Financial Accounting PDF - B.Com 1st Semester - Alagappa University

ALAGAPPA UNIVERSITY [Accredited with ‘A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle and Graded as Category–I University by MHRD-UGC] (A State University Established by the Government of Tamil Nadu) KARAIKUDI – 630 003 Directorate of Distance Education...

ALAGAPPA UNIVERSITY [Accredited with ‘A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle and Graded as Category–I University by MHRD-UGC] (A State University Established by the Government of Tamil Nadu) KARAIKUDI – 630 003 Directorate of Distance Education B.Com. I - Semester 102 14 FINANCIAL ACCOUNTING  Reviewer Assistant Professor, Dr. R. Ganapathi Directorate of Distance Education, Alagappa University, Karaikudi Authors: Dr. S.N. Maheshwari, Professor Emeritus and Academic Advisor Delhi Institute of Advanced Studies, Delhi Dr. Suneel K. Maheshwari, Professor of Accounting, Eberly College of Business and Information Technology, Indiana University of Pennsylvania, USA CA Sharad K. Maheshwari, Maheshwari Sharad & Co. Chartered Accountants, Gurugram, Haryana "The copyright shall be vested with Alagappa University" All rights reserved. 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LTD. E-28, Sector-8, Noida - 201301 (UP) Phone: 0120-4078900 Fax: 0120-4078999 Regd. Office: 7361, Ravindra Mansion, Ram Nagar, New Delhi 110 055 Website: www.vikaspublishing.com Email: [email protected] Work Order No. AU/DDE/DE1-238/Preparation and Printing of Course Materials/2018 Dated 30.08.2018 Copies - 500  SYLLABI-BOOK MAPPING TABLE Financial Accounting Syllabi Mapping in Book BLOCK I: BASIC FINANCIAL ACCOUNTING AND CONCEPTS Unit 1: Basic Concepts of Financial UNIT – I: Financial Accounting – Meaning of Book Keeping, Accounting Accounting and Accountancy - Distinction between Book Keeping and (Pages 1-20) Accounting, Accounting Process - Objectives of Accounting - Various Unit 2: Accounting Concepts: users of Accounting Information, Limitations of Accounting - Accounting Principles and Conventions Terminologies. (Pages 21-39) Unit 3: Recording of Transactions UNIT – II: Accounting Concepts - Principles and Conventions – Meaning (Pages 40-56) of Accounting Concepts – Principles – Conventions - Types of Accounting Unit 4: Secondary Books Concepts - Types of Accounting Principles - Types of Accounting (Subsidiary Books) Conventions - Accounting standards - International Financial Reporting (Pages 57-88) Standards [IFRS]. UNIT – III: Recording of Transactions - Meaning of Assets – Liabilities – Equity - Accounting Equation and Effects of Financial Transaction on Accounting Equation - Classification of Accounts under Modern Approach Method - Double Entry System and Rules of Debit and Credit Entries. UNIT – IV: Secondary Books – Cash Book - Petty Cash Book - Ledger. BLOCK II: FINAL ACCOUNTS AND ADJUSTMENTS Unit 5: Trial Balance and Rectification of Errors UNIT – V: Trial Balance and Rectification of Errors - Error in Accounting. (Pages 89-111) Unit 6: Final Accounts- I UNIT – VI: Final Accounts – 1 – Meaning - Objectives and Characteristics (Pages 112-139) of Final Accounts - Adjustments before Preparing Final Accounts - Closing Unit 7: Final Accounts- II Entries. (Pages 140-174) Unit 8: Bank Reconciliation Statement UNIT – VII: Final Accounts – 2 – Trading Account - Profit and Loss (Pages 175-190) Account - Balance Sheet - Treatment of Adjustments - Practical Problems. UNIT – VIII: Bank Reconciliation Statement - Meaning of Bank Reconciliation Statement - Importance of Bank Reconciliation Statement - Reasons for Difference - Procedure for Reconciliation. BLOCK III: PARTNERSHIP ACCOUNTS Unit 9: Bills of Exchange (Pages 191-210) UNIT – IX: Bills of Exchange - Acceptance of a Bill - Due Date - Recording Unit 10: Partnership Accounts of Bill of Exchange in the books of Accounts. (Pages 211-234) Unit 11: Retirement and Death UNIT – X: Partnership Accounts - Admission of a Partner - Partnership - of a Partner Meaning and Features - Partnership Deed and Contents - Admission of a (Pages 235-254) Partner - Good will-Meaning - Accounting Treatment of Goodwill at the Time of Admission - Revaluation of Assets and Liabilities - Adjustments of Reserves and Accumulated Profits or Losses. UNIT – XI: Retirement and Death of a Partner – Meaning of Retirement of Partner - Calculation of New Profit Sharing Ratio and Gaining Ratio - Adjustments with Regard to Goodwill - Revaluation of Assets and Unit 12: Depreciation Accounting Liabilities - Settling the Claim of Retiring Partner - Death of Partner. (Pages 255-280) Unit 13: Company Accounts-I BLOCK IV: COMPANY ACCOUNTS (Pages 281-320) Unit 14: Company Accounts-II UNIT – XII: Depreciation Accounting: Meaning of Depreciation - Causes (Pages 321-354) for Depreciation, Need for Depreciation - Computation of the Amount of Depreciation - Depreciation on Additions to Fixed Assets - Methods of Depreciation, Revised AS 6. UNIT – XIII: Company Accounts – Kinds of Companies - Formation of Companies - Share Capital - Issue of Shares - Under Subscription & Oversubscription - Issue of Shares at Premium & Discount - Buyback of Shares and Treasury Stock - Accounting Treatments and Ledger Preparation. UNIT – XIV: Company Accounts – Forfeiture of Shares - Reissue of Shares - Issue of Bonus Shares - Rights Issue - Share Split - Buy Back of Shares - Redemption of Preference Shares - Debentures.  CONTENTS INTRODUCTION BLOCK I: BASIC FINANCIAL ACCOUNTING AND CONCEPTS UNIT 1 BASIC CONCEPTS OF FINANCIAL ACCOUNTING 1-20 1.0 Introduction 1.1 Objectives 1.2 Meaning of Book-Keeping and Accounting and Distinction Between Them 1.2.1 Accounting and Accountancy 1.2.2 Various Users of Accounting Information 1.2.3 Objectives of Accounting 1.2.4 Limitations of Accounting 1.3 Accounting system and Process 1.3.1 Accounting Equation 1.3.2 Double Entry System and Single Entry System 1.3.3 Systems of Accounting 1.4 Accounting Terminologies 1.5 Answers to Check Your Progress Questions 1.6 Summary 1.7 Key Words 1.8 Self Assessment Questions and Exercises 1.9 Further Readings UNIT 2 ACCOUNTING CONCEPTS: PRINCIPLES AND CONVENTIONS 21-39 2.0 Introduction 2.1 Objectives 2.2 Meaning and Types of Accounting Concepts 2.3 Accounting Convention and Its Types 2.4 Accounting Principles 2.5 Accounting Standards 2.5.1 International Accounting Standards Committee and IAS/IFRS 2.6 Answers to Check Your Progress Questions 2.7 Summary 2.8 Key Words 2.9 Self Assessment Questions and Exercises 2.10 Further Readings UNIT 3 RECORDING OF TRANSACTIONS 40-56 3.0 Introduction 3.1 Objectives 3.2 Meaning of Assets, Liabilities and Equity, and Modern Approach to Classify Accounts 3.2.1 Classification of Accounts under Modern Approach Method 3.3 Journal 3.3.1 Rules of Debit and Credit  3.3.2 Compound Journal Entry 3.3.3 Opening Entry 3.4 Answers to Check Your Progress Questions 3.5 Summary 3.6 Key Words 3.7 Self Assessment Questions and Exercises 3.8 Further Readings UNIT 4 SECONDARY BOOKS (SUBSIDIARY BOOKS) 57-88 4.0 Introduction 4.1 Objectives 4.2 Different Types of Journals 4.3 Ledger 4.4 Answers to Check Your Progress Questions 4.5 Summary 4.6 Key Words 4.7 Self Assessment Questions and Exercises 4.8 Further Readings BLOCK II: FINAL ACCOUNTS AND ADJUSTMENTS UNIT 5 TRIAL BALANCE AND RECTIFICATION OF ERRORS 89-111 5.0 Introduction 5.1 Objectives 5.2 Trial Balance 5.3 Errors in Accounting and Its Rectification 5.3.1 Location of Errors 5.3.2 Rectifying Accounting Entries 5.4 Answers to Check Your Progress Questions 5.5 Summary 5.6 Key words 5.7 Self Assessment Questions and Exercises 5.8 Further Readings UNIT 6 FINAL ACCOUNTS- I 112-139 6.0 Introduction 6.1 Objectives 6.2 Meaning, Objectives and Characteristics of Final Accounts 6.2.1 Characteristics of Final Accounts 6.2.2 Objectives of Final Accounts 6.3 Adjustments Before Preparing Final Accounts 6.4 Answers to Check Your Progress Questions 6.5 Summary 6.6 Key Words 6.7 Self Assessment Questions and Exercises 6.8 Further Readings UNIT 7 FINAL ACCOUNTS- II 140-174 7.0 Introduction 7.1 Objectives 7.2 Trading Account 7.3 Profit and Loss Account 7.4 Balance Sheet 7.4.1 Treatment of Adjustments 7.5 Practical Problems 7.6 Answers to Check Your Progress Questions 7.7 Summary 7.8 Key Words 7.9 Self Assessment Questions and Exercises 7.10 Further Readings UNIT 8 BANK RECONCILIATION STATEMENT 175-190 8.0 Introduction 8.1 Objectives 8.2 Meaning, Importance and Procedure of Reconciliation 8.2.1 Reasons for Difference 8.2.2 Meaning and Importance of Bank Reconciliation Statement 8.2.3 Technique or Procedure of Preparing Bank Reconciliation Statement 8.3 Answers to Check Your Progress Questions 8.4 Summary 8.5 Key Words 8.6 Self Assessment Questions and Exercises 8.7 Further Readings BLOCK III: PARTNERSHIP