman and/or every accountant could follow his own definition of revenue and expense. Definition: The rules conventions of accounting are commonly referred to as 'principles'. A universal definition of the 'accounting principles' is difficult to give. However, 'accounting principles' can be defined in the following two ways: 1. Accounting Principle is a "General Truth" or a 'fundamental belief'. This definition implies a scientific bias and therefore, its application in the face of ever-changing socio- economics factors which affect the very basis of a business is doubtful. Accounting principle may be defined as a 'rule of action or conduct'. This definition finds favour with the American Institute of Certified Public Accountants as it refers to changing character of rules of action or conduct due to the changes in business practices etc. According to AICPA, accounting principle is a general law or rule adopted or processed as a guide to action. The accounting principles do not prescribe one way of doing things. They recognize that there are a number of ways in which one thing can be done. The accountant has considerable latitude and choice within the generally accepted accounting principles in which to express his own idea as to the best way of recording and reporting is specified account. The practice of recording and reporting may thus differ from company to company. It should be noted that it would be incorrect to suggest that accounting principles are a body of basic laws like those found in natural sciences like Physics and Chemistry. Accounting principles are man made and hence are more properly associated with such terms as concepts, conventions and standards. Accounting principles were not deducted from basic axioms, not is 14 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Financial Accounting their validity verifiable by observation and experiment in a laboratory. Accounting principles are constantly evolving, being influenced by business practices, the needs of statement users, legislation and governmental regulations, the opinions and actions of shareholders, labour unions, creditors, and management, and the logical reasoning of accountants. The sum total of all such influences finds its expression first in accounting theory. Some theories are accepted while some others are rejected. Theory becomes an accounting principle only when it is generally accepted. A distinction between Fundamental Accounting Assumptions and 'Accounting policies' has been made by the International Accounting Standards Committee (IASC). Fundamental Accounting assumptions or postulates according to the ISC underlie the preparation of financial statement. They need not be specifically stated on the face of such statements. Their acceptance and use are assumed in the preparation of financial statements Disclosure with full reasons, however, must be made in case they are not followed. Accounting policies on the other hand encompass the principles, basis, conventions, rules and procedures adopted by management in preparing and presenting financial statements. There are, as stated above, many different accountings and applying those which in the circumstances of the enterprise, are best suited to present properly its financial position and the results of its operations. 1.7 ESSENTIAL FEATURES OF ACCOUNTING PRINCIPLES The general acceptance of an accounting principle or practice depends on its capacity to meet the criteria of relevance, objectivity and feasibility. An accounting principle should be relevant, i.e., the use of it should result in information that is meaningful and useful to the financial statement users. In other words, only those accounting rules which increase the utility of the business records to its readers will be accepted as an accounting principle by them. It should be objective. The accounting information obtained should not be influenced by the personal bias or judgement of the statement makers. Objectivity can note reliability or trustworthiness. It means that there must be means of ascertaining the correctness of the information reported in a financial statement. A principle is feasible to the extent that it can be implemented without undue cost or complexity. The accounting principles may be adopted to the needs of business quickly and easily. It means the accounting principles should be flexible, i.e., they should not be static. They should be capable of being changed with the changes in business methods and procedures. The accounting principles generally combine all the above-mentioned features or criteria, but sometimes we may have to give up one criterion in favour of another or we may place greater importance on one and lesser importance on the other. For example, while valuing the fixed 15 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) assets at cost for Balance Sheet purposes we give up the criterion of objectivity and usefulness in favour of feasibility. The fixed assets are valued at cost and not at market price even though the cost figure is not of much use of the reader because of changes in the value of rupee, a measuring rod. This is done because of the following two reasons. 1. The market price or replacement value of the assets is difficult to ascertain. 2. The market price or the replacement value of the fixed assets even if one is able to ascertain will be less objective in nature. Thus, in developing new principles, the essential problem is to strike the right balance between objectivity and feasibility on the one hand and relevance on the other. Definition of Accounting Conventions: Accounting conventions mean and signify customs or tradition relating to accounting. Thus, they differ from accounting concepts which are used to connote accounting postulates. In other words, we can say that accounting conventions relate to the practical side of accounting. After understanding the meaning of accounting concepts and conventions let us now discuss each one of these concepts and conventions in some detail. (1) Going Concern Concept: Kohler defines going concern as, "A Business enterprise in operation with the prospects of continuing operation in the future; its assets, liabilities, revenues, operating costs, personnel policies and prospectus; a concept basic to accounting, of importance in