ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

Fundamentals of Accounting for CA CPT

CA Foundation : ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

The document ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev is a part of the CA Foundation Course Fundamentals of Accounting for CA CPT.
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(i) Dual aspect concept : This concept is the core of double entry book-keeping. Every transaction or event has two aspects:

(1) It increases one Asset and decreases other Asset;

(2) It increases an Asset and simultaneously increases Liability;

(3) It decreases one Asset, increases another Asset;

(4) It decreases one Asset, decreases a Liability.

Alternatively: 

(5) It increases one Liability, decreases other Liability;

(6) It increases a Liability, increases an Asset;

(7) It decreases Liability, increases other Liability;

(8) It decreases Liability, decreases an Asset.

Example :

ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

Transactions : (a) A new machine is purchased paying ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 50,000 in cash (b) A new machine is purchased for ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev50,000 on credit, cash is to be paid later on (c) Cash paid to repay bank loan to the extent of ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 50,000 (d) Raised bank loan of ` 50,000 to pay off other loan

Effect of the Transactions : (a) Increase in machine value and decrease in cash balance by ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 50,000.
ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

(b) Increase in machine value and increase in trade payables by ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 50,000.
ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

(c) Decrease in bank loan and decrease in cash by ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 50,000:
ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

(d) Increase in bank loan and decrease in other loan by ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 50,000:
ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

So every transaction and event has two aspects.

This gives basic accounting equation : 

Equity (E) + Liabilities (L) = Assets (A) or Equity (E)= Assets (A) – Liabilities(L) Or,
Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets Or,
Equity + Long Term Liabilities = Fixed Assets + (Current Assets – Current Liabilities) Or,
Equity = Fixed Assets + Working Capital – Long

Term Liabilities Whatever is received as funds is either expended (Expenses) – Debited to Profit & Loss Account
 Or Lost – Losses are transferred to Capital Account                    
 Or saved – Shown on the Assets side of the Balance Sheet Therefore, Capital + Income/Profits + Liabilities =

Expenses + Net Loss + Assets Or, Capital + Income – Expenses + Net Profits = Assets – Liabilities Since the net profit / loss is transferred to equity, the net effect is Equity + Liabilities = Assets

 

Illustration : 

Develop the accounting equation from the following information: -
ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

Find the profit for the year & the Balance sheet as on 31/3/2011.

Solution : For the year ended April 01, 2010 : Equity = Capital ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev1,00,000

Liabilities = Bank Loan + Trade Payables ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,00,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 75,000 =ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev1,75,000

Assets = Fixed Assets + Trade Receivables + Inventory + Cash & Bank ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev1,25,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 75,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 70,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 5,000 = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 2,75,000

Equity + Liabilities = Assets ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev1,00,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,75,000 =  ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 2,75,000

For the year ended April 01, 2011 : 
Assets = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,10,000 +ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 80,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 80,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 6,000 = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 2,76,000 Liabilities = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,00,000 + ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 70,000 = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,70,000

Equity = Assets - Liabilities = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 2,76,000 – ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,70,000 = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,06,000

Profits = New Equity - Old Equity = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,06,000 – ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 1,00,000 = ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev 6,000

(j) Conservatism : Conservatism states that the accountant should not anticipate income and should provide for all possible losses. When there are many alternative values of an asset, an accountant should choose the method which leads to the lesser value. Later on we shall see that the golden rule of current assets valuation - ‘cost or market price’ whichever is lower originated from this concept.

The Realisation Concept also states that no change should be counted unless it has materialised. The Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain but it is desirable to guard against all possible losses.
For this concept there should be atleast three qualitative characteristics of financial statements, namely,
(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as well as gains which are uncertain.
(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as well as to exclude uncertain gains,
(iii) Faithful representation of alternative values.
Many accounting authors, however, are of the view that conservatism essentially leads to understatement of income and wealth and it should not be the basis for the preparation of financial statements.

(k) Consistency :  In order to achieve comparability of the financial statements of an enterprise through time, the accounting policies are followed consistently from one period to another; a change in an accounting policy is made only in certain exceptional circumstances.

The concept of consistency is applied particularly when alternative methods of accounting are equally acceptable. For example a company may adopt any of several methods of depreciation such as written-down-value method, straight-line method, etc. Likewise there are many methods for valuation of inventories. But following the principle of consistency it is advisable that the company should follow consistently over years the same method of depreciation or the same method of valuation of Inventories which is chosen. However in some cases though there is no inconsistency, they may seem to be inconsistent apparently. In case of valuation of Inventories if the company applies the principle ‘at cost or market price whichever is lower’ and if this principle accordingly results in the valuation of Inventories in one year at cost price and the market price in the other year, there is no inconsistency here. It is only an application of the principle.