ACCOUNTS UNIT 9 BILLS OF EXCHANGE 191-210 9.0 Introduction 9.1 Objectives 9.2 Bills of Exchange: Fundamental Concepts 9.3 Recording of Bill of Exchange in the Books of Account 9.4 Answers to Check Your Progress Questions 9.5 Summary 9.6 Key Words 9.7 Self Assessment Questions and Exercises 9.8 Further Readings UNIT 10 PARTNERSHIP ACCOUNTS 211-234 10.0 Introduction 10.1 Objectives 10.2 Partnership: Meaning, Features, Deed and Contents 10.3 Admission of a Partner 10.4 Answers to Check Your Progress Questions 10.5 Summary  10.6 Key Words 10.7 Self Assessment Questions and Exercises 10.8 Further Readings UNIT 11 RETIREMENT AND DEATH OF A PARTNER 235-254 11.0 Introduction 11.1 Objectives 11.2 Retirement of a Partner 11.3 Death of a Partner 11.4 Answers to Check Your Progress Questions 11.5 Summary 11.6 Key Words 11.7 Self Assessment Questions and Exercises 11.8 Further Readings BLOCK IV: COMPANY ACCOUNTS UNIT 12 DEPRECIATION ACCOUNTING 255-280 12.0 Introduction 12.1 Objectives 12.2 Depreciation: Meaning, Need and Cause 12.2.1 Causes of Depreciation 12.2.2 Basic Features of Depreciation 12.2.3 Meaning of Depreciation Accounting 12.2.4 Objectives of Providing Depreciation 12.2.5 Fixation of Depreciation Amount 12.2.6 Methods of Recording Depreciation 12.3 Methods for Providing Depreciation 12.4 Answers to Check Your Progress Questions 12.5 Summary 12.6 Key Words 12.7 Self Assessment Questions and Exercises 12.8 Further Readings UNIT 13 COMPANY ACCOUNTS-I 281-320 13.0 Introduction 13.1 Objectives 13.2 Meaning and Characteristics of Companies 13.3 Kinds of Companies 13.4 Formation of Companies 13.5 Share Capital 13.6 Undersubscription, Oversubscription and Issue of Shares at Premium and Discount 13.7 Buyback of Shares and Treasury Stock 13.8 Answers to Check Your Progress Questions 13.9 Summary 13.10 Key Words 13.11 Self Assessment Questions and Exercises 13.12 Further Readings UNIT 14 COMPANY ACCOUNTS-II 321-354 14.0 Introduction 14.1 Objectives 14.2 Forfeiture of Shares 14.3 Redemption of Preference Shares 14.4 Right Issue 14.5 Debentures 14.6 Answers to Check Your Progress Questions 14.7 Summary 14.8 Key Words 14.9 Self Assessment Questions and Exercises 14.10 Further Readings Introduction INTRODUCTION Good accountants make good finance managers. This is wholly true since NOTES accounting is one of the important tools for modern managers providing quantitative information, primarily of financial nature, necessary for making vital economic decisions. Both accounting and finance are growing and developing subjects and as such, accounting and financial concepts, procedures and techniques are also constantly being reviewed and revised. A clear exposition of these concepts, procedures and techniques is a must for every business executive. The universities and professional institutions which prepare young men and women for careers in business and industry have, therefore, a solemn duty to perform. Their courses must be constantly updated so that they meet the growing and dynamic demands of business and industry. Keeping in mind the requirement of financial accounting, we will discuss in this book, the basic financial accounting concepts, the accounting entries related to final accounts and adjustments, the accounting treatment of partnership accounts and the provisions related to maintaining company accounts. This book, Financial Accounting, is written with the distance learning student in mind. It is presented in a user-friendly format using a clear, lucid language. Each unit contains an Introduction and a list of Objectives to prepare the student for what to expect in the text. At the end of each unit are a Summary and a list of Key Words, to aid in recollection of concepts learnt. All units contain Self Assessment Questions and Exercises, and strategically placed Check Your Progress questions so the student can keep track of what has been discussed. Self-Instructional 10 Material  Basic Concepts of Financial Accounting BLOCK - I BASIC FINANCIAL ACCOUNTING AND CONCEPTS NOTES UNIT 1 BASIC CONCEPTS OF FINANCIAL ACCOUNTING Structure 1.0 Introduction 1.1 Objectives 1.2 Meaning of Book-Keeping and Accounting and Distinction Between Them 1.2.1 Accounting and Accountancy 1.2.2 Various Users of Accounting Information 1.2.3 Objectives of Accounting 1.2.4 Limitations of Accounting 1.3 Accounting system and Process 1.3.1 Accounting Equation 1.3.2 Double Entry System and Single Entry System 1.3.3 Systems of Accounting 1.4 Accounting Terminologies 1.5 Answers to Check Your Progress Questions 1.6 Summary 1.7 Key Words 1.8 Self Assessment Questions and Exercises 1.9 Further Readings 1.0 INTRODUCTION Accounting has rightly been termed as the language of the business. The basic function of a language is to serve as a means of communication. Accounting also serves this function. It communicates the result of business operations to various parties who have some stake in the business, viz., the proprietor, creditors, investors, Government and other agencies. Though accounting is generally associated with business but it is not only business which makes use of accounting. Persons like housewives, Government and other individuals also make use of accounting. For example, a housewife has to keep a record of the money received and spent by her during a particular period. She can record here receipts of money on one page of her “household diary”, while payments for different items such as milk, food, clothing, house, education, etc., on some other page or pages of her diary in a chronological order. Such a record will help her in knowing about: (i) The sources from which she received cash and the purposes for which it was utilised. Self-Instructional Material 1 Basic Concepts of (ii) Whether her receipts are more than her payments or vice versa? Financial Accounting (iii) The balance of cash in hand or deficit, if any, at the end of a period. In case the housewife records her transactions regularly, she can NOTES collect valuable information about the nature of her receipts and payments. For example, she can find out the total amount spent by her during a period (say, a year) on different items, say milk, food, education, entertainment, etc. Similarly, she can find the sources of her receipts such as salary of her husband, rent from property, cash gifts from her near relations, etc. Thus, at the end of a period (say, a year) she can see for herself about her financial position, i.e., what she owns and what she owes. This will help her in planning her future income and expenses (or making out a budget) to a great extent. The need for accounting is all the more greater for a person who is running a business. He knows: (i) What he owns? (ii) What he owes? (iii) Whether he has earned a profit or suffered a loss on account of running a business? (iv) What is his financial position, i.e., whether he will be in a position to meet all his commitments in the near future or he is in the process of becoming a bankrupt. 1.1 OBJECTIVES After going through this unit, you will be able to: Discuss the meaning and differences between Book-Keeping and accounting Describe the concepts of accounting and accountancy Explain the various users of accounting information Identify the objectives of accounting Examine the accounting system and process Explain the limitation of accounting Discuss the accounting terminologies 1.2 MEANING OF BOOK-KEEPING AND ACCOUNTING AND DISTINCTION BETWEEN THEM Some people take book-keeping and accounting as synonymous terms, but they are different from each other. Book-keeping is mainly concerned with recording of financial data relating to the business operations in a significant and orderly manner. A book-keeper may be responsible for keeping all the records of a business or only of a minor segment, such as a position of the Customers’ accounts in a departmental store. A substantial portion of the Self-Instructional 2 Material book-keeper’s work is of a clerical nature and is increasingly being Basic Concepts of Financial Accounting accomplished through the use of mechanical and electronical devices. Accounting is primarily concerned with designing the systems for recording, classifying and summarizing the recorded data and interpreting NOTES them for internal and external endusers. Accountants often direct and review the work of the book-keepers. The larger the firm, the greater is the responsibility of the accountant. The work of an accountant in the beginning may include some book-keeping. An accountant is required to have a much higher level of knowledge, conceptual understanding and analytical skill than what is required for a book-keeper. The difference between book-keeping and accounting can be well understood with the help of the following