ICAI Notes 1.2, Accounting Concepts: Principles & Conventions- 1 - CA Foundation PDF Download

1. INTRODUCTION

Let us imagine a situation where you are a proprietor and you take copies of your books of account to five different accountants.  You ask them to prepare the financial statements on the basis of the above records and to calculate the profits of the business for the year. After few days, they are ready with the financial statements and all the five accountants have calculated five different amounts of profits and that too with very wide variations among them.  Guess in such a situation what impact would it leave on you about accounting profession.  To avoid this, a generally accepted set of rules have been developed.  This generally accepted set of rules provides unity of understanding and unity of approach in the practice of accounting and also in better preparation and presentation of the financial statements. Accounting is a language of the business.  Financial statements prepared by the accountant communicate financial information to the various stakeholders for decision-making purpose.  

Therefore, it is important that financial statements prepared by different organizations should be prepared on uniform basis.  Also there should be consistency over a period of time in the preparation of these financial statements.  If every accountant starts following his own norms and notions for accounting of different items then there will be an utter confusion. To avoid confusion and to achieve uniformity, accounting process is applied within the conceptual framework of ‘Generally Accepted Accounting Principles’ (GAAPs).  The term GAAPs is used to describe rules developed for the preparation of the financial statements and are called concepts, conventions, postulates, principles etc. These GAAPs are the backbone of the accounting information system, without which the whole system cannot even stand erectly.

 These principles are the ground rules, which define the parameters and constraints within which accounting reports are generated.  Accounting principles are basic norms and assumptions on which the whole accounting system has been developed and established.  Accountant also adheres to various accounting standards issued by the regulatory authority for the standardization of accounting policies to be followed under specific circumstances.  These conceptual frameworks, GAAPs and accounting standards are considered as the theory base of accounting.

2. ACCOUNTING CONCEPTS

Accounting concepts define the assumptions on the basis of which financial statements of a business entity are prepared.  Certain concepts are perceived, assumed and accepted in accounting to provide a unifying structure and internal logic to accounting process. The word concept means idea or notion, which has universal application.  

Financial transactions are interpreted in the light of the concepts, which govern accounting methods.  Concepts are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid.  Unlike physical science, accounting concepts are only result of broad consensus.  These accounting concepts lay the foundation on the basis of which the accounting principles are formulated.

3. ACCOUNTING PRINCIPLES

“Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting serving as an explanation of current practices and as a guide for selection of conventions or procedures where alternatives exits.” Accounting principles must satisfy the following conditions:

1. They should be based on real assumptions;

2. They must be simple, understandable and explanatory;

3. They must be followed consistently;

4. They should be able to reflect future predictions;

5. They should be informational for the users.

4. ACCOUNTING CONVENTIONS

Accounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted by various organizations over a period of time. These conventions are derived by usage and practice. The accountancy bodies of the world may change any of the convention to improve the quality of accounting information. Accounting conventions need not have universal application.

In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting conventions’ have been used interchangeably to mean those basic points of agreement on which financial accounting theory and practice are founded.

5. CONCEPTS, PRINCIPLES AND CONVENTIONS - AN OVERVIEW

Now we shall study in detail the various accounting concepts on which accounting is based.  The following are the widely accepted accounting concepts:

(a) Entity concept : Entity concept states that business enterprise is a separate identity apart from its owner. Accountants should treat a business as distinct from its owner. Business transactions are recorded in the business books of accounts and owner’s transactions in his personal books of accounts. The practice of distinguishing the affairs of the business from the personal affairs of the owners originated only in the early days of the double-entry book-keeping.  This concept helps in keeping business affairs free from the influence of the personal affairs of the owner.  This basic concept is applied to all the organizations whether sole proprietorship or partnership or corporate entities.  Entity concept means that the enterprise is liable to the owner for capital investment made by the owner.  Since the owner invested capital, which is also called risk capital he has claim on the profit of the enterprise.  A portion of profit which is apportioned to the owner and is immediately payable becomes current liability in the case of corporate entities.

