Accounting concepts and principles - Made Easy
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This document discusses key accounting concepts and principles. It defines concepts like business entity, money measurement, going concern, accounting period, accounting cost, dual aspect, objectivity, realization, accrual, and matching. It explains their meanings and significance for maintaining uniformity and consistency in accounting. Some principles covered are full disclosure, materiality, uniformity/consistency, prudence/conservatism, and substance over form. Various users of financial statements like investors, lenders, and management are also outlined.
Accounting concepts and principles - Made Easy
- 1. Accounting ConceptsAccounting Concepts and Principlesand Principles 1
- 2. Introduction In order to maintain uniformity and consistency in preparing and maintaining books of accounts, certain rules or principles have been evolved. These rules/principles are classified as concepts and conventions. These are foundations of preparing and maintaining accounting records. 2
- 3. Users of Financial Statements • Investors – Need information about the profitability, dividend yield and price earnings ratio in order to assess the quality and the price of shares of a company • Lenders – Need information about the profitability and solvency of the business in order to determine the risk and interest rate of loans • Management – Need information for planning, policy making and evaluation • Suppliers and trade creditors – Need information about the liquidity of business in order to access the ability to repay the amounts owed to them 3
- 4. • Government – Need information about various businesses for statistics and formulation of economic plan • Customers – Interested in long-tem stability of the business and continuance of the supply of particular products • Employees – Interested in the stability of the business to provide employment, fringe benefits and promotion opportunities • Public – Need information about the trends and recent development 4
- 5. Limitations of conventional financial statements Companies may use different methods of valuation, cost calculation and recognizing profit The balance sheet does not reflect the true worth of the company Financial statements can only show partial information about the financial position of an enterprise, instead of the whole picture 5
- 7. Accounting Concepts • Business Entity Concept • Money Measurement Concept • Going Concern Concept • Accounting Period Concept • Accounting Cost Concept • Dual Aspect Concept • Concept of Objectivity • Realization Concept • Accrual Concept • Matching Concept 7
- 9. • Full Disclosure • Materiality • Uniformity/ Consistency • Prudence/ Conservatism • Substance over form 9
- 11. Meaning This concept assumes that, for accounting purposes, the business enterprise and its owners are two separate independent entities. Thus, the business and personal transactions of its owner are separate. 11
- 12. • Examples Insurance premiums for the owner’s house should be excluded from the expense of the business The owner’s property should not be included in the premises account of the business Any payments for the owner’s personal expenses by the business will be treated as drawings and reduced the owner’s capital contribution in the business 12
- 14. Money Measurement • Meaning All transactions of the business are recorded in terms of money It provides a common unit of measurement • Examples Market conditions, technological changes and the efficiency of management would not be disclosed in the accounts 14
- 16. Going Concern • Meaning This concept states that a business firm will continue to carry on its activities for an indefinite period of time. Simply stated, it means that every business entity has continuity of life. Thus, it will not be dissolved in the near future. 16
- 17. Significance This concept facilitates preparation of financial statements. On the basis of this concept, depreciation is charged on the fixed asset. It is of great help to the investors, because, it assures them that they will continue to get income on their investments. In the absence of this concept, the cost of a fixed asset will be treated as an expense in the year of its purchase. A business is judged for its capacity to earn profits in future. Prepaid expenses shown an asset side of Balance sheet on the assumption that the business will continue for a long time. 17
- 18. Limitations- Going Concern not useful under following circumstances - When the business objectives is likely to be achieved in near future. Eg: business undertaken for a specific project work like construction of a building. When a business is passing through financial crisis When a liquidator is appointed for liquidation of a company. When an industrial unit is declared sick. 18
- 20. Meaning 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. This concept requires that a balance sheet and profit and loss account should be prepared at regular intervals. 20
- 21. • 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 analyse the performance of business for a particular period. It also helps the business firms to distribute their income at regular intervals as dividends. 21
- 23. Accounting Cost • Meaning Assets should be shown on the balance sheet at the cost of purchase instead of current value • Example The cost of fixed assets is recorded at the date of acquisition cost. The acquisition cost includes all expenditure made to prepare the asset for its intended use. It included the invoice price of the assets, freight charges, insurance or installation costs 23
- 24. Dual Aspect ConceptDual Aspect Concept 24
- 25. • Every transaction has dual effects • Assets of a business are always equal to the claims of owners and outsiders • Every transaction has an equal impact on assets and liabilities in such a way that total assets are always equal to total liabilities. 25
- 27. Concept of ObjectivityConcept of Objectivity 27
- 28. Meaning The accounting information should be free from bias and capable of independent verification The information should be based upon verifiable evidence such as invoices or vouchers. Eg: Any cash received should be supported by a receipt. 28
- 29. For any transaction for which vouchers are not available like depreciation and bad debt reserve, a note on policy decisions of management should be accepted as an evidence. 29
- 30. Realization Cost/Realization Cost/ Revenue RecognitionRevenue Recognition ConceptConcept 30
