2.Accounting Concepts Principles Bases and Policies

Financial Financia l and Management Accounting

Unit 2

Unit 2

Accounting Concepts, Principles, Bases and Policies Polici es

Structure 2.1

Introductions Objectives

2.2

Accounting concepts, principles, bases and policies – meaning meaning Self Assessment Questions 1

2.3

Types of accounting concepts Self Assessment Questions 2 2.3.1

Business entity concept Self Assessment Questions 3

2.3.2

Going concern concept Self Assessment Questions 4

2.3.3

Money measurement concept Self Assessment Questions 5

2.3.4

Periodicity concept Self Assessment Questions 6

2.3.5

Accrual concept Self Assessment Questions 7

2.4

Basic Principles Self Assessment Questions 8 2.4.1

Principle of Income recognition Self Assessment Questions 9

2.4.2

Principle of expense Self Assessment Questions 10

2.4.3

Principle of matching cost and revenue Self Assessment Questions 11

2.4.4

Principle of Historical cost Self Assessment Questions 12

2.4.5

Principle of full disclosure Self Assessment Questions 13

2.4.6

Double aspect principle Self Assessment Questions 14

Sikkim Manipal University

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2.4.7

Unit 2

Modifying Principle Self Assessment Questions 15

2.4.8

Principle of materiality Self Assessment Questions 16

2.4.9

Principle of consistency Self Assessment Questions 17

2.4.10 Principle of conservatism conservatism or prudence prudence Self Assessment Questions 18 Terminal Questions Answer to SAQs and TQs

2.1 Introduction: Any subject for that matter, is based on certain postulates, concepts and policies. Before understanding the subject, one has to go through the basic assumptions on which the subject is built upon. Accounting is a reflection of all business transactions expressed in terms of money relating to a definite period of time and the object of accounting being finding out profit or loss arising out of transactions and finally to judge the financial position of the business organization. In this Unit, the concepts, the basic principles and policies of accounting are briefly described.

Learning Objectives: After studying this unit, you should be able to understand the following following 1. To know the meaning of concepts, principles and policies policies basing on which which

Accounting

science has emerged e merged.. 2. To expose the students to different concepts of of accounting. 3. To have an insight insight into the basic principles principles of accounting. accounting.

2.2 Accounting concepts, concepts, principles, principles, bases bases and policies As we have understood in the Unit 1, accounting is the language of business and it is concerned with measurement of financial performance of a business by recording, analyzing and reporting the business results for the sake of stakeholders. Since all stakeholders should understand the accounting language in the same sense, certain principles, concepts and policies of accounting have been laid down. Principles are basically the rules of action adopted by the accountants universally while recording accounting transactions. The principles are doctrines associated with


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theory and procedures and current practices of accounting. These principles may be classified as concepts and conventions. While concepts are in the form of assumptions or conditions, conventions are those customs and traditions which guide the accountants while preparing accounting statements. For instance business is started with an assumption that it shall be continued for a long period of time and no body promotes a business organization to close it down within a short period. Basing on this assumption, business man purchases fixed assets, uses them and values them from time to time. This is a strong assumption that any businessman approaches with. Such assumption is called a concept. To give an example for convention, inventory (stock) in a business is valued at the end of an accounting period, at cost or market price which ever is lower. This is an accepted convention or a practice or a principle in accounting. On the other hand, an accounting policy is one which is adopted by management, relevant to the situations. For example, every asset should be depreciated (this is a concept) at the end of an accounting period. The practice is to adopt fixed installment or diminishing balance method or any other method me thod of depreciation.(this is a convention). The policy poli cy of the management management may be to adhere to fixed installment method of depreciation and it is their choice. Therefore no management can exercise discretion regarding fundamental presumptions of accounting. But every management has a choice of making an accounting policy. It is not out of place to mention that in order to bring uniformity in terminology, accounting concepts, conventions, and assumptions, the Institute of Chartered Accountants of India (ICAI) established Accounting Standards Board (ASB) in 1977. The principal objective of ASB is to formulate accounting standards so that such standards will be established by the council of ICAI. While formulating the accounting standards, ASB will give due consideration to the International Accounting Standards and try to integrate them to the extent possible. It also considers the customs, practices, laws and usages prevailing in Indian business. There are altogether 30 accounting standards issued by ASB which have to be adopted by management of different enterprises to improve the quality of presentation of financial statements in our country. Self Assessment Questions 1: 1. Accounting principles are _______ _______ , associated associated with with theory and practice practice of accountings. 2. Principles are are classified classified as ________ and ________. ________. 3. Assets may be depreciated depreciated on fixed installment installment method or reducing reducing balance method. method. Is this a concept or convention? 4. A business is started with with an assumption of making profit. Is this assumption, a concept or convention?


