Chapter 2

Theory Base of Accounting

Basic Accounting Assumptions

The basic accounting assumptions form the outline for developing additional principles. The accounting assumptions or concepts ultimately created the structure of accountancy. The following are recognized by International Accounting Standards Committee as fundamental accounting assumptions:

1. Business Entity Concept

According to this assumption a business unit should be understood as a separate entity apart from the businessman. When the owner invests money into the business it should be assumed that the business owes money to the owner. This is known as capital. Capital is the amount which a business owes to its owner. All transactions of the business should be considered from the point of view of the business. For example when the owner invests money into business the accountant should consider this transaction as follows:

i)      the business received cash in the cash box

ii)    the business owes this amount to the owner

 2. Money Measurement Concept

A business deals in various items, with different forms, sizes shapes and units of measurements. For the purpose of accounting the only relevant factor of measurement is money as a measure of value. A business may own a five storied office building and a single storied factory building. When making accounting entries these detailed descriptions, even though help us to understand the nature of buildings, do not have much significance. What we need is the value of office building and the value of factory building. A description such as ‘Office buildings worth Rs.550,000 and factory building worth Rs.240,000’ are meaningful information from the accounting point of view.

Money measurement concept restricts the scope of accounting to factors that are measurable in terms of money. While we can record values of various assets and liabilities, we cannot record the level of satisfaction of our customers and loyalty of our employees. We can say our customers are ‘happy’ or ‘very happy’. But we cannot write in our accounts how much our customers are happy, simply because “happiness” cannot be measured in terms of money.

3. Going Concern Concept

According to this concept, a normal business is to be viewed as an entity having indefinite life. We assume that our business will go on for ever. This assumption helps to solve various accounting issues. For example, when we calculate depreciation for an asset, we mainly consider the expected life of an asset rather than the market value of that asset each year. This will give us a more or less accurate amount we spent by way of depreciation. Minute variations in our estimate will automatically get corrected in future.

4. Accounting Period Concept

Accounting period is a segment of one year in the indefinite life of a business. This assumption helps us measure the progress of business accurately and on a consistent basis. This also facilitates comparison. It is also important for calculating income tax and other government dues.

Apart from the basic assumptions listed above there are several other accounting principles that govern accountancy.

1. Dual Aspect Principle

This principle is the backbone of accounting. Every business transaction affects at least two aspects in a business. When we buy goods, we get goods and pay cash. When we sell goods we give goods and get cash. Accounting is much more than just buying and selling. Dual aspect involves in everything. Thus accounting job is primarily to identify this dual aspect and record it accordingly.

2. Verifiable Objective Evidence

According to this principle, a business transaction should be supported by documentary evidence. No entry shall be passed without its supporting documents. Objectivity means the document should contain facts in an unbiased manner. Accounting should be done without favour or prejudice.

3. Historical Cost

Historical cost is the cost at which an asset is originally acquired. This is the cost to be considered for accounting purpose. The market value of the asset may fluctuate each year. The accountant need not readjust the value of assets according to the change in market values.

4. Revenue Realization Principle

Revenue is realized when:

1. earning process is reasonably complete

2. the amount is capable of objective measurement

3. it is realized in the form of cash or any other asset

A sale transaction is complete when goods are delivered an agreed price and the customer has paid the money or accepted his liability to pay the money. A sale can be considered complete even though the buyer has not taken delivery of goods due to his own reasons if the ownership of the goods is transferred to the buyer and seller got an asset in exchange either as cash or as a debtor.

Revenue from sale should be recognized for the period in which the sale occurred. For example if goods are sold in December and money received in January, it is considered as the income for December.

Revenue from services should be recognized for the period in which service is rendered. If the workers of a cleaning company worked in the month of March and the company received payment in April, it is the income for March not for April.

Revenue from use hiring out of firm’s assets should be recognized for the period of use of asset. For example if a building is given for rent in January, but the rent was received in advance in December, it is considered the income for January, not for December.

Revenue from disposal of assets is recognized at the time of sale.

5. Matching Revenue and Expenses

Business is carried out with the intension of making profits. Profit is the excess of revenue over expenditure. It is the net increase in assets due to business activity. To ascertain the profit for a period a businessman must identify the revenue for a period, expenditure for a period and compare both. When his revenue is more than the expenditure he has earned profit. Profit normally expand his asset position or wipe out the liabilities. If profit is not taken out of the business it will result in increase of capital, because capital is the difference between total assets and total liabilities.

