Unit – 1

Introduction

1.1 INTRODUCTION

Business is an economic activity undertaken with the motive of earning profits and to maximize the wealth for the owners. Business cannot run in isolation. Largely, the business activity is carried out by people coming together with a purpose to serve a common cause. This team is often referred to as an organization, which could be in different forms such as sole proprietorship, partnership, body corporate etc. The rules of business are based on general principles of trade, social values, and statutory framework encompassing national or international boundaries. While these variables could be different for different businesses, different countries etc., the basic purpose is to add value to a product or service to satisfy customer demand.

The business activities require resources (which are limited & have multiple uses) primarily in terms of material, labour, machineries, factories and other services. The success of business depends on how efficiently and effectively these resources are managed. Therefore, there is a need to ensure that the businessman tracks the use of these resources. The resources are not free and thus one must be careful to keep an eye on cost of acquiring them as well. As the basic purpose of business is to make profit, one must keep an ongoing track of the activities undertaken in course of business. Two basic questions would have to be answered:

(a) What is the result of business operations? This will be answered by finding out whether it has made profit or loss.

(b) What is the position of the resources acquired and used for business purpose? How are these resources financed? Where the funds come from?

The answers to these questions are to be found continuously and the best way to find them is to record all the business activities. Recording of business activities has to be done in a scientific manner so that they reveal correct outcome. The science of book-keeping and accounting provides an effective solution. It is a branch of social science. This study material aims at giving a platform to the students to understand basic principles and concepts, which can be applied to accurately measure performance of business. After studying the various chapters included herein, the student should be able to apply the principles, rules, conventions and practices to different business situations like trading, manufacturing or service.

Over years, the art and science of accounting has evolved together with progress of trade and commerce at national and global levels. Professional accounting bodies have been doing intensive research to come up with accounting rules that will be applicable. Modern business is certainly more complex and continuous updating of these rules is required. Every stakeholder of the business is interested in a particular facet of information about the business. The art and science of accounting helps to put together these requirements of information as per universally accepted principles and also to interpret the results. It is interesting to note that each one of us has an accountant hidden in us. We do see our parents keep track of monthly expenses. We make a distinction between payment done for monthly grocery and that for buying a house or a car. We understand that while grocery is a monthly expense and buying a house is like creating a resource that has indefinite future use. The most common accounting record that each one of us knows is our bank passbook or a bank statement, which the bank maintains for us. It tracks each rupee that we deposit or withdraw from our account. When we go to supermarket to buy something, the cashier at the counter will record things we buy and give us a ‘bill’ or ‘cash memo’. These are source documents prepared for the transaction between the supermarket and us. While these are simple examples, there could be more complex business activities. A good working knowledge of keeping records is therefore necessary. Professional accounting bodies all over the world have been functioning with the objective of providing this body of knowledge. These institutions are engaged in imparting training in the field of accounting. Let us start with some basic definitions, concepts, conventions and practices used in development of this art as well as science.

1.2 DEFINITIONS

(a) Book-keeping: The most common definition of book-keeping as given by J. R. Batliboi is “Book-keeping is an art of recording business transactions in a set of books.” As can be seen, it is basically a record keeping function. One must understand that not all dealings are, however, recorded. Only transactions expressed in terms of money will find place in books of accounts. These are the transactions which will ultimately result in transfer of economic value from one person to the other. Book-keeping is a continuous activity, the records being maintained as transactions are entered into. This being a routine and repetitive work, in today’s world, it is taken over by the computer systems. Many accounting packages are available to suit different business organizations. It is also referred to as a set of primary records. These records form the basis for accounting. It is an art because, the record is to be kept in such a manner that it will facilitate further processing and reporting of financial information which will be useful to all stakeholders of the business.

(b) Financial Accounting: It is commonly termed as Accounting. The American Institute of Certified Public Accountants defines Accounting as “an art of recoding, classifying and summarizing in a significant manner and in terms of money, transactions and events which are in part at least of a financial character, and interpreting the results thereof.”

The first step in the cycle of accounting is to identify transactions that will find place in books of accounts. Transactions having financial impact only are to be recorded. E.g. If a businessman negotiates with the customer regarding supply of products, this will not be recorded. The negotiation is a deal which will potentially create a transaction and will have exchange of money or money’s worth. But unless this transaction is finally entered into, it will not be recorded in the books of accounts.

Secondly, the recording of the business transactions is done based on the Golden Rules of accounting (which are explained later) in a systematic manner. Transaction of similar nature are grouped together and recorded accordingly. e.g. Sales Transactions, Purchase Transactions, Cash Transactions etc. One has to interpret the transaction and then apply the relevant Golden Rule to make a correct entry thereof.

Thirdly, as the transactions increase in number, it will be difficult to understand the combined effect of the same by referring to individual records. Hence, the art of accounting also involves the step of summarizing them. With the aid of computers, this task is simplified in today’s accounting world. The summarization will help users of the business information to understand and interpret business results.

Lastly, the accounting process provides the users with statements which will describe what has happened to the business. Remember the two basic questions we talked about, one to know whether business has made profit or loss and the other to know the position of resources that are used by the business. It can be noted that although accounting is often referred to as an art, it is a science also. This is because it is based on universally applicable set of rules. However, it is not a pure science as there is a possibility of different interpretation.

(c) Cost Accounting: According to the Chartered Institute of Management Accountants (CIMA), Cost Accountancy is defined as “application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability as well as the presentation of information for the purpose of managerial decision-making.”

It is a branch of accounting dealing with the classification, recording, allocation, summarization and reporting of current and prospective costs and analyzing their behaviours. Cost Accounting is frequently used to facilitate internal decision making and provides tools with which management can appraise performance and control costs of doing business. It primarily involves relating the costs to the different products produced and sold or services rendered by the business. While Financial Accounting deals with business transactions at a broader level, Cost Accounting aims at further breaking it up to the last possible level to identify costs with products and services. It uses the same Financial Accounting documents and records. Modern computerized accounting packages like ERP systems provide for processing Financial as well as Cost Accounting records simultaneously.

This branch of accounting deals with the process of ascertainment of costs. The concept of cost is always applied with reference to a context. Knowledge of cost concepts and their application provide a very sound platform for decision making. Cost Accounting aims at equipping management with information that can be used for control on business activities.

(d) Management Accounting: Management Accounting is concerned with the use of Financial and Cost Accounting information to managers within organizations, to provide them with the basis in making informed business decisions that would allow them to be better equipped in their management and control functions. Unlike Financial Accounting information (which, for public companies, is public information), Management Accounting information is used within an organization (typically for decision-making) and is usually confidential and its access available only to a selected few.

According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is “the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Management Accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory authorities and tax authorities”

Basically, Management Accounting aims to facilitate management in formulating strategies, planning and constructing business activities, making decisions, optimal use of resources, and safeguarding assets of business. These branches of accounting have evolved over years of research and are basically synchronized with the requirements of business organizations and all entities associated with them.

Difference between Book Keeping & Accountancy

1.3 DOUBLE ENTRY PRINCIPLE

In the present era double entry system of book-keeping is considered to be the best, common and universal system, because it is modem, scientific, and complete. It fulfils all the objects of a businessman. It originated in western countries and so it is also called western system of accounting. It is also called mercantile system of accounting because according to this system cash and credit transactions can be recorded.

Double entry system has been defined differently by different authorities. Some of which are as follow:

According to Carter, “The modem system of Accounting in use is known as Double Entry”. Double Entry is a system of Book-keeping by means of both personal and impersonal accounts.”

M.J. Keller defines Double Entry System as follows: “The most common system of accounting data for an enterprise is the Double Entry System. As the name implies, the entry made for each transaction is composed of two parts, a ‘Debit’ and a ‘Credit’.”

Each business transaction that result in transfer of money or money’s worth involves a two- fold aspect, (a) the yielding or giving of a benefit, and

(b) the receiving of that benefit.

In other words, every business transaction involves exchange of value for value, or inter-change of money or money’s worth or every business transaction involves receiving something having value and giving something which has value. According to Double Entry System, both these aspects of the transaction, the receiving aspect and the giving aspect, are recorded. Thus, if Building is bought from Mukesh, Building Account receives and Mukesh’s Account gives. There must, therefore, be double entry to have a complete record of each transaction.

For a clear understanding of the principles of double entry system, it is necessary to first carefully bear in mind that certain transactions are common to almost every business. These common transactions are as follows:

1. The businessman enters into business dealings with a number of persons or firms;
2. He must have some assets or properties in which or with the help of which he carries on the business; and
3. He must incur certain expenses such as office rent, salaries, advertising, etc. for carrying on the business, and that he must have some sources form which the income of the business is derived.

It follows, therefore, that in order to keep a complete record of all the business transactions, it will be necessary to keep the following accounts:

1. The account of each person or firm with whom the firm has to deal;
2. The account of each asset or property in the business; and
3. The account of each head of expense or source of income.

The accounts which come under first group are called Personal Accounts, those which come under second group are called Real Accounts, and those coming under the third group are called Nominal accounts.

Since words ‘debit and credit’, and ‘Account’ have been used in the above definitions and discussion, it will be better if we first understand the meaning of these words and then proceed to discuss the rules of double entry system.

The double entry system divides the page into two equal halves. The left hand side of each page is called the debit side, while the right hand side is called the credit side. There was no rational reason in the way in which the sides were chosen to represent different items, and the credit side could have easily been the left-hand side and the debit the right hand side. The Venation merchants who were the ‘first known businessmen to use double entry just happened to select the left hand or debit side for the assets and opposite side to represent capital and liabilities, and so it has remained ever since.

An Account is a classified and chronological record in which the money values (sometimes also the quantities or the money values and quantities together) of all the benefits given or received by a particular party (which may be a human being or a personified object) are arranged in two separate columns on the right and left sides respectively of each sheet of paper or each page or folio of the book in which it is written. There will be a debit side as well as credit side to every account. This is indicated by writing “Dr” and “Cr” on the left-hand side and right-hand side margin respectively of the account.

All entries in the Dr. Side are preceded by the word ‘To’, meaning that the account of which the record is being prepared is a debtor to the account the name of which appears in the entry. On the other hand, all entries in the credit side are preceded by the word ‘By’, so that each entry may mean that the account of which the record is being prepared is credited by the account the name of which appears in the entry. The title of the account is written across the top of the account at the centre.

The account of the party that gives a benefit is called a “Creditor” and that of the party that receives it is called a “Debtor”. As a general rule the value of each benefit received by an account is entered on the left-hand column of the account and the account is said to have been ‘debited’ with such value; on the other hand, the value of each benefit given by an account is entered on the right-hand column of the account and the account is said to have been ‘credited’ with such value. These are called debit and credit entries respectively.

Having understood the meaning of the words “Debit and Credit”, and “Account”, let us now proceed with the explanation of rules of double entry system.

