Professor Vipin 2014 Unit 2 Theory Base of Accounting

Professor Vipin 2014
Unit 2
Theory Base of Accounting
Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles (GAAP) refer to the standard framework of guidelines for
financial accounting used in any given jurisdiction; generally known as accounting standards or standard
accounting practice. These include the standards, conventions, and rules that accountants follow in
recording and summarizing and in the preparation of financial statements.
Accounting Concepts
The term ‘concept’ is used to denote accounting postulates, i.e., basic assumptions or conditions upon
the edifice of which the accounting super-structure is based.
1. Business Entity Concept: A business unit is an organization of persons established to accomplish
an economic goal. Business entity concept implies that the business unit is separate and distinct
from the persons who provide the required capital to it. This concept can be expressed through
an accounting equation, viz., Assets = Liabilities + Capital. The equation clearly shows that the
business itself owns the assets and in turn owes to various claimants. It is worth mentioning
here that the business entity concept as applied in accounting for sole trading units is different
from the legal concept. The expenses, income, assets and liabilities not related to the sole
proprietorship business are excluded from accounting. However, a sole proprietor is personally
liable and required to utilize non-business assets or private assets also to settle the business
creditors as per law. Thus, in the case of sole proprietorship, business and non-business assets
and liabilities are treated alike in the eyes of law. In the case of a partnership, firm, for paying
the business liabilities the business assets are used first and it any surplus remains thereafter, it
can be used for paying off the private liabilities of each partner. Similarly, the private assets are
first used to pay off the private liabilities of partners and if any surplus remains, it is treated as
part of the firm’s property and is used for paying the firm’s liabilities. In the case of a company,
its existence does not depend on the life span of any shareholder.
2. Money Measurement Concept: In accounting all events and transactions are recode in terms of
money. Money is considered as a common denominator, by means of which various facts,
events and transactions about a business can be expressed in terms of numbers. In other words,
facts, events and transactions which cannot be expressed in monetary terms are not recorded in
accounting. Hence, the accounting does not give a complete picture of all the transactions of a
business unit. This concept does not also take care of the effects of inflation because it assumes
a stable value for measuring
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3. Going Concern Concept: Under this concept, the transactions are recorded assuming that the
business will exist for a longer period of time, i.e., a business unit is considered to be a going
concern and not a liquidated one. Keeping this in view, the suppliers and other companies enter
into business transactions with the business unit. This assumption supports the concept of
valuing the assets at historical cost or replacement cost. This concept also supports the
treatment of prepaid expenses as assets, although they may be practically unsaleable.
4. Dual Aspect Concept: According to this basic concept of accounting, every transaction has a twofold aspect, Viz., certain benefits and 2. Receiving certain benefits. The basic principle of
double entry system is that every debit has a corresponding and equal amount of credit. This is
the underlying assumption of this concept. The accounting equation viz., Assets = Capital +
Liabilities or Capital = Assets – Liabilities, will further clarify this concept, i.e., at any point of
time the total assets of the business unit are equal to its total liabilities. Liabilities here relate
both to the outsiders and the owners. Liabilities to the owners are considered as capital.
5. Periodicity Concept: Under this concept, the life of the business is segmented into different
periods and accordingly the result of each period is ascertained. Though the business is assumed
to be continuing in future (as per going concern concept), the measurement of income and
studying the financial position of the business for a shorter and definite period will help in taking
corrective steps at the appropriate time. Each segmented period is called “accounting period”
and the same is normally a year. The businessman has to analyse and evaluate the results
ascertained periodically. At the end of an accounting period, an Income Statement is prepared
to ascertain the profit or loss made during that accounting period and Balance Sheet is prepared
which depicts the financial position of the business as on the last day of that period. During the
course of preparation of these statements capital revenue items are to be necessarily
6. Historical Cost Concept: According to this concept, the transactions are recorded in the books of
account with the respective amounts involved. For example, if an asset is purchases, it is
entered in the accounting record at the price paid to acquire the same and that cost is
considered to be the base for all future accounting. It means that the asset is recorded at cost at
the time of purchase but it may be methodically reduced in its value by way of charging
depreciation. However, in the light of inflationary conditions, the application of this concept is
considered highly irrelevant for judging the financial position of the business.
7. Matching Concept: The essence of the matching concept lies in the view that all costs which are
associated to a particular period should be compared with the revenues associated to the same
period to obtain the net income of the business. Under this concept, the accounting period
concept is relevant and it is this concept (matching concept) which necessitated the provisions
of different adjustments for recording outstanding expenses, prepaid expenses, outstanding
incomes, incomes received in advance, etc., during the course of preparing the financial
statements at the end of the accounting period.