the valuation of intangible assets and the depreciation of tangible and intangible assets." (Kohler, E.L.: A Dictionary for Accountants, Prentice- Hall Inc. Engle Wood Cliffs, N.I., 1963). Simply stated accounting assumes that the business will continue to operate for an indefinitely long period in the future. In other words, the accounting unit is considered to have a greater life expectancy than that of any asset which it now owns. This necessitates the making of a distinction between capital expenditure and revenue expenditure. Though every expenditure is a revenue expenditure in the long run, this distinction is important because accounts of a business supposed to run for a long period of time, are usually prepared for a short period say, a year. If this assumption is not made, the generally accepted accounting principles that have been developed and that are applied in the process of accounting for the financial affairs of a business entity and which are, in many instances, appropriate only for a going concern will become redundant or useless. If the business is failing and its assets are subject to forced sale, the conventional accounting approach, although acceptable for a going concern, would often result in wrong or inadequate financial information. Under this assumption a business is viewed as an Economic or financial system for adding value to the resources it uses. Its success is measured by comparing the value 16 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Financial Accounting of its output with the cost of the resources used in producing that output. The difference in the value of its output and the costs of the resources used to produce that output is called profit. Resources purchased but not yet used in production are called assets. They are shown not at current value to an outside buyer, but at their cost. Their current resale value is not relevant, since is assumed that they will be used in the creation of future output values rather than being sold. Thus, the accountant does not try to measure at all times what the business is currently worth to a potential buyer. He does not show in the balance sheets the value; the assets will fetch of the company goes into voluntary liquidation. He rather values the assets used for business purposes at cost. For a going concern that intends to continue using such assets for business purposes, forced sale or current market value is not particularly relevant. But if the business is winding up its affairs and must sell its assets to satisfy the claims of its creditors, the original cost of the assets is no indicator of realisable value. The fact should be kept in mind while preparing the account of a concern if it is clear that the life expectancy of such business is very sort. It is only because of this that in the case of contracts, assets purchased are debited entirely to the contract account and not treated as an asset. (2) The Business Entity Concept: For accounting purposes the business is treated as a complete unit or entity separate from those who own it or give credit to it. The owner or proprietor is considered o be separate and distinct from the business he owns or controls. Accounts are maintained for business entities as distinct from the persons who own them, operate them, or are otherwise associated with the business. For accounting purposes even, the proprietor will be treated as creditor to the extent of his capital. The proprietor's private affairs are thus not allowed to be mixed up with those of the business. It is only because of this concept that we are able to present a true picture of the firm. The entity concept is applicable to all forms of business organisations. For accounting purposes even, the sole trader or partner is considered to be an entity different from the business he owns although even in law there is no distinction between, the financial affairs of the business and those of the people who own it; a creditor of the business can use and if successful collect from the owner's personal resources as well as from the resources of the business. The field of this concept has now been extended. It is now also applied for finding out the results of various departments of the same organisation separately with a view to fixing the responsibility for the results thereof. "There follows from the distinction between the business entity and the outside world that an important purpose of financial accounting is to provide the basis for reporting on stewardship. The managers of a business are entrusted with funds supplied by 17 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) owners, banks and others. Management is responsible for the wise use of these funds, and financial accounting reports are in part designed to show how well this responsibility or stewardship, has been discharged". (Management Accounting Principles by Robert N. Anthony page 22-23). (3) Money Measurement Concept: Accounting records only those facts which could be expressed in terms of money. This concept ignores the records of events on which precise money values can not be put, even if they are very important. In other words, we cannot express qualitative events with the help of accounting unless they can be measured in terms of money with a fair degree of accuracy. This enables us to deal arithmetically (added, subtracted divided or multiplied) with things of diverse nature, e.g., cost of use of plant and machinery and use of skilled labour can be added up. This is so because money provides a common denominator by means of which heterogenous facts about a business can be expressed in terms of numbers that can be dealt with arithmetically. This concept imposes severe limitations on the scope of accounting statements. The Accounts of Gupta & Company, for example, do not reveal that a competitor has introduced an improved service to the customers; they do not report that a strike is beginning or for that matter they do not record the fact that the production manager is not on speaking terms with the Sales Manager because all these events can not be expressed in terms of money. Thus, accounting does not give a complete picture of what is happening in the business or that of the conditions prevailing in the business. It should, however, be noted that money is expressed