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5. The purpose purpose of establishing ICAI and ASB is to ________. ________. 6. How many accounting standards standards are are issued by ASB so far?

2. 3 Types of Accounting concepts concepts As said earlier, concepts are the basic assumptions or conditions upon which the science of accounting is based. There are five basic concepts of accounting, namely – business entity concept, which is also termed as separate entity concept, going concern concept, money measurement concept, periodicity concept and accrual concept. Each concept is discussed below. Self Assessment Questions 2:

1. What are the different types of accounting concepts? 2.3.1 Business Entity Concept The essence of this concept is that business is a separate entity and it is different from the owner or the proprietor. This is true in the case all forms of organization. If X starts business, he should not mix up his personal properties with that of the business. When he invests his funds into the business, it is regarded as capital to the business and capital is a liability from the business point of view. If X withdraws any money from the business, it is deductable from the capital and to that extent the liability of the business towards the owner is reduced. On the other hand, if the proprietor withdraws money from the business for business purposes, then it is treated as expenditure to the business.This legal separation between business and ownership is kept in mind while recording the transactions in the books of business. Self Assessment Questions 3: 1. Business entity entity concept concept is also termed termed as __________. __________. 2. Business and and its owner are ____________ _______________ ___ entities . 3. Can personal personal properties of of owner be mixed with with the properties of of business properties? 4. Capital brought brought in by proprietor proprietor to to the business is _______ to the business. 5. Profits earned earned in business form an addition addition to _____________ _____________ of of the owner. 2.3.2 Going concern concept The fundamental assumption is that the business entity will continue fairly for a long time to come. There is no reason why an enterprise should be promoted for a short period only to liquidate the business in the foreseeable future. This assumption is called “going concern concept”. For this reason accountants value fixed assets on historical cost method. Had the


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business been set up to last for a short period, fixed assets should have been valued at a market price. Besides, going concern concept provides for amortization of the cost of fixed assets over the life time of the assets. For example, an entrepreneu e ntrepreneurr purchases a plant for Rs. One crore and it has a life of 10 years. During this period, he sets aside every year certain funds from the income of the business so that it would help him for replacement of the asset at the end of ten years. This process of amortization amortization presupposes that that the enterprise will will continue to do business fairly for long time. Self Assessment Questions 4: 1. Can a company be promoted to last only only for a month? 2. A business concern continues to function for ________. ________. This is the essence essence of going concern concern concept. 3. Do you purchase purchase a building for your business to last for a short short period or long long period? 4. What is the underlying intention in making a provision every year when when an asset is purchased? 2.3.3 Money Measurement Measurement Concept All transactions of a business are recorded in terms of money. An event or a transaction that can not be expressed in money terms, can not find place in the books of account. The honesty of the employees, dynamism of the selling agents, promptness and integrity of the cashier, even though influence the business results, can not be brought to the books of accounts. Besides it makes no sense if a business has 10 tons of raw material, five vehicles, one premises and a few items of furniture, unless all these assets are expressed in terms of some monetary value. If it is said that the value of these assets is Rs. two crores, it makes a lot of sense. Money is the common denominator in which the business transactions should be expressed. Self Assessment Questions 5: 1. Can honesty honesty of an employee employee be expressed expressed in terms terms of of money? 2. Transactions should should be stated in terms of _______________. _______________. 3. We have in in a business 5 chairs, one godown, godown, 2 tons of cement. cement. What does does it mean? 4. Money is common common _______ in w which hich the business transactions transactions should be be expressed. 2.3.4 Periodicity Concept The time interval for which accounts are prepared prepared is an important factor, even though we assume long life for a business. The time interval is usually one year and this period is called accounting year. Often the accounting period could be half year or even a quarter. The financial statements