example: If A sells goods to B on credit, the only fundamental principle involved is of “dual aspect” and to give a true picture of the transaction, both the aspects must be considered. On the one hand, A has lost one asset, i.e., good and on the other hand, he has obtained another asset, i.e., a “debt due from B”. The book-keeper should debit B’s account in A’s books and credit the sales account. However, if at the end of a year, A has got some stock of goods with him, they should be properly valued in order to ascertain the true profit of the business. The principle to be followed in valuing the stock and many adjustment that will have to be made before the books of account can be closed and true profit or loss can be ascertained, are all matters of accounting. Thus, book-keeping is more of a routine work and a book-keeper, if instructed properly, can record the routine transactions quite efficiently even if he does not know much of accounting principles. Is Accounting A ‘Science’ or An ‘Art’? Any organized knowledge based on certain basic principles is a ‘science’. Accounting is also a science. It is a organized knowledge based on scientific principles which have been developed as result of study and experience. Of course, accounting cannot be termed as a “perfect science” like Physics or Chemistry where experiments can be carried and perfect conclusions can be drawn. It is a social science depending much on human behaviour and other social and economic factors. Thus, perfect conclusions cannot be drawn. Some people, therefore, though not very correctly, do not take accounting as a science. Art is the technique which helps us in achieving our desired objective. Accounting is definitely an art. The American Institute of Certified Public Accountants also defines accounting as “the art of recording, classifying and summarizing the financial transactions”. Accounting helps in achieving our desired objective of maintaining proper accounts, i.e., to know the profitability and the financial position of the business, by maintaining proper accounts. Self-Instructional Material 3 Basic Concepts of 1.2.1 Accounting and Accountancy Financial Accounting Honestly speaking, in today’s world, there is not much difference between accounting and accountancy. The terms have become pretty much NOTES interchangeable. Accounting is traditionally one of the three principles of accountancy (the others were bookkeeping and auditing), which was the application of reading and maintaining the financial records of said company. Traditionally, accountancy is the parent term for the entire field and accounting was a specific duty of an accountant. Accountancy is referred to as the actual process of communicating information about the financial state of a company to its shareholders, usually in the form of financial statements, which show the assets and resources under the company’s control in monetary terms. 1.2.2 Various Users of Accounting Information Accounting is of primary importance to the proprietors and the managers. However, other persons such as creditors, prospective investors, employees, etc., are also interested in the accounting information. 1. Proprietors A business is done with the objective of making profit. Its profitability and financial soundness are, therefore, matters of prime importance to the proprietors who have invested their money in the business. 2. Managers In a sole proprietary business, usually the proprietor is the manager. In case of a partnership business either some or all the partners participate in the management of the business. They, therefore, act both as managers as well as owners. In case of joint stock companies, the relationship between ownership and management becomes all the more remote. In most cases the shareholders act merely as rentiers of capital and the management of the company passes into the hands of professional managers. The accounting disclosures greatly help them in knowing about what has happened and what should be done to improve the profitability and financial position of the enterprise in the period to come. 3. Creditors Creditors are the persons who have extended credit to the company. They are also interested in the financial statements because these will help them in ascertaining whether the enterprise will be in a position to meet its commitment towards them both regarding payment of interest and principal. 4. Prospective Investors A person who is contemplating an investment in a business will like to know about its profitability and financial position. A study of the financial statements will help him in this respect. Self-Instructional 4 Material  5. Government The Government is interested in the financial statements Basic Concepts of Financial Accounting of business enterprise on account of taxation, labour and corporate laws. If necessary, the Government may ask its officials to examine the accounting records of a business. NOTES 6. Employees The employees are interested in the financial statements on account of various profit sharing and bonus schemes. Their interest may further increase in case they purchase shares of the companies in which they are employed. 7. Citizen An ordinary citizen may be interested in the accounting records of the institutions with which he comes in contact in his daily life, e.g., bank, temple, public utilities such as gas, transport and electricity companies. In a broader sense, he is also interested in the accounts of a government company, a public utility concern etc., as a voter and a tax-payer. 1.2.3 Objectives of Accounting The following are the main objectives of accounting: 1. To keep systematic records Accounting is done to keep a systematic record of financial transactions. In the absence of accounting there would have been terrific burden on human memory which is most cases would have been impossible to bear. 2. To protect business properties Accounting provides protection to business properties from unjustified and unwarranted use. This is possible on account of accounting supplying the following information to the manager or the proprietor. (i) The amount of the propreitor’s funds invested in the business. (ii) How much the business has to pay to others? (iii) How much the business has to recover from others? (iv) How much the business has in the form of (a) fixed assets, (b), cash in hand, (c) cash at bank, (d) stock of raw materials, work-in- progress and finished goods? Information about the above matters helps the proprietor in assuming that the funds of the business are not unnecessarily kept idle or under-utilised. 3. To ascertain the operational profit or loss Accounting helps in ascertaining the net profit earned or loss suffered on account of carrying the business. This is done by keeping a proper record of revenues and expenses of a particular period. The Profit and Loss Account is prepared at the end of a period and if the amount of revenue for the period is more than the expenditure incurred in earning that revenue, there is Self-Instructional Material 5 Basic Concepts of said to be a profit. In case the expenditure exceeds the revenue, there Financial Accounting is said to be a loss. Profit and Loss Account will help the management, investors, creditors, etc., in knowing whether running of the business has proved to be NOTES remunerative or not. In case it has not proved to be remunerative or profitable, the cause of such a state of affairs will be investigated and necessary remedial steps will be taken. 4. To ascertain the financial position of business The profit and Loss Account gives the amount of profit or loss made by the business during a particular period. However, it is not enough. The businessman must know about his financial position, i.e., where he stands what he owes and what he owns? This objective is served by the Balance Sheet or Position Statement. The Balance Sheet is a statement of assets and liabilities of the business on a particular date. It serves as barometer for ascertaining the financial health of the business. 5. To facilitate rational decision making Accounting these days has taken upon itself the task of collection, analysis and reporting of information at the required points of time to the required levels of authority in order to facilitate rational decision making. The American Accounting Association has also stressed this point while defining the term ‘accounting’ when it says that accounting is, “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information.” Of course, this is by no means an easy task. However, the accounting bodies all over the world and particularly the International Accounting Standards Committee, have been trying to grapple with this problem and have achieved success in laying down some basic postulates on the basis of which the accounting statements have to be prepared. 