in terms of its value at the time an event is recorded in the accounts. Change in the purchasing power of money due to inflation or deflation in future years are not taken note of. To sum up we. can say that while money is probably the only practical common denominator, the use of money implies homogeneity, a basic similarity between Re. 1 and another. This homogeneity does not, however, exist in periods of inflation or deflation. (4) Dual Aspect Concept: Dual aspects is perhaps the most important of all the concepts. We require use of this recording each and every business transaction. To understand this concept fully we must know the meaning of the words (i) Assets and (ii) equities. Assets mean the resources owned by a business, e.g., Land, Building, Plant, Machinery, Stock of goods and so on. Equities on the other hand mean the claims of various parties against these assets. Equities can be divided into two broad categories (a) Owner's equity, (or capital) which is the claim of the owner or proprietor of the business and (b) creditors equity, i.e., the claim of creditors of the business. Thus, from the above discussion it follows that the amount of the assets of the business will always be equal to the amount of owners' equity and creditors' equity. This is so because all the assets of a business are claimed by someone, either by the owners or 18 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Financial Accounting by the creditors of the business, and also because the total of these claims can never exceed the amount of assets to be claimed. To put it in the form of an equation we can say that Assets=Equities (Owners' equities as well as Creditor's equities) OR Capital + Liabilities = Assets In its most expanded form, it will be Capital + Revenue + Liabilities = Assets + Expenses. "Accounting systems are set up in such a way that a record is made of two aspects of each event that affects these records and in essence these aspects are changes in assets and changes in equities. Every event that is recorded in the accounts affects at least two items; there is no conceivable way of making only a single change in the accounts. Accounting is thereof properly called a "Double Entry System" (Robert N. Anthony-Management Accounting Principles, Page 26). (5) Realisation Concept: Accounting is a historical record of transaction. It records what was happened. It does not anticipate events, though it usually records adverse effects of anticipated events that have already taken place. Profit it considered to have been earned on the date at which it is realised or on the date when goods or services are furnished to the customers for some valuable consideration or when the third Party becomes legally liable to make payment for goods and services rendered to them. For tangible goods profit is recognised as and when goods are shipped or delivered to the customers and not when either a sales order is received or when a contract is signed or/ and not even when goods are manufactured to meet the order. This concept stops business firms from inflating their profits by recording sales and incomes that are likely to take place in future. There are certain exceptions to this general rule-(a) The revenue is recognised as realised on an earlier date in case where it can be objectively measured earlier than the date of exchange between the seller and the buyer. For example, in case of mining revenue is recognised when the metal is mined, rather than when it is sold. This is so because the metal always has a specified value and hence no market exchange or sale is necessary to establish this value. (b) In case of Hire purchase and instalment selling, revenue may be recognised only when the instalment payments are received and not when goods are delivered due to the doubt about the actual amount that will be received from the hirer. (c) Not full revenue or profits, if the contract of sale stipulates after sale service 19 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) agreement. Probable cost of adequate provision for repairs in such cases be made out of realised profits to arrive at the net revenue figure. (d) In a business where mere production leads to the earning of profits as sales require no effort on the part of the manufacturer, profits are assumed to have been realised as and when goods are manufactured and not when they are actually sold. (6) Accrual Concept: — According to accrual concept, income or profit arises only when there has been an increase in the owner's equity or increase in the owner's share of the assets of the firm but not if such increase results from money contributed by the owner himself. "Any increase in owner's equity resulting from the operations of the business is called a revenue. Any decrease is called an expense. Income is therefore the. excess of revenue over expenses. (If expenses exceed revenue, the difference is called a loss). It is extremely important to recognise that income is associated with change in owner's equity and that it has no necessary relation to change in cash. Income connotes. 'Well- offenses'. Roughly speaking the bigger the income, the better off are the owners. An increase in cash, however, does not necessarily mean that the owners are better off and that their equity is increased. The increase in cash may merely be offset by a decrease in some other asset or an increase in a liability with no effect on owner's equity at all". (Robert N. Anthony, Management Accounting principles, 8th Ptg., Page 45). Thus, the profit is said to have arisen only when the total revenues or incomes exceed total expenses or losses. Settlement, in cash, of transactions already entered into is immaterial for calculating or taking into account the expenses, losses or gain etc. It is enough if they are incurred or earned during the period for which profit is being calculated. (7) Verifiable objective evidence concept: -According to this concept all the entries recorded in the books of account should be supported by business documents known as vouchers. No entry be passed in the books unless it is supported by proper voucher which could also be verified later on as and when it becomes necessary to check the correctness of the accounts. The only limitation to this general rule is entries with regard to non-cash charges, e.g., Depreciation on fixed assets, provision for bad and doubtful debts and so on. (8) Cost Concept: -According to the cost concept which is closely related to Going Concern Concept the assets or resources owned by a business are entered on the accounting records at cost or the price paid to acquire them. According to the same concept the cost of the asset is the basis for all subsequent accounting for the asset. 