Rules of Double Entry System: For debiting or crediting a particular account, we have first to see which class of account are affected by the transaction which is entered into by the businessman. After ascertaining that, the following rules of debit and credit will have to be followed:

1. Personal Accounts: In the case of personal accounts we debit the person or the firm with the benefits received by him or by the firm and credit the person or the firm with the benefits imparted by the person or the firm. In short we can say that –

Debit the Receiver (of benefits): and

Credit the Giver (imparting the benefits)

2.                 Real Accounts: Real accounts are debited with the incomings and are credited with the outgoings

Or,

Debit what comes in the business; and

Credit what goes out (of the business)

3.                 Nominal Accounts: All amounts expended or lost are debited and all amounts gained are credited to nominal accounts

In other words:

Debit all expenses and losses; and

Credit all incomes and gains

It should be kept in mind that these rules never vary and will have to be rigidly followed under all conceivable conditions. It should also be noted that the above mentioned phenomena’s like ‘giver’ and ‘receiver’, ‘coming in’ and ‘going out’ etc. are to be judged not from the proprietor’s point of view but from the point of view of the business.

In addition to the above rules of double entry system, there are certain basic concepts and conventions of accounting which must be known before actual book-keeping and accounting work is started. These concepts are discussed here-in-after.

1.4 FUNCTIONS OF ACCOUNTING

1. Maintaining systematic records: Business transactions are properly recorded, classified under appropriate accounts and summarized into financial statements– income statement and the balance sheet.

2.  Communicating the financial results: Accounting is used to communicate financial information in respect of net profits (or loss), assets, liabilities etc., to the interested parties.

3.  Meeting legal needs: The provisions of various laws such as Companies Act, Income Tax and Sales Tax Acts require the submission of various statements, i.e., annual account, income tax returns, returns for sales tax purposes and so on.

4.  Protecting business assets: Accounting maintains proper records of various assets and thus enables the management to exercise proper control over them with the help of following information regarding them:

1. How much is balance of cash in hand and cash at bank?
2. What is the position of the inventories?
3. How much money is owed by the customers?
4. How much money is owing to the creditors?
5. What is the position of various fixed assets and how these are being used?

5.  Assistance to Management:Accounting assists the management in the task of planning, control and coordination of business activities.

6.  Stewardship: In the case of limited companies, the management is entrusted with the resources of the enterprise. The managers are expected to act true trustees of the funds and the accounting helps them to achieve the same.

7.  Fixing responsibility: Accounting helps in the computation of the profits of different departments of an enterprise. This would help in fixing the responsibility of departmental heads.

1.5 ADVANTAGES OF ACCOUNTING

1. Assistance to management: The accounting information helps the management to plan its future activities by preparing budgets in respect of sales, production, expenses, cash, etc. Accounting helps in coordination of various activities in different departments by providing financial details of each department. The managerial control is achieved by analyzing in money terms the departures from the planned activities and by taking corrective measures to improve the situation in future.

2.  Records rather than memory: It is not possible at all to do any, business by just remembering the business transactions which have grown in size and complexity. Transactions, therefore, must be recorded early in the books of accounts so that necessary information about them is available in time and free from bias.

3.  Intra-period comparisons: Accounting information when recorded properly can be used to compare the results of one year with those of previous year(s).

4.  Aid in legal matters: Systematically recorded accounting information can be produced as evidence in a court of law.

5.  Help in taxation matters: Income Tax and Sales Tax authorities could be convinced about the taxable income or actual turnover (sales), as the case may be with the help of written records.

6.  Sale of a business: In case, a sole trader or a partnership firm or even a company wants to sell its business, the accounting information can be utilized to determine proper purchase price.

1.6 LIMITATIONS OF ACCOUNTING

1. Accounting information is expressed in terms of money. Non-monetary events or transactions, however important they may be, are completely omitted.

2.   Fixed assets are recorded in the accounting records at the original cost, that is, the actual amount spent on them plus, of course, any incidental charges. In this way the effect of inflation (or deflation) is not taken into consideration. The direct result of this practice is that balance sheet does not represent the true financial position of the business.

3.   Accounting information is sometime based on estimates; estimates are often inaccurate. For example, it is not possible to predict with any degree of accuracy the actual useful life of an asset for the purpose of depreciation expense.

4.   Accounting information cannot be used as only test of managerial performance on the basis of more profits. Profits of a period of one year can readily be manipulated by omitting such cost of advertisement, research and development, depreciation and soon.

5.   Accounting information is not neutral or unbiased. Accountants calculate income as excess of revenue over expenses. But they consider only selected revenues and expenses. They do not, for example, include cost of such items as water or air pollution, employee’s injuries etc.

6.   Accounting like any other discipline has to follow certain principles which in certain cases are contradictory. For example: current assets (e.g., stock of goods) are valued on the basis of cost or market price whichever is less following the principle of conservatism. Accordingly, the current assets may be valued on cost basis in some year and at market price in other year. In this manner, the rule of consistency is not followed regularly.

1.7 USERS OF ACCOUNTING INFORMATION

Financial accounting is primarily concerned with preparation of accounting information for the outsiders who do not have direct excess to the accounting records. They obtain accounting information of business enterprises from their annual reports, data published by Government departments and information published in financial newspapers, e.g., the Economic Times, Financial Express etc., or business magazines e.g., Business India, Business World, The Economist, etc.

In the following paragraphs, the users of accounting information have been grouped into a number of major headings and the requirements for each considered therein:

Creditor and short-term lenders: Creditors include suppliers of goods and services on credit. Short-term such as commercial banks supply money for short period to business organizations. Bankers and suppliers inspect the accounting information before making loans or granting credit. They want to know whether or not the enterprise will be able to meet its financial repayment obligations in time. Their specific interest lies in solvency, liquidity and profitability positions of the business enterprise. Accounting serves their purpose by disclosing true and fair view of current assets in the balance sheet and profitability position in the income statement so as to assure the creditors and lenders that their debts would be paid in time.

Investors: Under this category are included the existing shareholders and future shareholders. Basically they will be interested in the dividends that are paid. They are also interested about the future prosperity of their enterprise. But the income statement and the balance sheet of one year will not be helpful to guide the investors about the future prospects. So the accounting information must provide the details of the profits and financial position of business so that the investors can find out the progress of the past few years and it may be assumed that this progress will be maintained in future as well. At present such information is generally given in the published accounts. The statement of the chairman in the annual reports also provides some indication about the future progress.

Long-term lenders: This category of users include debenture holders and those providing long-term loans, say; industrial banks, financial institutions, etc. They are interested in knowing that they will get the interest due to them and that the same will be paid when it is due and payable. They will also see to it that their principal amount is also paid on due date. So their main interest is in the profitability for interest payments and liquidity for the repayment of the loan amount. The availability of cash flow statements in addition to income statement and balance sheet has considerably helped users to evaluate the liquidity position of a business enterprise.

Management: The owners are not the only persons within the business enterprise who are interested in various aspects of the operations of a business. With the separation of management and ownership (particularly in a limited company), the managers are responsible for carrying on the operations of the business enterprises. The type of accounting information needed by managers may vary with the size of the enterprise. The manager of a small business may need relatively little accounting information. As the business enterprises grows in size, the manager loses direct contact with daily operations. As a result, information about the various aspects of the business enterprise must be supplied by accounting. Some of their needs for accounting information relate to:

(i) setting objectives or targets for future periods and devising methods to attain those objectives;

(ii) observing and measuring the performance of the various departments of the business as also the enterprise as a whole;

(iii) evaluating the performance in relation to the targets set up; highlighting the deviations from the planned targets; and

(iv) taking such corrective action as may be necessary to overcome the shortfalls.

Employees (Labour unions): In this category are included both individual employees and groups of them represented by labour unions. Employees want more salary and other benefits such as overtime payments, bonus, housing, medical facilities and so on. The bargaining power of the unions is increased if workers’ demands are based on facts and figures. In addition, some companies regularly issue certain reports containing financial information about the employers for a better understanding of the business by the employees. These reports highlight what the companies are doing for the welfare of their employees and what they intend to do in future.

Government and regulatory agencies: In recent years, the government has become one of the most important users of accounting information. The central, state and local governments have the responsibility of allocating the resources for different uses. Naturally they are interested in the activities of business enterprises such as sales, profits, dividend policies, investments, etc. Moreover, the Government activities are financed through the collection of tax. Thus, the accounting information about business activities is very helpful in the collection of income tax, excise duties, customs duties, sales tax, etc. Each tax requires a special tax return based on necessary accounting information of various business enterprises. Any distortion in the accounting information needed by the Government agencies would adversely affect the welfare policies of various types of governments. Similarly, a number of regulatory agencies like Securities and Exchange Board of India (SEBI), the Insurance Regulatory Authority, the Reserve Bank of India etc., need accounting information for the efficient operation of capital markets.

Individuals and society: People are affected by the operations of a business enterprise in their localities. They want to know through the accounting information the trends in the prosperity of the enterprise and also the range of activities. This would enable them to assess the employment opportunities in their local areas. Society as a whole is concerned with the environment pollution. The accounting information would disclose how much money has been allocated to control such pollution. This has come to be known as social responsibility accounting.

1.8 BRANCHES OF ACCOUNTING

Accountants tend to specialize in various types of accounting work and this has resulted in the development of different branches of accounting. Some of these divisions of accounting are given as:

1. Financial Accounting: Accounting designed for outsiders (persons other than owners and managers) is known as financial accounting. It is concerned with the recording of business transactions and periodic preparation of balance sheets and income statement from such records. In this manner, the financial accounting is useful for the ascertaining profit or loss made during a given period and financial position at the end of the period.

2.  Management Accounting: It is concerned with the interpretation of accounting information to guide the management for future planning. Decision making control, etc. Management Accounting, therefore, serves the information needs of the insiders, e.g. Owners, managers and employees.

3.  Cost Accounting: It has been developed to ascertain the cost incurred for carrying out various business activities and to help the management to exercise strict cost control.

4.  Tax Accounting: This branch of accounting has grown in response to the difficult tax laws such as relating to income tax, sales tax, excise duties, custom duties, etc. An accountant is required to be fully aware of various tax legislations.

5.  Social Accounting: This branch of accounting is also known as social reporting or social responsibility accounting. It discloses the social benefits created and the costs incurred by the enterprise. Social benefits include such facilities as medical, housing, education, canteen, provident fund, so on while the social costs may include such matters as extra hours worked by employees without payment, environment pollution, unreasonable terminations, etc.

6.  Human Resource Accounting: It is concerned with the human resources of an enterprise. Accounting methods are applied to identify human resources and its evolution is done in money terms so that the society might judge the total work of the business enterprises including its non-human net assets. It is, therefore, an accounting for the people of the organization. Unfortunately, no objectively verifiable measure has been developed for universal application.

7.  National Accounting means the accounting for the nation as a whole. It is generally not concerned with the accounting of individual business entities and is not based on generally accepted accounting principles. It has been developed by the economists and the statisticians.

1.9 BASIS OF ACCOUNTING

The business enterprises use accounting to calculate the profit from the business activities at the end of given period. There are two basis of calculating the profit, namely, the cash basis and accrual basis.

Cash basis of accounting: In this basis of accounting, the income is calculated as the excess of actual cash receipts in respect of sale of goods, services, properties, etc., over actual cash payments regarding purchase of goods, expenses on rent, electricity, salaries, etc. Credit transactions are not considered at all including adjustments for outstanding expenses and accrued income items. This method is useful for professional people like doctors, engineers, advocates, chartered accountants, brokers and small traders. It is simple to adopt because there are no adjustment entries. But this basis does not disclose the true profits because it does not consider the income and expense items which relate to the accounting period but not paid in cash. Moreover, this method is not applicable where the number of transactions is very large and expenditure on fixed assets is high. The income or profit is calculated with the help of receipts and payments account.