1.2.4 Limitations of Accounting Financial accounting well answered the needs of business in the initial stages when the business was not so complex. The growth and complexities of modern business brought out the following limitations of financial accounting: 1. Provides only limited information There are now no set patterns of business on account of radical changes in business activities. An expenditure may not bring an immediate advantage to the business but it may have to be incurred because it may bring advantage to the business in the long run or may be necessary simply to sell the name of the business. The management needs a lot of varied information to decide whether on the whole it will be justifiable to incur a particular expenditure or not. Financial accounting fails to provide such information. Self-Instructional 6 Material 2. Treats figures as single, simple and silent items Financial accounting Basic Concepts of Financial Accounting fails to make the people realize that accounting figures are not mere isolated phenomena but they represent a chain of purposeful and pertinent events. The role of accountant these days is not only of a book-keeper and auditor, but also that of a financial adviser. Recording NOTES of transactions is now the secondary function of the accountant. His primary function now is to analyse and interpret the results. 3. Provides only a post-mortem record of business transactions Financial accounting provides only a post-mortem record of business transactions since it records transactions only on historical basis. These days business decisions are made on the basis of estimates and projections rather than historical facts. Of course, past records are helpful in making future projections but they alone are not sufficient. Thus, needs of modern management demand a break-up from the principles and practice of traditional accounting. 4. Considers only quantifiable information Financial accounting considers only those factors which are capable of being quantitatively expressed. In modern times, the concept of welfare state has resulted in increased government interference in all sectors of the national economy. The management has, therefore, to take into account government decisions over and above purely commercial considerations. Some of these factors are not capable of being quantitatively expressed and hence their impact is not reflected in financial statements. 5. Fails to provide informational needs of different levels of management The shareholders are only rentiers of capital. The business is run in reality by different executives, each an expert in his area. These executives have powers based on the level of management to which they belong. There are usually three levels of management— top management, middle management and lower management. The type of information required by each level of management is different. The top management is mainly concerned with the policy decisions. They, therefore, are interested in knowing about the soundness of the plans, proper structuring of the organization, proper delegation of authority and its effectiveness. The middle management executives function as coordinators. They must know: (i) What happened? (ii) Where it happened? and (iii) Who is responsible? The lower management people function as operating supervisors. They should get information regarding effectiveness of their operations. The reports submitted to them should give details about the planned performance, actual performance and the deviations with their reasons. Financial accounting does not have a built-in system to provide all such information. Self-Instructional Material 7 Basic Concepts of Financial Accounting Check Your Progress 1. List some of the users of accounting information. NOTES 2. Which accounting tool helps to ascertain the financial position of a business?? 1.3 ACCOUNTING SYSTEM AND PROCESS Book-keeping, as explained earlier, is the art of recording pecuniary or business transactions in a regular and systematic manner. This recording of transactions may be done according to any of the following two systems: 1. Single entry system An incomplete double entry system can be termed as a single entry system. According to Kohler, “it is a system of book- keeping in which as a rule only records of cash and personal accounts are maintained, it is always incomplete double entry, varying with circumstances”. This system has been developed by some business houses, who for their convenience, keep only some essential records. Since all records are not kept, the system is not reliable and can be used only by small firms. 2. Double entry system The system of ‘double entry’ book-keeping which is believed to have originated with the Venetian merchants of the fifteenth century, is the only system of recording the two-fold aspect of the transaction. This has been, to some extent, explained while discussing the ‘dual aspect concept’ earlier in this unit. The system recognises that every transaction has a two-fold effect. If some one receives something then either some other person must have given it, or the first mentioned person must have lost something, or some service etc., must have been rendered by him. 1.3.1 Accounting Equation The double entry system of book-keeping can very well be explained by the “accounting equation” given below: Assets = Equities The properties owned by business are called ‘assets’. The rights to the properties are called ‘Equities’. Equities may be sub-divided into two principal types: the rights of the creditors and the rights of the owners. The equity of creditors representing debts of the business and are called “liabilities”. The equity of owners is called “capital”, or proprietorship or owner’s equity. Thus: Assets = Liabilities + Capital or Capital = Assets – Liabilities Self-Instructional 8 Material  The accounting equation can be understood with the help of the Basic Concepts of Financial Accounting following transactions: Transaction 1. A starts business with a capital of `10,000 There are two aspects of the transaction. The business has received cash of NOTES `10,000. It is its asset but on the other hand it has to pay a sum of `10,000 to A, the Proprietor. Thus: Capital and Liabilities ` Assets ` Capital 10,000 Cash 10,000 Transaction 2. A purchases furniture for cash worth `2,000. The position of his business will be as follows: Capital and Liabilities ` Assets ` Capital 10,000 Cash 8,000 Furniture 2,000 10,000 10,000 Transaction 3. A purchases cotton bales from B for `5,000 on credit. He sells for cash cotton bales costing `3,000 for `4,000 and `1,000 for `1,500 on credit to P. As a result of these transactions the business makes a profit of `1,500 (i.e. `5,500 –`4,000) this will increase A’s Capital from `10,000 to `11,500. The business will have a liability of `5,000 to B and two more assets in the form of a debtor P for `1,500 and stock of cotton bales of `1,000. The position of his business will now be as follows: Capital and Liabilities ` Assets ` Creditor (B) 5,000 Cash (`8,000 + 4,000) 12,000 Capital 11,500 Stock of Cotton Bales 1,000 Debtor (P) 1,500 Furniture 2,000 16,500 16,500 Transaction 4. A withdraws cash of `1,000 and cotton bales of `200 for his personal use. The amount and the goods withdrawn will decrease relevant assets and A’s capital. The position will be now as follows: Capital and Liabilities ` Assets    ` Creditor (B) 5,000 Cash (`12,000 – 1,000) 11,000 Capital (`11,500 – 1,200) 10,300 Stock of Cotton Bales 800 Debtor (P) 1,500 Furniture 2,000 15,300 15,300 The above type of statement showing the financial position of a business on a certain date is termed as balance sheet. Self-Instructional Material 9 Basic Concepts of The result of applying the system of double entry system may be Financial Accounting summarised in the form of following rule: “For every debit there must be equivalent credit and vice versa.” NOTES The rules of Debit and Credit have been explained in the succeeding chapter. Illustration 1.1. Anil had the following transactions. Use accounting equation to show their effect on his assets, liabilities and capital: 1. Started business with cash ` 5,000 2. Purchased goods on credit 400 3. Purchased goods for cash 100 4. Purchased furniture 50 5. Withdrew for personal use 70 6. Paid rent 20 7. Received Interest 10 8. Sold goods costing `50 on credit for 70 9. Paid to creditors 40 10. Paid for salaries 20 11. Further capital invested 1,000 12. Borrowed from P 1,000 Solution: Accounting Equation: Assets = Liabilities + Capital No. Transaction Assets = Liabilities + Capital ` ` ` 1. Anil started business with cash `5,000 5,000 = 