Chapter 2 - Theory Base of Accounting

• The importance of accounting theory need not be over emphasized as no discipline can develop without a sound theoretical base.
• The theory base of accounting consists of principles, concepts, rules and guidelines developed over a period of time to bring uniformity and consistency to the process of accounting and enhance its utility to different users of accounting information.
• Apart from these, the Institute of Chartered Accountants of India, (ICAI), which is the regulatory body for standardization of accounting policies in the country, has issued Accounting Standards which are expected to be uniformly adhered to, in order to bring consistency in the accounting practices.

Generally Accepted Accounting Principles

• In order to maintain uniformity and consistency in accounting records, certain rules or principles have been developed which are generally accepted by the accounting profession.
• These rules are called by different names such as principles, concepts, conventions, postulates, assumptions and modifying principles.
• The term ‘principle’ has been defined by AICPA as ‘A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice’.
• The word ‘generally’ means ‘in a general manner’, i.e. pertaining to many persons or cases or occasions.
• Thus, Generally Accepted Accounting Principles (GAAP) refers to the rules or guidelines adopted for recording and reporting of business transactions, in order to bring uniformity in the preparation and the presentation of financial statements.
• This brings in objectivity in the process of recording and makes the accounting statements more acceptable to various users.
• The Generally Accepted Accounting Principles have evolved over a long period of time on the basis of past experiences, usages or customs, statements by individuals and professional bodies and regulations by government agencies and have general acceptability among most accounting professionals.
• However, the principles of accounting are not static in nature. These are constantly influenced by changes in the legal, social and economic environment as well as the needs of the users.
• These principles are also referred as concepts and conventions.
• The term concept refers to the necessary assumptions and ideas which are fundamental to accounting practice, and the term convention connotes customs or traditions as a guide to the preparation of accounting statements.

Basic Accounting Concepts

• Business Entity Concept
• The concept of business entity assumes that business has a distinct and separate entity from its owners.
• It means that for the purposes of accounting, the business and its owners are to be treated as two separate entities.
• Keeping this in view, when a person brings in some money as capital into his business, in accounting records, it is treated as liability of the business to the owner.
• Here, one separate entity (owner) is assumed to be giving money to another distinct entity (business unit).
• Similarly, when the owner withdraws any money from the business for his personal expenses (drawings), it is treated as reduction of the owner’s capital and consequently a reduction in the liabilities of the business.
• The accounting records are made in the book of accounts from the point of view of the business unit and not that of the owner.
• The personal assets and liabilities of the owner are, therefore, not considered while recording and reporting the assets and liabilities of the business.
• Similarly, personal transactions of the owner are not recorded in the books of the business, unless it involves inflow or outflow of business funds.

 

• Money Measurement Concept
• The concept of money measurement states that only those transactions and happenings in an organization which can be expressed in terms of money are to be recorded in the book of accounts.
• All such transactions or happenings which cannot be expressed in monetary terms in general do not find a place in the accounting records of a firm.
• Another important aspect of the concept of money measurement is that the records of the transactions are to be kept not in the physical units but in the monetary unit.
• All transactions are recorded in rupees and paisa as and when they take place.
• The money measurement assumption is not free from limitations. Due to the changes in prices, the value of money does not remain the same over a period of time.
• The value of rupee today on account of rise in prices is much less than what it was, say ten years back. Therefore, in the balance sheet, when we add different assets bought at different points of time, we are in fact adding heterogeneous values, which cannot be clubbed together.
• As the change in the value of money is not reflected in the book of accounts, the accounting data does not reflect the true and fair view of the affairs of an enterprise.

 

• Going Concern Concept
• The concept of going concern assumes that a business firm would continue to carry out its operations indefinitely, i.e. for a fairly long period of time and would not be liquidated in the foreseeable future.
• This is an important assumption of accounting as it provides the very basis for showing the value of assets in the balance sheet.

 

• Accounting Period Concept
• Accounting period refers to the span of time at the end of which the financial statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that period.
• Such information is required by different users at regular interval for various purposes, as no firm can wait for long to know its financial results as various decisions are to be taken at regular intervals on the basis of such information.
• The financial statements are, therefore, prepared at regular interval, normally after a period of one year, so that timely information is made available to the users. This interval of time is called accounting period.
• The Companies Act 1956 and the Income Tax Act require that the income statements should be prepared annually.
• However, in case of certain situations, preparation of interim financial statements becomes necessary.