Accrual basis of accounting: Under this method the items of income (revenue) are recognized when they are earned and not when the money is actually received later on. Similarly expense items are recognized when incurred and not when actual payments are made for them. It means revenue and expenses arc taken into consideration for the purpose of income determination on the basis of the accounting period to which they relate. The accrual basis makes a distinction between actual receipts of cash and the right to receive cash for revenues and the actual payments of cash and legal obligations to pay expenses. It means that income accrued in the current year becomes the income of current year whether the cash for that item of income is received in the current year or it was received in the previous year or it will be received in the next year. The same is true of expense items. Expense item is recorded if it becomes payable in the current year whether it is paid in the current year or it was paid in the previous year or it will be paid in the next year.

The advantages of this system are:

1. It is based on all business transaction of the year and, therefore, discloses the current profit or loss;
2. The method is used in all types of business units;
3. It is more scientific and rational application;
4. It is most suitable for the application of matching principle.

The disadvantages are:

1. It is not simple one and requires the use of estimates and personal judgement;
2. It fails to disclose the actual cash flows.

Mixed or Hybrid basis of accounting: Under this method revenues (items of income) are recognized on cash basis while the expenses are recorded on accrual basis. The purpose is to remain cautious, safe and hundred per cent certain for revenues items and make adequate provisions for expenses.

1.10 INTRODUCTION-ACCOUNTING CONCEPTS & CONVENTIONS

Accounting in the past was mainly used to

(1) keep control over property and assets of the business concerned and

(2) ascertain and report about the profit or loss and the financial position relating to the various periods.

But now a day’s accounting is used not only for the above mentioned purposes but also for collecting, analysing and reporting of information to the management and others at the required points of time to facilities rational decision making. Moreover, the accounts in the past were prepared mainly for the use of proprietor. Today financial statements are required by the proprietors, creditors, potential investors, Government and many others. The proprietors study the financial statements to know about the profitability of their business. Creditors study them to ascertain the solvency of the business. Perspective investors are interested in them for the ascertainment of the correct earning potential of the business. Government makes use of these statements for finding out the net contribution that a business can make the economic well-being of the country.

To satisfy the diverse and complex needs of those who use accounting, one needs something more than the clerical procedures, journalising, posting, taking out trial balance and closing the books etc. The accountant should have ‘guides to action’ or ‘principles’ for completing his work of a wide dimensions. The usefulness of accounting will be maximized only if there exist some generally accepted concepts regarding the nature and measurement of liabilities, assets, revenues and expenses. There must also be some widely supported standards of disclosure and reporting. There will be widespread understanding of and reliance on accounting statements only if they are prepared in conformity with generally accepted accounting principles. If there is no common agreement on accounting matters then complete chaotic conditions prevail as in that case every businessman and/or every accountant could follow his own definition of revenue and expense.

Definition: The rules conventions of accounting are commonly referred to as ‘principles’. A universal definition of the ‘accounting principles’ is difficult to give. However, ‘accounting principles’ can be defined in the following two ways:

1. Accounting Principle is a “General Truth” or ‘fundamental belief. This definition implies a scientific bias and therefore, its application in the face of ever changing socio- economic factors which affect the very basis of a business is doubtful.

2.   Accounting principle may be defined as a ‘rule of action or conduct’. This definition finds favour with the American Institute of Certified Public Accountants as it refers to changing character of rules of action or conduct due to the changes in business practices etc. According to AICPA, accounting principle is a general law or rule adopted or processed as a guide to action. The accounting principles do not prescribe one way of doing things. They recognize that there are a number of ways in which one thing can be done. The accountant has considerable latitude and choice within the generally accepted accounting principles in which to express his own idea as to the best way of recording and reporting is specified account. The practice of recording and reporting may thus differ from company to company.

It should be noted that it would be incorrect to suggest that accounting principles are a body of basic laws like those found in natural sciences like Physics and Chemistry. Accounting principles are manmade and hence are more properly associated with such items as concepts, conventions and standards. Accounting principles were not deducted from basic atoms, not is their validity verifiable by observation and experiment in a laboratory. Accounting principles are constantly evolving, being influenced by business practices, the needs of statement users, legislation and governmental regulations the opinions and actions of shareholders, labour unions, creditors and management; and the logical reasoning of accountants. The sum total of all such influences finds its expression first in accounting theory. Some theories are accepted while some others are rejected. Theory becomes an accounting principle only when it is generally accepted.

A distinction between Fundamental Accounting Assumptions and Accounting policies has been made by the International Accounting Standards Committee (1ASC). Fundamental Accounting assumptions or postulates according to the ISC underlie the preparation of financial statement. They need not be specifically stated on the face of such statements. Their acceptance and use is assumed in the preparation of financial statements. Disclosure with full reasons, however, must be made in case they are not followed- Accounting policies on the other hand encompass the principles, basis, conventions, rules and procedures adopted by management in preparing and presenting financial statements. There are, as stated above, many different accounting and applying those which in the circumstances of the enterprise, are best suited to present properly its financial position and the results of its operations.

1.11 ESSENTIAL FEATURES OF ACCOUNTING PRINCIPLES

The general acceptance of an accounting principle or practice depends on its capacity to meet the criteria of relevance, objectivity and feasibility.

An accounting principle should be relevant, i.e. the use of it should result in information that is meaningful and useful to the financial statement users.

In other words, only those accounting rules which increase the utility of the business records to its readers will be accepted as an accounting principle by them.

It should be objective. The accounting information obtained should not be influenced by the personal bias or judgement of the statement makers. Objectivity can note reliability or trustworthiness. It means that there must be means of ascertaining the correctness of the information reported in a financial statement.

A principle is feasible to the extent that it can be implemented without undue cost or complexity. The accounting principles may be adopted to the needs of business quickly and easily. It means the accounting principles should be flexible, i,e. They should not be static. They should be capable of being changed with the changes in business methods and procedures.

The accounting principles generally combine all the above mentioned features or criteria, but sometimes we may have to give up one criterion in favour of another or we may place greater importance on one and lesser importance on the other. For example: while valuing the fixed assets at cost or Balance Sheet purposes we give up the criterion of objectivity and usefulness in favour of feasibility. The fixed assets are valued at cost and not at market price even though the cost figure is not of much use of the reader because of changes in the value of rupee, a measuring rod. This is done because of the following two reasons.

1. The market price or replacement value of the assets is difficult to ascertain.
2. The market price of the replacement value of the fixed assets even if one is able to ascertain will be less objective in nature.

Thus in developing new principles, the essential problem is to strike the right balance between objectivity and feasibility on the one hand and relevance on the other.

1.12 ACCOUNTING CONCEPTS

1. Going Concern Concept: Kohler defines going concern as, “A Business enterprise in operation with the prospects of continuing operation in the future; its assets, liabilities, revenues, operating costs, personnel policies and prospectus; a concept basic to accounting, of importance in the valuation of intangible assets and the depreciation of tangible and intangible assets.”

Simply stated accounting assumes that the business will continue to operate for an indefinitely long period in the future. In other words, the accounting unit is considered to have a greater life expectancy than that of any asset which it now owns. This necessitates the making of a distinction between capital expenditure and revenue expenditure. Though, every expenditure is revenue expenditure in the long run, this distinction is important because accounts of a business supposed to run for a long period of time, are usually prepared for a short period say, a year.

If this assumption is not made, the generally accepted accounting principles that have been developed and that are applied in the process of accounting for the financial affairs of a business entity and which are, in many instances, appropriate only for a going concern will become redundant or useless. If the business is failing and its assets are subject to forced sale, the conventional accounting approach, although acceptable for a going concern, would often result in wrong or inadequate financial information.

Under this assumption a business is viewed as an Economic or financial system for adding value to the resources it uses. Its success is measured by comparing the value of its output with the cost of the resources used in producing that output. The difference in the value of its output and the costs of the resources used to produce that output is called profit. Resources purchased but not yet used in production are called assets. They are shown not at current value to an outside buyer, but at heir cost. Their current resale value is not relevant, since it is assumed that they will be used in the creation of future output values rather than being sold.

Thus, the accountant does not try to measure at all times what the business is currently worth to a potential buyer. He does not show in the balance sheets the value, the assets will fetch of thecompany goes into voluntary liquidation. He rather values the assets used for business purposes at cost. For a going concern that intends to continue using such assets for business purposes, forced sale or current market value is not particularly relevant. But if the business is winding up its affairs and must sell its assets to satisfy the claims of its creditors, the original cost of the assets is no indicator of realizable value.

The fact should be kept in mind while preparing the account of a concern if it is clear that the life expectancy of such business is very sort. It is only because of this that in the case of contracts, assets purchased are debited entirely to the contract account and not treated as an asset.

2.  The Business Entity Concept: For accounting purposes the business is treated as a complete unit or entity separate from those who own it or give credit to it. The owner or proprietor is considered to be separate and distinct from the business he owns or controls. Accounts are maintained for business entities as distinct from the persons who own them, operate them, or are otherwise associated with the business. For accounting purposes, even the proprietor will be treated as creditor to the extent of his capital. The proprietor’s private affairs are thus not allowed to be mixed up with those of the business. It is only because of this concept that we are able to present a true picture of the firm. The entity concept is applicable to all forms of business organizations. For accounting purposes, even the sole trader or partner is considered to be an entity different from the business he owns although even in law there is no distinction between the financial affairs of the business and those of the people who own it; a creditor of the business can use and if successful collect from the owner’s personal resources as well as from the resources of the business.

The field of this concept has now been extended. It is now also applied for finding out the results of various departments of the same organization separately with a view to fixing the responsibility for the results thereof.

"There follows from the distinction between the business entity and the outside world that an important purpose of financial accounting is to provide the basis for reporting on stewardship. The managers of a business are entrusted with funds supplied by owners, banks and others. Management is responsible for the wise use of these funds, and financial accounting reports are in part designed to show how well this responsibility or stewardship, has been discharged".

3.  Money Measurement Concept: Accounting records only those facts which could be expressed in terms of money. This concept ignores the records of events on which precise money values cannot be put, even if they are very important. In other words, we cannot express qualitative events with the help of accounting unless they can be measured in terms of money with a fair degree of accuracy. This enables us to deal arithmetically (added, subtracted, divided or multiplied) with things of diverse nature, e.g., cost of use of plant and machinery and use of skilled labour can be added up. This is so because money provides a common denominator by means of which heterogeneous facts about a business can be expressed in terms of numbers that can be dealt with arithmetically.

This concept imposes severe limitations on the scope of accounting statements. The Accounts of Gupta & Company, for example, do not reveal that a competitor has introduced an improved service to the customers; they do no report that a strike is beginning or for that matter they do not record the fact that the production manager is not on speaking terms with the Sales Manager because all these events cannot be expressed in terms of money. Thus accounting does not give a complete picture of what is happening in the business or that of the conditions prevailing in the business.

It should, however, be noted that money is expressed in terms of its value at the time an event is recorded in the accounts. Change in the purchasing power of money due to inflation or deflation in future years are not taken note of.