0 + 5,000 2. Purchased goods on credit for `400 400 = 400 + 0 New Equation 5,400 = 400 + 5,000 3. Purchase goods for cash `100 + 100 – 100 = 0 + 0 New Equation 5,400 = 400 + 5,000 4. Purchased furniture `50 + 50 – 50 = 0 + 0 New Equation 5,400 = 400 + 5,000 5. Withdrew for personal use `70 – 70 = 0 – 70 New Equation 5,330 = 400 + 4,930 6. Paid rent – 20 = 0 + – 20 New Equation 5,310 = 400 + 4,910 7. Received interest `10 + 10 = 0 + 10 New Equation 5,320 = 400 + 4,920 8. Sold goods consisting `50 on credit + 70 for `70 – 50 = 0 + 20 New Equation 5,340 = 400 + 4,940 9. Paid to creditors `40 – 40 = – 40 + 0 New Equation 5,300 = 360 + 4,940 10. Paid for salaries `20 – 20 = 0 – – 20 Self-Instructional 10 Material  No. Transaction Assets = Liabilities + Capital Basic Concepts of Financial Accounting New Equation 5,280 = 360 + 4,920 11. Further capital Invested 1,000 = 0 + 1,000 New Equation 6,280 = 360 + 5,920 12. Borrowed from P `1,000 1,000 = 1,000 + 0 NOTES New Equation 7,280 = 1,360 + 5,920 1.3.2 Double Entry System and Single Entry System The difference between the double entry system and single entry system can be put as follows: (a) Recording of transactions: In case of double entry system, the dual aspect concept is completely followed while recording business transactions. In case of single entry system, the dual aspect concept is not followed for all transactions. In case of some transactions both the aspects are recorded, while for some only one aspect is recorded, while in case of some other transactions no recording is at all done. (b) Maintenance of books: In case of double entry system, various subsidiary books viz., sales book, purchases book, returns book, cash book etc., are maintained. While in case of single entry system, no subsidiary books except cash book is maintained. (c) Maintenance of books of account: In case of double entry system, all major accounts real, nominal and personal are maintained. However, in case of single entry system, only personal accounts are maintained. (d) Preparation of trial balance: In case of double entry system, trial balance is prepared to check arithmetical accuracy of the books of account. While in case of single entry system trial balance cannot be prepared. Hence, it is not possible to check the accuracy of books of account. (e) Accuracy of profits and financial position: In case of double entry system, Trading and Profit and Loss Account gives the true profit of the business while Balance Sheet shows the true and fair financial position of the business. While in case of single entry system only a rough estimate of profit or loss can be made. The Statement of Affairs prepared in single entry system also does not show the true financial position of the business. (f) Utility: Single entry system is used only by very small business units. It has no utility for large business units. As a matter of fact, they have to compulsorily adopt double entry system. 1.3.3 Systems of Accounting There are basically two systems of accounting: 1. Cash system of accounting It is a system in which accounting entries are made only when cash is received or paid. No entry is made when a Self-Instructional Material 11 Basic Concepts of payment or receipts is merely due. Government system of accounting Financial Accounting is mostly on the cash system. Certain professional people record their income on cash basis, but while recording expenses they take into account the outstanding expenses also. In such a case, the financial NOTES statement prepared by them for determination of their income is termed as Receipts and Expenditure Account. 2. Mercantile or accrual system of accounting It is a system in which accounting entries are made on the basis of amounts having become due for payment or receipt. This system recognises the fact that if a transaction or an event has occurred; its consequences cannot be avoided and, therefore, should be brought into books in order to present a meaningful picture of profit earned or loss suffered and also of the financial position of the firm concerned. The difference between Cash System and Mercantile System of accounting will be clear with the help of the following example: A firm closes its books on 31st December each year. A sum of `500 has become due for payment on account of rent for the year 2015. The amount has, however, been paid in January, 2016. In this case, if the firm is following cash system of accounting, no entry will be made for the rent having become due in the books of accounts of the firm in 2015. The entry will be made only in January 2016 when the rent is actually paid. However, if the firm is following mercantile system of accounting, two entries will made: (i) on 31st December, 2015, rent account will be debited while the landlord’s account will be credited by the amount of outstanding rent; (ii) In January, 2016 landlord’s account will be debited while the cash account will be credited with the amount of the rent actually paid. (This has been discussed in detail later while dealing with adjustments relating to final accounts.) The ‘mercantile system’ is considered to be better since it takes into account the effects of all transactions already entered into. This system is followed by most of the industrial and commercial firms. 1.4 ACCOUNTING TERMINOLOGIES It will be appropriate to get familiarised with certain basic terms which are used in accounting before proceeding with the technique of recording of business transactions. It is necessary for the readers to go through these basic terms and understand them clearly, since it will be then convenient for them to understand clearly the contents of the chapters which are to follow: 1. Assets The terms ‘assets’ include the resources acquired by a business from the funds made available either by the owners or by others. They are “tangible objects or intangible rights owned by an enterprise and carrying Self-Instructional 12 Material probable future benefits”1 In other words, property of all kinds owned by a Basic Concepts of Financial Accounting business comes within the category of the term ‘assets’. Assets may be classified into the following categories: (i) Fixed assets These are assets which are acquired for relatively long NOTES period for carrying on the business of the enterprise. They are not meant for resale. The examples of such assets are land, buildings, plant, machinery, etc. (ii) Current assets These are assets which are acquired with the intention of converting them into cash during the normal business operations of the company. They include ‘‘cash and other assets that are expected to be converted into cash or consumed in the production of goods or rendering of services in the normal course of business’’2 The essential difference between current assets and fixed assets is that the current assets are held essentially for a short period and they are meant for converting into cash. Examples of such assets are cash, inventories (i.e., stocks of raw material, work-in-progress and finished goods), bills receivable, debtors, etc. These assets are also termed as ‘Floating’ or ‘Circulating’ Assets. (iii) Liquid assets These are assets which are immediately convertible into cash without much loss. As a matter of fact, all current assets excluding prepaid expenses and inventories are included in the definition of liquid assets. (iv) Fictitious assets These are assets which have no real value but are shown in the books of accounts only for technical reasons. Examples of such assets are preliminary expenses incurred in connection with the establishment of a business or discount allowed on issue of shares by a company, etc. (v) Wasting assets These are the assets which are exhausted with, or which lose themselves in the goods they produce. Mines and quarries are common examples of such assets. The term is also used for describing such assets which get exhausted with the lapse of time, e.g., copyrights, patents, trademark, etc. 2. Liabilities The term ‘Liabilities’ is used to denote amounts which a business owes and has to return or account for. They are present obligations whose amounts can be ascertained with substantial accuracy. They can be divided into two categories: (i) Current liabilities The term ‘Current Liabilities’ is used to denote liabilities which will be due within a short time (usually one year or 1&2 The Institute of Chartered Accountants of India (ICAI), ‘Guidance Note on Terms used in Financial Statements, 1983’. Most of the terms in this unit have been defined as per the above guidelines. 