Financial Accounting Principles
Accounting principles are general law or rule adopted or professed as a guide for action. Accounting principle is a basis of conduct or practice, and bring uniformity in reporting of Financial Statements across the globe.
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Accounting Principles, Concepts & Conventions
Accounting Principles, Concepts & Conventions are a set of basic rules, perceptions, principles, and methods that are universally accepted and assumed.
Accounting Concepts are enumerated on certain Basic Assumptions. Assumptions are presumed perceptions and thoughts. Assumptions need not be proved or formulated. Assumptions are the basic foundation used to derive or formulate principles. So, Accounting Concepts are the basic foundations on which Accounting principles are founded.
The Basic concepts & assumptions are universal. They are understood by all in the same way. However, further extension of basic concepts may vary or there may be alternate meanings and interpretations.
Though these basic characteristics may be roughly categorised under the heads Accounting Principles, Concepts & Conventions, for sake of understanding, they may be interchangeably used. So, though we will discuss in separate heads but they may be considered as a whole as founding principles of Accounting
| Principles Separate Entity Going Concern Money Measurement Accounting Period | Concepts Matching Accrual Cost Realization Dual Aspect | Conventions Conservatism Consistency Materiality Prudence Disclosure |
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Accounting Standards (AS)
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.
The purpose is to promote the dissemination of timely and useful financial information to investors and others having an interest in the company’s economic performance.
The Institute of Chartered Accountants of India (ICAI) has taken initiatives in setting the procedure of Accounting Standards adopting a consultative and transparent approach.
International Financial Reporting Standards (IFRS)
While Accounting standards are set by Bodies of respective countries, specifically applicable in the respective country, the International Financial Reporting Standards (IFRS) specify a global standard all over the world. Multinational Companies having business operations scattered in various countries have to follow IFRS.
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Generally Accepted Accounting Principles (GAAP)
Accounting is language of Business. To bring uniformity among the financial statements prepared by diverse business organisations, it is important that they are prepared under uniform policy. To achieve this objective, Generally Accepted Accounting Principles have ben evolved and adopted by Accounting communities & bodies.
GAAP constitutes concepts, conventions, principles, etc, used to describe rules for preparation of Financial Statements
Generally Accepted Accounting principles (GAAP) are Accounting principles satisfying certain criterion and accepted by accountants all over the world.
The Generally Accepted Accounting principles (GAAP) are based on following criterion
- Usefulness: The Accounting principle should increase the usefulness of accounting records by making accounting information more meaningful.
- Objectivity: The accounting principle should be reliable, trustworthy and supported by facts, and should not be influenced by personal bias.
- Feasibility: Accounting principle should be practical, so that it can be implemented without any difficulty.
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Accounting Concept
Accounting Concepts are based on some basic assumptions or conditions of a Business Enterprise & its operations.
Separate Entity Concept
Business is treated as a separate entity from its owners. All transactions are recorded in the books of the business. Proprietor’s capital appear as a liability in the business as he is treated as a creditor. This concept makes a distinction between personal transaction and business transaction.
Separate Entity Concept makes the distinction between the Business from Business owner. It helps to evaluate the performance and issues of business, form the owner. Through this principle, we can understand the real performance of the business. Otherwise the business and the personal wealth of the owner would get mixed up and real performance of the business would not be revealed.
Example: X started a business with Rs.5, 00,000. As per the concept, it means the enterprise owes to X Rs.5, 00,000. The proprietor of a business is treated as a creditor for capital. If he spends Rs.6, 000 to meet his family expenses, it will be treated as drawing, not as business expenses and would be charged to his Capital A/c. Likewise Shareholders are treated as creditors of the Company for the amount they subscribed to share capital of the Company.
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Going Concern Concept
This term is based on the concept that a business will continue an indefinite long economical life. Though the market value of the asset may be different than book value, the book value should be taken at actual cost.
So, the increase or decrease in value of the asset in the short-run is ignored because the asset is used for generating future benefit.
Example. X has a building valued at Rs 1 Lac bought several years back. The current market value of the Building is Rs 10 Lac. A business is assumed as a going concern, which is likely to continue operation for long time to come. So, any asset being used for long term should, should be considered in Books of Accounts at historical cost. So, the organisation would show the value of building at historical cost, i.e Rs 1 Lac only. The current value should not be taken into account, unless the asset is going to be definitely sold immediately (and not continued to be used in the business).
Money Measurement Concept
Under this concept, only monetary transactions are recorded in the books of the accounts. Here money is accepted as a unit of account. Transactions, which can not be expressed in monetary values, are not entered in Accounting Records.
