Explain the accounting concepts

Explain the accounting concepts

CONVENTION OF CONSERVATION:

It is a world of uncertainty. So it is always better to pursue the policy of playing safe. This is the principle behind the convention of conservatism. According to this convention the accountant must be very careful while recognizing increases in an enterprise’s profits rather than recognizing decreases in profits. For this the accountants have to follow the rule, anticipate no profit, provide for all possible losses, while recording business transactions. It is on account of this convention that the inventory is valued `at cost or market price whichever is less’, i.e. when the market price of the inventories has fallen below its cost price it is shown at market price i.e. the possible loss is provided and when it is above the cost price it is shown at cost price i.e. the anticipated profit is not recorded. It is for the same reason that provision for bad and doubtful debts, provision for fluctuation in investments, etc., are created. This concept affects principally the current assets.

ACCOUNTING PERIOD CONCEPT

All the transactions are recorded in the books of accounts on the assumption that profits on these transactions are to be ascertained for a specified period. This is known as accounting period concept. Thus, this concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes like, calculation of profit, ascertaining financial position, tax computation etc. Further, this concept assumes that, indefinite life of business is divided into parts. These parts are known as Accounting Period. It may be of one year, six months, three months, one month, etc. But usually one year is taken as one accounting period which may be a calendar year or a financial year. Year that begins from 1st of January and ends on 31st of December, is known as Calendar Year. The year that begins from 1st of April and ends on 31st of March of the following year, is known as financial year. As per accounting period concept, all the transactions are recorded in the books of accounts for a specified period of time. Hence, goods purchased and sold during the period, rent, salaries etc. paid for the period are accounted for and against that period only.

Significance

·         It helps in predicting the future prospects of the business.

·         It helps in calculating tax on business income calculated for a particular time period.

·         It also helps banks, financial institutions, creditors, etc to assess and analyze the performance of business for a particular period.

·         It also helps the business firms to distribute their income at regular intervals as dividends.

ACCOUNTING COST CONCEPT

Accounting cost concept states that all assets are recorded in the books of accounts at their purchase price, which includes cost of acquisition, transportation and installation and not at its market price. It means that fixed assets like building, plant and machinery, furniture, etc are recorded in the books of accounts at a price paid for them. For example, a machine was purchased by XYZ Limited for Rs.500000, for manufacturing shoes. An amount of Rs.1,000 were spent on transporting the machine to the factory site. In addition, Rs.2000 was spent on its installation. The total amount at which the machine will be recorded in the books of accounts would be the sum of all these items i.e. Rs.503000. This cost is also known as historical cost. Suppose the market price of the same is now Rs 90000 it will not be shown at this value. Further, it may be clarified that cost means original or acquisition cost only for new assets and for the used ones, cost means original cost less depreciation. The cost concept is also known as historical cost concept. The effect of cost concept is that if the business entity does not pay anything for acquiring an asset this item would not appear in the books of accounts. Thus, goodwill appears in the accounts only if the entity has purchased this intangible asset for a price.

Significance

·         This concept requires asset to be shown at the price it has been acquired, which can be verified from the supporting documents.

·         It helps in calculating depreciation on fixed assets.

·         The effect of cost concept is that if the business entity does not pay anything for an asset, this item will not be shown in the books of accounts

ACCOUNTING PERIOD CONCEPT

All the transactions are recorded in the books of accounts on the assumption that profits on these transactions are to be ascertained for a specified period. This is known as accounting period concept. Thus, this concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. This is necessary for different purposes like, calculation of profit, ascertaining financial position, tax computation etc. Further, this concept assumes that, indefinite life of business is divided into parts. These parts are known as Accounting Period. It may be of one year, six months, three months, one month, etc. But usually one year is taken as one accounting period which may be a calendar year or a financial year. Year that begins from 1st of January and ends on 31st of December, is known as Calendar Year. The year that begins from 1st of April and ends on 31st of March of the following year, is known as financial year. As per accounting period concept, all the transactions are recorded in the books of accounts for a specified period of time. Hence, goods purchased and sold during the period, rent, salaries etc. paid for the period are accounted for and against that period only.

Significance

·         It helps in predicting the future prospects of the business.

·         It helps in calculating tax on business income calculated for a particular time period.

·         It also helps banks, financial institutions, creditors, etc to assess and analyze the performance of business for a particular period.

·         It also helps the business firms to distribute their income at regular intervals as dividends.