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should be prepared at the end of each accounting period so that income statement shows profit or loss for the accounting period. So also a balance sheet is prepared to depict the financial position of the business. Self Assessment Questions 6: 1. The time interval for which which accounts are are prepared is called ____________. ____________. 2. What is the usual accounting accounting period? 3. The expenses of a business are Rs.500000. Rs.500000. Why does this this statement not make make any sense? 2.3.5 Accrual Concept Profit earned or loss suffered for an accounting period is the result of both cash and credit transactions. It is possible that certain incomes are earned but not received and similarly expenses incurred but not yet paid during an accounting period. But it is relevant to consider them while computing the financial results just because they are a re related to the specific accounting period. For example, interest receivable on Fixed deposit for the year ending 31-12-2006 is Rs. 12000 but it is actually credited to the bank account only in February 2007. For calculating the income from interest, the amount Rs.12000 is considered even though it is not received before 31-12-2006. 31-12-2006. This amount a mount is called accrued interest. Similarly the expenses which are incurred for the accounting period, might be paid only after the accounting period. Such accrued expenses are deducted while calculating the profit for the accounting period. This is the accrual concept. Self Assessment Questions 7: 1. Interest earned earned but not received received within within an accounting period is called called _______. _______. 2. Salary payable for December, 2004 but paid in January, 2005 is known as _________________ for 2004. 3. Accrued items should should be _________ _________ to compute compute profit or los los for the said said period. 4. Accrual concept concept considers not only only cash transactions transactions but also ______ ______ transactions. transactions.

2.4 Basic principles As stated above basic principles are the rules basing on which accounting takes place and these rules are universally accepted. There are ten such basic principles, namely principle of income recognition, principle of expense, principle of matching cost and revenue, historical cost p rinciple, rinciple, principle of full disclosure, double aspect aspect principle, modifying modifying principle, principle principle of materiality, principle of consistency and principle of conservatism. A brief description is in the following paragraphs.


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Self Assessment Questions 8: 1. Basic principles principles of Accountancy are __________ _____________ ___ accepted. accepted. 2. How many basic principles of accountancy accountancy are there? 2.4.1 Principle of Income Recognition Recognition According to this concept, revenue is considered as being earned on the date on which it is realized., i.e., the date on which goods and services are transferred to customers for cash or for promise. It should further be noted that it is the amount which the customers are expected to pay which shall be recorded. In effect, only revenue which is actually realized should be taken to t o profit and loss account. Unreaslised Unreaslised revenue should not be taken into consideration for determining the profit. For example, a sale is considered to be made when the property in goods (ownership) is transferred from the seller to buyer. Similarly, when a businessman receives an order for the sale of such products, yet to be manufactured, then revenue is said to have been generated when the products are ready and physically present in deliverable state and payment is received or promised to be received but not when the order is received. Self Assessment Questions 9: 1. Income is considered considered as earned only when when it is __________ ____________. __. 2. Income is realized realized whether it is actually actually received in cash or promised to be received received . Is it True or False? 3. Income realized realized is different different from cash cash received. received. Is it true true or false? 4. A sale is made on on credit. Does Does it constitute constitute income income realization? 5. An order is received for sale of goods. goods. Is it realisation realisation of income? 6. An order is received with with an advance of Rs.100000 cash. Can this be called income? 2.4.2 Principle of of Expense Expenses are different from payments. A payment becomes expenditure or an expense only when such payment is revenue in nature n ature and made for consideration. Salaries are paid for having received the services of the employees and so it is an expense. If furniture is bought, it is not expenditure because it is a capital payment. Therefore all revenue expenses are transferred to profit and loss account account to ascertain profit profit or loss of the business undertaking. undertaking. In other words, words, there are revenue expenses and capital expenses. While revenue expenses are charged against profit, capital expenses are shown in the balance sheet as assets. as sets. Self Assessment Questions 10: 1. A cash payment may be a revenue revenue payment payment or capital capital payment. Is it true or false?