6. Principle of Full Disclosure

This principle implies that the accounting report should be full and accurate. There are standard forms for Balance Sheet, Schedules for Balance Sheet and Profit and Loss Account. It is a legal requirement for joint stock companies. But for sole proprietorships these reports are basically documents of management information only.

Disclosure of accounting information does not mean that the management should reveal its business secrets to the public. The law permits the companies to withhold information in a reasonable manner to safeguard its business interests. Therefore, a banking company need not show how much provision they have kept for bad debts, instead they are required to add a note in Balance Sheet that the “provision for bad and doubtful debts have been kept to the satisfaction of auditors”.

Modifying Accounting Principles

7. Materiality

Financial statements should disclose all items that are material enough to influence decision making. Items are accounted on the basis of significance rather than accurate adherence to principles. Purchase of a pencil is treated as an expense, not as an asset, but purchase of Machine is treated as purchase of asset not as expense. Unless we apply the principle of materiality we need to treat pencil as asset, and write off depreciation every time we sharpen the pencil.

8. Consistency

A business should follow accounting rules consistently for a reasonable period to make accounting results meaningful. Suppose the company keeps on changing the rate or method of depreciation every year, the item of depreciation becomes confusing and meaningless. Consistency eliminates personal bias. We must follow consistent rules year after year.

9. Conservatism (Prudence)

The principle of conservatism requires a business to be extremely cautious about possible losses. It should guard against any possible losses. If there is an anticipated loss there should be accurate provision in the account. There need not be any provision for anticipated revenue or gain. Provision for bad debts is created on the basis of this principle. When a business says they have debtors, our experience reminds us that a part of this can be lost while collecting the money by way of bad debts. We reduce bad debts from debtors to present a conservative estimate of realizable value of debtors. Creating a provision for discount on creditors is against the principle of conservatism. The following examples indicate the application of conservatism in accounting:

1. valuation of closing stock at cost price or market price whichever is less

2. creating provision for bad debts and discount on debtors, but not creating provision for discount on creditors

3. not showing assets such as goodwill in the books

4. writing off fictitious assets from the books as early as possible

5. treating small capital expenditure as revenue item (principle of materiality is also involved here)

10. Timeliness

According to this principle accounting information should be recorded in time and supplied in time. Decisions can be taken only if the current information is available. Accounting information should be presented to management before the loss of its utility. On account of this reason, most companies in western countries have started supplying quarterly financial statements.

11. Substance over Form

According to this principle the real fact of a matter is taken into account not the strict form or format. When goods are purchased on hire purchase, the purchaser becomes owner only after the last installment is paid. But for practical purpose the asset is with the purchaser right from the time of paying first installment. It is acceptable to treat this item as the asset of the purchaser and the installments due as loan.

12. Variations in Accounting Practices

In some cases prevailing industry practice should be taken in to account rather than the strict accounting principles. For example agricultural stock is generally valued at predetermined price or support price, rather than its cost price or market price.

Short Answer Questions

1. Why is it necessary for accountants to assume that business entity will remain a going concern?

2. When should revenue be recognised? Are there exceptions to the general rule?

3. What is the basic accounting equation?

4. The realisation concept determines when goods sent on credit to customers are to be included in the sales figure for the purpose of computing the profit or loss for the accounting period. Which of the following documents to be used in practice to determine when to include a transaction in the sales figure for the period when the goods have been:

a. dispatched

b. invoiced

c. delivered

d. paid for

Give reasons for your answer.

5. Complete the following work sheet:

(i) If a firm believes that some of its debtors may ‘default’, it should act on this by making sure that all possible losses are recorded in the books. This is an example of the ___________ concept.

(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the ___________ concept.

(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the ___________ concept.

(iv) The ___________ concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.

(v) A firm may hold stock which is heavily in demand. Consequently, the market value of this stock may be increased. Normal accounting procedure is to ignore this because of the ___________.

(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the ___________.

(vii) The management of a firm is remarkably incompetent, but the firms accountants can not take this into account while preparing book of accounts because of ___________ concept.

Long Answer

1. ‘The accounting concepts and accounting standards are generally referred to as the essence of financial accounting’. Comment.

2. Why is it important to adopt a consistent basis for the preparation of financial statements? Explain.

3. Discuss the concept-based on the premise ‘do not anticipate profits but provide for all losses’.

4. What is matching concept? Why should a business concern follow this concept? Discuss.

5. What is the money measurement concept? Which one factor can make it difficult to compare the monetary values of one year with the monetary values of another year?

End of Chapter 2