Accounting Concepts and Principles

After reading this article you will learn about the accounting concepts and principles. Also learn about fundamental accounting assumptions.

Core Accounting Concepts:

Two core accounting principles are entity and money measurement

Entity means a economic unit that performs economic activities. It may be a business entity – any form of business i.e. sole proprietorship, partnership, company, co-operatives and non-business organisations.

i. Entity concept:

It sets out the principle that entity and its owners, who provided capital or otherwise became owner as promoters, are distinct and separate. Any personal transactions of the owners cannot be mixed up the transactions of the entity. This separation is fundamental to accounting.

Example 1:

Mr. Terazzo is a majority shareholder of Terazzo Computer Services Ltd. He is the Chairman of the company. He purchased a property for Rs.100 lacs and instructed the Chief Financial Officer of the company to pay for it. How should this transaction be accounted for?

Solution:

Loan to Employees – Dr. Rs. 100 lacs

Cash – Cr. Rs. 100 lacs

The loan is an asset of the company. There is specific disclosure requirement for related party transactions like this.

ii. Money measurement concept:

All transactions and events are measured in terms of monetary units. It can be the currency of transactions. But for financial reporting it is to be translated into functional currency. Let us get acquainted with the concepts of functional currency and presentation currency.

Functional currency is the currency of the primary economic environment in which the entity operates.

Presentation currency is the currency in which the financial statements are presented.

In globalised economic environment, an entity’s functional currency and presen­tation currency may be different. For example, an Indian software company which operates in Europe may have its transactions recorded in euros but since it is an Indian company it will prepare and present financial statements in terms of Indian rupee. Euro is its functional currency but Indian rupee is its presenta­tion currency.

In fact, the broad view which money measurement concept carry is transactions and events which cannot be measured in terms of money is not accounted for. An example is human resource which is not considered as an asset because it cannot be objectively valued in monetary terms.

Fundamental Accounting Assumptions:

The Indian accounting standard AS 1 Disclosure of Accounting Policies talks about three fundamental accounting assumptions – going concern, consistency and accrual.

i. Going concern:

The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of the operations.

While preparing financial statements, management shall make an assessment of an entity’s ability to continue as a going concern. An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.

The management may be aware of material uncertainties that create doubt on the ability of the entity’s continuance as going concern. While pursuing going concern basis, it is necessary to disclose those uncertainties.

The going concern assessment is normally based on the ability of the entity to continue for least 12 months from the end of the financial period.

ii. Consistency:

It is assumed that accounting policies are consistent from one period to another.

Whereas IAS 1 Presentation of Financial Statements (which is part of IFRSs) talks about Consistency of presentation. Presentation and classification of items of financial statements should be maintained from one period to another. The change in presentation and classification is made when there is a significant change in the nature of the entity’s operations. The change can also be made when required by a standard or an interpretation. This is to facilitate comparison of financial information over the accounting periods.

Example 2:

ABC Ltd. is a listed company. Its share price as on 31.3.2007 was Rs.400 and as on 30.11.2008 was Rs.600, whereas as on 31.3.2008 it was nosedived to Rs.270 because of general market downturn. Should the going concern status of the company be reviewed?

Solution:

No. The volatility in the share price was simply because of market swings. Business conditions did not change.

Example 3:

ABC Ltd. is a listed company. Its share price as on 31.3.2007 was Rs.400 and as on 30.11.2008 was Rs.600, whereas as on 31.3.2008 it was nosedived to Rs.170 because of general market downturn and poor perfor­mance of the company. Should the going concern status of the company be reviewed? What general parameters are to be looked into?

Solution:

Yes. There is a change in company’s performance level apart from market swings.

A company considers a wide range of factors for reviewing its going concern status which may include:

1. Current and expected profitability;

2. Debt repayment schedule;

3. Potential sources of replacement financing.

In case the going concern concept is not satisfied, the company should value its assets and liabilities on liquidation basis

iii. Accrual:

Revenues and costs are accrued, that is, recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate.