2 Self-Instructional Material 13 Basic Concepts of less) and that are to be paid out of current assets or by creation of Financial Accounting other current liabilities. Creditors for goods, bills payable, outstanding expenses are some of the examples of current liabilities. (ii) Fixed liabilities Liabilities that will not be due for a comparatively long NOTES time (usually more than one year) are termed as ‘Fixed Liabilities’ or ‘Long-term Liabilities’. These liabilities would continue to be treated as Fixed Liabilities if they are renewed rather than paid at maturity. 3. Capital The term ‘Capital’ is used to denote the owners’ equity in the business. It is a residual claim against the assets of the business after the total liabilities are deducted. Owners’ Equity, Proprietorship and Net-Worth are some of the other terms which are also used to denote Capital. Capital may be classified into the following categories: (i) Fixed Capital It is the capital invested in or represented by Fixed Assets.  (ii) Circulating Capital It is the capital in the form of Current or Floating Assets. (iii) Working Capital It is the excess of Current Assets over Current Liabilities. 4. Contingent Asset An asset, the existence, ownership value of which may be known or determined only on the occurrence or non-occurrence of one more future uncertain events. It usually arises from unexpected events that give rise to possibility of inflow of economic benefits to the business enterprise. For example, a claim that the firm is pursuing the outcome of which is uncertain, is a contingent asset. A contingent asset is not recognised in the books of an enterprise. It also does not require any disclosure in the financial statements. Such an asset is assessed continuously and when it becomes virtually certain that it will result in inflow to economic benefits to the enterprise, the asset and the related income may be recognised in the financial statements of the firm in which such change occurs. 5. Contingent Liability It is an obligation relating to existing condition or situation which may arise in future depending upon the occurrence or non- occurrence of one or more uncertain future events. It is a possible obligation which may or may not arise depending upon the situation. Following are the examples of contingent liabilities: 1. A claim against the enterprise not acknowledged as debt. 2. Uncalled liability on shares partly paid. 3. Arrears of fixed cumulative dividends. 4. Estimated amount of contracts remaining to be executed on capital account and not provided for. Self-Instructional 14 Material An enterprise should not recognise a contingent liability. However, it may be Basic Concepts of Financial Accounting disclosed as a note to the financial statements. Such liabilities are assessed on a continuing basis to determine whether an outflow of economic resources has become probable, if so to the extent of the probable amount, the liability will have to be recognised in the books and a provision will have to be created. NOTES 6. Provision An amount written off or retained by way of providing for depreciation or diminution in value of assets or for providing any known liability, the amount of which cannot determined with substantial accuracy. Examples of a provision are provision for bad and doubtful debts, a provision for discount on debtors, etc. Difference between a Contingent Liability, a Provision and a Liability This can be understood with the following example: A lawsuit has been filed against a firm claiming damages of `1,00,000. The firm feels that the case against the firm may or may not be dismissed by the court. Such a liability is a contingent liability and may be disclosed by way of a note to the financial statements. However, if the firm feels that it may be required to pay the damages of around `20,000 in the suit in all probabilities, the provision to the extent of `20,000 for the lawsuit will be created. Finally if the court fixes the damages payable of `25,000 against the firms, a liability of `25,000 will be recognised in the books of the firm. 7. Transaction and Event Every economic activity is performed through transactions and events. A transaction may be a business, performance of an act or an agreement. While an event is the happening, consequence or result of a transaction. 8. Revenue The term ‘Revenue’ means income of a recurring nature from any source. The source may be sale of goods, performance of services for a customer or a client, the rental of a property, the lending of money and any other business or professional activity carried on for the purpose of earning income. 9. Expenditure The term includes incurring a liability disbursement of cases or transfer of property for the purpose of obtaining assets goods or services. It may be of three types: (i) Capital expenditure An expenditure incurred for obtaining a long-term advantage for the business. (ii) Revenue expenditure An expenditure where benefits expire within a year or which has been incurred merely to maintain the business or keep the assets in good working condition. (iii) Deferred expenditure An expenditure or liability for which payment has been made or incurred but which is carried forward on the presumption that it will be of benefit over a subsequent period or periods. This is also referred to as deferred revenue expenditure. Self-Instructional Material 15 Basic Concepts of 10. Expense The term ‘Expense’ denotes the cost of services and things Financial Accounting used for generating revenue. An ‘Expense’ is to be distinguished from a Loss. An Expense is supposed to bring some benefit to the firm, whereas a Loss brings no benefit to the firm, NOTES e.g., loss by theft, loss by fire, etc. 10A. Expired Cost That portion of an expenditure from which no further benefit is expected. Also termed as expense. 11. Goods The term ‘Goods’ means the property in which the business deals. In other words, ‘Goods’ are properties for resale. For example, if a furniture dealer purchases furniture for sale, the furniture so purchased will come within the definition of the term ‘Goods’. However, if the furniture has been purchased by a furniture dealer for using it in his business, such furniture will come within the definition of the term ‘Fixed Assets’. 12. Debtor The person who owes money to the business is called a ‘Debtor’. 13. Creditor A person who has a claim for money against the business is termed as ‘Creditor’. 14. Bill of Exchange It is a document in writing directing a certain person to pay a certain sum of money to the order of a certain person or to the bearer of the instrument. For example, if A, a creditor by a document in writing asks his debtor B to pay a sum of `10,000 (owed by B on account of purchase of certain goods) after 3 months, such a document is termed as ‘Bill of Exchange’. The document will be termed as ‘Bill Receivable’ for A (i.e., the person entitled to get the payment) and a ‘Bill Payable’ for B (i.e., the person who is liable to pay the money under the document). 15. Accounts Receivable The term includes both Debtors and Bills Receivable 16. Accounts Payable The term included both Creditors and Bills Payable. 17. Discount An allowance or a deduction allowed from an amount due is termed as ‘Discount’. It may be of three types: (i) Trade discount A deduction allowed to the buyers from the gross or catalogue price is termed as ‘Trade Discount’. (ii) Quantity discount A deduction allowed to the buyers from the gross catalogue price on making bulk purchases is termed as ‘Quantity Discount’. (iii) Cash discount A discount allowed to a debtor on prompt payment of cash is termed as ‘Cash Discount’. Trade or quantity discount is not taken into account evolute recording accounting transactions. The transactions are recorded at ‘net’ while cash discount is recorded in the books of account. Self-Instructional 16 Material 18. Commission Commission may be termed as remuneration payable to an Basic Concepts of Financial Accounting employee for his services to the firm or to the agent for purchasing or selling goods, collection of debtors on behalf of the firm, etc. The commission is computed as a percentage of the amount involved. The commission earned is considered as an income while commission allowed is considered as an NOTES expense for the business. Following are examples of persons to whom commission may be allowed: (1) Selling or buying agents. (2) Brokers and bankers. (3) Property dealers for helping in renting out or purchase or sale of properties. (4) Import-export agent in foreign trade. 19. Merchandise Cost It is the same as cost of goods sold. It is computed as follows: Opening Inventory................. Add: Net Purchases (i.e., purchases less returns)................. Direct Expenses (i.e., expenses incurred for acquiring the goods and making them fit for sale)................. Less: Closing Inventory................. Cost of goods sold................. 20. Gross profit It is the excess of the selling price over the cost of goods sold (without deducting any expenses incurred in selling the goods). 