Lesson-2

FUNDAMENTALS OF ACCOUNTING AND MANAGEMENT –I ACCOUNTING: AN OVERVIEW 2. BASIC CONCEPTS AND CONVENTIONS OF ACCOUNTING In understanding Accounting, the concepts and conventions of accounting form the foundations. Therefore all the concepts and conventions should be thoroughly understood, well grasped and constantly referred to for better understanding in lessons ahead and proper accounting management.

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Objectives After going through this lesson you will be able to:

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Understand and use the basic Accounting concepts Understand the Accounting conventions Understand the systems of Accounting & Book keeping

Introduction This lesson gives an insight to the basic principles, rules and conventions involved in the accounting process. These serve as guidelines in identifying the events and transactions for accounting, measuring, recording, summarizing and publishing them.

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Basic Accounting Concepts Accounting can be regarded as the language of business and it is a very useful tool for any business to take care of its financial resources. As every language has a grammar and it is necessary to have a good command over the grammar to understand the language, so accounting also has its grammar, generally called accounting principles or “Generally Accepted Accounting Principles (GAAP)”. The information of a business unit can be made understood to insiders (within the business unit) or outsiders (outside the business unit). This accounting information has to be suitably recorded, summarised and presented. In order to make this language convey the same meaning to everybody, accountants have agreed on a number of concepts, which they follow universally.

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2.2.1 Business Entity Concept In this concept a distinction is made between the business and the owner. All accounting records are maintained from the view point of the business rather than that of the owner. An enterprise is considered as an economic unit separate and apart from the owner’s. As such transactions related to business are only recorded in Books of Accounts. On the basis of this concept, the Owner is treated as creditor and the capital contributed by him appears on the liability side of the Balance Sheet. For example, if there is a partnership carrying on the business in the name of M/s ABC and Co. where Mr. Y & Z are equal partners M/s ABC & Co. is supposed to be a separate and distinct entity from Mr. Y & Z. This accounting concept is also extended to separate divisions of a firm in order to ascertain the results for each division separately.

2.2.2 Money Measurement Concept As per this concept only those transactions and events which can be expressed in terms of money are recorded in Books of Accounts. As such, all those transactions and facts which cannot be expressed in terms of money do not find a place in accounting. For example A Company which has not been able to hike the salaries of the workers for the past 5 years in turn affecting the morale and motivation of the workers. This however cannot be recorded since its monetary effect cannot be measured with a fair degree of accuracy.

2.2.3 Cost Concept This concept proposes that transactions are recorded in the Books of accounts at the price at which it is acquired or the price which is paid for it.

Suppose a firm purchases a flat for Rs. 10,00,000 but considers it as worth Rs. 20,00,000. The purchase of the flat will be recorded at Rs. 10,00,000 and not any other value.

2.2.4 Going Concern Concept In this concept, it is assumed that the business will continue to operate in the foreseeable future and is not likely to close down in a short period of time.

This concept is also termed as Continuity concept.

2.2.5 Dual Aspect Concept As per this concept, every business transaction has two aspects. The set of records based on this concept is called Double Entry System of Book Keeping. This concept is the foundation on which the entire system of Book Keeping and Accountancy is based. e.g. If Mr. X starts the business by introducing the capital of Rs. 50,000 the assets and liabilities structure will be as below:

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Liabilities Capital

Assets

50,000

Cash

50,000

Now if Mr. X uses the cash to purchase material worth Rs. 20,000 the assets and liability structure will change as follows: Liabilities Capital

50,000

Assets Cash Stock

30,000 20,000 --------50,000

-------50,000

If Mr. X sells the above material worth Rs. 20,000 for Rs. 30,000 on credit basis, assets and liabilities structure will change as follows: Liabilities Capital (incl. profit)

60,000 ---------60,000

Assets Cash Debtors

30,000 30,000 --------60,000

2.2.6 Realisation Concept As per this concept, revenue is considered as realised or earned on the date when the sale process is completed and transfer of title or ownership takes place. This is of great importance in stopping business firms from inflating their profits by recording sales and incomes that are likely to accrue.

2.2.7 Accrual Concept This concept recognises that all transactions and events are to be recorded in the Books at the time of its accrual, irrespective of the transaction being of the nature of cash or credit. This is done to match the expenses and costs incurred during a period whether paid or not with revenues generated during the period. For example, if one borrows Rs 1000 @10% p.a., at the end of the year Rs. 100 will become due as interest. If the amount is paid, the records will show it. If however the amount is not yet paid, there is the liability of interest and there being no corresponding increase in total assets, the capital will stand reduced.

In actual business the obligation to pay and the actual movement of cash may not coincide. In connection to sale of goods, revenue may be received before the right to receive arises and after the right to receive has been created. In the former case, the receipt will not be recognised as the revenue of the period for the reason that right to receive the same has not yet arisen or become due. In the later case the revenue will be be recognised even though

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the amount is received in the subsequent period. Similar treatment would be given to expenses incurred by the firm.

Self-Check Questions Answer True or False 1. The Going concern concept is not followed when the venture concerned has a short life.

2. The Cost concept demands an absolutely strict measurement in terms of money.

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Accounting Conventions In order to make the message contained in the financial statements – the Income statement (Profit and Loss account) and the statement showing the financial position clear and meaningful, these are drawn up according to the following conventions:

2.3.1 Convention of Conservation Business has an uncertain future full of risk. According to this rule “anticipate no profit but provide for all possible losses.� Conservatism is a quality of judgement to be exercised in evaluating the uncertainties and risk present in business and to ensure that reasonable provisions are made for potential losses. The potential losses can be in realisation of recorded assets and settlement of actual and contingent liabilities. This principle requires the accountant to follow a cautious approach and to use that method in accounting which is less optimistic. For example, inventory having a cost of Rs. 80 and market value of Rs. 100 should be valued at lower of the cost or market value i.e. Rs. 80. If the market value was Rs. 70, the cautious approach would be to value it at Rs. 70.