8. Realisation Concept: This concept assumes or recognizes revenue when a sale is made. Sale is
considered to be complete when the ownership and property are transferred from the seller to
the buyer and the consideration is paid in full. However, there are two exceptions to this
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concept, viz., 1. Hire purchase system where the ownership is transferred to the buyer when the
last installment is paid and 2. Contract accounts, in which the contractor is liable to pay only
when the whole contract is completed, the profit is calculated on the basis of work certified
each year.
9. Accrual Concept: According to this concept the revenue is recognized on ts realization and not
on its actual receipt. Similarly the costs are recognized when they are incurred and not when
payment is made. This assumption makes it necessary to give certain adjustments in the
preparation of income statement regarding revenues and costs. But under cash accounting
system, the revenues and costs are recognized only when they are actually received or paid.
Hence, the combination of both cash and accrual system is preferable to get rid of the
limitations of each system.
10. Objective Evidence Concept: This concept ensures that all accounting must be based on
objective evidence, i.e., every transaction recorded in the books of account must have a
verifiable document in support of its, existence. Only then, the transactions can be verified by
the auditors and declared as true or otherwise. The verifiable evidence for the transactions
should be free from the personal bias, i.e., it should be objective in nature and not subjective.
However, in reality the subjectivity cannot be avoided in the aspects like provision for bad and
doubtful debts, provision for depreciation, valuation of inventory, etc., and the accountants are
required to disclose the regulations followed.
Accounting Conventions
The following conventions are to be followed to have a clear and meaningful information and data in
1. Consistency: The convention of consistency refers to the state of accounting rules, concepts,
principles, practices and conventions being observed and applied constantly, i.e., from one year
to another there should not be any change. If consistency is there, the results and performance
of one period can he compared easily and meaningfully with the other. It also prevents personal
bias as the persons involved have to follow the consistent rules, principles, concepts and
conventions. This convention, however, does not completely ignore changes. It admits changes
wherever indispensable and adds to the improved and modern techniques of accounting.
2. Disclosure: The convention of disclosure stresses the importance of providing accurate, full and
reliable information and data in the financial statements which is of material interest to the
users and readers of such statements. This convention is given due legal emphasis by the
Companies Act, 1956 by prescribing formats for the preparation of financial statements.
However, the term disclosure does not mean all information that one desires to get should be
included in accounting statements. It is enough if sufficient information, which is of material
interest to the users, is included.
3. Conservatism: In the prevailing present day uncertainties, the convention of conservatism has
its own importance. This convention follows the policy of caution or playing safe. It takes into
account all possible losses but not the possible profits or gains. A view opposed to this
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convention is that there is the possibility of creation of secret reserves when conservatism is
excessively applied, which is directly opposed to the convention of full disclosure. Thus, the
convention of conservatism should be applied very cautiously.
Basis of Accounting
There are three bases of accounting in common usage. Any one of the following bases may be used to
finalize accounts.
1. Accounting on ‘Cash basis: Under cash basis accounting, entries are recorded only when cash is
received or paid. No entry is passed when a payment or receipt becomes due. Income under
cash basis of accounting, therefore, represents excess of receipts over payments during an
accounting period. Government system of accounting is mostly on cash basis. Certain
professional people record their income on cash basis, but while recording expenses they take
into account the outstanding expenses also. In such a case, the financial statements prepared by
them for determination of their income are termed as Receipts and Expenditure Account.
2. Accrual Basis of Accounting or Mercantile System: Under accrual basis of accounting, accounting
entries are made on the basis of amounts having become due for payment or receipt. Incomes
are credited to the period in which they are earned whether cash is received or not. Similarly,
expenses and losses are detailed to the period in which, they are incurred, whether cash is paid
or not. The profit or loss of any accounting period is the difference between incomes earned and
expenses incurred, irrespective of cash payment or receipt. All outstanding expenses and
prepaid expenses, accrued incomes and incomes received in advance are adjusted while
finalising the accounts. Under the Companies Act 1956, all companies are required to maintain
the books of accounts according to accrual basis of accounting.