But the concept of consistency does not imply non-flexibility as not to allow the introduction of improved method of accounting.  An enterprise should change its accounting policy in any of the following circumstances only:

a. To bring the books of accounts in accordance with the issued Accounting Standards.

b. To compliance with the provision of law.

c. When under changed circumstances it is felt that new method will reflect more true and fair picture in the financial statement.

(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is not considered material. This principle is an exception of full disclosure principle.  According to materiality principle, all the items having significant economic effect on the business of the enterprise should be disclosed in the financial statements and any insignificant item which will only increase the work of the accountant but will not be relevant to the users’ need should not be disclosed in the financial statements.

The term materiality is the subjective term.  It is on the judgement, common sense and discretion of the accountant that which item is material and which is not.  For example stationary purchased by the organization though not used fully in the accounting year purchased still shown as an expense of that year because of the materiality concept.  Similarly depreciation on small items like books, calculators etc. is taken as 100% in the year of purchase though used by the company for more than a year.  This is because the amount of books or calculator is very small to be shown in the balance sheet though it is the asset of the company.  The materiality depends not only upon the amount of the item but also upon the size of the business, nature and level of information, level of the person making the decision etc.  Moreover an item material to one person may be immaterial to another person.  What is important is that omission of any information should not impair the decision-making of various users.

ICAI Notes 1.2, Accounting Concepts, Principles & Conventions (Part - 2) CA Foundation Notes | EduRev

6. FUNDAMENTAL ACCOUNTING ASSUMPTIONS

There are three fundamental accounting assumptions : (i) Going Concern (ii) Consistency (iii) Accrual All the above three fundamental accounting assumptions have already been explained in this unit.

If nothing has been written about the fundamental accounting assumption in the financial statements then it is assumed that they have already been followed in their preparation of financial statements. However, if any of the above mentioned fundamental accounting assumption is not followed then this fact should be specifically disclosed. 

 

7. FINANCIAL STATEMENTS

The aim of accounting is to keep systematic records to ascertain financial performance and financial position of an entity and to communicate the relevant financial information to the interested user groups.  The financial statements are basic means through which the management of an entity makes public communication of the financial information along with selected quantitative details. They are structured financial representations of the financial position and the performance of an enterprise. To have a record of all business transactions and also to determine whether all these transactions resulted in either ‘profit or loss’ for the period, all the entities will prepare financial statements viz., balance sheet, profit and loss account, cash flow statement etc. by following various accounting concepts, principles, and conventions which have been already discussed in detail in para 5. 

 

7.1 QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

Qualitative characteristics are the attributes that make the information provided in financial statements useful to users.  The following are the important qualitative characteristics of the financial statements:

1. Understandability : An essential quality of the information provided in financial statements is that it must be readily understandable by users. For this purpose, it is assumed that users have a reasonable knowledge of business and economic activities and accounting and study the information with reasonable diligence. Information about complex matters that should be included in the financial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the ground that it may be too difficult for certain users to understand.

2. Relevance : To be useful, information must be relevant to the decision-making needs of users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. The predictive and confirmatory roles of information are interrelated. For example, information about the current level and structure of asset holdings has value to users when they endeavour to predict the ability of the enterprise to take advantage of opportunities and its ability to react to adverse situations. The same information plays a confirmatory role in respect of past predictions about, for example, the way in which the enterprise would be structured or the outcome of planned operations.
Information about financial position and past performance is frequently used as the basis for predicting future financial position and performance and other matters in which users are directly interested, such as dividend and wage payments, share price movements and the ability of the enterprise to meet its commitments as they fall due. To have predictive value, information need not be in the form of an explicit forecast. The ability to make predictions from financial statements is enhanced, however, by the manner in which information on past transactions and events is displayed. For example, the predictive value of the statement of profit and loss is enhanced if unusual, abnormal and infrequent items of income and expense are separately disclosed.

3. Reliability : To be useful, information must also be reliable, Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.
Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under a legal action against the enterprise are highly uncertain, it may be inappropriate for the enterprise to recognise the amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim.