Example 4:

X Ltd. is preparing income statement for the year 2008. The company Collected Rs.300 million during the year on account of sales of goods of which Rs.100 million for sales during 2007. Out of sales of 2008, amount yet to be collected is Rs.90 million. What amount of sales should the company recognise as income of 2008?

Solution:

Example 5:

X Ltd. is preparing income statement for the year 2008. At the beginning of the year balance of creditors Rs.20 million, payment made during the year is Rs.80 million and closing balance of creditors is Rs.15 million. What amount of purchases should the company record as expense during the year?

Solution:

Purchases for 2008 –

Other Concepts:

Three other important accounting concepts are periodicity, matching and realisation:

Periodicity: Normally an entity has infinite or very long life. But the stakeholders would require to know the financial performance, financial position and cash flow of the entity more frequently.

The appropriate frequency of releasing financial statements has been developed taking into consideration cost of preparation and timeliness of the information. Any financial information which is released very late would lose its relevance. The usual periodicity of releasing financial statements is one year. However, listed companies are required to provide additional quarterly financial information.

Many Indian companies follow financial year, i.e. April 1 to March 31 as their accounting period. This matches with the fiscal year of the Government of India and therefore is very useful in determining tax liability and drawing relevant accounting information for the purpose of taxation.

IAS 1 Preparation and Presentation of Financial Statements (issued by the International Accounting Standards Board, IASB) states that financial state­ments shall be presented at least annually. If an entity changes its balance sheet, it may have longer or shorter accounting period for more than one year. Similarly, a newly established company may have its first accounting period shorter or longer than one year. The management has to explain the reasons for choosing an accounting period longer or shorter than one year.

For example, ACC Ltd., a leading cement manufacturing company India, has changed its accounting period from financial year (April – March) to calendar year (Jan. – Dec.) in 2005. The company reported it’s for the year 2004-05 from 1.4.2004- 31.3.2005, thereafter it switched over to calendar year and prepared a 9 months financial statements for the period 1.4.2005 -31.12.2005.

On the other hand, Ambuja Cements Ltd. also changed its accounting period from 30 June to 31 December in 2006. Its accounting period in the year of change was of 18 months i.e. from 1.7.2005 to 31.12.2006. Before that it prepared financial statements for period 1.7.2004 to 30.6.2005. Its latest accounting period is 1.1.2007 to 31.12.2007.

Do you wish to know the accounting period followed by the Nifty 50 Companies ? See Table 4.1 below:

1. Matching concept:

It is a relevant concept for the preparation of profit and loss account. While preparing profit and loss account (income statement) expenses are matched with revenue. Matching is a process in which expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income.

There are two types of expenses – direct expenses which are directly related to revenue and indirect expenses which are periodic expense. This principle guides that expenses should be matched with revenues. When expenses are matched with revenues, they are not recognized until the associated revenue is also recognized.

In sale of goods, direct expenses are cost of goods sold. Direct expenses incurred for earning the revenue is matched while valuation of cost of goods sold and indirect or periodic expenses are matched on the basis of accounting period.

Example 6:

ABC Ltd., a retail house, purchases various items of toilet goods. It has purchased 100 lac packets of beauty soaps and sold 90 lac units @ Rs.6 per unit.

The company has incurred the following expenses:

Purchase of soaps @ Rs.3 per unit, Transportation charge Rs.2, 50,000, Transit insurance Rs.50,000.

Rent Rs.6,50,000 for April 2007 to April 2008 Advertisement Rs.12 lacs

Employee Benefits Rs.20,00,000 which includes advance salary for April 2008 Rs.1 lac.

Find out profit for the year 2007-2008 (April 2007 – March 2008).

Solution:

Closing stock is valued applying weighted average cost method. As per AS -2 Inventory Valuation (ICAI) the costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase.

