The term Standard, in general terms, means uniformity. It means adherence to specified rules, principles, policies, methods, procedures, reporting, etc to bring uniformity among all counterparts.
To understand & interpret the Accounts in same manner, it is imperative that every organisation follow some uniform policy & practice in preparation of Accounts, otherwise comparison of accounts between various enterprises would be misleading. Accounting Standard help and enforce the organisation to follow standard principles and policies to bring uniformity in Accounting Statements.
Accounting Standards (AS) are written policy documents issued by expert accounting body, Government or other regulatory body, covering the aspects of recognition, measurement, presentation and disclosure of accounting transactions in the financial statements.
- Purpose : Accounting Standards aims to promote the dissemination of timely and useful financial information to investors and others having an interest in the company’s economic performance. Accounting Standards bring uniformity in financial statements, enabling comparability of financial statements of different enterprises.
- Issues : Accounting Standards deal with the issue like: Recognition of events and transactions in the financial statements, and their measurement, Presentation of transactions and events in the financial statements, in a meaningful and understandable manner, Adequate disclosure to enable the public at large, stakeholders and potential investors take prudent and informed business decisions.
- Policies : Accounting Standards standardize diverse accounting policies to eliminate or reduce the non-comparability of financial statements, improving the reliability of financial statements and provide a set of standard accounting policies, valuation norms and disclosure requirements.
Accounting Standards Setting Process
- Standard Setting Bodies : The ICAI has taken initiatives in setting and the procedure of Accounting Standards adopting a consultative and transparent approach.
The composition of ASB includes representatives of industries (namely, ASSOCHAM, CII, and FICCI), regulators, academicians, government departments etc. Although ASB is a body constituted by the Council of the ICAI, it (ASB) is independent in the formulation of accounting standards.
- International Standards : The ASB considers the International Accounting Standards (IASs)/ international Financial Reporting Standards (IFRSs) while framing Indian Accounting Standards (ASs) and try to integrate them, in the light of the applicable laws, customs, usages and business environment in the country.
The accounting standard on the relevant subject is then issued by the ICAI.
Compliance of Accounting Standards
For the purpose of the compliance of the Accounting Standards, all enterprises in India are classified into three broad categories: (Level I, II, & III)
Level I Enterprise
- Enterprises whose equity or debt securities are either listed (or in the process to be listed) in India or outside India.
- Banks, Insurance Companies and Financial Institutions.
- All commercial, industrial and other reported business enterprises, whose total turnover during the previous year is in excess of Rs.50 crores (as per the audited financial statement).
- All commercial, industrial and other reporting business enterprises, whose total borrowings including public deposits during the previous year are in excess of Rs.10 crores.
- Holding or subsidiary company of any of the above enterprises any time during the year.
Level II Enterprises
- All commercial, industrial and other reporting business enterprises, whose total turnover during the previous year exceeds Rs.40 lakhs but does not exceed Rs.50 crores.
- All commercial, industrial and other reporting business enterprises, whose total borrowings including public deposits during the previous year exceeds Rs.1 crore but does not exceed Rs.10 crores.
- Holding or subsidiary company of any of the above enterprises any time during the year.
Level III Enterprise
All the enterprises not covered in level I & Level II, come under level III.
Accounting Standards – Key points
- Standardisation : In order that the accounting statements are interpreted and understood by everyone in similar and uniform manner, Accounting Standards are evolved by expert Accounting Bodies, to be followed by organisation in respect of recording, treatment, presentation & disclosure of critical and Important information.
- Uniformity & Reliability : The purpose of Accounting Standards is to provide timely, reliable and unbiased information to all. It aims to bring uniformity in financial statements, enabling comparability of financial statements of different enterprises.
- Disclosure : Accounting Standards deals with issues of recognition of events & transactions in Financial Statements and adequate disclosure to enable users to take prudent & informed business decisions.
- Compliance : To enable proper compliance, the enterprises are divided into 3 levels. The smaller organisations are to comply the basic standard, while the more stringent requirements are to be complied by larger organisations.