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2. A payment which which is revenue in nature is expenditure. expenditure. Is it true or false? 3. Plant is purchased purchased and payment payment is made. made. Is it an expenditure or acquisition of of asset? 4. All revenue revenue expenses are charged charged against ––––––––––––– ––––––––––––– . 5. Capital payments resulting resulting in acquisition of assets appear in the balance balance sheet. True or False? 2.4.3 Principle of Matching M atching Cost and Revenue Revenue earned during a period is compared with the expenditure incurred to earn that income, whether the expenditure is paid during that period or not. This is matching cost and revenue principle, which is important to find out the profit earned for that period. Here costs are reported as expenses in the accounting period in which the revenue associated with those costs is reported. For example, sales revenue reported in 2005 is Rs 50 lakh. The expenses to earn this revenue, comprising purchases, wages, salaries, sales commission and so on amount to Rs. 30 Lakh. It is possible that some of these costs might be payable actually in 2006. Even then, they are considered only for the period 2005, when the sales revenue was earned. Adjustments are made for outstanding and prepaid expenses as well as outstanding and pre received incomes while preparing the final accounts for f or the accounting period. Self Assessment Questions 11: 1. Matching concept of accounting considers considers only revenue revenue incomes and expenses expenses relating to a particular accounting period. True or False? 2. Incomes and and expenses for an accounting period period are considered to compute _____ _____ . 3. Expenditure paid paid or payable payable and revenue revenue earned earned whether whether realised or not in cash are taken into account to find out profit or o r loss. True or False? 4. For the actual revenue received, outstanding incomes are ________ ________ and pre-received incomes are_________________ are_________________ to find out the revenue income for the given period. 5. For the actual revenue expenses expenses (costs) paid during the accounting period, outstanding outstanding expenses are _____ and prepaid expenses are _____ to find out o ut expenses for the accounting period. 2.4.4 Principle of Historical Costs This is called ‘cost’ principle. All assets are are recoded at the cost of acquisition acquisition and this cost is the basis for all subsequent accounting accounting for the assets. The expenses and the goods purchased purchased are all shown at the value v alue at which they are incurred i ncurred.. The assets are a re constantly reduced in their value by charging depreciation against their cost to present their book value in the balance sheet. For


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example, land bought for Rs.5,00,000 will be shown at that price only and market value will not be considered. In financial statements, historical cost is considered but not market value for the purpose of consistency. However, on account of inflationary situations, this cost c oncept does not portray correct picture of the business and so inflation accounting has emerged. Self Assessment Questions 12: cos t in balance sheet. True or False? 1. All assets are shown at historical cost

2. Depreciation is charged against the historical cost of assets. True or False? 3. Historical cost is the cost at which an asset is actually purchased. True or False? 4. A machinery is bought for Rs.200000 and its market value is Rs.80000. Which of these values, do you consider reasonable to mention in the balance sheet?

5. Inflation accounting has emerged as a result of limitation of historical cost concept. True or False? 2.4.5 Principle of Full Disclosure The business enterprise should disclose relevant relevant information to all the parties concerned c oncerned with with the t he organization. It means that any information of substance or of interest to the average investors will have to be disclosed in the financial statements. For example, the liabilities of the business should be stated along with assets. If only assets are exhibited without disclosing liabilities, it amounts to fraud. The Companies Act, 1956 requires that income statement and balance sheet of a company co mpany must give a fair and true view of the state of affairs of the company. Self Assessment Questions 13:

1. The principle of full disclosure implies that information which is of ___________ should be stated in financial statements.