To sum up we can say that while money is probably the only practical common denominator, the use of money implies homogeneity, a basic similarity between Re. 1 and another. This homogeneity does not, however, exist in periods of inflation or deflation.

4.  Dual Aspect Concept: Dual aspect is perhaps the most important of all the concepts. We require use of this recoding in each and every business transaction. To understand this concept fully we must know the meaning of the words (i) Assets and (ii) equities. Assets mean the resources owned by a business, e.g., Land, Building, Plant machinery, Stock of goods and so on, Equities on the other hand mean the claims of various parties against these assets. Equities can be divided into two broad categories

(a) Owner’s equity (or capital) which is the claim of the owner or proprietor of the business and

(b) creditors equity, i.e., the claim of creditors of the business.

Thus from the above discussion it follows that the amount of the assets of the business will always be equal to the amount of owners’ equity and creditors’ equity. This is so because all the assets of a business are claimed by someone, either by the creditors of the business, and also because the total of these claims can never exceed the amount of assets to be claimed. To put it in the form of an equation we can say that

Assets=Equities (Owners’ equities as well as Creditor’s equities)

OR

Capital + Liabilities = Assets

In its most expanded form it will be Capital + Revenue + Liabilities = Assets + Expenses.

5.  Realisation Concept: Accounting is a historical record of transaction. It records what was happened. If does not anticipate events, though it usually records adverse effects of anticipated events that have already taken place. Profit it considered to have been earned on the date at which it is realized or on the date when goods or services are furnished to the customers for some valuable consideration or when the third Party becomes legally liable to make payment for goods and services rendered to them. For tangible goods profit is recognized as and when goods are shipped or delivered to the customers and not when either a sales order is received or when a contract is signed or/and not even when goods are manufactured to meet the order.

This concept stops business firms from inflating their profits by recording sales and incomes that are likely to take place in future.

There are certain exceptions to this general rule–

(a) The revenue is recognized as realised on an earlier date in case where it can be objectively measured earlier than the date of exchange between the seller and the buyer. For example, in case of mining revenue is recognized when the metal is mined, rather than when it is sold. This is so because the metal always has a specified value and hence no market exchange or sale is necessary to establish this value.

(b) In case of Hire purchase and instalment selling, revenue may be recognized only when the instalment payments are received and not when goods are delivered due to the doubt about the actual amount that will be received from the hirer.

(c) Not full revenue or profits, if the contract of sale stipulates after sale service agreement. Probable cost of adequate provision for repairs in such cases be made out of realized profits to arrive the net revenue figure.

(d) In a business where mere production leads to the earning of profits as sales require no effort on the part of the manufacturer, profits are assumed to have been realized as and when goods are manufactured and not when they are actually sold.

6.  Accrual Concept: According to accrual concept, income or profit arises only when there has been an increase in the owner’s equity or increase in the owner’s share of the assets of the firm but not if such increase results from money contributed by the owner himself.

“Any increase in owner’s equity resulting from the operations of the business is called a revenue. Any decrease is called an expense. Income is therefore the excess of revenue over expenses. (If expenses exceed revenue, the difference is called a loss).

It is extremely important to recognize that income is associated with change in owner’s equity and that it has no necessary relation to change in cash. Income connotes. ‘Well-offness’. Roughly speaking the bigger the income, the better off are the owners. An increase in cash, however, does not necessarily mean that the owners are better off and that their equity is increased. The increase in cash may merely be offset by a decrease in some other asset or an increase in liability with no effect on owner’s equity at all”.

Thus the profit is said to have arisen only when the total revenues or incomes exceed total expenses or losses. Settlement, in cash, of transactions already entered into is immaterial for calculating or taking into account the expenses, losses or gain etc. It is enough if they are incurred or earned during the period for which profit is being calculated.

7.  Verifiable objective evidence concept: According to this concept all the entries recorded in the books of account should be supported by business documents known as vouchers. No entry be passed in the books unless it is supported by the proper voucher which could also be verified later on as and when it becomes necessary to check the correctness of the accounts. The only limitation to this general rule is entries with regard to non-cash charges, e.g., Depreciation on fixed assets, provision for bad and doubtful debts and so on.

8.  Cost Concept: According to the cost concept which is closely related to Going Concern Concept the assets or resources owned by a business are entered on the accounting records at cost or the Price paid to acquire them. According to the same concept the cost of the asset is the basis for all subsequent accounting for the asset. Thus the accounting measurement of assets does not normally reflect the worth of assets except at the moment they are purchased because it is assumed that the purchaser is a prudent businessman and that he will, therefore, not pay more for an asset or service that it is worth at the time. This being so the historical cost is presumed to be equal to the fair value of the asset required. In other words, it means, that the accountant observing this concept does not ordinarily record the changes in the real worth of an asset which might have occurred with passage in time or due to changes in the value of money, a measuring rod. For example, a building if purchased for Rs. 1,00,000 will be recorded in the books of accounts at Rs. 1,00,000. Subsequent changes in the worth or in the market value of this building would not ordinarily be recorded in the accounts books. The change in the market priceof this building, say Rs. 2,00,000 on the date of preparation of the balance sheet will not be considered.

It be noted that not all assets, but only fixed assets, are recorded according to this concept. ‘There may be certain assets called current assets, in case of which there may well be a correspondence between accounting measurements and their real market values, cash, for example, is always shown not at its original cost but at its actual worth. Similarly, marketable securities and stock held for resale are generally shown at their near actual worth figure, i.e. at cost or market value whichever is lower. It is because of this fact that it is said that subsequent changes in the market value of assets would ordinarily not be reflected by changes in the accounts.

However, it should also be noted that cost concept does not mean that all assets remain in the accounting records at their historical or original cost so long as the company owns them. The cost of a fixed asset, such as a building, that has a long but nevertheless a limited life is systematically reduced over the life of the asset by the process called depreciation. It is because of the process of changing depreciation that the asset disappears from the balance sheet when its economic or useful life is over.

“Another important consequence of the concept is that if the company pays nothing for an item it acquires, this item will usually not appear in the accounting records as an asset. The knowledge, skill and expertise of an electronic company’s research and development team do not appear in the company’s balance sheet as an asset”.

Following this the goodwill appears in the accounts of the company only when the company has purchased an intangible and valuable property right and paid for it. Even then it is shown at its purchase price even though the management may believe that its real value is considerably higher. No amount for “goodwill” or any other asset for that matter will be shown in the accounts if the company does not actually purchase such intangibles or assets.

It also follows from the cost concept that an event may affect the value of a business without having any effect on the accounting records. To take an extreme case, suppose that several key executives are killed in a plane accident. To the extent that “an organization is but the lengthened shadow of a man, the real value of the company will change immediately, and this will be reflected in the market price of the company’s stock, which reflects investor’s appraisal of value. The accounting records however, will not be affected by this event.

The cost concept provides an excellent illustration of the problem of applying the three basic criteria : Relevance, Objectivity and Feasibility. If the only criterion were relevance, then the cost concept would not be defensible. Clearly, investors and others are more interested in what the business is actually worth today rather than what the assets cost originally.

But who knows what a business is worth today? The fact is that any estimate of current value is just that—an estimate and informed people will disagree on what is the right estimate. Furthermore, accounting reports are prepared by the management of a business, and if they contained estimates of what the business is actually worm, these would be management’s estimates. It is quite possible that such estimates be biased.

The cost concept, by contrast, provides a relatively objective foundation of accounting. It is not purely objectives, for judgements are necessary in applying it. It is much more objective, however than the alternative of attempting to estimate current values. Essentially, the reader of an accounting report must recognize that it is based on cost concept, and he must arrive at his own estimate of current value, partly by analyzing the information in the report and partly by using non-accounting information.

Furthermore, a “market value” or “current worth” concept would be difficult to apply, because it would require that the accountant attempt to keep track of the ups and downs of the market prices. The cost concept leads to a system that is much more feasible.

9.  Accounting Period Concept: The net income being the difference between value assets at the time of commencement of business and at the time of liquidation of the business, is easier to calculate when the business comes to an end. But only a few business ventures have a small life. Generally, the business houses last for a very long period of time. Moreover, accountants assume an indefinite life of the business houses (Going concern concept). But the management and other parties will not like to wait for a very long period of time, until; the business has terminated, to obtain information on how much income has been earned or loss suffered by such businesses. It would be too late then to take any corrective steps at that time if the final accounts report that the business was incurring losses. Therefore, they need to know at frequent intervals as to how things are going. The accountant, therefore, measures the income or loss not for the entire life of the business but only for a convenient segment of time. The time interval chosen is called the accounting period. Realisation concept and accrual concept are the main or basic guides for sorting out the transactions occurring during an accounting year with a view to measure the income of that period.

It should, however, be noted that more frequent reports, called the interim reports, be prepared and sent to management for their perusal and action, if necessary.

10.             Matching Concept: The main motive of doing business now-a-days is to maximize profits. The proprietors want their accountants to ascertain the profit or loss made by their businesses. The accountants in turn are, therefore, busy most of their time in finding out techniques of measuring profits. For finding out the profits they have to match the revenues of a particular period with the expenses or cost which can be assigned to earning such revenues.

Thus the problem is of matching revenues of the period with the cost of securing that revenue to ascertain the profit for a particular period. It should be noted here that the problem is that of matching the expenses. It means the first step is to ascertain what revenues are to be recognized in a given accounting period. The second step, of course, is to determine the expenses that are associated with these revenues. Some difficulties in measuring the revenue for the artificial accounting year are raised because business is as said above, a continuous process.

Measurement of Revenue—Revenues are measured in accordance with the accrual concept. According to accrual concept the revenues accrue in the accounting year in which they are earned. It is immaterial whether equivalent cash received in that year or not.

Cash basis of determining income has, however, considerable appeal to many people. This is so because it is not only simple but also appears to be realistic. Moreover, it is verifiable and based upon convention of conservatism. It satisfies those businessmen who think that their profit is equal to the excess of current bank balance over the beginning bank balance. According to this basis income is equal to cash received during the year and expense is equal to cash paid out during the same period. Exceptions are, however, made of additional investments by the owners and creditors. These investments are regarded as non-income transactions.

The cash basis of determining income for the year is deficient in many respects. Therefore, the accountant generally rejects this basis and adopts accrual basis of determining income which rests on the concept of realization. According to this basis a careful distinction must be made between revenues and cash receipts as revenues need not result in an equivalent amount of cash. It is possible that revenue may be earned this year even though payment is not received until next year. The balance sheet of this year in such a case will show the amount outstanding either as debtors or as accrued revenue. It may also be possible that the business receives cash in the current years which creates a liability to render a service in some future period. The examples of such cases may be subscription received in advance by a magazine publisher or insurance premium received in advance by an insurance company. Similarly it may still happen that the firm may have received cash last year which become revenue in this year as the services promised then are rendered now. The balance sheet of last year in such a case will show cash received in advance as a liability under the head Differed revenue or pre collected (received in advance) revenues.

Revenue is considered to have been earned on the date when goods or services are furnished to the customer in exchange for cash or some other valuable consideration. Barring a few exceptions, the revenues are not considered as being earned when an order is received or when goods are manufactured to meet the order or when a contract is signed. Accountants generally recognise revenues only when goods are dispatched to customers.