20 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting Thus, the accounting measurement of assets does not normally reflect the worth of assets except at the moment they are purchased because it is assumed that the purchaser is a prudent businessman and that he will, therefore, not pay more for an asset or service that it is worth at the time. This being so the historical cost is presumed to be equal to the fair value of the asset acquired. In other words, it means that the accountant observing this concept does not ordinarily record the changes in the real worth of an asset which might have occurred with passage in time or due to changes in the value of money, a measuring rod. For example, a building if purchased for Rs. 1,00,000 will be recorded in the books of accounts at Rs. 1,00,000. Subsequent changes in the worth or in the market value of this building would not ordinarily be recorded in the account’s books. The change in the market price of this building, say Rs. 2,00,000 on the date of preparation of the balance sheet will not be considered. It be noted that not all assets, but only fixed assets, are recorded according to this concept. There may be certain assets called current assets, in case of which there may well be a correspondence between accounting measurements and their real market values, cash, for example, is always shown not at its original cost but at its actual worth. Similarly, marketable securities and stock held for resale are generally shown at their near actual worth figure, i.e., at cost or market value which ever is lower. It is because of this fact that it is said that subsequent changes in the market value of assets would ordinarily not be reflected by changes in the accounts. However, it should also be noted that cost concept does not mean that all assets remain in the accounting records at their historical or original cost so long as the company owns them. The cost of a fixed asset, such as a building, that has a long but nevertheless a limited life is systematically reduced over the life of the asset by the process called depreciation. It is because of the process of changing depreciation that the asset disappears from the balance sheet when its economic or useful life is over. "Another important consequence of the concept is that if the company pays nothing for an item it acquires, this item will usually not appear in the accounting records as an asset. The knowledge, skill and expertise of an electronic company's research and development team does not appear in the company's balance sheet as an asset". (An insight into management accounting First Ed., by John Sizer; Page 42.) Following this the goodwill appears in the accounts of the company only when the company has purchased an intangible and valuable property right and paid for it. Even then it is shown at its purchase price even though the management may believe that its real value is considerably higher. No amount for "goodwill" or any other asset for that matter will be shown in the accounts if the company does not actually purchase such intangibles or assets. It also follows from the cost concept that an event may affect the value of a business without having any effect on the accounting records. To take an extreme case, suppose that several key executives are killed in a plane accident. To the extent that "an organisation is but the 21 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) lengthened shadow of a man, the real value of the company will change immediately, and this will be reflected in the market price of the company's stock, which reflects investor's appraisal of value. The accounting records, however, will not be affected by. this event. The cost concept provides an excellent illustration of the problem of applying the three basic criteria... relevance, objectivity and feasibility. If the only criterion were relevance, then the cost concept would not be defensible. Clearly, investors and others are more interested in what the business is actually worth today rather than what the assets cost originally. But who knows what a business is worth today? The fact is that any estimate of current value is just that-an estimate and informed people will disagree on what is the right estimate. Furthermore, accounting reports are prepared by the management of a business, and if they contained estimates of what the business is actually worth, these would be management's estimates. It is quite possible that such estimates be biased. The cost concept, by contrast, provides a relatively objective foundation of accounting. It is not purely objectives, for judgements are necessary in applying it. It is much more objective, however than the alternative of attempting to estimate current values. Essentially, the reader of an accounting report must recognise that it is based on cost concept, and he must arrive at his own estimate of current value, partly by analysing the information in the report and partly by using nonaccounting information. Furthermore a "market value" or "current worth" concept would be difficult to apply, because it would require that the accountant attempt to keep track of the ups and downs of the market prices. The cost concept leads to a system that is much more feasible. In summary, "adherence to the cost concept indicates a willingness on the part of those who developed accounting principles to sacrifice some degree of relevance in exchange for greater objectivity and greater feasibility." (Robert N. Anthony-Management Accounting Principles, Eighth Print., Page 25). (9) Accounting Period Concept: —The net income being the difference between value assets at the time of commencement of business and at the time of liquidation of the business, is easier to calculate when the business comes to an end. But only a few business ventures have a small life. Generally, the business houses