Matching of cost with revenues is supplemented by accrual concept. Matching is applied to both direct and indirect expenses whereas accrual guides that payment is not criteria for recognition of expense. Twelve months rent and employee benefits should be matched against revenue whether such expenses are already paid or remain outstanding. Any payment for the preceding or succeeding accounting periods is not a match against revenue for the period.

To further clarify application of accrual and matching, let us take up the employee benefits of Rs.20 lacs once more of which Rs.1 lac were for the next accounting period. Suppose that out of Rs.19 lacs employee benefits, the company paid Rs.18 lacs and Rs.1 lac were outstanding on the balance sheet date.

Matching concept requires that employee benefits relevant to April 2007- March 2007 should be recognized. So advance payment of Rs.1 lac is ignored. Accrual concept requires that employee benefits of Rs.19 lacs should be charged even if Rs.1 lac were not yet paid.

Other examples of matching concepts:

i. Depreciation is another example of the matching principle: The cost of purchasing a fixed asset is spread over the period in which it is expected to generate revenue. Similarly, cost of an intangible is amortised over its useful life.

ii. Wages paid to manufacturing labourers are not recognized as expenses until the actual products are sold. When the products are sold, the expenses are recognized as cost of goods sold.

iii. Product costs are costs which add value to inventory. These costs are added to inventory, and later expensed as cost of goods sold.

iv. Only if no connection with revenue can be established, cost can be charged as expenses to the current period (e.g. office salaries and other administrative expenses).

These are period costs which are expensed immediately.

Example 7:

The following information is available regarding ABC Ltd. which follows financial year as its accounting period:

On March 14, 2008 the company received inventory of Rs.15 lacs.

On April 13, 2008 the vendor is paid in full.

On May 11, 2008 the company sold the inventory for Rs.20 lacs.

Should ABC Ltd. recognize revenue in 2007-08 or 2008-09? When should the inventory become an expense?

Solution:

In the month of May 2008 the inventory was sold. So revenue is recognized in 2008-09. As on 31.3.2008 (2007-08) the inventory should be accounted for as an asset. ABC Ltd. has the income of Rs.20 lacs in 2008-09 which it needs to match with the cost of goods sold Rs.15 lacs. Thus in 2008-09 (May), inventory should be expensed.

Example 8:

XYZ Ltd. bought a machinery for Rs.20 lacs. It expects the machinery to be able to generate incomes for a period of 10 years. The company uses the straight line method for depreciating the machinery which means equal charge over the useful life of the asset. It has been assessed that useful life of the machine is about 32,000 machine hours whereas during the accounting period 2008-09, it was used only for 1500 machine hours.

What should be the annual depreciation to be expensed off to match the generation of income? Is it a proper matching?

Solution:

The company should expense off Rs.20 lacs/5 years = Rs.4 lacs p.a. so as to match against the income. In this case straight line depreciation is not appropriate. The company can choose appropriate depreciation method. AS-6 Depreciation Accounting (ICAI) explains that – The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset. However, Schedule – XIV to the Companies Act, 1956 provides depreciation schedule requiring minimum depre­ciation charge (conservatism). A company cannot charge depreciation lower than that amount.

Example 9:

Ambar Ltd. bought a Rs.20,000 yearly motor vehicle insurance from July 2007 to June 2008. The company follows calendar year as its account­ing period. How much should the company expense into the Profit and Loss Account (income statement) from 1st January to 31st December 2007 pertaining to this motor vehicle insurance?

Solution:

The company should expense off only half the year motor vehicle insurance relating to the period from July 2007 to December 2007, i.e. Rs.10,000 into the income statement. This is because from January 2008 to June 2008 the motor vehicle insurance does not relate to the generating of income for that period.

ii. Realization Concept:

This concept signifies that accounts recognise transactions (and any profit or loss arising from them) at the point of sale or transfer of legal ownership-rather than just when valuation changes.

Example 10:

X Ltd. sold its old machinery which purchased five years before and sold after five years of usage. The company purchased the machinery on 1.1.2002 for Rs.10 lacs. It has charged depreciation of Rs.5 lacs during five years to account for usage of the machinery. After five year of usage the asset was sold for Rs.6 lacs.