 

• Cost Concept
• The cost concept requires that all assets are recorded in the book of accounts at their purchase price, which includes cost of acquisition, transportation, installation and making the asset ready to use.
• To illustrate, on June 2005, an old plant was purchased for Rs. 50 lakhs by Shiva Enterprise, which is into the business of manufacturing detergent powder. An amount of Rs. 10,000 was spent on transporting the plant to the factory site. In addition, Rs. 15,000 was spent on repairs for bringing the plant into running position and Rs. 25,000 on its installation. The total amount at which the plant will be recorded in the books of account would be the sum of all these, i.e. Rs. 50, 50,000.
• The concept of cost is historical in nature as it is something, which has been paid on the date of acquisition and does not change year after year.
• Adoption of historical cost brings in objectivity in recording as the cost of acquisition is easily verifiable from the purchase documents. The market value basis, on the other hand, is not reliable as the value of an asset may change from time to time, making the comparisons between one period to another rather difficult.
• However, an important limitation of the historical cost basis is that it does not show the true worth of the business and may lead to hidden profits. During the period of rising prices, the market value or the cost at leading to hidden profits.

 

• Dual Aspect Concept
• Dual aspect is the foundation or basic principle of accounting. It provides the very basis for recording business transactions into the book of accounts.
• This concept states that every transaction has a dual or two-fold effect and should therefore be recorded at two places. In other words, at least two accounts will be involved in recording a transaction.
• This can be explained with the help of an example. Ram started business by investing in a sum of Rs. 50, 00,000. The amount of money brought in by Ram will result in an increase in the assets (cash) of business by Rs. 50, 00,000. At the same time, the owner’s equity or capital will also increase by an equal amount. It may be seen that the two items that got affected by this transaction are cash and capital account.
• The duality principle is commonly expressed in terms of fundamental Accounting Equation, which is as follows :

Assets = Liabilities + Capital

• In other words, the equation states that the assets of a business are always equal to the claims of owners and the outsiders. The claims also called equity of owners is termed as Capital and that of outsiders, as Liabilities. The two-fold effect of each transaction affects in such a manner that the equality of both sides of equation is maintained.

 

• Revenue Recognition Concept
• The concept of revenue recognition requires that the revenue for a business transaction should be included in the accounting records only when it is realized.
• Revenue is the gross inflow of cash arising from
• The sale of goods and services by an enterprise
• use by others of the enterprise’s resources yielding interest, royalties and dividends.
• Revenue is assumed to be realized when a legal right to receive it arises, i.e. the point of time when goods have been sold or service has been rendered. Thus, credit sales are treated as revenue on the day sales are made and not when money is received from the buyer. As for the income such as rent, commission, interest, etc. these are recognized on a time basis.
• There are some exceptions to this general rule of revenue recognition. In case of contracts like construction work, which take long time, say 2-3 years to complete, proportionate amount of revenue, based on the part of contract completed by the end of the period is treated as realized. Similarly, when goods are sold on hire purchase, the amount collected in installments is treated as realized.

 

• Matching Concept
• The process of ascertaining the amount of profit earned or the loss incurred during a particular period involves deduction of related expenses from the revenue earned during that period.
• The matching concept emphasizes exactly on this aspect. It states that expenses incurred in an accounting period should be matched with revenues during that period. It follows from this that the revenue and expenses incurred to earn these revenues must belong to the same accounting period.
• The matching concept, thus, implies that all revenues earned during an accounting year, whether received during that year, or not and all costs incurred, whether paid during the year, or not should be taken into account while ascertaining profit or loss for that year.

 

• Full Disclosure Concept
• Information provided by financial statements are used by different groups of people such as investors, lenders, suppliers and others in taking various financial decisions.
• In the corporate form of organization, there is a distinction between those managing the affairs of the enterprise and those owning it. Financial statements, however, are the only or basic means of communicating financial information to all interested parties.
• It becomes all the more important, therefore, that the financial statements make a full, fair and adequate disclosure of all information which is relevant for taking financial decisions.
• The principle of full disclosure requires that all material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes.
• This is to enable the users to make correct assessment about the profitability and financial soundness of the enterprise and help them to take informed decisions.

 

• Consistency Concept
• The accounting information provided by the financial statements would be useful in drawing conclusions regarding the working of an enterprise only when it allows comparisons over a period of time as well as with the working of other enterprises.
• Thus, both inter-firm and inter-period comparisons are required to be made. This can be possible only when accounting policies and practices followed by enterprises are uniform and are consistent over the period of time.
• Consistency eliminates personal bias and helps in achieving results that are comparable.
• Also the comparison between the financial results of two enterprises would be meaningful only if same kind of accounting methods and policies are adopted in the preparation of financial statements.

 

• Conservatism Concept
• The concept of conservatism (also called ‘prudence’) provides guidance for recording transactions in the book of accounts and is based on the policy of playing safe.
• The concept states that a conscious approach should be adopted in ascertaining income so that profits of the enterprise are not overstated. If the profits ascertained are more than the actual, it may lead to distribution of dividend out of capital, which is not fair as it will lead to reduction in the capital of the enterprise.
• The concept of conservatism requires that profits should not to be recorded until realized but all losses, even those which may have a remote possibility, are to be provided for in the books of account.
• This approach of providing for the losses but not recognizing the gains until realized is called conservatism approach. This may be reflecting a generally pessimist attitude adopted by the accountants but is an important way of dealing with uncertainty and protecting the interests of creditors against an unwanted distribution of firm’s assets.
• However, deliberate attempt to underestimate the value of assets should be discouraged as it will lead to hidden profits, called secret reserves.