last for a very long period of time. Moreover, accountants assume an indefinite life of the business houses (Going concern concept). But the management and other parties would not like to wait for a very long period of time, until, the business has terminated, to obtain information on how much income has been earned or loss suffered by such businesses. It would be too late then to take any corrective steps at that time if the final accounts report that the business was incurring losses. Therefore, they need to know at frequent intervals as to how things are going. The accountant, therefore, measures the income 22 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting or loss not for the entire life of the business but only for a convenient segment of time. The time interval chosen is called the accounting period. Realisation concept and accrual concept are the main or basic guides for sorting out the transactions occurring during an accounting year with a view to measure the income of that period. It should, however, be noted that more frequent reports, called the interim reports, be prepared and sent to management for their perusal and action, if necessary. "Business are living, continuing organisms. The act of chopping the stream of business events into time periods is therefore somewhat arbitrary since business activities do not stop or change measurably as one accounting period ends and another begins. It is this fact which makes the problem of measuring income in an accounting period the most difficult problem of accounting"(Robert N. Anthony, Management Accounting Principles, Eighth Print., Page 44). (10) Matching Concept: — The main motive of doing business now a days is to maximise profits. The proprietors want their accountants to ascertain the profit or loss made by their businesses. The accountants in turn are, therefore, busy most of their time in finding out techniques of measuring profits. For finding out the profits they have to match the revenues of a particular period with the expenses or cost which can be assigned to earning such revenues. Thus, the problem is of matching revenues of the period with the cost of securing that revenue to ascertain the profit for a particular period. It should be noted here that the problem is that of matching the expenses. It means the first step is to ascertain what revenues are to be recognised in a given accounting period. The second step, of course, is to determine the expenses that are associated with these revenues. Some difficulties in measuring the revenue for the artificial accounting year are raised because business is, as said above, a continuous process. (a) Measurement of Revenue: — Revenues are measured in accordance with the accrual concept. According to accrual concept the revenues accrue in the accounting year in which they are earned. It is immaterial whether equivalent cash received in that year or not. Cash basis of determining income has, however, considerable appeal to many people. This is so because it is not only simple but also appears to be realistic. Moreover, it is verifiable and based upon convention of conservatism. It satisfies those businessmen who think that their profit is equal to the excess of current bank balance over the beginning bank balance. According to this basis income is equal to cash received during the year and expense is equal to cash paid out during the same period. Exceptions are, however, made of additional investments by the owners and creditors. These investments are regarded as non-income transactions. 23 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) The cash basis of determining income for the year is deficient in many respects. Therefore, the accountant generally rejects this basic and adopts accrual basis of determining income which rests on the concept of realisation. According to this basis a careful distinction must be made between revenues and cash receipts as revenues need not result in an equivalent amount of cash. It is possible that revenue may be earned this year even though payment is not received until next year. The balance sheet of this year in such a case will show the amount outstanding either as debtors or as accrued revenue. It may also be possible that the business receives cash in the current years which creates a liability to render a service in some future period. The examples of such cases may be subscription received in advance by a magazine publisher or insurance premium received in advance by an insurance company. Similarly, it may still happen that the firm may have received cash last year which become revenue in this year as the services promised then are rendered now. The balance sheet of last year in such a case will show cash received in advance as a liability under the head deferred revenue or pre-collected (received in advance) revenues. Revenue is considered to have been earned on the date when goods or services are furnished to the customer in exchange for cash or some other valuable consideration, barring a few exceptions the revenues are not considered as being earned when an order is received or when goods are manufactured to meet the order or when a contract is signed. Accountants generally recognise revenues only when goods are dispatched to customers. Measurement of Expenses: —Expenses are the costs incurred in connection with the earning of revenue. The term 'expenses' 'connotes' 'Sacrifices made', 'the cost of services or benefits received' or 'resources consumed' during in accounting period. The term 'Cost' is not synonymous with 'Expenses’ Expenses means a decrease in owner's equity that arises from the operation of a business during a specified accounting period, whereas cost means any monetary sacrifice whether or not the sacrifice affects the owner's equity during a given accounting period; (Robert N. Anthony, Management Accounting Principle, Eighth Print, Page 46). The AAA (American Accounting Association) committee gives the following definition of expenses—" Expense is the expired cost directly or indirectly related to given fiscal period of the flow of goods or services into the market and of related operations Recognition of cost expiration is based either on a complete or partial decline in the usefulness of assets or on the appearance of a liability