2.3.2 Convention of Disclosure This convention requires that accounting should focus on material facts i.e. care should be taken to disclose all material information (relevant and reliable) in order to make accounting information useful for the users. Thus full, fair and adequate disclosure can help in accurate assessment of financial position and performance. For example, if the organisation purchases some stationary, some of which remains unused at the end of the accounting period, the cost

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of such unused stationary should not be considered as the item of cost. If its impact on the overall profitability is likely to be negligible, the cost of stationary may be ignored, treating the cost of purchases as the expenditure.

2.3.3 Convention of Consistency The need for consistency arises from the need to make comparisons of business over a period of time and of various enterprises belonging to one industry or many industries. As per this convention, the various accounting policies and conventions adopted in one accounting year should be continued from one year to another. However, a change in accounting method or technique is not strictly prohibited. If there is any change in the accounting policies and procedures, then the resultant effect on the profitability should be disclosed clearly while preparing the financial statements.

Self-Check Questions 3. List the various conventions of accounting.

Answer True or False 4. Consistency demands that the accounting is done for a transaction on same principles from year to year.

5. In the financial statements, all information, material or immaterial should be disclosed; that is required by the disclosure convention.

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Systems of Accounting

2.4.1 Cash System of Accounting In this system of accounting, transactions are not recognized till they are settled in cash, implying that expenses are considered to be expenses when they are paid for and the incomes are considered to be incomes only when they are actually received. This system of accounting is mainly used by nonprofit organisations. Government accounts are also on this basis. This system is considered to be defective in nature, as it may not represent the true picture of the profitability, as well as of the state of affairs.

2.4.2 Mercantile System of Accounting In this system of accounting, expenses are considered as expenses for the period to which they pertain. Similarly, incomes are considered to be incomes

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for the period to which they pertain. When the expenses are actually paid or when the incomes are actually received is not significant in case of Mercantile system of Accounting. This system of accounting is considered to be better and is preferred by accountants.

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Systems of Book Keeping There are two systems of Book keeping:

2.5.1 Single Entry System In this system, some of the transactions are partly recorded in account books while some transactions may not at all be recorded in account books. Proper results cannot be obtained in this system of Book accounting. Government accounting normally follows the Single Entry system of accounting.

In the Single Entry system, only one transaction is recorded. For example, in a transaction relating to the payment of salary, only cash account will be affected and salary account will not appear in the books of account.

2.5.2 Double Entry System This system makes a proper and full record of all transactions. The basic presumption made by this system of accounting is that every business transaction has two elements i.e. when the business receives something, it has to pay something. If for instance, goods are purchased, the stock of goods will increase but either cash in hand (or at bank) will be reduced (due to payment) or an obligation to pay the price of the goods at a later date will arise. Another example is if goods are sold to the Customer for cash, goods of the business go out, but it receives corresponding amount of cash. In this system, every business transaction affects two accounts. One account is debited while the other account is credited by the same account. Thus this system of accounting follows the principle of “every debit has a corresponding credit” and hence total of all debits has to be equal to total of all credits.

Double Entry System of Accounting proves to be advantageous due to certain reasons: • • • •

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It takes into consideration both the aspects of each business transaction.

Arithmetical accuracy of the accounting records can be verified by preparing the Trial balance.

The correct result of operations can be ascertained by preparing the final accounts periodically.

Correct valuation of assets and liabilities is possible at any given point of time by preparing the balance sheet.

Self-Check Questions 6. Which system of book keeping follows the principle of “every debit has a corresponding credit� and hence total of all debits has to be equal to total of all credits.

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Summing Up In this lesson, you have familiarised yourself with the basic principles, rules and conventions followed in an accounting process.

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Answers to the self check questions.

1. True 2. False 3. Convention of conservation, convention of disclosure & convention of consistency 4. True 5. False 6. Double entry book keeping

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Terminal Questions

1. How do you define mercantile system of accounting? How is it different from Cash system of accounting?

2. A company projects to sell some 1000 units of finished product in future.

Whether the company should recognize the revenue during the current year?

Judge by using principle of conservatism.

3. What is the materiality concept in accounting?

4. Why, in your view, is the convention of consistency important?

5. How is the double entry book keeping system better than the single entry system of accounting?

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References

1. Grewal, T.S. Introduction to Accountancy ; S Chand & Company 2. Dhameja, N. Financial Management

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2.10 Suggested Further Reading 1. Weygandt, J. J., Kieso, D. E., & Kimmel, P. D. (2000). Financial accounting (University of Phoenix Special Edition Series). New York: Wiley.

2. Needles Jr, B.E., Power, M. & Crosson, S.V. (2005).Financial and Managerial Accounting". New Delhi: BizMantra Publishers.

3. Gupta. Financial Accounting for Management :An Analytical Perspective. New Delhi: Pearson Education.

2.11 Glossary • • •

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Accrual - Accrual signifies that for a particular transaction, a right has arisen, even though no monetary transaction has taken place.

Cash Accounting - Accounting which recognizes that transactions be recorded only when they occur in cash.

Mercantile Accounting - Accounting which is prevalent and subscribes to the concept of recording transactions which relate to the period irrespective of their cash flow.

Single Entry Book Keeping - Book keeping with incomplete records or the defective Double Entry System. Under this system neither all the transactions are recorded nor are all the account books maintained.

Double Entry Book Keeping - This system recognizes and records both the aspects of every transaction. Thus for every Debit there will be an equivalent Credit, i.e. the account which involves receiving aspect is debited and the account which involves giving aspect is credited.