Measurement of Expenses—Expenses are the costs incurred in connection with the earning of revenue. The term ‘expenses’ ‘connotes’ ‘Sacrifices made’, ‘the cost of services or benefits received’ or ‘resources consumed’ during in accounting period. The term ‘Cost’ is not synonymous with ‘Expenses’. Expenses means a decrease in owner’s equity that arises from

The operation of a business during a specified accounting period, whereas cost means any monetary sacrifice whether or not the sacrifice affects the owner’s equity during a given accounting period;

The AAA (American Accounting Association) committee gives the following definition of expenses— "Expense is the expired cost directly or indirectly related to given fiscal period of the flow of goods or services into the market and of related operations. Recognition of cost expiration is based either on a complete or partial decline in the usefulness of assets or on the appearance of a liability without a corresponding increase in assets.” It describes the recognition of expenses as, ‘Expense is given recognition in the period in which there is (a) a direct identification or association with the revenue of that period, as in the case of merchandise delivered to customers; (b)an indirect association with the revenue of the period, as in the case of office salaries or rent: (c) a measurable expiration of assets costs even though not associated with the production of revenue for the current period, as in the case of losses from flood or fire.”

It should also be noted that the words expenses and expenditure connote different meanings. An expenditure takes place when we purchase an asset or service. It may be made by cash or by incurring a liability or by the exchange of another asset. There may not necessarily be a correspondence between expenses and expenditure made by a concern become expense or in other words there are no expenses that are not represented by expenditure.

According to the definition of the word expense given by the AAA Committee expense of the current year include the cost of the products sold in this year, though purchased or manufactured in a prior year. Similarly, other expenses like salaries of salesman who sold these goods and the cost of other services like telephone and electricity etc. consumed or used during the year whether paid or not in the current year shall also be included in the expenses of the current year. Thus we can say that—

1. There may be some expenditure which may become expenses also in the same year because the benefit of the same is consumed in the same year. Such expenses will be recognised as an expense of the current year.
2. There may be other expenditures which were paid in previous year/years but become expense in the current year as the benefit thereof is consumed in the current year, insurance protection is one such item. The premium is paid in advance but the insurance protection is received later in the year. Till then the amount paid by way to premium is an asset. It becomes an expense in the accounting period when such protection is received.
3. Some expenditure incurred now may become expenses next year as the goods bought now will be sold next year. These will be shown as an asset on the balance sheet of the current year and will be treated as an expense when these goods are sold.
4. Some expenditure may not be paid for in the current year although goods and services were purchased and consumed during the current year. These will be treated as expenses of the current year. The amounts outstanding will be shown as a liability in the balance sheet of the current year.

In contrast to accrual basis, in cash basis an expense is said to have been incurred as and when cash is disbursed. Results of this approach are far from being satisfactory and so the accountant makes a distinction between an incurred cost, a disbursement, and the expiration of a cost. He pinpoints the events of expiration to determine the period to be charged.

1.13 ACCOUNTING CONVENTIONS

Definition of Accounting Conventions: Accounting conventions mean and dignify customs or traditions relating to accounting. Thus they differ from accounting concepts which are used to connote accounting postulates. In other words, we can say that accounting conventions relate to the practical side of accounting.

1. Convention of Consistency: Accounting is not composed of a set of rules which prescribe the 'one way that things can be done’. There are many different ways in which items may be recorded in the accounts. For example, there are several methods of computing yearly depreciation. Then firm should, within these limits, select the methods which give the most equitable importance that the method selected be applied consistently year after year. Successive, periodical financial statements would not be comparable, if the accountant continuously changed the method of accounting for certain expenses or assets though each method might be fully acceptable. For example, the profit figure can be changed significantly by changing the methods of depreciation. The user of the statement may be misled and think that the earnings had improved. Whereas in reality the increase was solely due to change in the methods of depreciation. Change in net income reported in successive statement should be due to changes in business conditions or management effectiveness and not simply due to changes in accounting methods.

However, it does not bind the firm to follow the same method until the firm closes down. A firm can change the method used, but such a change is not effected without the deepest consideration. It means that the accountant can change the method if he thinks that the results of operations and the financial position of the business would more fairly be reflected by such a change. When such a change occurs, then either in the profit and loss account itself or in one of the reports accompanying it, the effect of the change should be stated.

It should, however, be noted here that the word consistency used here has a narrow meaning. It does not refer to logical consistency at a given moment of time rather it refers to different categories of transactions should be consistent with each other. It only means that the transaction of the same category must be treated consistently from one accounting period to another. Thus there will be no inconsistency involved if different categories of assets are valued on different basis, e.g., if stock is valued at cost or market value, whichever is lower and fixed assets are valued at cost.

Consistency offers the following advantages to the users of the statements—

1. Intra-Firm comparisons are made possible—’Financial statements are most meaningful as source of information about a particular business unit when statements made at several different times are compared with each other. Trends can be discerned, for example, only when the balance sheets of three or more years are placed side by side. To provide optimum comparability, transactions must be analysed and recorded in the same way from one period to another. Items included under one caption on one balance sheet or operating statement should he included under the same caption on another statement. The virtue of consistency is so great that even incorrect procedures consistently applied may produce useful results.”
2. Inter-Firm comparisons are made possible— Another use of financial statements is in the comparison of the one business with another business. Some consistency of treatment within an industry would therefore enhance the value of accounting reports. Consistency then, is one objective of generally accepted accounting principles.

2.  Convention of Conservatism: It is the policy of "Playing safe”. Financial statements are drawn upon rather a conservative basis. Window dressing in preparing the financial statements is not permitted. This convention is particularly applicable when matters of opinion or estimate are involved. In cases of doubt the accountant choose to under late the owner’s equity rather than overstate them. This could also be said. “Anticipate no profit and provide for all possible losses.” Business men are generally inclined to be optimistic. The bankers, creditors, investors and other who use financial statements may be misled as assets in many cases be overstated or liabilities understated in the absence of this convention.

To take an example, the provision for doubtful debts is a matter of estimates. Most accountants prefer leaning in the direction of over statement rather than under-statement of the allowance for bad and doubtful debts. The consequences of overstatement of assets and net income are more serious than those of understatement.

Balance sheet conservatism was once regarded as the most important of all the accounting principles. But this position of the convention of conservatism is questioned now. Accountants are now becoming increasingly aware that adherence to this principle may result in incorrect statement or sometimes in un-conservative statement.

Charging expense accounts with expenditure which would more properly be charged to fixed asset accounts or to make excessive provision for depreciation may be conservative from the balance sheet stand point, but it would result in misstatement of net income. Moreover, the net income for periods in which no depreciation will be charged to income statements will be over stands. The income statements for these years will be un-conservative to that extent.

Thus we can say that the conservatism can be regarded as a virtue if, as its consequence, income statements and balance sheets do fairly present the result of operations and the financial position stretching this convention to excessive lengths will imply creation of secret reserves which is in direct conflict with the doctrine of full disclosure.”

3.  Convention of full disclosure: The accountant proposes to make disclosure of all material facts necessary to complete understanding by third parties-or relevant to any decision which might be based on accounting statements. The accountant is supposed to prepare the accounts honestly and to disclose all material information. The Companies Act makes ample provision for the disclosure of material information in company accounts. It has prescribed standard form of balance sheet and a sheathe of contents of revenue statement. These forms are so designed that the disclosure of all relevant facts had become compulsory.

Disclosure prompts the accountant to report the realisable value of stock or marketable securities, for example, when that value is substantially different from cost. Disclosure calls for the details of each type of capital stock, such as the par of stated value per share, the preference attached to this issue, the number of shares authorized and the number outstanding and any other fact which would be an important consideration for the present or potential shareholders. If the business entity faces a possible liability or loss that is not definite in amount at the time of preparing statements, but reasonably certain of happening, the accountant is obliged to report the facts as accurately as he can.

It should however, be noted that the convention of disclosure does not imply that any one’s or everyone’s desire with regard to disclosure shall be fulfilled. It only implies full disclosure of accounts which are of interest to the owners, creditors and present or prospective investors of business. Disclosure of minor details is neither possible nor desirable.

4.  Convention of Materiality: Materiality should be interpreted negatively. In its negative sense it means the information, the non-disclosure of which would vitiate the true and fair character of financial statement. The decision with regard to materiality of an information or amount depends upon the magnitude of the amount or the importance of the information for the statements users. Thus, as to what is or is not material depends on the nature and size of the firm and on the accountants’ Judgement.

American Accounting Association defines the term ‘materiality’ as “An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor.”

According to this convention less important items are left out whereas mention by way of a footnote or otherwise is made of more important items. Thus if a bottle of ink was bought it would be used up over a period of time and this cost is used up every time someone dips his pen into ink. It is possible to record this as an expense every time it happens, but obviously the price of a bottle of ink is so little that it is not worthy recording it in this fashion. The bottle of ink is not a material item and therefore, would be charged as an expense in the period it was bought irrespective of the fact that it could last for more than one accounting period.

However, the effect of change in the profit or loss of a business due to change in the method of charging depreciation on fixed assets, provision for gratuity, basis of valuation of stock, etc. are considered to be material and hence the fact of the change and the extent of its effect on the profit or loss of the concern need to be disclosed.

Based on this principle, the most modern published accounts usually avoid to mention the fraction of the rupee in the statements and reports. But in any case actual accounting entries are always exact.

“The materiality concept is important in the process of determining the expenses and revenues for a given accounting period. Many of the expense items that are recorded for an accounting period are necessarily estimates, and in some cases they are very close estimates, and in some cases they are not so. There is a point beyond which it is not worthwhile to attempt to refine these estimates. Telephone expense is a familiar example. Telephone bills although rendered monthly often do not coincide with a calendar month. It would be possible to analyse each bill and classify all the calls according to the month in which they were made. This would be following the accrual concept precisely. Few companies bother to do this, however. They simply consider telephone bills as an expense of the month in which the bill is received on the grounds that a system that would ascertain the real expense would not be justified by the accuracy gained. Since in many businesses the amount of the bills is likely to be relatively stable from one month to another, no significant error may be involved in this practice. Similarly, very few businesses attempt to match the expenses of making telephone calls to the specific revenues that might have been produced by these Calls.”