without a corresponding increase in assets." It describes the recognition of expenses as, 'Expense is given recognition in the period in which there is (a) a direct identification or association with the revenue of that period, as in the case of merchandise delivered to customers; (b) an indirect association with the revenue of the period, as in the case of office 24 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting salaries or rent; (c) a measurable expiration of assets costs even though not associated with the production of revenue for the current period, as in the case of losses from flood or fire." It should also be noted that the words expenses and expenditure connote different meanings. An expenditure takes place when we purchase an asset or service. It may be made by cash or by incurring a liability or by the exchange of another asset. There may not necessarily be a correspondence between expenses and expenditure in a time segment of one year though over the entire life of a business most expenditures made by a concern become expense or in other words there are no expenses that are not represented by an expenditure. According to the definition of the word expense given by the AAA Committee expense of the current year include the cost of the products sold in this year, though purchased or manufactured in a prior year. Similarly, other expenses like salaries of salesman who sold these goods and the cost of other services like telephone an electricity etc. consumed or used during the year whether paid or not in the current year shall also be included in the expenses of the current year. Thus, we can say that: — (a) There, may be some expenditure which may become expenses also in the same year because the benefit of the same is consumed in the same year. Such expenses will be recognised as an expense of the current year. (b) There may be other expenditures which were paid in previous year/years but become expense in the current year as the benefit thereof is consumed in the current year. Insurance protection is one such item, The premium is paid in advance, but the insurance protection is received later in the year. Till then the amount paid by way of premium is an asset. It becomes an expense in the accounting period when such protection is received. (c) Some expenditure incurred now may become expenses next year as the goods bought now will be sold next year. These will be shown as an asset on the balance sheet of the current year and will be treated as an expense when these goods are sold. (d) Some expenditure may not be paid for in the current year although goods and services were purchased and consumed during the current year. These will be treated as expenses of the current year. The amounts outstanding will be shown as a liability in the balance sheet of the current year. In contrast to accrual basis, in cash basis an expense is said to have been incurred as and when cash is disbursed. Results of this approach are far from being satisfactory and so the accountant makes a distinction between an incurred cost, a disbursement, and the expiration of a cost. He pinpoints the events of expiration to determine the period to the charged. 25 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) IN-TEXT QUESTIONS 6. _______________ is concerned with the interpretation of accounting information to guide the management for future planning, decision-making, control, etc Management accounting 7. ______ basis of accounting, the income is calculated as the excess of actual cash receipts. Cash 8. In _________ basis of accounting, the items of income (revenue) are recognised when they are earned and not when the money is actually received. Accrual 9. Going concern concept assumes that the business will continue to operate for an indefinitely long period in the future. True/False 10. Under ___________ concept the business is treated as a complete unit or entity separate from those who own it or give credit to it. 1.8 ACCOUNTING CONVENTIONS (i) Convention of Consistency: Accounting is not composed of a set of rules which prescribe the 'one way that things can be done. There are many different ways in which items may be recorded in the accounts. For example, there are several methods of computing yearly depreciation. Each firm should, within these limits, select the methods which give the most equitable importance that the method selected be applied consistently year after year. Successive periodical financial statements would not be comparable, if the accountant continuously changed the method of accounting for certain expenses or assets though each method might be fully acceptable. For example, the profit figure can be changed significantly by changing the methods of depreciation, The user of the statement may be misled and think that the earnings had improved, whereas in reality the increase was solely due to change in the methods of depreciation, change in net income reported in successive statement should be to changes in business conditions or management effectiveness and not simply to changes in accounting methods. However, it does not bind the firm to follow the same method until the firm closes down. A firm can change the method used, but such a change is not affected without the deepest consideration. It means that the accountant can change the method if he thinks that the results of operations and the financial position of the business would more fairly be reflected by such a change. When such a change occurs, then either in the profit and loss account itself or in one of the reports accompanying it, the effect of the change should be stated. 