MONEY MEASUREMENT CONCEPT

This concept assumes that all business transactions must be in terms of money that is in the currency of a country. In our country such transactions are in terms of rupees. Thus, as per the money measurement concept, transactions which can be expressed in terms of money are recorded in the books of accounts. For example, sale of goods worth Rs.200000, purchase of raw materials Rs.100000, Rent Paid Rs.10000 etc. are expressed in terms of money, and so they are recorded in the books of accounts. But the transactions which cannot be expressed in monetary terms are not recorded in the books of accounts. For example, sincerity, loyalty, honesty of employees are not recorded in books of accounts because these cannot be measured in terms of money although they do affect the profits and losses of the business concern. Another aspect of this concept is that the records of the transactions are to be kept not in the physical units but in the monetary unit. For example, at the end of the year 2006, an organization may have a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50 personal computers, 50 office chairs and tables, 100 kg of raw materials etc. These are expressed in different units. But for accounting purposes they are to be recorded in money terms i.e. in rupees. In this case, the cost of factory land may be say Rs.12 crore, office building of Rs.10 crore, computers Rs.10 lakhs, office chairs and tables Rs.2 lakhs, raw material Rs.30 lakhs. Thus, the total assets of the organization are valued at Rs.22 crore and Rs.42 lakhs. Therefore, the transactions which can be expressed in terms of money is recorded in the accounts books, that too in terms of money and not in terms of the quantity.

Significance

            The following points highlight the significance of money measurement Concept:

·         This concept guides accountants what to record and what not to record.

·         It helps in recording business transactions uniformly.

·         If all the business transactions are expressed in monetary terms, it will be easy to understand the accounts prepared by the business enterprise.

·        It facilitates comparison of business performance of two different periods of the same firm or of the two different firms for the same period.

What do you mean by ‘accounting’? Explain the various concepts of accounting and the need for having accounting standards?

What  do  you  mean  by  ‘accounting’?  Explain  the  various  concepts  of accounting and the need for having accounting standards?

Answer. The American Accounting Association define accounting as follows:

"the  process  of  identifying,  measuring  and  communicating  economic  information  to permit informed judgements and decisions by users of the information!.

Let's look at the key words in the above definition:

- It suggests that accounting is about providing information to others. Accounting information is economic information - it relates to the financial or economic activities of the business or organization.

- Accounting information needs to be identified and measured. This is done by way of a "set of accounts", based on a system of accounting known as double-entry bookkeeping. The accounting system identifies and records "accounting transactions".

- The "measurement" of accounting information is not a straight-forward process. it involves making judgements about the value of assets owned by a business or liabilities owed by a business. it is also about accurately measuring how much profit or loss has been made by a business in a particular period. As we will see, the measurement of accounting information often requires subjective judgement to come to a conclusion

- The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are several forms of accounting communication (e.g. annual report and accounts, management accounting reports) each of which serve a slightly different purpose. The communication need is about understanding who needs the accounting information, and what they need to know! The main purpose of accounting is to provide information, which is critical for the success of business organizations. Information is the data that have been put into a meaningful and useful context. System may be defined as a composite entity consisting of a number of elements, which are inter-dependent and interacting, operating together for the accomplishment of an objective. From the definition of information and system, we can understand that why accounting is also called an information system All elements of accounting work together to process different data feeded to them into a meaningful presentation, which is also called information.

CONCEPTS AND CONVENTIONS

Going concern: This concept is the underlying assumption that any accountant makes when he prepares a set of accounts. That the business under consideration will remain in existence for the foreseeable future. Without this concept, accounts would have to be drawn up on the 'winding up' basis. That is, on what the business is likely to be worth if it is  sold  piecemeal  at  the  date  of  the  accounts.  The  winding  up  value  would  almost certainly be different from the going concern value shown. Such circumstances as the state of the market and the availability of finance are important considerations here.

Accruals: Otherwise known as the matching principle. The purpose of this concept is to make sure that all revenues and costs are recorded in the appropriate statement at the appropriate time. Thus, when a profit statement is compiled, the cost of goods sold relevant to those sales should be recorded accurately and in full in that statement. Costs concerning a future period must be carried forward as a prepayment for that period and not charged in the current profit statement. For example, payments made in advance such as the prepayment of rent would be treated in this way. Similarly, expenses paid in arrears must, although paid after the period to that they relate, also be shown in the current period's profit statement: by means of an accruals adjustment.

Consistency: Because the methods employed in treating certain items within the accounting records may be varied from time to time, the concept of consistency has come to be applied more and more rigidly. For example, because there can be no single rate of depreciation chargeable on all fixed assets, every business has potentially a lot of discretion over the precise rate it chooses to use. However, if it wishes, a business may vary the rates at which it charges depreciation and alter the profits it reports at the same time. Consider the effects on profit of charging depreciation at 15% this year on 10,000 worth of fixed assets and then charging depreciation at 10% next year on the same 10,000 worth of fixed assets. This year you would charge 1,500 against profits and next year it would be only 1,000, using the straight line method of providing for depreciation.

Because of these sorts of effects, it is now accepted practice that when a company chooses to treat items such as depreciation in a particular way in the accounts it should go on using that method year after year. If it is NECESSARY to change the method being employed or the rates being charged then an explanation of the change and the effects it is having on the results must be shown as a note to the accounts being presented.

Prudence or conservatism concept: It is this concept more than any other that has given rise to the idea that accountants are pessimistic boring people!! Basically the concept says that whenever there are alternative procedures or values, the accountant will choose the one that results in a lower profit, a lower asset value and a higher liability value. The concept is summarized by the well known phrase 'anticipate no profit and provide for all possible  losses'.  Thus,  undue  optimism  can  never  be  part  of  the  make  up  of  an accountant! The danger is that if an optimistic view of profits is given then dividends may be paid out of profits that have not been earned.