Example: The value of a worker can not be expressed in terms of money, though they are integrated part of production. So their values are not taken in accounts books.
Though, many intrinsic and intangible values acquired by the business, have substantial economic value and advantage contributing to the current and future performance of the business for long time, like Employee skills, Brand value, Customer Loyalty, strategic locations & positions etc., these cannot be recorded in the books as they cannot be expressed in specific measured monetary terms.
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Accounting Period Concept
Accounting period is a segmentation of business life for studying the results shown by business in each segment (normally one year). Under this concept, the life of a business is divided into appropriate period to get correct financial position of the business related to each such segmented period. This concept helps to segregate and compare the earnings and status for each segment period of the business. So, the Accounting Statements always refer to a specific Date or Period.
A business is going to run for a long period. The business has to know its performance and status on regular basis for control & management. So, the timeline of business operation is split into equal time period.
Accounting Period concept helps the organisation to find the current status, compare with past periods of same duration and compare with peer organisation of similar nature. So, Accounts are prepared for a specified period, normally for one year, called Financial Year.
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Matching Concept
Under this concept, accounting record is made in such a manner that cost may be compared with revenue. This concept enables comparison of revenue and cost.
Example: An Item is purchased at Rs 5000, freight paid Rs 500, Handling charges paid Rs. 100, packing charged of Rs 50 spent and the Item sold at Rs 6000. So, all the expenses, i.e purchase cost of Rs 5000, freight of Rs 500, Handling charges of Rs. 100, packing charged of Rs 50, are to be charged against the revenue earned of Rs 6000. So, the net profit would be Rs 6000 – (5000+500+100+50) = 6000- 5650=Rs.350 only
Example: Rs.10,000 is earned and for that Rs.3,000 is paid towards cost and Rs.2,000 towards cos remains to be paid. Under this concept the net profit would be 10,000-(3,000 + 2,000) = Rs.5,000.
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Accrual Concept
Under this system, revenues and expenses are recognized as they are earned or incurred, irrespective of the date of receipt or payment. It may be considered as a consequence of periodicity concept. All outstanding, prepaid expenses and incomes are taken into account while preparing final accounts.
Both Accrual Accounting & Matching Period Concept work together for measurement and recognisation of Income, assets and liabilities. The profit of an accounting period is the revenues less expenses incurred for those revenues.
Example: Rs 20,000 of employee salary for the month of March 2015 (relating to FY 14-15), is paid in April 2015, i.e in next accounting period (FY 15-16). In this case, as the expenses relate to the financial year FY 14-15 (though not paid in FY 14-15), under accrual principle, Rs 20000 would be considered as Expense for FY 14-15 and shown in P L Account for FY 14-15 in Expense side and Rs 20000 would be shown as Liability payable in Balance Sheet of FY 14-15.
Example: Mr. A borrows Rs.1, 50,000. The rate of interest is 10%. At the end of the year he will pay Rs.15,000 as interest. If it is not paid within the accounting period, it will be accounted for the year and taken as liability.
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Cost Concept
Under this concept, assets are shown in cost price (i.e. in acquisition price). The cost price is systematically reduced by charging depreciation to reflect its reduction in value over time.
Example : A building was acquired by the organisation at a cost of Rs 10 Lac. However, the value of such building at market cost would be Rs 15 lac. But the building was acquired cheap as the seller was in distress need of money.
The building acquired by the buying organisation, would record in their books at Rs 10 Lac only (even though the market value was Rs15 Lac). Accordingly, it would charge deprecation on Rs 10 lac only (i.e on acquisition cost) and show the depreciated value ( Rs 10 Lac – Depreciation charged) at the end of the Financial year.
Example: A building has been acquired paying Rs.5, 00,000. The building would be recorded at cost price, i.e Rs.5,00,000 in the books. If after one year, its market value comes down to Rs.4, 00,000, there will not be any change in acquisition cost in books of account. After charging depreciation (e.g Rs.50, 000 (@ 10% p.a.) the assets would be shown at Rs.4, 50,000 at the end of the year.
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Realization Concepts
Under this concept, revenue is recorded only when it is realized (except Hire Purchase and some Long-term Contract).
It does not allow business firms from inflating their profits by recording incomes that are likely to accrue (like expected incomes or gains).
Example: An asset is recorded at its historical cost of Rs. 3,00,000 and its cost at current market price is Rs. 7,00,000. In this case, such change is considered if it is to materialize (i.e. the asset is going to be sold at Rs.7,00,000) certainly.
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Proprietary Concept
The concept stresses the importance of the proprietors (owners) of a business, rather than the business itself.