- 31. Meaning This concept states that revenue from any business transaction should be included in the accounting records only when it is realised. The term realisation means creation of legal right to receive money. Selling goods is realisation, receiving order is not. In other words, it can be said that revenue is said to have been realised when cash has been received or right to receive cash on the sale of goods or services or both has been created. Sales are recognized when the goods are sold and delivered to customers or services are rendered. 31
- 32. Recognition of revenue Revenue is said to have been realized when cash has been received or right to receive cash on sale of goods or services or both has been created The concept provides that revenues are recognized when it is earned, and not when money is received A receipt in advance for the supply of goods should be treated as prepaid income under current liabilities Since revenue is a principal component in the measurement of profit, the timing of its recognition has a direct effect on the profit 32
- 33. • Example – Goods sent to our customers on sale or return basis – This means the customer do not pay for the goods until they confirm to buy. If they do not buy, those goods will return to us – Goods on the ‘sale or return’ basis will not be treated as normal sales and should be included in the closing stock unless the sales have been confirmed by customers 33
- 34. Exceptions to rule of sales recognition 1. Long-term contracts Owning to the long duration of long-term contracts, part of the total profit estimated to have been arisen from the accounting period should be included in the profit and loss account 1. Hire Purchase Sale Hire purchase sales have long collection period. Revenue should be recognized when cash received rather than when the sale (transfer of ownership) is made –The interest charged on a hire purchase sale constitutes the profit of transaction 34
- 35. 3. Gold • Revenue from gold is said to be recognized during the period when its production is completed and not when it is sold, as sale is certain. 4. Accounts maintained on cash basis • Professionals like doctors, advocates, etc recognize revenue only when the amount of fee is received in cash. 35
- 37. Meaning The meaning of accrual is something that becomes due especially an amount of money that is yet to be paid or received at the end of the accounting period. The accrual concept makes a distinction between the actual receipt of cash and the right to receive cash as regards revenue and actual payment of cash and obligation to pay cash as regards expenses. 37
- 38. All the expenses should be recognized when they become payable and not when actual cash is paid All the incomes should be recognized when they become receivable and not when actual cash is received. 38
- 40. Meaning The matching concept states that the revenue and the expenses incurred to earn the revenues must belong to the same accounting period. For determining income of a year only that expenses which have been incurred to earn that revenue should be taken into account. The net income for the period is determined by subtracting expenses incurred from revenues earned. 40
- 41. • Example – Expenses incurred but not yet paid in current period should be treated as accrual/accrued expenses under current liabilities – Expenses incurred in the following period but paid for in advance should be treated as prepayment expenses under current asset – Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use 41
- 42. Recognition criteria for expenses • Association between cause and effect – Expenses are recognized on the basis of a direct association between the expenses incurred on the basis of a direct association between the expenses incurred and revenues earned – For example, the sales commissions should be accounted for in the period when the products are sold, not when they are paid 42
- 43. • Systematic allocation of costs – When the cost benefit several accounting periods, they should be recognized on the basis of a systematic and rational allocation method – For example, a provision for depreciation should be made over the estimated useful life of a fixed asset • Immediate recognition – If the expenses are expected to have no certain future benefit or are even without future benefit, they should be written off in the current accounting period, for example, stock losses, advertising expenses and research costs 43
- 46. Meaning Financial statements should be prepared to reflect a true and fair view of the financial position and performance of the enterprise All material and relevant information must be disclosed in the financial statements 46
- 48. Meaning Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be presented separately Materiality depends on the size and nature of the item 48
- 49. • Example Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss account as revenue expenditures, although they can last for more than one accounting period 49
- 51. Consistency • Meaning – Companies should choose the most suitable accounting methods and treatments, and consistently apply them in every period – Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company – The change and its effect on profits should be disclosed in the financial statements 51
- 52. • Examples – If a company adopts straight line method and should not be changed to adopt reducing balance method in other period – If a company adopts weight-average method as stock valuation and should not be changed to other method e.g. first- in-first-out method 52
- 54. • Meaning Provision should be made for all likely losses but no credit must be taken for probable income Revenues and profits are not anticipated. Only realized profits with reasonable certainty are recognized in the profit and loss account However, provision is made for all known expenses and losses whether the amount is known for certain or just an estimation This treatment minimizes the reported profits and the valuation of assets 54
- 55. • Example – Closing stock should be valued at lower of cost or market value. – The provision for doubtful debts should be made. – Fixed assets must be depreciated over their useful economic lives . 55
- 57. Meaning Financial statements should be prepared to meet the objectives of the users Relevant information which can satisfy the needs of most users is selected and recorded in the financial statement 57
- 58. Substance Over FormSubstance Over Form 58
- 59. Meaning Meaningful presentation should be given more importance than form. Additional information should be provided where required by going beyond mere form prescribed by law. 59