1.14 INTRODUCTION TO ACCOUNTING STANDARDS

Meaning of Accounting Standards

Accounting Standards are written policy documents issued by expert accounting body or by the government or other regulatory body covering the aspects of recognition, measurement, treatment, presentation, and disclosure of accounting transactions in financial statements

Classification of Enterprises

The enterprises are classified and labelled as Level I, Level II and Level III companies. Based on this classification and the category in which they fall the Accounting standards are applicable to the enterprises

Level I Enterprises

Enterprises which fall under any one or more category below mentioned are termed as Level I Companies

• Enterprises whose equity or debt securities are listed whether in India or outside India
• Enterprises which are in the process of listing their equity or debt securities. Board of directors resolution must be available as an evidence
• Banks including co-operative banks
• Financial institutions
• Enterprises carrying on insurance business
• All commercial, industrial and business reporting enterprises, whose turnover not including ‘other income’ for the immediately preceding accounting period on the basis of audited financial statements exceeds Rs. 50 crore
• All commercial, industrial and business reporting enterprises having borrowings, including public deposits, in excess of Rs. 10 crores at any time during the accounting period
• Holding and subsidiary enterprises of any one of the above at any time during the accounting period

Level II Enterprises

Enterprises which fall under any one or more category below mentioned are termed as Level II Companies

• All commercial, industrial and business reporting enterprises, whose turnover (excluding ‘other income’) for the immediately preceding accounting period on the basis of audited financial statements is greater than Rs. 40 lakhs but less than Rs. 50 crore
• All commercial, industrial and business reporting enterprises having borrowings, including public deposits, is greater Rs. 1 crore but less than  Rs. 10 crores at any time during the accounting period
• Holding and subsidiary enterprises of any one of the above at any time during the accounting period

Level III Enterprises:

Enterprises which do not fall under Level I and Level II, are considered as Level III enterprises

Applicability of Accounting Standards

1.15 OBJECTIVES OF ACCOUNTING STANDARDS

Accounting is often considered the language of business, as it communicates to others the financial position of the company. And like every language has certain syntax and grammar rules the same is true here. These rules in the case of accounting are the Accounting Standards (AS). They are the framework of rules and regulations for accounting and reporting in a country. Let us see the main objectives of forming these standards.

1. The main aim is to improve the reliability of financial statements. Now because the financial statements have to be made following the standards the users can rely on them. They know that not conforming to these standards can have serious consequences for the companies.
2. Then there is comparability. Following these standards will allow for inter-firm and intra-firm comparisons. This allows us to check the progress of the firm and its position in the market.

It also looks to provide one set of accounting policies that include the necessary disclosure requirements and the valuation methods of various financial transactions.

1.16 BENEFITS & LIMITATIONS OF ACCOUNTING STANDARDS

Benefits of AS

Accounting Standards are the ruling authority in the world of accounting. It makes sure that the information provided to potential investors is not misleading in any way. Let us take a look at the benefits of AS.

1] Attains Uniformity in Accounting

Accounting Standards provides rules for standard treatment and recording of transactions. They even have a standard format for financial statements. These are steps in achieving uniformity in accounting methods.

2] Improves Reliability of Financial Statements

There are many stakeholders of a company and they rely on the financial statements for their information. Many of these stakeholders base their decisions on the data provided by these financial statements. Then there are also potential investors who make their investment decisions based on such financial statements.

So it is essential these statements present a true and fair picture of the financial situation of the company. The Accounting Standards (AS) ensure this. They make sure the statements are reliable and trustworthy.

3] Prevents Frauds and Accounting Manipulations

Accounting Standards (AS) lay down the accounting principles and methodologies that all entities must follow. One outcome of this is that the management of an entity cannot manipulate with financial data. Following these standards is not optional, it is compulsory.

So these standards make it difficult for the management to misrepresent any financial information. It even makes it harder for them to commit any frauds.

4] Assists Auditors

Now the accounting standards lay down all the accounting policies, rules, regulations, etc in a written format. These policies have to be followed. So if an auditor checks that the policies have been correctly followed he can be assured that the financial statements are true and fair.

5] Comparability

This is another major objective of accounting standards. Since all entities of the country follow the same set of standards their financial accounts become comparable to some extent. The users of the financial statements can analyze and compare the financial performances of various companies before taking any decisions.

Also, two statements of the same company from different years can be compared. This will show the growth curve of the company to the users.

6] Determining Managerial Accountability

The accounting standards help measure the performance of the management of an entity. It can help measure the management’s ability to increase profitability, maintain the solvency of the firm, and other such important financial duties of the management.

Management also must wisely choose their accounting policies. Constant changes in the accounting policies lead to confusion for the user of these financial statements. Also, the principle of consistency and comparability are lost.

Limitations of AS

There are a few limitations of Accounting Standards as well. The regulatory bodies keep updating the standards to restrict these limitations.

1] Difficulty between Choosing Alternatives

There are alternatives for certain accounting treatments or valuations. Like for example, stocks can be valued by LIFO, FIFO, weighted average method, etc. So choosing between these alternatives is a tough decision for the management. The AS does not provide guidelines for the appropriate choice.

2] Restricted Scope

Accounting Standards cannot override the laws or the statutes. They have to be framed within the confines of the laws prevailing at the time. That can limit their scope to provide the best policies for the situation.

1.17 AS 1: DISCLOSURE OF ACCOUNTING POLICIES

Accounting Standard (1): Disclosure of Accounting Policies: - AS – 1 is now mandatory (compulsory). It must be following by all of types concern i.e. sole proprietor, firm or a company.

Meaning: - Accounting policies refer to specific accounting principles and the method of applying those principles adopted by the enterprises in preparation and presentation of the financial statement (i.e. Final Accounts)

Purpose: - The purpose of disclosing Accounting policies is for proper and better understanding of financial statement. All-important accounting policies should be disclosed at one place to help the reader in understanding the financial statements. Statements of accounting policies are part of financial statements.

Areas: - At the time of preparation of final accounts there are many areas where more than one method of accounting treatment can be followed.

E.g.

a)     Method of Depreciation: -

i)                   Fixed Instalment Method.

Ii)                 WDV Method.

b)    Valuation of Stock: -

i)                   FIFO.

Ii)                 Weighted Average.

c)     Treatment of Expenditure during Construction: -

i)                      Written Off.

Ii)                    Capitalisation.

Iii)                 Deferment.

Iv)                  Conversion of Foreign currency Item.

v)                    Valuation of Investment.

Vi)                  Treatment of Goodwill.

Vii)               Treatment of Retirement Benefits.

Viii)             Treatment of Contingent Liabilities.

Disclosure of Policies: - For proper and better understanding of financial statements it is required that all significant accounting policies followed in preparation of financial statements should be disclosed. Statement showing disclosure of accounting policies are part of financial statement. To help the reader to understand, it is better to disclose all the policies at one place.

Disclosure of Change in Policies: - If there is any change in accounting policies in preparation of financial statement from one period to subsequent period and such changes affects the state of affairs of Balance Sheets & Profit & Loss A/c of current period or of later period, then such change must be disclosed in the financial statement.

The amount by which the financial statement is affected should be disclosed to the extent possible.

Fundamental Accounting Assumptions: - If fundamental accounting assumptions are followed, then specific disclosure is not required.

E.g.

a)     Treatment of Expenditure during Construction: - It means that the concern is going to continue the business in future and has no intention of closing the business.

b)    Consistency: - It means that same accounting policies are followed from one period to another.

c)     Accrual: - It means that financial statements are prepared on mercantile system only. It means revenue and costs are recorded as they are earned or incurred and not as when money is received or paid.

If fundamental accounting assumption is not followed, then the fact should be disclosed.

1.18 AS 6:  DEPRECIATION ACCOUNTING

Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, passage of time or obsolescence through technology and market changes.

Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is predetermined.

The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset.

Depreciable assets are assets which

[1] are expected to be used during more than one accounting period; and

[2] have a limited useful life; and

[3] are held by an enterprise for use in the production or supply or for administrative purposes.

Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost less the estimated residual value.

Useful life is the period over which a depreciable asset is expected to be used by the enterprise.

The useful life of a depreciable asset is shorter than its physical life.

There are two method of depreciation:

1] Straight Line Method (SLM)/Fixed Instalment Method/Cost Method

2] Written Down Value Method (WDVM)/Reducing Balance Method (RBM)

Note: A combination of more than one method may be used.

The depreciation method selected should be applied consistently from period to period. The change in method of depreciation should be made only if;

The adoption of the new method is required by statute; or

For compliance with an accounting standard; or

If it is considered that change would result in a more appropriate preparation of financial statement; or

When there is change in method of depreciation, depreciation should be recalculated in accordance with the new method from the date of the assets coming into use. (i.e. RETROSPECTIVELY)

The deficiency or surplus arising from such re-computation should be adjusted in the year of change through profit and loss account.

Such change should be treated as a change in accounting policy and its effect should be quantified and disclosed.

• The useful lives of major depreciable assets may be reviewed periodically. Where there is a revision of the estimated useful life, the unamortised depreciable amount should be charged over the revised remaining useful life. (i.e. PROSPECTIVELY)

• Any addition or extension which becomes an integral part of the existing asset should be depreciated over the remaining useful life of that asset.The depreciation on such addition may also be applied at the rate applied to the existing asset.Where an addition or extension retains a separate identity and is capable of being used after the existing asset is disposed of, depreciation should be provided independently on the basis of estimate of its own useful life.

• Where the historical cost of a depreciable asset has undergone a change due to increase or decrease in the long term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors, the depreciation on the revised unamortised depreciable amount should be provided prospectively over the residual useful life of the asset.

• This accounting standard is not applied on the following items.

• Forests and plantations

• Wasting assets

• Research and development expenditure

• Goodwill

• Live stock

• Disclosure requirements

1] the historical cost

2] total depreciation for each class charged during the period

3] the related accumulated depreciation

4] depreciation method used (Accounting policy)

5] depreciation rates if they are different from those prescribed by the statute governing the enterprise.

Please Note that this Accounting Standard on Depreciation has now been removed, and new revised A.S - 10 Property, Plant and Equipment has been issued by ICAI.

1.19 AS 9: REVENUE RECOGNITION

Meaning: - Revenue means gross inflow of cash, receivable or other consideration arising in the course of ordinary activities of an enterprise such as

a)     Sale of goods.

b)    Rendering of services.

c)     Use of the enterprises resources by other, yielding interest, dividend and royalties.

Timing: - Revenue should be recognized at the time of sale of rendering of services.

Transaction Excluded: - AS 9 is not applicable to the following:

a)     Revenue arising from construction contracts.

b)    Revenue arising from hire, purchase, lease agreements.

c)     Revenue arising from government grants and subsidies.

d)    Revenues of insurance companies arising from insurance contracts.

Sale of Goods: - As per AS 9 revenue from sale of goods is recorded when

a)     Seller has transferred the ownership of goods to the buyer for a price.

b)    All significant risks and rewards of ownership have been transferred to the buyer.

c)     Seller does not retain any effective control of ownership of the transferred goods.

d)    There is no significant uncertainty in collection of amount of consideration.

Rendering of Services: - Revenue from service is recorded as the service is performed. It is measured by 2 methods.

a)     Completer Service Contract Method: - Revenue is recorded on completion of the contract i.e. when rendering of service is complete.

b)    Propionate Completion Method: - Revenue is recorded proportionately i.e. in proportion to the degree of completion of services under a contract.

Effect of Uncertainties: - Revenue is recorded only when there is no significant uncertainty in collection of amount of consideration. Revenue recognition is if the ultimate collection is uncertain.

When uncertainty of collection of revenue arises after the revenue recognition it is better to make provision for the uncertainty in collection.

Disclosure: - If revenue recognition is postponed, then the circumstances necessitating the postponement must be disclosed.

1.20 AS 10: ACCOUNTING FOR FIXED ASSETS

Meaning: Fixed Asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business. (It is expected to be used for more than one accounting period.)

Cost of the Fixed Asset: The cost of fixed asset includes:

•       Purchase price

•       Import Duties and other non-refundable taxes

•       Direct cost incurred to bring the asset to its working condition

•       Installation cost

•       Professional fees like fees of architects

•       General overhead of enterprise when these expenses are specifically attributable to acquisition/preparation of fixed assets

•       Any expenses before the commercial production, including cost of test run and experimental production

•       Any expenses before the asset is ready for use not put to use

•       Loss on deferred payment arising out of foreign currency liability

•       Price adjustment, changes in duties and similar factors.