4. Comparability : Users must be able to compare the financial statements of an enterprise through time in order to identify trends in its financial position, performance and cash flows. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position, performance and cash flows. Hence, the measurement and display of the financial effects of like transactions and other events must be carried out in a consistent way throughout an enterprise and over time for that enterprise and in a consistent way for different enterprises.
An important implication of the qualitative characteristic of comparability is that users be informed of the accounting policies employed in the preparation of the financial statements, any changes in those polices and the effects of such changes. Users need to be able to identify differences between the accounting policies for like transactions and other events used by the same enterprise from period to period and by different enterprises. Compliance with Accounting Standards, including the disclosure of the accounting policies used by the enterprise, helps to achieve comparability.
The need for comparability should not be confused with mere uniformity and should not be allowed to become an impediment to the introduction of improved accounting standards. It is not appropriate for an enterprise to continue accounting in the same manner for a transaction or other event if the policy adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and reliable alternatives exist.
Users wish to compare the financial position, performance and cash flows of an enterprise over time. Hence, it is important that the financial statements show corresponding information for the preceding period(s).
The four principal qualitative characteristics are understandability, relevance, reliability and comparability.

5. Materiality : The relevance of information is affected by its materiality. Information is material if its misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information. Materiality depends on the size and nature of the item or error, judged in the particular circumstances of its misstatement. Materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which the information must have if it is to be useful.

6. Faithful Representation : To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria.
Most financial information is subject to some risk of being less than a faithful representation of that which it purports to portray. This is not due to bias, but rather to inherent difficulties either in identifying the transactions and other events to be measured or in devising and applying measurement and presentation techniques that can convey messages that correspond with those transactions and events. In certain cases, the measurement of the financial effects of items could be so uncertain that enterprises generally would not recognise them in the financial statements; for example, although most enterprises generate goodwill internally over time, it is usually difficult to identify or measure that goodwill reliably. In other cases, however, it may be relevant to recognise items and to disclose the risk of error surrounding their recognition and measurement.

7. Substance Over Form : If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, where rights and beneficial interest in an immovable property are transferred but the documentations and legal formalities are pending, the recording of acquisition/disposal (by the transferee and transferor respectively) would in substance represent the transaction entered into.

8. Neutrality :  To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgement in order to achieve a predetermined result or outcome.

9. Prudence : The preparers of financial statements have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collectability of receivables, the probable useful life of plant and machinery, and the warranty claims that may occur. Such uncertainties are recognised by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the financial statements would then not be neutral and, therefore, not have the quality of reliability.

10. Full, fair and adequate disclosure :  The financial statement must disclose all the reliable and relevant information about the business enterprise to the management and also to their external users for which they are meant, which in turn will help them to take a reasonable and rational decision.  For it, it is necessary that financial statements are prepared in conformity with generally accepted accounting principles i.e the information is accounted for and presented in accordance with its substance and economic reality and not merely with its legal form.  The disclosure should be full and final so that users can correctly assess the financial position of the enterprise. The principle of full disclosure implies that nothing should be omitted while principle of fair disclosure implies that all the transactions recorded should be accounted in a manner that financial statement purports true and fair view of the results of the business of the enterprise and adequate disclosure implies that the information influencing the decision of the users should be disclosed in detail and should make sense.
This principle is widely used in corporate organizations because of separation in management and ownership.  The Companies Act, 1956*  in pursuant of this principle has came out with the format of balance sheet and profit and loss account.  The disclosures of all the major accounting policies and other information are to be provided in the form of footnotes, annexes etc.  The practice of appending notes to the financial statements is the outcome of this principle.

11. Completeness : To be reliable, the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance.

Thus, if accounting information is to present faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality, not by their legal form. For example, if a business enterprise sells its assets to others but still uses the assets as usual for the purpose of the business by making some arrangement with the seller, it simply becomes a legal transaction. The economic reality is that the business is using the assets as usual for deriving the benefit. Financial statement information should contain the substance of this transaction and should not only record going by legality. In order to be reliable the financial statements information should be neutral i.e., free from bias. The preparers of financial statements however, have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collectability of doubtful receivables, the probable useful life of plant and equipment and the number of warranty claims that many occur. Such uncertainties are recognised by the disclosure of their nature and extent and by exercise of prudence in the preparation of financial statements. Prudence is the inclusion of a degree of caution in the exercise of judgement needed in making the estimates required under condition of uncertainty such that assets and income are not overstated and loss and liability are not understated.

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