Even if Accounting Standards are followed, there may be differences in Accounting policies. The Standard may not be able to specify al situations for all types of business. There may be alternative different ways and methods of Accounting. So, there are certain accepted policy guidelines to deal how these diversities may be resolved and the underlying policies and its impact is properly disclosed.
Irrespective of extent of standardization, diversity in accounting policies is necessary
- Diverse Areas : Accounting standards cannot (and do not) cover all possible areas of accounting. An enterprise may adopt any reasonable accounting policies in areas not covered by a standard.
- Diverse Policies : Differences in accounting policies adopted by organisations, lead to differences in reported information, even if underlying transactions are same. The accounting standards permit more than one policies, within an area covered by it.
Areas of Different Accounting Policies – Examples
- Methods of depreciation, depletion and amortization.
- Treatment of expenditure during construction.
- Conversion or transaction of foreign currency items.
- Valuation of inventories, Investments, Fixed Assets.
- Treatment of goodwill, retirement benefits, contingent liabilities.
- Recognition of profit on long term contracts.
Considerations for Selection of Accounting Policies
- Prudence: Due to uncertainty of future events, probable losses are provided for as a matter of conservatism.
- Substance over form: The accounting treatment and presentation in financial statements of transactions should be in accordance to their substance & financial reality of transaction and not merely by the legal form.
- Materiality: Financial statements should disclose all material items, knowledge of which might influence the decisions of the user of the financial statements.
Disclosure of Accounting Policy
The principle of consistency requires use of same accounting policies for similar transactions consistently in all accounting periods. All significant Accounting Policies adopted in preparation & presentation of financial statements should be disclosed.
Change of Accounting Policies
A change in accounting policies may be made when adoption of different accounting policies is required by statute or for compliance with an Accounting Standard, or it is considered that change would result in more appropriate presentation of financial statement.
Disclosure of change in accounting policies
Any change in the accounting policies, which has a material effect in the current period or expected to have a material effect in a later period, should be disclosed.
Financial Statements sometimes require certain estimates to be made. Such estimate affects the balances of assets and liabilities and their disclosure in financial statement.
If the change in accounting estimate has material effect, or expected to have material effect in subsequent year, it should be disclosed. For example, estimates of useful life of asset, provision for income tax, provision for bad debts etc. Accounting estimate may vary from actual, and should be disclosed in the financial statement.
Accounting Policies – Key points
- Adoption of Policies : The basic Accounting policies specify the rules where Accounting Standards are not specified or alternate methods exist.
- Prudence : In uncertain events, under conservation criterion, due prudence should be taken for provision of possible losses
- Substance over form : While reporting financial transactions, substance should take precedence over form. This means if the rules are not sufficient to disclose the transaction properly, the disclosure format may be deviated from rules to explain the transaction properly.
- Materiality : All Material statements, which influence decisions of the user, must be adequately disclosed
- Disclosure of Policies : All significant Accounting policies adopted should be disclosed. In case of any changes in accounting policy, the financial impact should be properly disclosed.
- Accounting Estimates : Any change in Accounting Estimates, like depreciable life of Asset, Provision for Tax, Bad Debts etc., should be properly disclosed and its impact
Assets and liabilities are to be recorded in the Statement of Financial Accounts (i.e Balance Sheet). There exists several valuation principles which may be adopted for recording the value of Assets & Liabilities
- Historical Cost: Under this principle, assets are recorded at cash (or cash equivalent) paid, or the fair value of other consideration given to acquire them at the time of their acquisition. Similarly, liabilities are recorded at the amount of cash received or expected to receive in near future.
Example: An asset was purchased for Rs.19,00,000, so this is the historical cost of the asset .
In case of tax payment, until the income is earned, tax payable amount can not be determined. In such case, the tax liability is determined on the basis of estimated income amount. In case of Income , the amount that is received, or expected to be receivable is to be considered.
- Current Cost: Under this valuation principle, assets are carried at the amount of cash or cash equivalent, which have to be paid now to acquire same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents, that would be required to settle the obligation currently.
