Accounting Principles PDF

Accounting Principles ===================== Accounting is often called the language of business through which a business house communicates with the outside world. In order to make this language intelligible and commonly understood by all, it is necessary that it should be based on certain uniform...

Accounting Principles ===================== Accounting is often called the language of business through which a business house communicates with the outside world. In order to make this language intelligible and commonly understood by all, it is necessary that it should be based on certain uniform scientifically laid down standards. These standards are termed as accounting principles. Accounting principles have been defined as \"the body of doctrines commonly associated with the theory and procedure of accounting, serving as an explanation of current practices and as a guide for the selection of conventions or procedures where alternatives exist\". In short, accounting principles are guidelines to establish standards for sound accounting practices and procedures in reporting the financial status and periodic performance of a business. These principles can be classified into two categories: (i) Accounting concepts; and (ii) Accounting conventions. **Accounting Concepts** Accounting concepts are defined as basic assumptions on the basis of which financial statements of a business entity are prepared. They are used as a foundation for formulating various methods and procedures for recording and presenting business transactions. The important accounting concepts are given below: \(i) **Business Entity Concept**: According to this concept, business is treated as an entity separate from its owners. It is treated to have a distinct accounting entity which controls the resources of the concern and is accountable thereof. Accounts are kept for a business entity as distinguished from the person(s) owning it. All transactions of the business are recorded in the books of the business from the point of view of the business. Transactions are also recorded between the owner and the business, for instance, when capital is provided by the owner, the accounting record will show the business as having received so much money and as owing to the proprietor. This concept is based on the sense that proprietors entrust resources to the management and the management is expected to use these resources to the best advantage of the firm and to account for the resources placed at its disposal. Hence, in accounting for every type of business organization, be it sole tradership or partnership or joint stock company, business is treated as a separate accounting entity. The failure to recognize the business as a separate accounting entity would make it extremely difficult to evaluate the performance of the business since the private transactions would get mixed with business transactions. The overall effect of adopting this concept is: - Only the business transactions are recorded and reported and not the personal transactions of the owners. - Income or profit is the property of the business unless distributed among the owners. - The personal assets of the owners or shareholders are not considered while recording and reporting the assets of the business entity. \(ii) **Money Measurement Concept**: Money measurement concept holds that accounting is a measurement and communication process of the activities of the firm that are measurable in monetary terms. Thus, only such transactions and events which can be interpreted in terms of money are recorded. Events which cannot be expressed in money terms do not find place in the books of account though they may be very important for the business. Non-monetary events like death, dispute, sentiments, efficiency etc. are not recorded in the books, even though these may have a great effect. Accounting therefore, does not give a complete account of the happenings in a business or an accurate picture of the conditions of the business. Thus, accounting information is essentially in monetary terms and quantified. The system of accounting treats all units of money as the same irrespective of their time dimension. This has created doubts about the utility of the accounting data, leading to the introduction of inflation accounting. \(iii) **Cost Concept**: According to cost concept, the various assets acquired by a concern or firm should be recorded on the basis of the actual amounts involved or spent. This amount or cost will be the basis for all subsequent accounting for the assets. The cost concept does not mean that the assets will always be shown at cost. The fixed asset will be recorded at cost at the time of its purchase but it may systematically be reduced in its value by charging depreciation. These assets ultimately disappear from the balance sheet when their economic life is over and they have been fully depreciated and sold as scrap. It may be noted that if nothing has been paid for acquiring something, it would not be shown in the accounting books as an asset. Cost concept is not much relevant for investors and other users because they are more interested in knowing what the business is actually worth today rather than the original cost. \(iv) **Going Concern Concept**: Business transactions are recorded on the assumption that the business will continue for a long time. There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future. Therefore, it would be able to meet its contractual obligations and use its resources according to the plans and pre-determined goals. It is on this concept that a clear distinction is made between assets and expenses. Transactions are recorded in such a manner that the benefits likely to accrue in future from money spent now or the future consequences of the events occurring now are also taken into consideration. It is because of this concept that fixed assets are valued on the basis of cost less proper depreciation keeping in mind their expected useful life ignoring fluctuations in the prices of these assets. However, if it is certain that a business will continue for a limited period, then the accounting records will be kept on the basis of expected life of the business and there will be no need for such detailed accounting information as to revenue and capital expenditure. When an enterprise liquidates a branch or one segment of its operations, the ability of the enterprise to continue as a going concern is not impaired. But the enterprise will not be considered as a going concern if it goes into liquidation or it has become insolvent. If the assumption of the going concern is not valid, the financial statements should clearly state this fact. \(v) **Dual Aspect Concept**: This concept is based on double entry book-keeping which means that accounting system is set up in such a way that a record is made of the two aspects of each transaction that affects the records. The recognition of the two aspects to every transaction is known as dual aspect concept. Modern financial accounting is based on dual aspect concept. One entry consists of debit to one or more accounts and another entry consists of