The sale of the asset is signifies by transfer of title of the asset to buyer and fulfillment of other conditions attached to the sale. Such conditions may include transport of the asset to the buyer’s place at the risk of the seller, etc. Once the sale of the asset is incomplete, the profit or loss arising out the transaction can be recognized.

If the sale is not complete but the buyer has made full or part payment, that should be treated as an advance. On the other hand, if the buyer has not paid even when the sale is complete, then asset should be removed from the Balance Sheet, profit or loss should be recognized and amount due from the buyer should be treated as an asset.

However, presently financial reporting standards are based on fair value con­cept. Profit or loss is recognized even if the asset is not sold or liability is not settled. For example, tangible fixed asset like plant and machinery, building etc. can be revalued and revaluation profit should be recognized.

Example 11:

ABC Ltd. purchased a building for Rs.20lacs on 1.1.1990 and charged depreciation @ Rs.1 lac p.a. for last 18 year, i.e. on 31.12.2007 the written down value of the building was Rs.2 lacs. Considering the irrelevance of this valuation, the company appointed a valuer and revalued the building at Rs.20 lacs on 1.1.2008. Can the company revalue its fixed assets like building? How should the company account for the profit? Is realization concept meaningful under fair value accounting?

Solution:

AS -10 Accounting For Fixed Assets (ICAI) allows revaluation of fixed assets to reflect true and fair view of the financial position of an entity. AS-10 requires that revaluation surplus should be directly credited to owner’s interest (i.e. shareholders’ equity in case of a company).

It will be presented as Revaluation Reserve. This is an unrealized profit. There are examples wherein accounting standards require to recognise fair value of an asset or liability and thus unrealized profit or loss is recognized in the financial statements. But still realization concept remains meaningful as it guides an entity to distinguish between a realized income and unrealized income.

Example 12:

An Indian company sold goods to a customer located in the US for US$ 20,000 on 1 February, 2008 and amount remained outstanding at the end of the accounting period on 31 March, 2008. There is no uncertainty about collection of the money from foreign customer.

(i) Should the company recognize sales? If yes, under which concept? What are the conditions for revenue recognition? At what amount the sales should be recorded?

(ii) If sale is recognized but no cash received, how is dual aspect completed?

(iii) At what amount debtors should be valued on the balance sheet date?

(iv) How is realization concept affected under this valuation?

Solution:

(i) For recognition of sales accrual concept is applied. The test is that if the sale of goods is completed, sales should be recognized. Payment can be received before, after or simultaneously with the sales, Under AS-9 Revenue Recognition (ICAI), sale is performed when the property in the goods is transferred by the seller to a buyer for price or the seller has transferred all risk and rewards associated with the ownership of the goods.

The seller does not retain any effective control on the goods. Also there is no uncertainty about the consideration to be derived from such sale. In this case consideration of sale US$ 20,000 is certain. So revenue should be recognized.

In case of foreign currency transaction, AS -11 The Effects of Changes in Foreign Exchange Rates (ICAI) becomes applicable. As per AS-11, the transac­tion involving sale of goods should be recorded at equivalent reporting currency (i.e. Indian rupee) applying the closing exchange rate on the date of transaction. So the company needs to apply the closing US$/INR exchange rate of the transaction date, i.e. 1.2.2008.

(ii) Double entry principle is complied with by creating asset of equivalent amount i.e. Trade Debtors of Rs.7, 87,500. Remember dual aspect concept. Income is equity, and debtor is asset – thus there is increase in equity and increase in asset. But the debtors will pay only US$ 20,000. The company may get more, less or the exact amount of Rs.7, 87,500 when the money is collected depending upon the exchange rate.

(iii) Debtor is a monetary item. Monetary items are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money. AS-11 requires that at the balance sheet foreign currency monetary items should be reported at the closing exchange rate. This means the company has to find out the exchange rate as on 31.3.2008.