The basic accounting equation is ASSETS – LIABILITIES = PROPRIETORSHIP. Here the proprietor is the centre of accounting system. The proprietary concept is followed in sole proprietorship and in partnership business where the owners are involved in all decision making. In these types of organization, the owners enjoy all the profits of the business. Legally all of the firm’s debts and liabilities are borne by the proprietors.
Fund Concept: According to the fund concept, each fund is aimed to fulfill some purpose, and the services embodied in the assets are the primary means to achieve that purpose. Fund concept has not gained general acceptance in financial accounting, it has been found useful for government and non profit organizations, where capital expenditure is quite substantial compared to the revenue expenses.
Dual Aspect Concept: Under this concept, every transaction is recorded under double entry system. The concept can be expressed as ASSETS = LIABILITIES + CAPITAL.
This concept helps to detect errors and indicates true position of the business.
- One asset increases and another asset decreases : New machinery purchased for Rs.25, 000. The effect is- Machinery will be increased and cash will be decreased by Rs.25, 000.
- Asset increases along with increase in liability : Suppose the same machinery is purchased on credit. The effect is- Machinery will be increased and creditor will be increased also.
- Both asset and liabilities decrease : Cash paid to repay Bank o/d of Rs.50, 000. The effect is- Bank o/d and cash both will be decreased by Rs.50, 000.
- One liability increases and another decrease : Loan was taken to repay another loan of Rs.1, 00,000. The effect is- A new loan account will be created (liability increases) another will be paid off (liability decreases).
The outside liabilities of a business are Rs.30, 000. The proprietor’s capital is Rs.40, 000. Total assets of the firm are = (Liability + Capital) i.e. Rs. (30,000 + 40,000) = Rs.70, 000.
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Accounting Convention
The term ‘convention’ denotes customs or traditions pursued by the accountant, while preparing the accounting statement.
Accounting Convention – Conservatism
It provides for future losses but anticipates no profit. For example, provisions for bad debts are shown in accounts, while window dressing, secret reserve are not permitted.
As per Conservatism concept, all possible future losses are to be fully provided for, and Income are to be recognized only when realized. In a business, it is likely that some Debtors may not pay up fully. So, a provision for Bad Debt is made each year, considering the possibility of Bad Debts on realistic basis. So, the value of Debtor is reduced by the amount of provision for Bad Debt, to reflect the real Income of the business after providing the possible losses of Bad Debts.
In the same way, if the market value of stock goes up, the stock would still be recorded at Cost. However, if the market value of Stock reduces, according to conservatism principle, the stock would be valued at Cost or Market value, whichever is lower.
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Accounting Convention – Consistency
It implies continuance of accounting practices uniformly.
The consistency convention requires that accounting practices must be used uniformly in every accounting period, unless any change is necessary as per statute, or the change is necessary to make the accounts more realistic and accurate. In case of change, the impact of the change would be separately disclosed in the Accounting Statements, so that users may understand the hidden impact of the change separately.
For example, a company can adopt any method for valuation of stock, out of several acceptable methods. If change becomes necessary, it should be stated clearly along with its impact on the financial result.
Example: A company has switched over to weighted average formula for ascertaining cost of inventory, from the earlier practice of using FIFO. The closing inventory by FIFO is Rs.2 lakh and that by weighted average formula is Rs.1.5 lakh.
The fact that changes in accounting policy pulls down profit and value of inventory by Rs.50, 000, is to be disclosed, as per AS- 1.
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Accounting Convention- Materiality
All material facts, the knowledge of which might influence the decisions of the user of the financial statements, must be recorded.
The Materiality concept ensures that the accounting statements must be properly drawn considering all facts accurately. However, in real life, there are many trivial transactions that do not affect the final result materially and cost of maintaining such minor and trivial accounts may be more than the benefits accrued. In such case, such trivial facts may be ignored.
For example, the cost of purchase of stationery, if not significant to the entire amount of indirect cost, may be charged, overlooking the stock of stationery remaining at the end of the year.
However, materiality is a subjective matter. Sometimes, a small amount, like fine, imposed by court of law, may indicate lapse or wrongdoing. Such facts may be considered to be material (though amount is insignificant) and separately reported.
However, the general rule is, any significant Income or cost, which amount to be more than 1% of the total cost or Income, should be separately revealed so that these are brought to the notice of the user and does not remain suppressed.
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Accounting Convention- Prudence
Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates under conditions of uncertainty, to recognize unrealized profits. Creation of excess provisions, hidden reserve, is not permitted.
4-5 Accounting Convention- Disclosure: All material information, the knowledge of which might influence the decisions of the user of the financial statements must be disclosed.