Example: A liability is due to a creditor for Rs.5,000. So Rs.5,000 is historical cost. Now the creditor informs that he will allow 6% discount on instant cash payment. Thus the current cost of the liability will be [5,000-(6% on 5,000) i.e.(5,000 – 300)= Rs.4,700.
- Realizable Value: Under this principle, assets are carried out at the amount of cash or cash equivalent that could currently be obtained by selling the assets. Similarly, liabilities are carried out at the present value of future net cash out flows, that are expected to be required, to settle the liabilities.
Example: An asset was purchased for Rs.15,00,000 3 years ago. Now its written down value is Rs.10,00,000. It can correctly sell at Rs.13,00,000, and selling expense would be Rs. 2,000. Its realizable value is (13,00,000 – 2,000)= Rs.12,98,000.
- Present Value: Under this principle, assets are valued at present value of future net cash flows generated by the assets. Similarly liabilities are carried at present value or future net cash outflow to settle the liability.
Assets are carried at present value of future net cash flows generated by the concerned assets in the normal course of business. Liabilities are carried at present value of future net cash flows that are expected to be required to settle the liability in the normal course of business.
Example: At the discount rate of 10%, present value of Re.1, after 1 year will be = 1/ (1+0.10)1 =0.909, After 2 year will be = 1/ ((1+0.10) 2 =0.826 so on. So, liability of Rs.10,000 is payable after 2 years. Its present value Rs.10,000 x .826 = Rs.8,260.
Valuation Principles – Key Points
The criterion of valuation of Assets and Liabilities under different valuation principles, in a going concern, in normal course of business, are summarised below :
- Historical Cost : Assets are recorded at Historical Cost (Money or money equivalent paid for). Liabilities are carried at Cash Received or receivable in near future
- Current Cost : Assets are recorded at cash or cash equivalent to be paid to acquire the asset. Liabilities would be carried at the amount to be paid currently to settle the obligation.
- Realizable Value : Assets are recorded at cash or cash equivalent that could be realized by currently selling the Asset. Liabilities are carried at present value of future cash flows to settle the obligation
- Present Value : Assets are carried at present value of future net cash inflow generated by the asset. Liabilities are carried at present value of future cash outflow to settle the obligation.
Book Keeping & Accounting Process
Books of accounts are maintained to keep records of transaction in a systematic way. Accounting Statements are prepared on compiling & summarizing the data maintained in Books of Accounts (Book Keeping data) in acceptable and understandable formats.
- Recording of Transactions: Transactions are recorded in books of original entries (like Journal).
The transactions are recorded in Primary Books (also referred as Original Books) of Accounts. Primary Books of Accounts are books in which the transaction is first recorded, like Journal, Cash Book.
The entry should show the complete details of transactions, accounts heads with proper Debit / Credit column. Each transaction is properly dated, chronologically recorded.
Each entry must be explained through adequate description to fully explain and validate the correctness of entry. Mere entry of Accounts heads / amount is not considered to be proper and complete entry, unless the transaction is properly and adequately described.
Description (narration) of transaction is forming part and parcel of transaction, without which the Primary Book (Journal / Cash Book) is not said to be complete.
- Posting in Ledgers : From the original books posting made in ledger in various accounts. Each account is balanced at the end of a specified period.
The Journal Books contain data of all transactions in chronological order. But such entries do not explain anything to the management. These entries only serve as basic records. To understand and make inference about the actual status, the similar transactions must be collated and posted in one place to get the totals of and the balance of nature (Debits & Credits), For example, from Journal or Cash Book, we cannot know the cumulative sales till date. Similarly, we cannot know the amount of other income or expenses incurred. We can not know the position of the Assets (like Debtor) and liabilities (like Creditor). In fact, we can hardly get Important management information from the records of Primary Books.
To get the figures of each account, we have to post the entries related to each ledger account in Ledger Book. The Leger book contains the chronological posting of entries from primary books, with amount in respective Debit / Credit columns. The amounts of each column (Debit & Credit) are then totalled and the net balance is computed (difference of total debits & credits).
