accounting principles and concepts

Accounting Principles -Concepts and Conventions

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Page 1: Accounting Principles and Concepts

Accounting Principles -Concepts and Conventions

Page 2: Accounting Principles and Concepts

Accounting Principles

Principle • general law or rule adopted or professed as a

guide to action• Includes practices, procedures, methods,

techniques, concepts and conventions in accounting.

Page 3: Accounting Principles and Concepts

Accounting Principles are acceptable, if they satisfy the following basic norms :

1) Relevance – refers to the usefulness of accounting data generated.

2) Objectivity – An accounting principle is said to be objective when it cannot be influenced by the personal bias and whims.

3) Feasibility – Accounting principle must be practicable. Cost Benefit Analysis.

4) FlexibilityAccounting principles are developed for common usage to

ensure uniformity and understandability.

Page 4: Accounting Principles and Concepts

Accounting principles are usually concepts and conventions which have been adopted as a general guide by the accountancy professional.

Concepts – a concept is a notion, an idea. It denotes the basic assumptions or propositions or predictions or conditions upon which accounting is based.

Page 5: Accounting Principles and Concepts

Accounting concepts are such ideas as are commonly associated with the theory and practice of accountancy. Concepts can be classified into 4 categories as follows.

a) Natural – i.e. matching cost with revenue is a natural concept.

b) Real i.e. practical eg. prov for RDDc) Ideal i.e. theoreticald) Borrowed concepts

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• Convention – denotes customs or traditions. It refers to a statement or rule of practice which,

by common consent express or implied, is employed in the solution of a given class of problems or guides behaviour in a certain kind of situation.

Conventions are established usages or rules or statement of practice.

Eg. Debit on left hand side, liability on left hand side, expenditure on left hand side etc.

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Accounting Concepts

1. Business/Separate Entity Concept2. Dual Aspect Concept3. Money Measurement Concept4. Going Concern Concept5. Cost concept6. Cost Attach concept7. Matching costs and revenue concept8. Realisation Concept9. Accrual Concept10.Accounting Period Concept

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Accounting Conventions

1) Conservatism2) Consistency3) Materiality 4) Disclosure5) Objective Evidence

Page 9: Accounting Principles and Concepts

1) Business Entity Concept

• A firm or business is regarded as separate and distinct from the owner.

• All transactions pertaining to business are recorded separately without mixing the private transactions of the owner.

• Proprietor is considered a creditor and his capital is shown as a liability for the business.

• Any amount/goods withdrawn by the proprietor are treated as drawings and reduced from his capital account.

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Following Accounting Equation is the expression of the entity concept

Assets = Liabilities + Capital The above equation shows that the business

itself owns the assets and in turn owes the various claimants.

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2) Dual Aspect Concept

• Every business transaction has dual effect i.e. twofold effect i.e. first receiving of the benefit and second giving of that benefit.

• For every receiver, there must be a giver. • So there must be a double entry to have a

complete record of each business transaction.• Thus every debit must have a corresponding


Page 12: Accounting Principles and Concepts

For eg. Mr. X started his business with cash Rs. 1,00,000 and purchased Plant and machinery worth Rs. 5,00,000 and furniture worth Rs. 1,00,000. Thus he has provided Rs. 7,00,000 to business.

Assets = Equities (or Liabilities + Capital)Cash + P & M + Fur = Capital

Page 13: Accounting Principles and Concepts

Subsequently, if the business purchases stock worth Rs. 80,000/- on credit, position will be as under.

Cash 100000 + P & M 500000 + Furniture 100000 + stock 80000 = Capital 700000 + creditors 80000

Thus, we see thatAssets = Liabilities + Capital

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3) Money Measurement Concept

• All transactions are recorded in terms of money.

• Money – used as a measuring unit for financial reporting

• Money acts as a means of indicating the value of the commodity or prices.

• Thereby simplifies the business of calculating the rate at which one commodity can be exchanged for another.

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• This concept makes accounting information more meaningful and useful for analysis of financial statements.

• Measurement of business events in monetary terms helps in understanding the exact state of affairs of the business in much better way.

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• For eg. A business unit has the following assets on 31st Dec 10

The above items are different in units and therefore they cannot be added together to get the idea of total value of assets

Capital Rs. 1,00,000

Cash in hand Rs. 5,000

Motor Cars 2 Nos.

Stock 100 Tons

Furniture 10 Tables and 50 Chairs

Land 5 Acres

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• If we express all above items in terms of money, we get a clear picture of the assets of business as under

Capital Rs. 1,00,000

Cash in hand Rs. 5,000

Motor Cars Rs. 3,00,000

Stock Rs. 50,000

Furniture Rs. 30,000

Land Rs. 5,00,000Total Rs. 9,85,000/-

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Limitations of money measurement concept 1) The value of money is not constant. It may change

due to inflation or deflation in the country.2) It restricts the scope of accounting because all

business assets cannot be measured in money terms. It is very difficult to calculate the value of goodwill, or measure the efficiency of employees or measure the efficiency of management, sales and pricing policy of management, working conditions etc.