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Financial Statement
Financial statements are a way of public communication in the hands of the management of the enterprise (e.g. Profit and Loss A/c. Balance sheet, Cash flow & Fund flow statement etc.)
Financial Statements are used by various users to analyse, interpret, plan and for making prudent business decisions.
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Characteristics of Financial Statement
- Understandable: Easily understood by the user.
- Relevant: The information contained should be relevant in comparing and analyzing past & present and in forecasting the future.
- Reliable: Reliable and contain most objective information.
- Standard: Comparable and formulated as per standards.
- Neutral: Free from any bias.
- Adequate disclosure: The information should be complete, full and fair, with adequate disclosures.
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Limitations of Financial Statements
The financial statements depict performance & status based only on the historical monetary figures. But business values are depicted by many other factors, which are not considered in Financial Statement. So, the Financial Statements may not reveal the real position as accounting figures are subject to limitations of various restraints it works within, like:
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- Intrinsic Value : Financial statements just provide the performance & state of affairs based on financial data. But business may be valued or its worth may be different from the figures depicted by Financial Statement. Particularly in the modern days of IT enabled companies, even a currently loss making company, but is believed to be potential in view of technology and wide customer base, may be exorbitantly high valued (e.g FaceBook, UBER).
The financial statements are based on historical figures. Financial Statements do not depict the expected future earning, its technological edge, management edge, customer base, customer loyalty, brand value etc. This is due to the limitations emanated from the principles of monetary value. As explained in Money Measurement Concept, Accounting records take cognizance of monetary transactions only. But the value of a business is influenced by many non-monetary activities, which are not reflected in accounting system.
Real worth or value of a business is measured in terms of a holistic view of all the factors of a business, whether it is reflected in Financial statement or not.
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- Changing Value of Money: The financial reports are based on historical figures and do not take into accounts, the impact of change of value of Money (inflation etc). There is a trend of emergence of modern concept like Inflation Accounting, to consider the changing value of money over time period, traditional accounts do not reflect the impact of emerging inflation
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- Human Resources : The traditional Accounts do not reflect anything about the value of human resources, though Human Resources is considered to be the most valuable resource of an organisation. The earning power & value of a business is greatly influenced by the key personnel, their pragmatic policies, work culture and other human qualities, and the efficacy of mass working manpower down the stream. Though there is a trend of emergence of modern concept like Human Resources Accounting, human resources value of an organisation are not depicted in traditional Financial Statement.
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- Estimation Errors : In preparing accounts, we often make estimates of various provisions (e.g for Bad Debts, Market / fair Value of Stock), which are subjective on the basis of assumptions made by the management. So, they may be wrong, often under assessed or over assessed. So, the Accounts considering such estimated values, may not depict the real position of the business. Sometimes one principle may conflict with the other.
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In summary, it can be said that Accounting has some practical limitations. So, Financial Statements should be interpreted carefully keeping all these factors into consideration
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Accounting Concepts – key points
Accounting concepts define the basic assumptions, ideas & notions, evolved on broad consensus. Accounting Concepts lay the foundation on which Financial Statements are prepared. The basic accounting concepts may be summarised as :
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- Entity : Business and owner are distinct and separate entity.
- Money Measurement : Only those transactions, which can be measured in terms of money, are to be recorded in books of accounts.
- Periodicity : The indefinite life of business are split into definite equal specified time periods called Financial Year, for preparation of accounting reports.
- Accrual : Transactions are accounted for when they occur, irrespective of the fact whether or not the money is received or paid. So, time of occurrence of the event is the point of consideration, rather than the time of money transaction.
- Matching : Expenses of a specified period must be matched against Income of the corresponding period.
- Going Concern : It is assumed that the operations of the business would go on perpetually, over indefinite period. So, historical cost is traditionally used for recording & valuation of Assets and Liabilities.
- Cost : Value of asset is carried at historical cost.
- Realisation : Any change in value of asset cannot be recorded until sold.
- Duality : Every transaction has two equal and opposite aspects denoted by Debit & Credits. Consequently change in Income / Expenses, Liabilities & Assets by the resulting effect of any transaction, cause equal and compensatory change on the corresponding amount on the counterpart, conforming to the Accounting Equation.
- Conservatism: All foreseen and probable losses / expenses should be provided for, and unrealised gain should not be recorded.
- Consistency : Accounting policies should be consistently followed from year to year. Impact of any policy change should be separately quantified and reported.
- Materiality : All material facts which influence decisions, must be reported.
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Fundamental Accounting Assumptions
The concepts of a) Going Concern, b) Consistency & c) Accrual, as described above are assumed to be followed, hence need not be reported separately, unless any change is followed
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