- Trial Balance: Balance from ledger (debit or credit) is transferred to a statement called Trial Balance. The total of debit balances in Trial Balance should be equal to total of credit balances. This statement forms the basis for preparation of Trading and Profit & Loss A/c and Balance sheet
The Balance of ledger figure just gives the information about individual ledger, but does not give the total position of all ledger accounts as a whole. The ledger balances also do not ensure that all postings, castings balancing are properly done and the balances are correct.
To get the total position of all ledger accounts and to ensure the accuracy of ledger balances, the ledger balances (debit or credit) are compiled in to a statement called Trial Balance. As the accounts are recorded in Double entry system, in which each transaction has equal debits & credits, the total of all Debits & credits of all ledger account balances must be equal. Trial balance ensures the arithmetic accuracy of preparation of Books of Accounts.
If the Trial Balance do not tally, it indicates error in preparation of books of accounts, totaling, casting or in preparation of Trial Balance. All these aspects are carefully scrutinized to detect errors
- Final Accounts: From Trial Balance, balances of nominal accounts are transferred to Profit and Loss Account, while remaining balances are transferred to Balance Sheet.
Form the agreed Trial Balance, the figures (ledger balances) of Revenue (Nominal) Accounts are posted into Profit & Loss Account to get the figure of net Profit / Loss.
The figures of net Profit / Loss and the balances of other ledger accounts (Real & Personal Accounts) are compiled in Balance Sheet.
Double Entry System
Luca Pacioli the Italian mathematician, first published his comprehensive treatise on the principles of Double Entry System. The use of principles of double entry system allows to record all sorts of Mercantile transactions (cash or non cash).
Double means same thing 2 times. In Accounting same figures are entered two times, one for debit & another for credit.
The concept of Double entry springs from the concept of Accounting equation, which ensures that Total Liabilities must be equal to Total Assets. So, every transaction is recorded maintaining the Accounting Equation. The concept of Debit and Credit and their equality in each transaction ensures adherence to the principle of Accounting Equation.
For computation, the Debits & Credits in accounts may be somewhat viewed akin to positive & negative numbers in arithmetical computation are summed or deducted in opposite manner. In case of addition, two positive numbers are added and the result is positive. Two negative numbers are added and the result is negative. While adding or deducting one positive numbers and one negative number, the difference is computed and the balance is net of the two numbers and the sign depends on which number is greater. In the same way, the figures of Debits & Credits are summed up, deducted and balance computed.
Every transaction has two aspects. Debit and Credit, affecting two Accounts in the reverse direction. Debit comes from latin word ‘Debitum’ which means ‘due for date’ and Credit comes from the latin word ‘Creder’ which means ‘due to that’.
Double Entry system is the most scientific system used widely by all institutions and business centers. Since one aspect of each transaction is debited and other aspect is credited by equal amount, total of all debits always tally to the total of all credits. It gives logical accuracy of accounting records.
Book Keeping Process – Key Points
- Recording of Transactions in Journal Book : Transactions are recorded in books of original entries (like Journal). The transactions are recorded in Primary Books (also referred as Original Books) of Accounts, like Journal, Cash Book.
- Posting in Ledgers from Journal Books : From the original books posting is made in ledger in various accounts. Each account is balanced at the end of a specified period.
- Compilation of Trial Balance from Ledger Balances : Balance from ledger (debit or credit) is transferred to a statement called Trial Balance. The total of debit balances in Trial Balance should be equal to total of credit balances.
- Compilation of P L Account & Balance Sheet : From Trial Balance, balances of nominal accounts are transferred to Profit and Loss Account, while remaining balances are transferred to Balance Sheet.
Classification of Account
The business transactions are recorded in accounts. An account is an individual record of a person, firm, or thing, an item of income or an expense. An account is prepared for each type of asset, liability, owner(s) equity, revenue and expense.
An account represents a collection of business transactions, relating to a particular head. Account may be broadly classifies as:
The accounts which are related with real persons, artificial persons and representative persons are called personal accounts. Personal accounts may further be classified as.
