Chapter 2 Theory Base of Accounting

It is necessary for accountants to assume that business entity will remain a going concern because

• It is assumed that the business will continue to exist for a long period in the future. Hence the cost of the asset is spread over its useful life and only the current year depreciation is treated as expense

• Outside parties enter into long term with the enterprise, give loans and purchase the debentures and shares of the enterprise

• For Example - A state-owned company is in a tough financial situation and is struggling to pay its debt. The government gives the company a bailout and guarantees all payments to its creditors. The state-owned company is a going concern despite its poor financial position.

Revenue should be recognised when sales take place either in cash or credit and/or right to receive income from any source is established. Similarly, rent for the month of March even if received in April month will be treated as revenue of the financial year ending 31st March.

There are two exceptions of this rule:

a) In case of sales on installment basis, only the amount collected in installments is treated as revenue.
b) In case of long term construction contracts, proportionate amount of revenue, based on part of the contract completed by the end of the financial year is treated as realised.

The basic accounting equation is,

Assets = Liabilities + Capital

It means that all the monetary value of all assets of a firm are equal to the total claims, viz. owners and outsiders.

According to the realisation concept, revenue is recognised when an obligation to receive the amount arises. When the goods are invoiced, it is treated as the transfer of ownership of goods from the seller to the buyer and hence the revenue is recognised.

(i) conservatism
(ii) entity
(iii) aspect
(iv) consistency
(v) conservatism
(vi) revenue recognition
(vii) money measurement

Financial accounting is concerned with the preparation of the financial statements and provides financial information to various accounting users. It is performed according to the basic accounting concepts like Business Entity, Money Measurement, Consistency, Conservatism, etc. These concepts allow various alternatives to treat the same transaction. For example, there are a number of methods available for calculating stock and depreciation, which can be followed by various firms. This leads to wrong interpretation of financial results by external users due to the problem of inconsistency and incomparability of financial results among different business entities. In order to mitigate inconsistency and incomparability and to bring uniformity in preparation of the financial statements, accounting standards are being issued in India by the Institute of Chartered Accountant of India. Accounting standards help in removing ambiguities and inconsistencies. Hence, accounting standards and accounting concepts are referred as the essence of financial accounting.

Financial statements are drawn to provide information about growth or decline of business activities over a period of time or comparison of the results, i.e. intra-firm (comparison within the same organisation) or inter-firm comparisons (comparison between different firms). Comparisons can be performed only when the accounting policies are uniform and consistent.

According to the Consistency Principle, accounting practices once selected should be continued over a period of time (i.e. years after years) and should not be changed very frequently. These help in a better understanding of the financial statements and thus make comparisons easy. For example, if a firm is following FIFO method for recording stock, and switches over to the weighted average method, then the results of this year cannot be compared to that of the previous years. Although consistency does notprevent change in the accounting policies, but if change in the policies is essential for better presentation and better understanding of the financial results, then the firm must undertake change in its accounting policies and must fully disclose all the relevant information, reasons and effects of those changes in the financial statements.

According to the Conservatism Principle, profits should not be anticipated; however, all losses should be accounted (irrespective whether they occurred or not). It states that profits should not be recorded until they get recognised; however, all possible losses even though they may happen rarely, should be provided. For example, stock is valued at cost or market price, whichever is lower. If the market price is lower than the cost price, loss should be accounted; whereas, if the former is more than the latter, then this profit should not be recorded until unless the stock is sold. There are numerous provisions that are maintained based on the conservatism principle like, provision for discount to debtors, provision for doubtful bad debts, etc. This principle is based on the common sense and depicts pessimism. This also helps the business to deal uncertainty and unforeseen conditions.

Matching Concept states that all expenses incurred during the year, whether paid or not, and all revenues earned during the year, whether received or not, should be taken into account while determining the profit of that year. In other words, expenses incurred in a period should be set off against its revenues earned in the same accounting period for ascertaining profit or loss. For example, insurance premium paid for a year is Rs1200 on July 01 and if accounts are closed on March 31, every year, then the insurance premium of the current year will be ascertained for nine months (i.e. from July to March) and will be calculated as,

Rs 1200 − Rs 900 = Rs 300

Thus, according to the matching concept, the expense of Rs 900 will be taken into account and notRs 1200 for determining profit, as the benefit of only Rs 900 is availed in the current accounting period.

The business entities follow this concept mainly to ascertain the true profit or loss during an accounting period. It is possible that in the same accounting period, the business may either pay or receive payments that may or may not belong to the same accounting period. This leads to either overcasting or undercasting of the profit or loss, which may not reveal the true efficiency of the business and its activities in the concerned accounting period. Similarly, there may be various expenditures like, purchase of machinery, buildings, etc. These expenditures are capital in nature and their benefits can be availed over a period of time. In such cases, only the depreciation of such assets is treated as an expense and should be taken into account for calculating profit or loss of the concerned year. Thus, it is very necessary for any business entity to follow the matching concept.

Money Measurement Concept states that only those events that can be expressed in monetary terms are recorded in the books of accounts. For example, 12 television sets of Rs10,000 each are purchased and this event is recorded in the books with a total amount of Rs 1,20,000. Money acts a common denomination for all the transactions and helps in expressing different measurement units into a common unit, for example rupees. Thus, money measurement concept enables consistency in maintaining accounting records. But on the other hand, the adherence to the money measurement concept makes it difficult to compare the monetary values of one period with that of another. It is because of the fact that the money measurement concept ignores the changes in the purchasing power of the money, i.e. only the nominal value of money is concerned with and not the real value. What Rs 1 could buy 10 years back cannot buy today; hence, the nominal value of money makes comparison difficult. In fact, the real value of money would be a more appropriate measure as it considers the price level (inflation), which depicts the changes in profits, expenses, incomes, assets and liabilities of the business.

(c) Accounting period

(d) None of the above

(a) Going concern

(b) Reliability and comparability

1. matching
2. conservatism
3. revenue realisation
4. consistency
5. objectivity