 

• Materiality Concept
• The concept of materiality requires that accounting should focus on material facts. Efforts should not be wasted in recording and presenting facts, which are immaterial in the determination of income.
• The materiality of a fact depends on its nature and the amount involved. Any fact would be considered as material if it is reasonably believed that its knowledge would influence the decision of informed user of financial statements.
• All such information about material facts should be disclosed through the financial statements and the accompanying notes so that users can take informed decisions.
• In certain cases, when the amount involved is very small, strict adherence to accounting principles is not required.

 

• Objectivity Concept
• The concept of objectivity requires that accounting transaction should be recorded in an objective manner, free from the bias of accountants and others.
• This can be possible when each of the transaction is supported by verifiable documents or vouchers.
• One of the reasons for the adoption of ‘Historical Cost’ as the basis of recording accounting transaction is that adherence to the principle of objectivity is made possible by it.
• As stated above, the cost actually paid for an asset can be verified from the documents but it is very difficult to ascertain the market value of an asset until it is actually sold.

Systems of Accounting

• The systems of recording transactions in the book of accounts are generally classified into two types, viz. Double entry system and Single entry system.
• Double entry system is based on the principle of “Dual Aspect” which states that every transaction has two effects, viz. receiving of a benefit and giving of a benefit. Each transaction, therefore, involves two or more accounts and is recorded at different places in the ledger. The basic principle followed is that every debit must have a corresponding credit. Thus, one account is debited and the other is credited.
• Double entry system is a complete system as both the aspects of a transaction are recorded in the book of accounts. The system is accurate and more reliable as the possibilities of frauds and misappropriations are minimized. The arithmetic inaccuracies in records can mostly be checked by preparing the trial balance. The system of double entry can be implemented by big as well as small organizations.
• Single entry system is not a complete system of maintaining records of financial transactions. It does not record two-fold effect of each and every transaction.
• Instead of maintaining all the accounts, only personal accounts and cash book are maintained under this system.
• In fact, this is not a system but a lack of system as no uniformity is maintained in the recording of transactions. For some transactions, only one aspect is recorded, for others, both the aspects are recorded.
• The accounts maintained under this system are incomplete and unsystematic and therefore, not reliable. The system is, however, followed by small business firms as it is very simple and flexible.

Basis of Accounting

• From the point of view the timing of recognition of revenue and costs, there can be two broad approaches to accounting. These are:
1. Cash basis; and
2. Accrual basis.
• Under the cash basis, entries in the book of accounts are made when cash is received or paid and not when the receipt or payment becomes due.
• Under the accrual basis, however, revenues and costs are recognized in the period in which they occur rather when they are paid. A distinction is made between the receipt of cash and the right to receive cash and payment of cash and legal obligation to pay cash. Thus, under this system, the monitory effect of a transaction is taken into account in the period in which they are earned rather than in the period in which cash is actually received or paid by the enterprise.
• This is a more appropriate basis for the calculation of profits as expenses are matched against revenue earned in relation thereto. For example, raw material consumed is matched against the cost of goods sold.

Accounting Standards

• Accounting standards are written statements of uniform accounting rules and guidelines or practices for preparing the uniform and consistent financial statements and for other disclosures affecting the user of accounting information.
However, the accounting standards cannot override the provision of applicable laws, customs, usages and business environment in the country.
• The Institute tries to persuade the accounting profession for adopting the accounting standards, so that uniformity can be achieved in the presentation of financial statements.
• In the initial years the standards are of recommendatory in nature. Once awareness is created about the requirements of a standard, steps are taken to enforce its compliance by making them mandatory for all companies to comply with.
• In case of non-compliance, the companies are required to disclose the reasons for deviations and the financial effect, if any, arising due to such deviation.

International Financial Reporting Standards (IFRSs)

• International Financial reporting Standards (IFRSs) are globally accepted accounting standards developed by International Accounting Standard Board (IASB).
• IFRS is a set of accounting standards for reporting different types of business transactions and events in the financial statements.
• The objective is to facilitate international comparisons for true and fair valuation of a business enterprise. The qualitative characteristics associated with the preparation of financial statements are useful to the users of accounting information in making financial decisions.

Benefits to Convergence to IFRSs

1. Easy access to global or international capital markets.
2. Easy comparisons and transparency.
3. True and fair valuation.
4. Increased trust and reliance.
5. Eliminates multiple reporting.