2. The material information that is disclosed should be of great interest to the average investors. True or False? of material information amounts amounts to ___________. ___________. 3. Non-disclosure of

4. Disclosing about assets without disclosing about liabilities is against to the principle of full disclosure. True or False? 2.4.6 Double Aspect Principle This concept is the most fundamental one for accounting. A business entity is an independent unit and it receives benefits from some and gives benefits to some other. Benefit received and benefit given should always match and balance. For instance capital, say Rs.20000 provided by


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the proprietor is a liability to the business and it is used for purchasing goods Rs.10000, kept in bank account of the business Rs.8000 and the balance held in cash.Rs.2000. The goods, cash at bank and cash in hand (10000 + 8000 + 2000) are regarded as assets. The total liabilities balance with total of assets. This is dual aspect of accounting. The established principle of accounting is that for every debit there is an equivalent credit and this is called double entry principle of accounting. Self Assessment Questions 14:

1. Under dual aspect principle, total benefits received by business should match with total benefits given. True or False?

2. Total liabilities should be equal to ___________ as per dual aspect principle. _________ of accounting. 3. For every debit, there should be an equivalent credit. This is called _________ 2.4.7 Modifying Principle The modifying principle states that the cost of applying a principle should not be more than the benefit derived from. If the cost is more than the benefit, then that principle should be modified. This is called cost-benefit principle. There should be flexibility in adopting a principle and the advantage out of the principle should over weigh the cost of implementing the the principle. Self Assessment Questions 15: 1. Modifying principle is also known as _____________. _____________. 2. The advantage advantage out of the Principle Principle should over weigh the cost of of implementing the principle itself. True or False? 3. If the establishment establishment of costing department department is too high that the cost of the products products produced in the organisation is going to overshoot by50%., far more than the market price. Is it advisable to have cost-department? cost-department? 2.4.8 Principle of Materiality M ateriality While important details of financial status must be informed to all relevant parties, insignificant facts, which do not influence any decisions of the investors or any interested group, need not be communicated. Such less significant facts are not regarded as material facts. What is material and what is not material depends upon the nature of information and the party to whom the information is provided. While income has to be shown for income tax purposes, the amount can be rounded off to the nearest ten. And fraction does not matter. When we send statement to a


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debtor, all details have to be presented. The same information about the debtors need not be given in great detail, de tail, while sending the information to the Registrar of companies. Self Assessment Questions 16: 1. Principle of materiality materiality states that relevant relevant information should should be given to relevant relevant parties. True or False? 2. Details of debtors should should be given to creditors. creditors. True True or False? False? 3. What is material material information to one party may may not be so so for another another party. True or False? 4. The method of depreciation adopted adopted should be disclosed to Income Income Tax Authorities. Authorities. True or False? 2.4.9 Principle of Consistency Consistency Consistency is required to help comparison of financial data from one period to another. Once a method of accounting is adopted, it should not be changed. For instance, stock is valued under FIFO method in an year and it should s hould not be valued under LIFO method in another year. If assets are depreciated under diminishing balance method, it should be continued for ever. It should not be changed. Self Assessment Questions 17 : 1. The purpose purpose of principle principle of consistency consistency is to to help for ______ from one period to another period. 2. Consistency principle principle helps for proper assessment assessment of profit profit or loss. True or False? 2.4.10 Principle of Conservatism Conservatism or Prudence Accountant follow the rule “anticipate no profit but provide for all anticipated losses “Whenever risk is expected, provision should be made. The value of investments is normally taken at cost, even if the market value is higher than the cost. If the market value expected is lower than the cost, then provision should be made by charging profit and creating investment fluctuation fund. This is the principle of conservatism and it does not mean that the income or the value of assets should be intentionally under stated. Self Assessment Questions 18: 1. Provision should should be made whenever whenever ___________ _____________ __ is expected. expected. 2. The underlying underlying spirit spirit of principle principle of conservatism is __________ __________ . 3. The prices of shares shares in which the business business has invested are are going up. Do Do you consider advisable to provide any provision for that?