26 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting It should, however, be noted here that the word consistency used here has a narrow meaning. It does not refer to logical consistency at a given moment of time rather it refers to different categories of transactions should be consistent with each other. It only means that the transaction of the same category must be treated consistently from one accounting period to another. Thus, there will be no inconsistency involved if different categories of assets are valued on different basis, e.g., if stock is valued at cost or market value, whichever is lower and fixed assets are valued at cost. Consistency offers the following advantages to the users of the statements: — (1) Intra-Firm comparisons are made possible: — 'Financial statements are most meaningful as source of information about a particular business unit when statements made at several different times are compared with each other. Trends can be discerned, for example, only when the balance sheets of three or more years are placed side by side. To provide optimum comparability, transactions must be analysed and recorded in the same way from one period to another. Items included under one caption on one balance sheet or operating statement should be included under the same caption on another statement. The virtue of consistency is so great that even incorrect procedures consistently applied may produce useful results." (2) Inter-Firm comparisons are made possible: Another use of financial statements is in the comparison of the one business with another business. Some consistency of treatment within an industry would therefore enhance the value of accounting reports. Consistency then, is one objective of generally accepted accounting principles. (ii) Convention of Conservatism: It is the policy of "Playing safe". Financial statements are drawn upon rather a conservative basis. Window dressing in preparing the financial statements is not permitted. This convention is particularly applicable when matters of opinion or estimate are involved in cases of doubt the accountants choose to understate the owner's equity rather than overstate them. This could also be said, "Anticipate no profit and provide for all possible losses." Businessmen are generally inclined to be optimistic. The bankers, creditors, investors and others who use financial statements may be misled as assets in many cases be overstated or liabilities understated in the absence of this convention. To take an example, the provision for doubtful debts is a matter of estimates. Most accountants prefer leaning in the direction of over statement rather than under-statement of the allowance for bad and doubtful debts. The consequences of overstatement of assets and net income are more serious than those of understatement. Balance sheet conservatism was once regarded as the most important of all the accounting principles. But this position of the convention of conservatism is questioned now. Accountants 27 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) are now becoming increasingly aware that adherence to this principle may result in incorrect statement or sometimes in unconservative statement. Charging expense accounts with expenditure which would more properly be charged to fixed asset accounts or to make excessive provision for depreciation may be conservative from the balance sheet standpoint, but it would result in misstatement of net income. Moreover, the net income for periods in which no depreciation will be charged to income statements will be over stands. The income statements for these years will be unconservative to that extent. Thus, we can say that the conservatism can be regarded as a virtue if, as its consequence, income statements and balance sheets do fairly present the result of operations and the financial position stretching this convention to excessive lengths will imply creation of secret reserves which is in direct conflict with the doctrine of full disclosure." "It was probably this convention that led to accountants being portrayed as being rather miserable by nature; they were used to favouring looking on the black side of things and ignoring the bright side. However, the convention has been considerable changes in the last few decades and there has been a shift along the scale away from the gloomy view and more towards the desire to paint a brighter picture when it is warranted." (Business Accounting by Frank Wood, First edition, Page 43) (iii) Convention of full disclosure: —"The accountant proposes to make disclosure of all material facts necessary to complete understanding by third parties or relevant to any decision which might be based on accounting statements." (Smith and Ashburne, Financial and Administrative Accounting, second edition page, 53). The accountant is supposed to prepare the accounts honestly and to disclose all material information. The Companies Act makes ample provision for the disclosure of material information in company accounts. It has prescribed standard form of balance sheet and a schedule of contents of revenue statement these forms are so designed that the disclosure of all relevant facts had become compulsory. Disclosure prompts the accountant to report the realisable value of stock or marketable securities, for example, when that value is substantially different from cost. Disclosure calls for the details of each type of capital stock, such as the par of stated value per share, the preference attached to this issue, the number of shares authorised and the number outstanding and any other fact which would be an important consideration for the present or potential shareholders. If the business entity faces a possible liability or loss that is not definite in amount at the time of preparing statements, but reasonably certain of happening, the accountant is obliged to report the facts as accurately as he can. It should, however, be noted that the convention of disclosure does not imply that any one's or everyone's desire with regard to disclosure shall be fulfilled. It only implies full disclosure of accounts which are of interest to the owners, creditors and present or prospective investors of business. Disclosure of minor details is neither possible nor desirable. 