The cost of fixed asset is deducted with:

•       Trade discounts and rebates

•       Sale proceeds of test run production

•       Amount of government grants received/receivable against fixed assets (See AS- 12)

•       Gain on deferred payment arising out of foreign currency liability

Similarly, historical cost of self-constructed fixed assets will include:

•       All cost which are directly related to the specific asset

•       All costs that are attributable to the construction activity should be allocated to fixed assets

•       Any internal profit included in the cost should be eliminated.

•       Any expenses incurred on asset between date of ready for use and put to use is either charged to P&L A/c or treated as deferred revenue expenditure to be amortised in 3-5 years after commencement of production.

When fixed asset is acquired in exchange for another asset, the cost of the asset acquired should be recorded

- either at, fair market value

- or at, the net book value of the assets given up

For this purpose, fair market value may be determined by reference either to the asset given up or to the asset acquired, whichever is more clearly evident.

Fixed asset acquired in exchange for shares or other securities should be recorded at FMV of assets given up or asset acquired, whichever is more clearly evident. (i.e. the option of recording the asset at net book value of asset given up is closed).

Fair market value is the price that would be agreed to in an open and unrestricted market between knowledgeable and willing parties dealing at arm’s length distance.

Subsequent expenditures related to an item of fixed asset should be added to its book value only if they increase the future benefits from the existing asset beyond its previously assessed standard of performance.

Material items retired from active use and held for disposal should be stated at the lower of their net book value and net realizable value and shown separately. Fixed assets should be eliminated from the financial statements on disposal or when no further benefit is expected from its use and disposal. Profit/loss on such disposal or writing off is recognized in the profit and loss account.

REVALUATION

When the fixed assets are revalued, these assets are shown at revalued price. Revaluation of fixed assets should be restricted to the net recoverable amount of fixed asset.

When a fixed asset is revalued, an entire class of assets should be revalued or selection of assets for revaluation should be made on a systematic basis. That basis must be disclosed.

Accounting treatment of revaluation under different situation:

When revaluation is made upward

Fixed Assets A/c  Dr

To Revaluation Reserve

When revaluation is made downward

P&L A/c   Dr

To Fixed Assets

When revaluation is made upward subsequent to previous upward revaluation

Fixed Assets A/c  Dr

To Revaluation Reserve A/c

When revaluation is made downward subsequent to previous upward revaluation

Revaluation Reserve A/c Dr (To the extent of carrying amount of R.R)

P&L A/c   Dr (Balancing Figure)

To Fixed assets A/c

When revaluation is made upward subsequent to previous downward revaluation

Fixed assets A/c  Dr

To P&L A/c (To the extent ofprevious downward revaluation)

To Revaluation Reserve A/c (Balancing Figure)

When revaluation is made downward subsequent to previous downward revaluation

P& L A/c  Dr

To Fixed Assets A/c

Accounting treatment on disposal of Fixed Assets:

On sale of fixed assets

Bank A/c Dr

P & L A/c Dr (If Loss)

To Fixed Assets A/c

To P & L A/c (If Profit)

On sale of fixed assets where upward revaluation has taken place

On disposal of a previously revalued item of fixed asset, the difference between net disposal proceeds and the net book value is normally charged or credited to the profit and loss account except that, to the extent such a loss is related to an increase which was previously recorded as a credit to revaluation reserve and which has not been subsequently reversed or utilized, it is charged directly to that account. The amount standing in revaluation reserve following the retirement or disposal of an asset which relates to that asset may be transferred to general reserve.

In the case of fixed assets owned by the enterprise jointly with others, the extent of the enterprise’s share in such assets, and the proportion of the original cost, accumulated depreciation and WDV should be stated in the B/S.

Alternatively, the pro rata cost of such jointly owned assets may be grouped together with similar fully owned assets with an appropriate disclosure thereof.

Only purchased goodwill should be recorded in books.

Disclosure:

•       Gross and net book value of fixed assets at the beginning and end of period showing additions and disposals

•       Revalued amounts substituted for historical costs of fixed assets, the method adopted to compute the same and whether an external valuer was involved.

1.21 INTRODUCTION TO IFRS

International Financial Reporting Standards

The field of financial reporting in India has seen major changes in the last 5 years. As the trade increasingly moves beyond the national boundaries, the compliance and reporting requirements move too. Presenting the financial statements of an entity in accordance with the reporting requirements of every country it has a presence in, is becoming increasingly difficult.

What is IFRS?

The International Financial Reporting Standards (IFRS) are accounting standards that are issued by the International Accounting Standards Board (IASB) with the objective of providing a common accounting language to increase transparency in the presentation of financial information.

What is IASB?

The International Accounting Standards Board (IASB), is an independent body formed in 2001 with the sole responsibility of establishing the International Financial Reporting Standards (IFRS). It succeeded the International Accounting Standards Committee (IASC), which was earlier given the responsibility of establishing the international accounting standards. IASB is based in London. It has also provided the ‘Conceptual Framework for Financial Reporting’ issued in September 2010 which provides a conceptual understanding and the basis of the accounting practices under IFRS.

Components of Financial Statements under IFRS

A complete set of financial statements prepared in compliance with the IFRS would ideally comprise of the following:

• A statement of financial position as at the end of the period – more commonly known to us as the ‘Balance sheet’
• A statement of profit and loss for the year and the statement of other comprehensive income – Other comprehensive income would include those items of income/expense that are not recognized in the profit and loss account to comply with the other relevant standards.

Both these statements may either be combined or shown separately.

• A statement of changes in equity – This would include a reconciliation between amounts shown at the beginning and the end of the year.
• A statement of cash flows for the period
• Notes to the financial statements – including a summary of significant accounting policies followed and other explanatory information

The financial statements would sometimes also include a statement of the financial position of an earlier period in the following scenarios:

• When an entity applies an accounting policy retrospectively;
• When an entity retrospectively restated an item in its financial statements; or
• When an entity reclassifies an item in its financial statements.

List of International Financial Reporting Standards (IFRS)

As already discussed, the Standards issued by the IASB are called IFRS. The predecessor body, IASC, had however already issued certain International Standards which are called International Accounting Standards (IAS). These IAS were issued by the IASC between 1973 and 2001. Both IAS and the IFRS continue to be in force. The standards are listed below:

1.22 IAS 1: PRESENTATION OF FINANCIAL STATEMENTS

Objective

This standard prescribes the guide lines to be used by the entity, in the presentation of general purpose financial statements, to make sure that financial statements of the entity are comparable both with its previous periods financial statement and with the financial statements of the other entity. For this purpose, it provides overall requirements for the structure and contents of financial statements along with some general features.

Scope

The requirements of this standard are applicable to all the general purpose financial statements (individual and consolidated both) which are prepared and presented in accordance' with 'International Financial Reporting Standards (IFRSs).

However, this standard is not applicable to the structure and contents of statement of cash flows and interim financial statements.

Definitions

General Purpose Financial Statements:

These are financial statements which are prepared and presented to satisfy the information needs of the general users, who are not able to require the reporting entity to prepare accounting reports according to their particular information needs.

Complete Set of Financial Statements:

The complete set of financial statements entails the following:

•         Statement of profit or loss and other comprehensive income

•         Statement of financial position

•         Statement of changes in equity

•         Statement of cash flows

•         Notes to accounts

•         Comparative year information

•         Opening Statement of financial position in respect of retrospective application or restatement of a change in accounting policy or error, or when entity first adopts the IFRSs

International Financial Reporting Standards (IFRSs):

These are accounting standards and related Interpretations, which are issued and regulated by the International Accounting Standards Board (IASB) and these encompasses:

•         International Financial Reporting Standards (IFRS)

•         International Accounting Standards (IAS)

•         Interpretations issued by IFRIC and

•         Interpretations issued by SIC

Impracticable:

It is when the entity is not able to apply the requirement of a particular standard, after any reasonable effort to do so.

Notes

These are one of the essential component of financial statements and include the information (financial and non-financial) in addition to the information which is  presented in the other components of financial statements such as statement of profit or loss and other comprehensive income, statement of changes in equity, statement of financial' position and statement of cash flows. These are in the form of narrative descriptions

Other comprehensive income:

It entails the incomes and expenses which are not permitted to be recognized in profit or loss as per the requirements of the other standards. It also includes the reclassification, adjustments

Reclassification Adjustments:

It is the reclassification of certain amounts to profit or loss during the current accounting period, which were previously recognized in statement of other comprehensive income

Total comprehensive income:

It is the increase or decrease in the equity in the current accounting period resulting due to the events and transactions, which are other than the transactions with shareholders in their capacity as owners.

General Features

Fair Presentation:

This standard requires that the financial. Performance, financial position and cash flows of an entity should be fairly presented. Fair presentation of financial statements, the events and transactions should be reported to financial statements in accordance with the recognition and measurement principle for the elements of financial statements, given in the IASB’s framework, and financial statements should be prepared in accordance with IFRS with related disclosure requirements.

To achieve the fair presentation, the entity should make sure the following:

•         The selection and application of accounting policies as per IAS8

•         The information contained in financial statements should have all the qualitative characteristics of financial statements

•         Complete disclosure should be given as per the IFRS

Un-reserved Statement

The entity which prepares financial statements in compliance with all the lFRSs, should place an un-reserved statement in the notes to accounts, in respect of such compliance with IFRSs. This is termed as un-reserved statement. However, the entity cannot make such a statement unless the financial statements are in compliance with all the requirements of IFRSs.

Disagreement with IFRSs

If in very rare situations, the management identifies that compliance with a particular requirement of a specific standard or Interpretation will result in the information, which is in conflict with the objectives of financial statements as laid down in the Framework, the entity will account for such situation as follows:

a) If the regulatory frame work permits departure from such requirement, the entity will take departure from that requirement and will disclose the following:

•         The financial statements fairly present the financial performance, financial position and cash flows of the entity, as per the judgment of management

•         The financial statements of the entity are in compliance with all the relevant IFRS’s other than the departure from the particular requirement

•         The title of the standard from which departure is taken, the details of departure and related reason for the departure

•         The financial effect on financial statements due to such departure

b) If the regulatory frame work does not permit departure from such requirement, the entity will reduce the related impact of such compliance by giving following disclosures:

•         The title of the standard from which departure is taken, the details of departure and related reason for the departure

•         The adjustment which is required as per the judgment of the management to achieve fair presentation

Going Concern

At the end of each reporting period, when entity will prepare its financial statements, the management is required to assess of whether the entity has ability to continue its business as a going concern. If management identifies that it has ability to continue its business as a going concern then its financial statement will be prepared on a going concern basis.

The entity will be treated as going concern, if it can continue its operations for the foreseeable future such that neither the management has intention nor the circumstances are there that the entity will have to curtail its business activities

Accrual Basis of Accounting

The entity is required to report all the events and transactions in the financial statements in the period to which these relate except for the cash flows

Consistency of Presentation

The entity should use the same accounting policies in the preparation and presentation of financial statements for the similar events and transactions, from one period to the next in order to ensure the comparability of financial statements unless the change is required by the circumstance laid down in IAS 8

Materiality and Aggregation

The entity is required to present each material class of items separately in the financial statements, unless these are immaterial.