(iv) The realization concept requires that asset should be realized or liability should be settled for recognition of any gain or loss. But fair value accounting demands that unrealized gain or loss should be recognized. In some countries, there is a practice of presenting a statement of realized income (in IFRSs this is termed as other comprehensive income). As you could understand, you do not know how much amount will be collected out of foreign currency debtors. Still you recognize gain based on current market value – the argument of fair value accounting is that a balance sheet should reflect fair value of all assets and liabilities as on the balance sheet date.

iii. Conservatism (also termed as prudence):

As per AS 1 Disclosure of Accounting Policies (ICAI) prudence signifies recognition of profit only when realized. In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.

As has been discussed, realization concept that fair value account­ing demands recognition of unrealized profit or loss. Thus application of prudence remains limited to only to creating provisions for possible losses.

Accounting Principles relating to Selection of Accounting Policies:

Accounting policies are specific accounting principles and the methods of applying those principles adopted by an entity in the preparation and presenta­tion of financial statements. Of course, no single list of accounting policies is applicable to all circumstances. The differing circumstances in which an entity functions and the diverse situations would require an entity to adopt alternative accounting principles and methods of applying those principles.

The choice of the appropriate accounting principles and the methods of applying those principles in the specific circumstances of each entity calls for consider­able judgment by the management of the entity.

Normally, three principles provide guidance to the entity:

i. Prudence:

In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.

ii. Substance over form:

The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.

iii. Materiality:

Financial statements should disclose all material items, i.e. items the knowledge of which might influence the decisions of the user of the financial statements.

Generally Accepted Accounting Principles (GAAP):

GAAP is common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of authoritative standards (set by accounting standards board – either national standard setting board or international standard setting board or promulgated by laws). They include commonly accepted ways of recording and reporting accounting information.

For example, the US GAAP comprise of accounting standards set out by the Financial Accounting Standards Board (FASB) for public and private com­panies, as well as non-profit entities. For local and state governments, GAAP is determined by the Governmental Accounting Standards Board (GASB), which operates under a set of assumptions, principles, and constraints, different from those of standard private-sector GAAP.

Financial reporting in federal Government entities is regulated by the Federal Accounting Standards Advisory Board (FASAB). US GAAP includes interpretation and guidelines provided by the Securities Exchange Commission of the US and American Institute of Certified Public Accountants (AICPA).

Accounting Cycle:

Series of steps in recording an accounting event from the time a transaction occurs to its reflection in the financial statements; also called accounting cycle. They are also called book-keeping cycle. The order of the steps in the accounting cycle are: recording in the journal, posting to the ledger, preparing a trial balance, and preparing the financial statements.

The steps in the accounting cycle are shown below:

Step 1:

Identification of transactions and events for record keeping and creation of source documents. For example, when a business entity sells goods, it creates sales voucher.

Step 2:

Analyzing the transactions and events. Identification of accounts which are affected by such transactions and events, and which account is debit and which is credit.

Step 3:

Journalisation: Recording the transaction and events in a journal which is called Day Book or book of primary entry.

Step 4:

Ledger Posting and Balancing: Account-wise classification of transaction and events into main books of account and periodically balancing the accounts to determine how much is debit or credit.

Step 5:

Trail Balance: Periodic compilation of accounts balance to verify whether aggregate debit balance of all accounts are equal to credit balance.

Step 6:

End of period adjustments: Accruals and deferrals are identified and accounted for at the end of each accounting period. Trial balance can be reworked after these adjustments.

Step 7:

Preparation of Final Accounts: Income Statements, Balance Sheet, Statement of Changes in Shareholders’ Equity and Statement of Cash Flow are prepared.

It is to mention that in a computerised accounting system, normally repetitive transactions and events are not analysed and journalised. They are automati­cally accounted for (i.e. journalised and posted to ledger) as soon as the source document is generated. This means as and when the counter cashier enter for cash sales, automatically the system captures the transaction, records as cash sales, posts to cash book updating the cash balance and also posts to sales account. Students may check. Tally which is a simplified accounting software.