28 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting (iv) Convention of Materiality: Materiality should be interpreted negatively. In its negative sense it means the information, the non-disclosure of which would vitiate the true and fair character of financial statement. The decision with regard to materiality of an information or amount depends upon the magnitude of the amount or the importance of the information for the statement’s users. Thus, as to what is or is not material depends on the nature and size of the firm and on the accountants' Judgement. American Accounting Association defines the term 'materiality' as "An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor." According to this convention less important items are left out whereas mention by way of a footnote or otherwise is made of more important items. Thus, if a bottle of ink was bought it would be used up over a period of time, and this cost is used up every time some one dips his pen into ink. It is possible to record this as an expense every time it happens, but obviously the price of a bottle of ink is so little that it is not worthy recording it in this fashion. The bottle of ink is not a material item and therefore, would be charged as an expense in the period it was bought irrespective of the fact that it could last for more than one accounting period. However, the effect of change in the profit or loss of a business due to change in the method of charging depreciation on fixed assets, provision for gratuity, basis of valuation of stock, etc. are considered to be material and hence the fact of the change and the extent of its effect on the profit or loss of the concern need to be disclosed. Based on this principle, the most modern published accounts usually avoid mentioning the fraction of the rupee in the statements and reports. But in any case, actual accounting entries are always exact. "The materiality concept is important in the process of determining the expenses and revenues for a given accounting period. Many of the expense items that are recorded for an accounting period are necessarily estimates, and in some cases, they are very close estimates, and in some cases, they are not so. There is a point beyond which it is not worth while to attempt to refine these estimates. Telephone expense is a familiar example. Telephone bills although rendered monthly often do not coincide with a calendar month. It would be possible to analyse each bill and classify all the calls according to the month in which they were made. This would be following the accrual concept precisely. Few companies bother to do this, however. They simply consider telephone bills as an expense of the month in which the bill is received on the grounds that a system that would ascertain the real expense would not be justified by the accuracy gained. Since in many businesses the amount of the bills is likely to be relatively stable from one month to another, no significant error may be involved in this practice. Similarly, very few businesses attempt to match the expenses of making telephone calls to the specific revenues that might have been produced by these Calls." (Robert N. Anthony-Managements Accounting Principles-Eighth Print Page 56) 29 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) IN-TEXT QUESTIONS 11. Convention of consistency implies that the methods of accounting should be same over a period of time to ensure the consistency. True/False 12. Convention of conservatism refers to the disclosure of the relevant information to the concerned stakeholders. True/False 13. Convention of Materiality states that less important items are left out whereas mention by way of a footnote or otherwise is made of more important items. True/False. 1.9 SUMMARY The Chapter discusses about the basics of accounting. The accounting works on the double entry basis. The chapter focuses upon the main terms used in the financial accounting like credit and debit. It talks about the real, personal and nominal accounts and the rules of debit and credit followed in these three cases. The lesson talks about the main functions and the users of the accounting as well. Towards the end of the chapter, the accounting concepts and the conventions have been discussed. 1.10 GLOSSARY Debit: In accounts, the debit term is used whenever there is an increase in the asset of decrease in the liability. Credit: The term credit is used when there is a decrease in the asset or increase in the liability. Personal Accounts: In the case of personal accounts, we debit the. person or the firm with the benefits received by him or by the firm and credit the person or the firm with the benefits imparted by the person or the firm. Real Accounts: Real accounts are debited with the incomings and are credited with the outgoings Nominal Accounts: All amounts expended or lost are debited and all amounts gained are credited to nominal accounts. Financial Accounting: Accounting designed for outsiders (persons other than owners and managers) is known as financial accounting. It is concerned with the recording of 30 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Financial Accounting business transactions and the periodic preparation of balance sheet and income statement from such records. 1.11 ANSWER TO IN-TEXT QUESTIONS 1. Financial 8. Accrual 2. Budget 9. True 3. Creditors 10. Separate legal entity 4. Managers 11. True 5. True 12. False 6. Management Accounting 13. True 7. Cash 1.12 SELF-ASSESSMENT QUESTIONS 1. What are the various branches of accounting? 2. The going concern concept and separate business entity concept are the two sides of the same coin. Explain. 3. What is the convention of consistency? What are its limitations? 1.13 REFERENCES Pandey, K. (1999). Financial accounting. Lulu. com. 1.14 SUGGESTED READINGS Monga, J R. Financial Accounting: Concept and Applications. Mayur Paper Backs, New Delhi Goyal, Bhushan Kumar and H.N. Tiwari, Financial Accounting, Taxmann 31 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.Com. (Programme)/ B.Com. (Hons.) LESSON 2 ACCOUNTING STANDARDS STRUCTURE 2.1 Learning Objectives 2.2 Introduction 2.3 Utility of Accounting Standards 2.4 Accounting Standards in India 2.5 Procedure of Preparing Accounting Standards 2.6 Propagation of Accounting Standards 2.7 Preface to the Statements of Accounting Standards 2.7.1 Formation of Accounting Standard Board 2.7.2 Scope and Functions of Accounting Standard Board 2.7.3 Audited Financial Statements 2.7.4 Scope of Accounting Standards 2.7.5 Procedure for Issuing Accounting Standards 2.7.6 Compliance with the Accounting Standards 2.8 Summary 2.9 Glossary 2.10 Answers to In-text Questions 2.11 Self-Assessment Questions 2.12 References 2.13 Suggested Readings 2.1 LEARNING OBJECTIVES To understand the meaning generally accepted accounting principles To know the Accounting Standards applicable in India To explore the procedure followed during the preparation of Accounting Standards 32 | P a g e © Department of Distance & Continu