Example: Mr. X started business investing  7,00,000 with which he purchased machinery for  5,00,000 and maintained the balance in hand. The financial position of the business (which is shown by Balance Sheet) will be as follows:

This means that the enterprise owes to Mr. X  7,00,000. Now if Mr. X spends  5,000 to meet his family expenses from the business fund, then it should not be taken as business expenses and would be charged to his capital account (i.e., his investment would be reduced by 5,000).  Following the entity concept the revised financial position would be

(b) Money measurement concept : As per this concept, only those transactions, which can be measured in terms of money are recorded. Since money is the medium of exchange and the standard of economic value, this concept requires that those transactions alone that are capable of being measured in terms of money be only to be recorded in the books of accounts. Transactions, even if, they affect the results of the business materially, are not recorded if they are not convertible in monetary terms.

 Transactions and events that cannot be expressed in terms of money are not recorded in the business books.  For example; employees of the organization are, no doubt, the assets of the organizations but their measurement in monetary terms is not possible therefore, not included in the books of account of the organization.  Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency of a country provides a common denomination for the value of material objects.  The monetary unit though an inelastic yardstick, remains indispensable tool of accounting.

It may be mentioned that when transactions occur across the boundary of a country, one may see many currencies. Suppose an Indian businessman sells goods worth  50 lakhs at home and he also sells goods worth of 1 lakh Euro in the United States. What is his total sales? 50 lakhs plus 1 lakh Euro.

These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform monetary unit i.e. in one currency. Suppose EURO 1 =  55.

Total Sales =  50 lakhs plus 55 lakhs =  105 lakhs. Money Measurement Concept imparts the essential flexibility for measurement and interpretation of accounting data.

This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit assumption that purchasing power of the money is not of sufficient importance as to require adjustment.  Also, many material transactions and events are not recorded in the books of accounts just because it cannot be measured in monetary terms.  Therefore it is recognized by all the accountants that  this concept has its own limitations and inadequacies.  Yet it is used for accounting purposes because it is not possible to adopt a better measurement scale.

Entity and money measurement are viewed as the basic concepts on which other procedural concepts hinge.

(c) Periodicity concept : This is also called the concept of definite accounting period. As per ‘going concern’ concept an indefinite life of the entity is assumed. For a business entity it causes inconvenience to measure performance achieved by the entity in the ordinary course of business.

If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as financial position only at the end of its life.

So a small but workable fraction of time is chosen out of infinite life cycle of the business entity for measuring performance and looking at the financial position. Generally one year period is taken up for performance measurement and appraisal of financial position. However, it may also be 6 months or 9 months or 15 months.
According to this concept accounts should be prepared after every period & not at the end of the life of the entity. Usually this period is one calendar year. In India we follow from 1st April of a year to 31st March of the immediately following year.

Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an unduly long time-frame. This concept makes the accounting system workable and the term ‘accrual’ meaningful. If one thinks of indefinite time-frame, nothing will accrue. There cannot be unpaid expenses and non-receipt of revenue. Accrued expenses or accrued revenue is only with reference to a finite time-frame which is called accounting period.

Thus, the periodicity concept facilitates in :

(i) Comparing of financial statements of different periods
(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the business
(iii) Matching periodic revenues with expenses for getting correct results of the business operations

(d) Accrual concept :  Under accrual concept, the effects of transactions and other events are recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past events involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future.
To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the gross inflow of cash, receivables and other consideration arising in the course of the ordinary activities of an enterprise from sale of goods, from rendering services and from the use by others of enterprise’s resources yeilding interest, royalties and dividends. For example,
(1) Mr. X started a cloth merchandising. He invested  50,000, bought merchandise worth ` 50,000. He sold such merchandise for  60,000. Customers paid him  50,000 cash and assure him to pay  10,000 shortly. His revenue is  60,000. It arose in the ordinary course of cloth business; Mr. X received  50,000 in cash and 10,000 by way of receivables.