21. Net profit/income It is the profit left after deducting all business expenses from the Gross Profit made by the business. 21A. Cash Profit The net profit as increased by non-cash costs such as depreciation, amortisation etc. when the result of computation is negative, and termed as cash loss. 22. Drawings The withdrawal of goods or cash from the business by the owner for personal use is called ‘Drawings’. 23. Entry Recording of a transaction in any book of account is called an ‘Entry’. 24. Insolvent A person who is not in a position to pay his debts in full. It means that the liabilities of such a person are more than his assets. 25. Solvent A person who is in a position to pay his debts as they become due. 26. Bad debts The amount lost from a debtor on account of his inability to pay his debts. Self-Instructional Material 17 Basic Concepts of 27. Net Assets The excess of the book value of assets (other than fictitious Financial Accounting assets) of an enterprise over its liabilities. This is also referred to as Net Worth or Shareholders’ Funds. NOTES 28. Working Capital The funds available for day-to-day operations of an enterprise. Also represented by the excess of current assets over current liabilities including short-term loans. Check Your Progress 3. List the types of accounts which are maintained under double entry and single entry system. 4. What is contingent liability? 1.5 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS 1. Some of the users of accounting information are proprietors, managers, creditors, prospective investors, government, employees and citizen. 2. The Balance Sheet or the Position Statement of a business is the accounting tool which helps to ascertain the financial position of a business. 3. In case of double entry system, all major accounts real, nominal and personal are maintained. However, in case of single entry system, only personal accounts are maintained. 4. Contingent liability is an obligation relating to existing condition or situation which may arise in future depending upon the occurrence or non-occurrence of one or more uncertain future events. 1.6 SUMMARY Earlier, accounting was considered simply as a process of recording business transactions and the role of accountant as that of record- keeper. However, accounting is now considered to be a tool of management providing vital information concerning the organisation’s future. Accounting today is thus more of an information system rather than a mere recording system. Some people take book-keeping and accounting as synonymous terms, but they are different from each other. Book-keeping is mainly concerned with recording of financial data relating to the business operations in a significant and orderly manner. Accounting is primarily concerned with designing the systems for recording, classifying and summarizing the recorded data and Self-Instructional 18 Material  interpreting them for internal and external end users. Accountants often Basic Concepts of Financial Accounting direct and review the work of the book-keepers. Accounting is of primary importance to the proprietors and the managers. However, other persons such as creditors, prospective NOTES investors, employees, etc., are also interested in the accounting information. The objectives of accounting are: to keep systematic records, to protect business properties, to ascertain the financial position of business, to facilitate rational decision making, etc. Limitations of accounting are: provides only limited information, provides only a post-mortem record of business transactions, considers only quantifiable information, etc. An incomplete double entry system can be termed as a single entry system. According to Kohler, “it is a system of book-keeping in which as a rule only records of cash and personal accounts are maintained, it is always incomplete double entry, varying with circumstances”. This system has been developed by some business houses, who for their convenience, keep only some essential records. The system of ‘double entry’ book-keeping which is believed to have originated with the Venetian merchants of the fifteenth century, is the only system of recording the two-fold aspect of the transaction. Cash system of accounting is a system in which accounting entries are made only when cash is received or paid. Mercantile or accrual system of accounting is a system in which accounting entries are made on the basis of amounts having become due for payment or receipt. 1.7 KEY WORDS · Accounting: The process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of information. · Financial Accounting: The art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are at least in part of a financial character and interpreting the results. · Asset: A tangible object or an intangible right owned by an enterprise and carrying probable future benefits. · Capital: Owners’ equity in the business. · Capital Expenditure: An expenditure incurred for the purpose of obtaining a long-term advantages for the business. Self-Instructional Material 19 Basic Concepts of · Goods: The property in which the business deals. Financial Accounting · Liability: An amount which business owes and has to return or account for. NOTES · Revenue: An income of a recurring nature from any source. · Revenue Expenditure: An expenditure whose benefit expires within a year or which is incurred merely to maintain the business or keeping the assets in good working condition. 1.8 SELF ASSESSMENT QUESTIONS AND EXERCISES Short Answer Questions 1. Define Accounting. State its functions. How does it differ from Book- keeping? 2. State the persons who should be interested in accounting information. Long Answer Questions 1. Define the term ‘Assets’. Explain the different types of ‘Assets’ with suitable examples. 2. What do you understand by the term ‘Liabilities of a business’? How they can be classified? Explain with suitable examples. 3. Explain the concepts of: Merchandise Cost, Gross Profit and Net Income. 1.9 FURTHER READINGS Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy, Vol I. New Delhi: Vikas Publishing House. Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to Accountancy, 12th edition. New Delhi: Vikas Publishing House. Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani Publishers. Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and Distributors Pvt. Ltd. Self-Instructional 20 Material  Accounting Concepts: UNIT 2 ACCOUNTING CONCEPTS: Principles and Conventions PRINCIPLES AND NOTES CONVENTIONS Structure 2.0 Introduction 2.1 Objectives 2.2 Meaning and Types of Accounting Concepts 2.3 Accounting Convention and Its Types 2.4 Accounting Principles 2.5 Accounting Standards 2.5.1 International Accounting Standards Committee and IAS/IFRS 2.6 Answers to Check Your Progress Questions 2.7 Summary 2.8 Key Words 2.9 Self Assessment Questions and Exercises 2.10 Further Readings 2.0 INTRODUCTION It has already been stated in Unit 1 that accounting is the language of business through which normally 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 principles1 may be defined as those rules of action adopted by the accountants universally while recording accounting transaction. “They are a body of doctrines commonly associated with the theory and procedures of accounting, serving as an explanation of current practices and as a guide for selection of conventions or procedures where alternatives exist”. These principles can be classified into two categories: (i) Accounting Concepts2 (ii) Accounting Conventions Accounting Concepts The term ‘concepts’ includes those basic assumptions or conditions upon which the science of accounting is based. The following are the important accounting concepts: 1. also termed as ‘Accounting Standards’. 2. also termed as ‘Accounting Postulates’. Self-Instructional Material 21 Accounting Concepts: (i) Separate Entity Concept Principles and Conventions (ii) Going Concern Concept (iii) Money Measurement Concept NOTES (iv) Cost Concept (v) Dual Aspect Concept (vi) Accounting Period Concept (vii) Periodic Matching of Cost and Revenue Concept (viii) Realisation Concept Accounting Conventions The term ‘conventions’ includes those customs or traditions which guide the accountant while preparing the accounting statements. The following are the important accounting conventions. (i) Convention of Conservatism (ii) Convention of Full Disclosure (iii) Convention of Consistency (iv) Convention of Materiality 2.1 OBJECTIVES After going through this unit, you will be able to: Explain the meaning and types of accounting concepts Discuss the accounting convention and its types Examine the accounting principles Identify the accounting standards 2.2 MEANING AND TYPES OF ACCOUNTING CONCEPTS Let’s study the different accounting concepts. 