credit to some other one or more accounts. However, the total amount debited is always equal to the total amount credited. Therefore, at any point of time total assets of a business are equal to its total liabilities. Liabilities to outsiders are known as liabilities, but a liability to owners is referred to as capital. Thus, this concept expresses the relationship that exists among assets, liabilities and the capital in the form of an accounting equation which is as follows: Assets = Liabilities + Capital, or Capital = Assets - Liabilities Since accounting system requires recording of the two aspects of each transaction, this concept shows the effect of each transaction on them. Assets and liabilities are two independent variables and capital is the dependent variable, for it is the difference between assets and liabilities. Any change in any one of these three, must lead to a change in any of the other two. \(vi) **Realization Concept**: According to this concept revenue is recognized only when a sale is made. Unless money has been realized i.e., cash has been received or a legal obligation to pay has been assumed by the customer, no sale can be said to have taken place and no profit can be said to have arisen. It prevents business firms from inflating their profits by recording incomes that are likely to accrue i.e. expected incomes or gains are not recorded. \(vii) **Accrual Concept**: Every transaction and event affects, one or more or all the three aspects viz., assets, liabilities and capital. Normally all transactions are settled in cash but even if cash settlement has not taken place, it is proper to record the transaction or the event concerned into the books. This concept implies that the income should be measured as a difference between revenues and expenses rather than the difference between cash received and disbursements. Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information. It is not necessary that there is an immediate settlement in cash for any transaction or event therefore accrued revenues and costs are recognized as they are earned and incurred and recorded in the financial statements of the period. On the basis of this concept, adjustment entries relating to outstanding and prepaid expenses and income received in advance etc. are made. They have their impact on the profit and loss account and the balance sheet. \(viii) **Accounting Period Concept**: It is customary that the life of the business is divided into appropriate parts or segments for analyzing the results shown by the business. Each part or segment so divided is known as an accounting period. It is an interval of time at the end of which the income or revenue statement and balance sheet are prepared in order to show the results of operations and changes in the resources which have occurred since the previous statements have been prepared. Normally, the accounting period consists of twelve months. \(ix) **Revenue Match Concept**: This concept is based on accounting period concept. In order to determine the profit earned or loss suffered by the business in a particular defined accounting period, it is necessary that expenses of the period should be matched with the revenues of that period. The term \'matching\' means appropriate association of related revenues and expenses. Therefore, income made by the business during a period can be ascertained only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. According to this concept, adjustments should be made for all outstanding expenses, accrued incomes, unexpired expenses and unearned incomes etc. while preparing the final accounts at the end of the accounting period. **Accounting Conventions** The term \'convention\' denotes custom or tradition or practice based on general agreement between the accounting bodies which guide the accountant while preparing the financial statements. It is a guide to the selection or application of a procedure. In fact financial statements, namely, the profit and loss account and balance sheet are prepared according to the following accounting conventions: \(i) **Consistency**: The consistency convention implies that the accounting practices should remain the same from one year to another. The results of different years will be comparable only when accounting rules are continuously adhered to from year to year. For example, the principle of valuing stock at cost or market price whichever is lower should be followed year after year to get comparable results. Similarly, if depreciation is charged on fixed assets according to diminishing balance method, it should be done year after year. The rationale behind this principle is that frequent changes in accounting treatment would make the financial statements unreliable to the persons who use them. The consistency convention does not mean that a particular method of accounting once adopted can never be changed. When an accounting change is desirable, it should be fully disclosed in the financial statements along with its effect in terms of rupee amounts on the reported income and financial position of the year in which the change is made. \(ii) **Disclosure**: Apart from statutory requirements good accounting practice also demands all significant information should be fully and fairly disclosed in the financial statements. All information which is of material interest to proprietors, creditors and investors should be disclosed in accounting statements. This convention is gaining more importance because most of big business units are in the form of joint stock companies where ownership is divorced from management. The Companies Act makes ample provisions for disclosure of essential information so that there is no chance of any material information being left out. \(iii) **Conservatism**: Financial statements are usually drawn up on a conservative basis. There are two principles which stem directly from conservatism. \(a) The accountant should not anticipate income and should provide for all possible losses, and \(b) Faced with the choice between two methods of valuing an asset, the accountant should choose a method which leads to the lesser value. Examples: - Making provisions for bad debts in respect of doubtful debts. - Amortizing intangible assets like goodwill, patents, trade marks, etc. as early as possible. - Valuing the stock in hand at lower of cost or market value. \(iv) **Materiality**: According to the convention of materiality, accountants should report only what is material and ignore insignificant details while preparing the final accounts. The decision whether the transaction is material or not should be made by the accountant on the basis of professional experience and judgment. An item may be material for one purpose while immaterial for another. For the items appearing in the profit and loss account, materiality should be judged in relation to the profits shown by the profit and loss account. And for the items appearing in the balance sheet, materiality may be judged in relation to the groups to which the assets or liabilities belong e.g. for any item of current liabilities, it should be judged in relation to the total current liabilities.