Take another example;
(2) an electricity supply undertaking supplies electricity spending  16,00,000 for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricity charges. This is also revenue which arose from rendering services.
Lastly,
(3) Mr. A invested  1,00,000 in a business. He purchased a machine paying  1,00,000. He hired it out for  20,000 annually to Mr. B.  20,000 is the revenue of Mr. A; it arose from the use by others of the enterprise’s resources.

Expense is a cost relating to the operations of an accounting period or to the revenue earned during the period or the benefits of which do not extend beyond that period.
In the first example, Mr. X spent ` 50,000 to buy the merchandise; it is the expense of generating revenue of  60,000. In the second instance  16,00,000 are the expenses. Also whenever any asset is used it has a finite life to generate benefit. Suppose, the machine purchased by Mr. A in the third example will last for 10 years only. Then 10,000 is the expense he met. For the time being, ignore the idea of accounting period.
Accrual means recognition of revenue and costs as they are earned or incurred and not as money is received or paid. The accrual concept relates to measurement of income, identifying assets and liabilities.

Example: Mr. J D buys clothing of  50,000 paying cash  20,000 and sells at  60,000 of which customers paid only  50,000.
His revenue is  60,000, not  50,000 cash received. Expense (i.e., cost incurred for the revenue) is  50,000, not  20,000 cash paid. So the accrual concept based profit is  10,000 (Revenue – Expenses).

As per Accrual Concept : Revenue – Expenses = Profit Accrual Concept provides the foundation on which the structure of present day accounting has been developed. 

Alternative as per Cash basis Cash received in ordinary course of business – Cash paid in ordinary course of business = profit.

Revenue may not be realised in cash. Cash may be received simultaneously or

(i) before revenue is created (A. 1) (ii) after revenue is created (A. 2) Expenses may not be paid in cash. Cash may be paid simultaneously or (i) before expense is made (B. 1)

(ii) after expense is made (B. 2) A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Trade receivables. B. 1 creates an asset called Trade Advance when cash is paid in advance while B. 2 creates a liability called payables or Trade payables or outstanding liabilities. If the expenses remain unpaid in respect of goods, it is called Trade payables, if it remains unpaid for other expenses, it is called Expense payables.

(e) Matching concept : In this concept, all expenses matched with the revenue of that period should only be taken into consideration. In the financial statements of the organization if any revenue is recognized then expenses related to earn that revenue should also be recognized. This concept is based on accrual concept as it considers the occurrence of expenses and income and do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like prepaid and outstanding expenses, unearned or accrued incomes.

It is not necessary that every expense identify every income. Some expenses are directly related to the revenue and some are time bound.  For example:- selling expenses are directly related to sales but  rent, salaries etc are recorded on accrual basis for a particular accounting period.  In other words periodicity concept has also been followed while applying matching concept.

Mr. P K started cloth business. He purchased 10,000 pcs. garments @  100 per piece and sold 8,000 pcs. @ 150 per piece during the accounting period of 12 months 1st January to 31st December, 2011. He paid shop rent @  3,000 per month for 11 months and paid ` 8,00,000 to the suppliers of garments and received 10,00,000 from the customers.
Let us see how the accrual and periodicity concepts operate.

Periodicity Concept fixes up the time-frame for which the performance is to be measured and financial position is to be appraised. Here, it is January 2011-December, 2011. So revenues and expenses are to be measured for the year 2011 and assets and liabilities are to be ascertained as on 31st December, 2011.

Accrual Concept operates to measure revenue of 12,00,000 (arising out of sale of garments 8,000 Pcs ×  150) which accrued during 2011, not the cash received  10,00,000 and also the expenses correctly. Shop rent for 12 months is an expense item amounting to  36,000, not 33,000 the cash paid.
Should the accountant treat  10,00,000 as expenses for purchase of merchandise ? And should he treat 1,64,000 as profit? (Revenue  12,00,000-Merchandise  10,00,000. Shop Rent  36,000). Obviously the answer is No. Matching links revenue with expenses.