3. Mixed or Hybrid Basis of Accounting: When certain items of revenue or expenditure are
recorded in the books of account on cash basis and certain items on mercantile basis, the basis
of accounting so employed is called ‘hybrid basis of accounting’. For example, a company may
follow mercantile system of accounting in respect of its export business. However, government
subsidies and duty drawbacks on exports to be received from government are recorded only
when they are actually received i.e., on cash basis. Such a method could be adopted because of
uncertainty with respect of quantum, amount and time of receipt of such incentives and
drawbacks. Such a method of accounting followed by the company is called the hybrid basis of
accounting. In practice, the profit or loss shown under this basis will not be realistic.
Conservative people prefer recognizing income when received but cautious to provide for all
expenses, whether paid or not prefer this system. It is not widely practiced due to the
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Systems of Accounting
Single Entry System
Single entry accounting (single entry system, or single entry bookkeeping) is a simple form of
bookkeeping and accounting in which each financial transaction is recorded with a single entry in a
journal or transaction log. The single entry approach contrasts with double entry bookkeeping and
accounting, in which every transaction results in two equal and offsetting entries, one a debit (DR) and
the other a credit (CR).
Single entry bookkeeping and accounting can be adequate for a small business practicing cash basis
accounting. The single entry approach may, in fact, be preferred over a double-entry system for small
companies where all or most of these conditions apply:
The company uses cash basis accounting, not accrual accounting.
The company has few financial transactions per day.
The company does not sell on its own credit, meaning it does not deliver goods or services and
then invoice customers for payment later. Customers must pay at the time of the sale either in
cash, or by written check or bank transfer, or with a 3rd-party credit/debit card.
The company has very few employees.
The company owns few expensive business-supporting physical assets (e.g., it may own some
product inventory, office supplies, and cash in a bank account, but it does not own buildings,
substantial amounts of office furniture, large computer systems, production machinery,
vehicles, etc.).
The company is privately held or operates as a sole proprietorship or partnership (i.e., the
company does not need to publish the income statement, balance sheet, or other financial
statements that are required of publicly owned companies).
Double Entry System
When establishing an accounting system, entities choose to use either a single entry system or a double
entry system. In business, the overwhelming majority of companies choose the double entry approach,
by which each financial event brings at least two changes in the accounts: A credit entry in one account
causes an equal, offsetting debit entry in another account.
The practice of using two account entries for every transaction in this way serves two purposes:
Double entries play an error-checking role. The sum of all debit entries in the account ledgers must
equal the sum of all credit entries. That is, at all time: Total Debits = Total Credits
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Accounting Standards
Indian Accounting Standards (abbreviated as India AS) are a set of accounting standards notified by the
Ministry of Corporate Affairs which are converged with International Financial Reporting Standards
(IFRS). These accounting standards are formulated by Accounting Standards Board of Institute of
Chartered Accountants of India.
Now India will have two sets of accounting standards viz. existing accounting standards under
Companies (Accounting Standard) Rules, 2006 and IFRS converged Indian Accounting Standards(Indian
AS). The Indian AS are named and numbered in the same way as the corresponding IFRS. NACAS
recommend these standards to the Ministry of Corporate Affairs. The Ministry of Corporate Affairs has
to spell out the accounting standards applicable for companies in India. As on date the Ministry of
Corporate Affairs notified 35 Indian Accounting Standards (Indian AS). But it has not notified the date of
implementation of the same.
Mandatory Accounting Standards
AS 1 Disclosure of Accounting Policies
AS 2 Valuation of Inventories
AS 3 Cash Flow Statements
AS 4 Contingencies and Events Occurring after the Balance Sheet Date
AS 5 Net Profit or Loss for the period, Prior Period Items and Changes in Accounting Policies
AS 6 Depreciation Accounting
AS 7 Construction Contracts (revised 2002)
AS 9 Revenue Recognition
AS 10 Accounting for Fixed Assets
AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003),
AS 12 Accounting for Government Grants
AS 13 Accounting for Investments
AS 14 Accounting for Amalgamations
AS 15 Employee Benefits (revised 2005)
AS 16 Borrowing Costs
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AS 17 Segment Reporting
AS 18 Related Party Disclosures
AS 19 Leases
AS 20 Earnings Per Share
AS 21 Consolidated Financial Statements
AS 22 Accounting for Taxes on Income.
AS 23 Accounting for Investments in Associates in Consolidated Financial Statements
AS 24 Discontinuing Operations
AS 25 Interim Financial Reporting
AS 26 Intangible Assets
AS 27 Financial Reporting of Interests in Joint Ventures
AS 28 Impairment of Assets
AS 29 Provisions, Contingent` Liabilities and Contingent Assets
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