1. Separate Entity Concept In accounting business is considered to be a separate entity from the proprietor(s). It may appear to be ludicrous that one person can sell goods to himself but this concept is extremely helpful in keeping business affairs strictly free from the effect of private affairs of the proprietor(s). Thus, when one person invests `10,000 into business, it will be deemed that the proprietor has given that much of money to the business which will be shown as a ‘liability’ in the books of the business. In case the proprietor withdraws `2,000 from the business, it will be charged to him and the net amount payable by the business will be shown only as `8,000. The concept of separate entity is applicable to all forms of business organisations. For example, in case of a partnership business or sole Self-Instructional 22 Material proprietorship business, though the partners or sole proprietor are not Accounting Concepts: Principles and Conventions considered as separate entities in the eyes of law, but for accounting purposes they will be considered as separate entities. 2. Going Concern Concept According to this concept it is assumed that NOTES the business will continue for a fairly long time to come. There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future. On account of this concept, the accountant while valuing the assets does not take into account forced sale value of assets. Moreover, he charges depreciation on fixed assets on the basis of their expected lives rather than on their market value. It should be noted that the ‘going concern concept’ does not imply permanent continuance of the enterprise. It rather presumes that the enterprise will continue in operation long enough to charge against income, the cost of fixed assets over their useful lives, to amortise over appropriate period other costs which have been deferred under the actual or matching concept, to pay liabilities when they become due and to meet the contractual commitments. Moreover, the concept applies to the business as a whole. When an enterprise liquidates a branch or one segment of its operations, the ability of the enterprise to continue as a going concern is normally not impaired. The enterprise will not be considered as a going concern when it has gone into liquidation or it has become insolvent. Of course, the receiver or the liquidator may endeavour to carry on business operations for some period pending arrangement with the creditors or the final buyer for the sale of the business as a going concern, the going concern status of the concern will stand terminated from the date of his appointment or will be at least regarded as suspended, pending the results of his efforts. 3. Money Measurement Concept Accounting records only monetary transactions. Events or transactions which cannot be expressed in money do not find place in the books of accounts though they may be very useful for the business. For example, if a business has got a team of dedicated and trusted employees, it is definitely an asset to the business but since their monetary measurement is not possible, they are not shown in the books of the business. Measurement of business event in money helps in understanding the state of affairs of the business in a much better way. For example, if a business owns `10,000 of cash, 600 kg of raw materials, two trucks, 1,000 square feet of building space etc., these amounts cannot be added together to produce a meaningful total of what the business owns. However, if these items are expressed in monetary terms such as `10,000 of cash, `12,000 of raw materials, `2,00,000 of trucks and `50,000 of building, all such items can be added and much more intelligible and precise estimate about the assets of the business will be available. Self-Instructional Material 23 Accounting Concepts: 4. Cost Concept The concept is closely related to going concern concept. Principles and Conventions According to this concept: (a) an asset is ordinarily entered in the accounting records at the price paid to acquire it, and NOTES (b) this cost is the basis for all subsequent accounting for the assets. If a business buys a plot of land for `50,000, the asset would be recorded in the books at `50,000 even if its market value at that time happens to be `60,000. In case a year later the market value of this assets comes down to `40,000, it will ordinarily continue to be shown at `50,000 and not at `40,000. The cost concept does not mean that the asset will always be shown at cost. It has also been stated above that cost becomes the basis for all future accounting for the asset. It means that asset is recorded at cost at the time of its purchase, but it may systematically be reduced in its value by charging depreciation. Cost concept has the advantage of bringing objectivity in the preparation and presentation of financial statements. In the absence of this concept the figures shown in the accounting records would have depended on the subjective views of a person. However, on account of continued inflationary tendencies the preparation of financial statements on the basis of historical costs, has become largely irrelevant for judging the financial position of the business. This is the reason for the growing importance of inflation accounting. 5. Dual Aspect Concept This is the basic concept of accounting. According to this concept every business transaction has a dual effect. For example, if A starts a business with a capital of `10,000, there are two aspects of the transaction. On the one hand, the business has asset of `10,000 while on the other hand the business has to pay to the proprietor a sum of `10,000 which is taken as proprietor’s capital. This expression can be shown in the form of following equation: Capital (Equities) = Cash (Assets) 10,000 = 10,000 The term ‘assets’ denotes the resources owned by a business while the term “Equities” denotes the claims of various parties against the assets. As we have learned before, equities are of two types. They are: owners’ equity and outsiders’ equity. Owners’ equity (or capital) is the claim of owners against the assets of the business while outsiders’ equity (for liabilities) is the claim of outside parties, such as creditors, debenture-holders etc., against the assets of the business. Since all assets of the business are claimed by some one (either owners or outsiders), the total of assets will be equal to total of liabilities, Thus: Self-Instructional 24 Material  Equities = Assets Accounting Concepts: Principles and Conventions or Liabilities + Capital = Assets In the example given above, if the business purchases furniture worth `5,000 out of the money provided by A, the situation will be as follows: NOTES Equities = Assets Capital `10,000 = Cash `5,000 + Furniture `5,000 Subsequently, if the business borrows `30,000 from a bank, the new position would be as follows: Equities = Assets Capital `10,000 + Bank Loan `30,000 = Cash `35,000 + Furniture `5,000 The term ‘accounting equation’ is also used to denote the relationship of equities to assets. The equation can be technically stated as “for each debit, there is an equivalent credit”. As a matter of fact the entire system of double entry book-keeping is based on this concept. 6. Accounting Period Concept According to this concept, the life of the business is divided into appropriate segments for studying the results shown by the business after each segment. This is because though the life of the business is considered to be indefinite (according to going concern concept), the measurement of income and studying the financial position of the business after a very long period would not be helpful in taking proper corrective steps at the appropriate time. It is, therefore, absolutely necessary that after each segment or time interval the businessman must ‘stop’ and ‘see back’, how things are going. In accounting such a segment or time interval is called ‘accounting period’. It is usually of a year. At the end of each accounting period an Income Statement and a Balance Sheet are prepared. The Income Statement discloses the profit or loss made by the business during the accounting period while the Balance Sheet depicts the financial position of the business as on the last day of the accounting period. While preparing these statements a proper distinction has to be made between capital and revenue expenditure. 7. Periodic Matching of Costs and Revenue Concept This is based on the accounting period concept. The paramount objective of running a business is