Revenue – Expenses = Profit

But this unqualified equation may create misconception. It should be defined as :

Periodic Profit = Periodic Revenue – Matched Expenses

From the revenue of an accounting period such expenses are deducted which are expended to generate the revenue to determine profit of that period.

In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000 pcs of garments should be treated as expenses.

Thus, accrual, matching and periodicity concepts work together for income measurement and recognition of assets and liabilities.

(f) Going Concern concept : The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.

The valuation of assets of a business entity is dependent on this assumption.  Traditionally, accountants follow historical cost in majority of the cases.
Suppose Mr. X purchased a machine for his business paying 5,00,000 out of 7,00,000 invested by him. He also paid transportation expenses and installation charges amounting to ` 70,000. If he is still willing to continue the business, his financial position will be as follows:

Now if he decides to back out and desires to sell the machine, it may fetch more than or less than  5,70,000. So his financial position should be different. If going concern concept is taken, increase/ decrease in the value of assets in the short-run is ignored. The concept indicates that assets are kept for generating benefit in future, not for immediate sale; current change in the asset value is not realisable and so it should not be counted.

(g) Cost concept : By this concept, the value of an asset is to be determined on the basis of historical cost, in other words, acquisition cost. Although there are various measurement bases, accountants traditionally prefer this concept in the interests of objectivity. When a machine is acquired by paying  5,00,000, following cost concept the value of the machine is taken as  5,00,000. It is highly objective and free from all bias. Other measurement bases are not so objective. Current cost of an asset is not easily determinable. If the asset is purchased on 1.1.1995 and such model is not available in the market, it becomes difficult to determine which model is the appropriate equivalent to the existing one. Similarly, unless the machine is actually sold, realisable value will give only a hypothetical figure. Lastly, present value base is highly subjective because to know the value of the asset one has to chase the uncertain future.

However, the cost concept creates a lot of distortion too as outlined below :

(a) In an inflationary situation when prices of all commodities go up on an average, acquisition cost loses its relevance.  For example, a piece of land purchased on 1.1.1995 for  2,000 may cost  1,00,000 as on 1.1.2011.  So if the accountant makes valuation of asset at historical cost, the accounts will not reflect the true position.

(b) Historical cost-based accounts may lose comparability. Mr. X invested 1,00,000 in a machine on 1.1.1995 which produces  50,000 cash inflow during the year 2011, while Mr. Y invested  5,00,000 in a machine on 1.1.2005 which produced  50,000 cash inflows during the year. Mr. X earned at the rate 20% while Mr. Y earned at the rate 10%. Who is more-efficient ? Since the assets are recorded at the historical cost, the results are not comparable. Obviously it is a corollary to (a).

(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example. The cost concept fails to recognise such asset although it is a very important asset of any organization.
Many other controversial issues have arisen in financial accounting that revolves around the cost concept which will be discussed at the advanced stage. However, later on we shall see that in many circumstances, the cost convention is not followed. See conservatism concept for an example, which will be discussed later on in this unit.

(h) Realisation concept : It closely follows the cost concept. Any change in value of an asset is to be recorded only when the business realises it. When an asset is recorded at its historical cost of 5,00,000 and even if its current cost is 15,00,000 such change is not counted unless there is certainty that such change will materialise.
However, accountants follow a more conservative path. They try to cover all probable losses but do not count any probable gain. That is to say, if accountants anticipate decrease in value they count it, but if there is increase in value they ignore it until it is realised. Economists are highly critical about the realisation concept. According to them, this concept creates value distortion and makes accounting meaningless.
Example : Mr. X purchased a piece of land on 1.1.1995 paying 2,000. Its current market value is 1,02,000 on 31.12.2011. Should the accountant show the land at 2000 following cost concept and ignoring 1,00,000 value increase since it is not realised? If he does so, the financial position would be :

Is it not proper to show it in the following manner?

Now-a-days the revaluation of assets has become a widely accepted practice when the change in value is of permanent nature. Accountants adjust such value change through creation of revaluation (capital) reserve.

Thus the going concern, cost concept and realization concept gives the valuation criteria.