Offsetting

The entity should not offset any assets and liabilities or any income and expense, except it is required by a IFRS

Frequency of Reporting

An entity shall present a complete set of financial statements (including comparative

Information) at least annually. When an entity changes the end of its reporting period and presents financial statements for a period longer or shorter than one year an entity shall disclose, in addition to the period covered by the financial statements

(a) The reason for using a longer or shorter period, and

(b) The fact that amounts presented in the financial statements are not entirely comparable. 

Comparative Information

This standard requires an entity to disclose the comparative information in respect of the previous accounting period similar to those amounts which are presented in the financial statements of the current accounting period

Identification of Financial Statements

The financial statements of the entity should be identified and distinguished from the other information using the following:

•         The title of the entity presenting financial statements

•         Whether these are the financial statements of an individual entity or consolidated financial statements for the group of entities:

•         The reporting date for which financial statements are presented

•         The presentation currency for the amounts reported in financial statements

•         The level of rounding up for the amounts reported in financial statements

Contents of Financial Statements

Statement of Financial Position

Assets:

The assets of the entity will be presented into current and non-current assets as per the definition on the face of statement of financial position, unless the presentation on the basis of liquidity is more appropriate

Current assets

The entity will present an asset as current asset, if it meets any of the following criteria:

•         It is held for trading in the normal course of business

•         It will be realized within a period of 12 months from the reporting date

•         It is expected to be sold or consumed in the normal course of business

•         It is cash or cash equivalent as defined in IAS 7

The entity will present all other assets as non-current assets.

Liabilities:

The liabilities of the entity will be presented into current and non-current liabilities as per the definition on the face of statement of financial position as follows:

Current Liabilities

The entity will present a liability as current liability, if It relates to the normal course of the business and will be paid within 12 months from the reporting date

The entity will present all other liabilities as non-current liabilities

Statement of Profit or Loss and other comprehensive income

The entity the all items of incomes and expenses relating to the current accounting period in the form of either:

•         A single statement of profit or loss and other comprehensive income or

•         Two separate statements, one is the statement of profit or loss and another statement of other comprehensive income

Statement of profit or loss

The entity will present the following Information in the statement of profit or loss at minimum:

•         Entity’s Revenue for the current accounting period

•         Interest costs

•         Entity’s share of the profit or loss from associates or joint ventures

•         Any reclassification adjustment recognized during the current accounting period

•         Income tax

•         Net profit or loss for the current accounting period

Other comprehensive Income

The entity will present the line items of statement of comprehensive income into two sections as follows:

a) Items that are not reclassify to profit or loss

b) Items that may be reclassify to profit or loss, when certain conditions will meet

The line items of statement of comprehensive income may be presented either

•         Net of tax or

•         Before tax with the tax effect being presented as a separate line item under the respective section

The entity is required to disclose the allocation of profit or loss and comprehensive Income as follows in addition to the statement of profit or loss and other comprehensive income:

a) Profit or loss for the current accounting period attributable to:

•         Owners of the group

•         Non-controlling interests in the entity

b) Total comprehensive income for the current accounting period attributable to:

•         Owners of the group

•         Non-controlling interests, and

Statement of Changes in Equity

The entity is required to present the following in respect of each component of entity, in the statement of changes in equity:

•         Changes in the elements of equity due to transaction with owners in the current accounting period

•         Changes in the elements of equity due to the total comprehensive income for the year

•         Changes in the components of equity due to the change in accounting policy

•         Changes in the components of the equity due to the requirement of a standard

Notes

These contain the information (financial and non-financial) in addition to the information which is presented in the other components of financial statements such as statement of profit or loss and other comprehensive income, statement of changes in equity, statement of financial' position and statement of cash flows. These are in the form of narrative descriptions and include the following:

•         Basis used by the entity for the preparation of the financial statements

•         Accounting policies of the entity

•         Disclosures required by the standards

1.23 IAS 2: INVENTORIES

Purpose: - The purpose of this standard is to formulate the method of computation of cost of stock, determine the value of closing stock to be shown in the Balance Sheet.

Definition: - IAS – 2 defines inventories as assets.

a)     held for sale in ordinary course of business (finished goods).

b)    in the process of production of such sale (raw material and work in progress).

c)     in the form of materials or supplies to be consumed with production process or in the rendering of services.

Measurement: - Stock should be valued at lower cost and net realizable value.

Cost: - Cost of inventory includes:

a)     Cost of Purchase.

b)    Cost of Conversion.

c)     Other cost incurred in bringing the inventories to their present location and condition.

Net Realisable Value (NRV): - means estimated selling price in the ordinary course of business less the estimated costs of completion of work in progress and estimated costs of making the sale.

Cost of Purchase: - Cost of purchase includes Purchase Price, Duties and Taxes, Freight Inward and other expenditure directly attributable to the acquisition. Less Duties and Taxes recoverable by enterprises from taxing authorities, Trade Discount, Rebate, Duty drawback.

Disclosure in Financial Statement: - The financial statement should disclose the following:

a)     Accounting policy adopted in measuring inventories.

b)    Cost formula used.

Classification of inventories i.e. finished goods, work in progress, raw materials etc.

1.24 NEED FOR COMPUTERIZED ACCOUNTING

The need for computerized accounting arises from advantages of speed, accuracy and lower cost of handling the business transactions.

1. Numerous Transactions: The computerized accounting system is capable of large number of transactions with speed and accuracy.

2.  Instant Reporting: It is capable of offering quick and quality reporting because of its speed and accuracy.

3.  Reduction in Paper Work: Manual accounting system requires large storage space to keep accounting records/books, and vouchers/documents. The requirement of books and stationery and books of accounts along with vouchers and documents is directly dependent on the volume of transactions beyond certain point.

There is a dire need to reduce the paper work and dispense with large volume of books of account. This can be achieved with the help of computerized accounting system.

4.  Flexible Reporting: The reporting is flexible in computerized accounting system. It is capable of generating reports of any balance as when required and for any duration which is within the accounting period.

5.  Accounting Queries: There are accounting queries, which are based on some external parameters. For example, a query relating to overdue customers’ accounts can be easily answered by using the structured query language [SQL] support of database technology in the computerized accounting system. Such an exercise would be quite difficult and expensive in manual accounting system.

6.  Online Facility: Computerized accounting system offers online facility to store and process transaction data so as to retrieve information to generate and view financial reports.

7.  Accuracy: The information and reports generated are accurate and quite reliable for decision-making. In manual accounting system, as many people do the job and the volume of transactions is quite large, such information and reports are likely to be distorted and unreliable and inaccurate.

8.  Security: This system is highly secured and the data and information can be kept confidential, when compared to manual accounting system.

9.  Scalability: The system can cope easily with the increase in the volume of business. It requires only additional data operators for storing additional vouchers.

1.25 FEATURES OF COMPUTERIZED ACCOUNTING SYSTEM

1. It leads to quick preparation of accounts and makes available the accounting statements and records on time.
2. It ensures control over accounting work and records.
3. Errors and mistakes would be at minimum in computerized accounting.
4. Maintenance of uniform accounting statements and records is possible.
5. Easy access and reference of accounting information is possible.
6. Flexibility in maintaining accounts is possible.
7. It involves less clerical work and is very neat and more accurate.
8. It adapts to the current and future needs of the business.

1.26 REQUIREMENTS OFCOMPUTERIZED ACCOUNTING SYSTEM

1. Accounting Framework: A good accounting framework in terms of accounting principles, coding and grouping structure is a pre-condition. It is the application environment of the computer­ized accounting system.

2.  Operating Procedure: A well-conceived and designed operating procedure blended with suitable operating environment is necessary to work with the computerized accounting system. The computer accounting is one of the database-oriented applications, wherein the transaction data is stored in well-organized database.

The user operates on such database using the required interface. And he takes the required reports by suitable transformations of stored data into information. Hence, it includes all the basic requirements of any database-oriented application in computers.

1.27 ADVANTAGES OFCOMPUTERIZED ACCOUNTING SYSTEM

1. Better Quality Work:The accounts prepared with the use of computers are usually uniform, neat, accurate, and more legible than manual job.

2. Lower Operating Costs:Computer is a labour and time saving devise. Hence, the volume of job handled with the help of computers results in economy and lower operating costs.

3. Improved Efficiency:Computer brings speed and accuracy in preparing the records and accounts and thus, increases the efficiency of employees.

4. Facilitates Better Control:From the management point of view, greater control is possible and more information may be available with the use of computer in accounting. It ensures efficient performance in accounting work.

5. Greater Accuracy:Computerized accounting ensures accuracy in accounting records and statements. It prevents clerical errors and omissions.

6. Relieve Monotony:Computerized accounting reduces the monotony of doing repetitive accounting jobs, which are tiresome and time consuming.

7. Facilitates Standardization:Computerized accounting facilitates standardization of accounting routines and procedures. Therefore, standardization in accounting is ensured.

8. Minimizing Mathematical Errors:While doing mathematics with computers, errors are virtually eliminated unless the data is entered improperly in the first instance.

1.28 DISADVANTAGES OFCOMPUTERIZED ACCOUNTING SYSTEM

1. Reduction of Manpower:The introduction of computers in accounting work reduces the number of employees in an organization. Thus, it leads to greater amount of unemployment.

2. High Cost:A small firm cannot install a computer accounting system because of its high installation and maintenance cost. To be more economical there should be large volume of work. If the system is not used to its full capacity, then it would be highly uneconomical.

3. Require Special Skills:Computer system calls for highly specialized operators. The availability of such skilled personnel is very scarce and very costly.

4. Other Problems: Frequent repair and power failure may affect the accounting work very much. Computers are prone to viruses. Often time’s people will assume the computer is doing things correctly and problems will go unchecked for long period of time.

1.29 PROBLEMS FACED INCOMPUTERIZED ACCOUNTING SYSTEM

1. User Training: The user, for using computer accounting software, needs to understand the concepts of the software. Hence, he should undergo proper training. A computer operator must learn the basics of computer, concepts of software, working with the operating system software [such as Windows/DOS] and the accounting software.

2. System Dependency:Using a computer solution makes the user to depend fully on the com­puter system and necessitates the availability of computer at all times. If the system is not available [due to hardware failure or power cut], it would be difficult to verify the accounts.

3. Hardware Requirements:A full-fledged computer system with a printer is required to operate the computerized accounting system. Most small organizations may not afford to have such facility with necessary software.

4. System Failure:When there is a system crash [hard disk crash], there is high risk of losing the data available on the hard disk drive at any point of time. It would be highly painful, if the problem occurs at end of the financial year, when the financial statements should be ready.

5. Backups and Prints:Backups of the data should be done regularly so that, when the data is lost, it can be restored from floppies [backups]. Regular print outs of the system information would be useful as manual records.

6. Voucher Management:Accounting software allows easy alteration of data. If a voucher is wrongly placed in a wrong head, it would be very difficult to sort out and bring back the voucher. A good voucher management is very essential.

7. Security:Additional security has to be provided because improper handling of the system [hardware/software] could be dangerous. Passwords, locks, etc., have to be set so that no unauthorized person can handle the system.