- Real or natural person: For example Aamir’s A/c, Sourav’s Account. Proprietors A/c is represented by ‘Capital account’ in respect of his investments in business, and by ‘drawings account’ for all that which he withdraws from business. So, capital account and drawings account is also a sort of personal accounts.
- Artificial persons’ accounts: Firms’ Account, Limited Companies Accounts, Banks are known as artificial persons’ accounts.
- Representative Account: All accounts representing outstanding expenses accrued or prepaid incomes are representative accounts.
These are accounts which represent a person or group of persons of same nature, referred as a common name. For example, Outstanding Salary representing salary payable to a number of employees.
Rule for Personal Account – Examples
Debit the receiver and Credit the giver.
Example: Cheque paid to Sourav of Rs.5,000.
Sourav Dr 5,000
To Bank 5000
Sourav, the receiver has been debited and Bank, the giver has been credited. As the amount has been paid by cheque, the bank will be credited.
Example: Wages of Rs.400 has not been paid yet.
Wages A/c Dr. 400
To Outstanding Wages A/c 400
Outstanding Wages is a representative personal account. It shows the amount payable to the workers. When the amount will be paid, the Outstanding wages account will be debited, and the cash account will be credited.
Example: Accrued Interest of Rs.400.
Accrued Interest A/c Dr. 400
To Interest A/c 400
Accrued Interest A/c is a representative personal account. It shows the amount earned but not yet received. When the amount will be received, the Accrued Interest account will be credited and the cash account will be debited.
Example : Prepaid Expense of Rs.400 has been paid.
Prepaid Expense A/c Dr. 400
To Cash A/c 400
Prepaid expense is also a representative personal account.
Real Accounts represent tangible assets (like Building, Furniture, Cash etc. as they have a physical existence) and intangible assets (like trademarks and goodwill etc).
Rule for Real Account: Debit what comes in, and Credit what goes out.
Example: A Fixed asset is purchased for Rs.15,000.
Fixed asset A/c Dr. 15,000
To Cash A/c 15,000
Here, the Fixed Assets, which is acquired, is debited and the Cash, which goes out, is credited 15,000
Expenses and income are called nominal accounts. (e.g. wages account, rent account etc).
Rule for nominal account: Debit all losses and expenses and Credit all gains and incomes.
Example: Rent paid for Rs.1,500.
Rent A/c Dr. 1,500
To Cash A/c 1,500
Rent has been debited as it is an expense.
Example: Discount received for Rs.1,000.
Cash A/c Dr. 1,000
To Discount Received A/c 1,000
Discount Received A/c is an income so it has been credited.
British & American Accounting System
While the Double entry system follows British Method of accounts, classified as Personal, Real & Nominal (comprising of Income & Expenses), the American system follows Equity, Liabilities, Assets, Income & Expenses. In British system the business is viewed as separate entity. So, money owed to owner & outsiders (lender / supplier) is viewed as Liability for the organisation. While, in American System, money owed by business to the owner (i.e. Capital) is viewed distinctly from the money owed (i.e Liabilities) by business to outsiders (lender / supplier),
So, as per British System, the accounting equation is Liabilities = Assets, while in American System, the equation is Capital + Liabilities = Assets.
Classification of Accounts – Key Points
Accounts can be classified into 3 major types
- Personal Accounts : Personal Accounts represent Persons or representative persons, like Proprietor’s or personal Capital Account, Bank Account, Sundry Debtors / Creditors Account, Accrued Interest, Pre paid Accounts etc.
Rule for Personal Accounts : Debit the Receiver, Credit the Payer
- Real Accounts : Real Accounts represent all types of Assets, tangible (like Cash, Plant & Machinery, Building etc) and intangible assets (like Trademark, Patent, Goodwill etc)
Rule for Real Accounts : Debit what comes in, and Credit what goes out
- Nominal Accounts: Expenses and income are called nominal accounts. (e.g. wages account, rent account etc).
Rule for Nominal account: Debit all losses and expenses and Credit all gains and incomes.
The balances of Real and Personal accounts are carried to next Financial Year. The balances of Nominal Accounts are adjusted through Profit & Loss Account and are not carried in next Financial year.
To see PDF file Click Here