Objectivity: The objectivity concept requires an accountant to draw up any accounts, and further analysis, only on the basis of objective and factual information. Thus, this concept attempts to ensure that if, for example, 100 accountants were to draw up a set of accounts for one business, there would be 100 identical accounting statements prepared. Everyone would be obtaining and using only facts. The problem here is that there are many aspects of accounting ensuring that objectivity cannot be universally applicable in the preparation of accounts. For example, with fixed assets: the cost of a van must be known at its purchase: say 30,000. However, how long will this van be in service? I say five years, my colleague could say 10 years. If I prepare the accounts using the straight line method of depreciation calculation, I would provide 30,000 ÷ 5 = 6,000 each year for depreciation; my colleague would charge 30,000 ÷ 10 = 3,000 each year for depreciation; and both of us could be correct! The problem is that with an issue such as depreciation we are not always able to be objective.

Duality: This is the very foundation of the universally applicable double entry book keeping system and it stems from the fact that every transaction has a double (or dual) effect on the position of a business as recorded in the accounts. For example, when an asset is bought, another asset cash (or bank) is also and simultaneously decreased OR a liability such as creditors is also and simultaneously increased. Similarly, when a sale is made the asset of stock is reduced as goods leave the business and the asset of cash is increased (or the asset of debtors is increased) as cash comes into the business (or a promise to pay is made and accepted). Every financial transaction behaves in this dual way.

Accounting Entity Concept: The idea here is that the financial transactions of one individual or a group of individuals must be kept separate from any unrelated financial transactions of those same individuals or group. The best example here concerns that of the sole trader or one man business: in this situation you may have the sole trader taking money by way of 'drawings': money for his own personal use. Despite it being his business and apparently his money, there are still two aspects to the transaction: the business is 'giving' money and the individual is 'receiving' money. So, the affairs of the individuals behind a business must be kept separate from the affairs of the business itself.

Cost Concept: This concept is based on the notion that only the costs paid to acquire an asset are relevant and thus should be the only costs to be shown in the accounts. For example, fixed assets are shown on the balance sheet at the price paid to acquire them; that is, their historic cost less depreciation written off to date.

There is a problem in this area. That is the one of value. The accountant will rarely talk of value in this context since the use of such a term implies personal bias. After all, the value of an asset as far as I am concerned may be different to the value of the same asset as  far  as  you  may  be  concerned.  The  application  of  the  cost  concept  ensures  that subjective judgements play no part in the drawing up of accounting statements.

Monetary  Measurement:  The  money  measurement  concept  is  one  of  the  simpler concepts. It simply and clearly states that only those transactions that are true financial transactions may be accounted for. That is, only those transactions that may be expressed in money values (whatever the currency) are of interest to the accountant.

A  new  manager  might  improve  employee  morale  and  the  improved  morale  might improve the performance of the business, but unlike the purchase of a new asset for example, the improved morale cannot be accurately expressed in monetary terms and therefore will not be recorded in the financial statements.

Materiality: We are concerned here with the idea that accountants should concern themselves only with matters that are significant because of their size and should not consider trivial matters. The problem, of course, is in deciding what is and what is not material:  we  are  concerned  here  with  RELATIVE  IMPORTANCE.  As  far  as  an individual is concerned, the loss of a £10 would be important and MATERIAL. As far as Chevron  or  Barclays  Bank  are  concerned,  the  loss  of  £10  could  be  considered unimportant in many circumstances and therefore immaterial: please note I am not suggesting that fraud or carelessness in the handling of money is acceptable!!

                                                                                      

Realization: The realization concept helps the accountant to determine the point at that he feels that a transaction is certain enough for the profit to be made on it to be calculated and taken to the profit and loss account. Realization occurs when a sale is made to a customer. The basic rule is that revenue is created at the moment a sale is made, and not when the account is later settled by cheque or by cash. Thus, profit can be taken to the profit and loss account on sales made, even though the money has not been collected. The sale is deemed to be made when the goods are delivered, and thus profit cannot be taken to the profit and loss account on orders received and not yet filled. An exception to this rule would be a long term contract that involve payments on account before completion of the work.

Accounting Standard

If  there  exists  a  tool  which  bridges  the  expectation  gap  that  exists  between  the expectations of the users of financial statements and those who prepare and attest the same then the tool, in my opinion, is ‘accounting standards’.

Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult.

Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are "generally accepted" because an authoritative body has set them or the accounting profession widely accepts them as appropriate.

Accounting Standards in India are issued By the Institute of Chartered Accountanst of

India (ICAI). At present there are 30 Accounting Standards issued by ICAI.

Objective of Accounting Standards is to standarize the diverse accounting policies and practices  with  a  view  to  eliminate  to  the  extent  possible  the  non-comparability  of financial statements and the reliability to the financial statements.

The institute of Chatered Accountants of India, recognizing the need to harmonize the diversre accounting policies and practices, constituted at Accounting Standard Board (ASB) on 21st April, 1977.