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Terminal Questions: 1. What are the basic basic principles principles of Accountancy? Accountancy? 2. The salaries paid in 2004 Rs.500000; Rs.500000; Salaries outstanding outstanding Rs.20000; Salaries Salaries paid in advance for 2005 Rs.30000; What is the actual salary expenditure for 2004? What is the accounting principle involved in this? 3. What is wrong wrong if assets like buildings buildings are shown shown at market value in in the balance sheet? sheet? 4. A business receives capital capital of Rs.100000 and and a loan is raised for Rs.50000. This is represented by cash Rs.15000; Machinery Rs.85000; Furniture Rs.20000 and goods Rs30000. Find the total debits and credits from business point of view. What principle of accounting is underlying in this case? Answer for Self Assessment Questions Self Assessment Questions 1: 1. Doctrines 2. Concepts, conventions 3. Convention 4. Concept 5. Bringing uniformity in accounting accounting terminology terminology and principles 6. 30 Self Assessment Questions 2: 1. Business entity concept, concept, Going concept, concept, Money measurement measurement concept, concept, Periodicity concept, and Accrual concept. Self Assessment Questions 3: 1. Separate entity concept 2. separate 3. No 4. Liability 5. capital Self Assessment Questions 4: 1. No 2. Long time 3. Long period 4. To replace replace it after a certain certain period. period.


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Self Assessment Questions 5: 1. No 2. Money value 3. It makes no sense unless expressed expressed in terms of money value 4. Denominator Self Assessment Questions 6: 1. Accounting period 2. Year 3. It is because it does not indicate indicate for what what period the the expenditure is. Self Assessment Questions 7: 1. Accrued interest 2. Accrued salary 3. Added 4. Credit Self Assessment Questions 8: 1. Universally 2. Ten Self Assessment Questions 9: 1. Realised 2. True 3. True 4. Yes 5. No 6. No Self Assessment Questions 10: 1. True 2. True 3. Asset Acquisition 4. Profit 5. True


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Self Assessment Questions 11: 1. True 2. Profit or loss 3. True 4. Added, Deducted 5. Added, Deducted Self Assessment Questions 12: 1. True 2. True 3. True 4. Rs.200000 5. True Self Assessment Questions 13: 1. Substance 2. True 3. Fraud 4. True Self Assessment Questions 14: 1. True 2. b) Total Assets 3. c) Double entry principle Self Assessment Questions 15: 1. Cost-benefit Cost-benefit principle 2. True 3. No Self Assessment Questions 16: 1. True 2. False 3. True 4. True


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Self Assessment Questions 17: 1. Comparison 2. True Self Assessment Questions 18: 1. Risk 2. Anticipate no profit profit but provide for all anticipated anticipated losses losses 3. No. Answers for Terminal Question: 1. Income recognition, recognition, principle of expense, matching of cost and revenue, historical cost principle, full disclosure principle, double aspect principle, modifying principle, materiality principle, consistency principle and conservatism principle. 2. Rs.490000 (500000 + 20000 – 30000); 30000); Matching Matching cost and revenue revenue principle. principle. 3. If assets like building building are shown shown at market value instead of historical cost in the balance balance sheet, the profit or loss arising out of such valuation is against to the principle of income recognition. The profit or loss is said to arise only when the asset is sold or revalued for a specific purpose. The day when the assets assets are valued, the market value may may be high and later the prices may fall. Therefore it is wrong to consider the unrealized or anticipated profit. Hence the assets should be shown at historical cost in the balance sheet. 4. Benefits received Rs.150000 Rs.150000 (Capital (Capital Rs.100000 Rs.100000 + Loan Rs.50000); Rs.50000); Benefit given Rs.150000 Rs.150000 (Cash Rs.15000 + Machinery Rs.85000 + Furniture Rs.20000 + Goods Rs.30000). It is as per p er double aspect principle.


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2.Accounting Concepts Principles Bases and Policies

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