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4) Going Concern Concept

• Also called as the “Concept of permanency” or “continuity concept”

• Assumed that the business will last for a long time and there will be no intention of closing down the business.

• It will continue to operate in future and transactions are recorded from this point of view.

• Going concern concept ensures a long life of the business.

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Main implications of a going concern concept

• The assets acquired need not be sold and are not meant for resale.

• The expenditure is classified into capital and revenue.

• The revenue income is compared with revenue expenditure to ascertain the results from business.

• The assets are recorded at cost and shown in the balance sheet at cost less depreciation

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• Deferred revenue expenditure and unexpired costs are carried forward to the next year.

• The fluctuations in the market rates are ignored. Exceptions 1) In case of liquidation, realisation value may be taken

into consideration.2) In case of contractual commitments, the cost of

equipment purchased is charged to that contract, even though the same equipment may be useful for a longer period.

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5) Cost Concept

• Is closely related to going concern concept. • Adopted for the purpose of convenience and

feasibility.• All transactions and events are recorded in

the books of accounts at the actual price involved.

• Acquisition cost is considered highly reliable, definite and free from bias.

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Limitations of cost concept1)Depreciation is computed on historical cost.

This understates the depreciation when current value of the asset is high. So revaluation of asset is necessary.

2)When the prices of all commodities are rising continuously, the financial accounts will not depict the true picture of business.

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3) This concept ignores managerial competence, reputation or goodwill, efficiency of employees as they cannot be expressed in terms of money.

4) Inter firm comparision becomes difficult.While considering the above limitations as such

it is recommended to adhere to the cost concept only.

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6) Cost Attach Concept

Total Cost = Material Cost + Labour Cost + Overhead Cost

When appropriate portion of material costs, labour costs and other overhead costs are added or merged together, product costs are obtained.

Also known as “Cost Merge Concept”

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7) Matching Costs with Revenue concept

• Also called as periodic matching of costs with revenues.

• Accounts should be presented at fixed intervals regularly.

• Revenue and cost incurred to obtain that revenue should be properly matched.

• This helps in measuring the business performance periodically.

• For eg. Profit = Sales Value – Total Cost• Or Loss = Total Cost – Sales Value

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• Following points to be considered for this concept1)Revenue is considered to be earned on the date of

transaction and not on the date at which payment is realised.

2)The purchase price of fixed assets is not taken but only depreciation on fixed assets related to that accounting period is taken.

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3) Expenses paid in advance are excluded from the total cost.

4) Outstanding expenses are added to the total cost to arrive at the cost attached to that period.

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8) Realisation Concept

• The profit on sale is generally regarded as earned at the time when the goods or services are passed on to the purchaser and the purchaser incurs the liability for that.

• No profit is considered to have been earned till it is either realised in cash or the other party involved is legally liable to pay the amount for sale of goods.

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• For eg. 1)Cash sales of Rs. 10,000/-, here the income is recd in

cash.2)Credit sales of Rs. 50000/-, here the seller creates a

legal right to receive the income. Thus, though the income is not recd in cash, still is said to be realized.

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• Exceptions1)Income like interest, rent etc. are credited to

profit and loss account on accrual basis, though they are not realised.

2)In case of hire purchase system, ownership of the goods passes to the buyer, when he pays the last instalment. But sales are presumed to have been made to the extent of cash received by way of instalment.

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9) Accrual Concept

• Also known as “Mercantile System of Accounting”• Revenue is recognised at the time of sale rather than

at the time of collection of cash.• It is a system of recording revenues whether they are

received in cash or not and expenses whether they are paid in cash or not.

• Outstanding, prepaid, pre-received expenses and income are considered under this concept.

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• Because of this concept, the net profit or loss of any period cannot be equal to corresponding cash increase or decrease.

• For this purpose, the necessary entries will be passed at the end of accounting year in respect of following items:

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a) Income earned but not receivedb) Income received in advancec) Income received but pertaining to previous

yeard) Expenses due but not paide) Expenses paid but not related to accounting


Page 35: Accounting Principles and Concepts

10) Accounting Period Concept

• The life of the business is divided into appropriate segments for studying the result of each segment.

• The life of business as per going concern is indefinite and therefore the businessman after each segment or time interval must “Stop” and “See back” how things are going on. Such segment or time interval is called as accounting period.

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• This concept indicates that the profitability of a business is to be measured periodically.

• The period for which income is measured is termed as accounting period.

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Accounting Conventions1) Conservatism

“Anticipate no profit but provide for all possible losses”

Also known as prudence concept implying the common and accepted behaviour of accounting

Eg. Closing stock is valued at cost or market price whichever is lower,creating a provision for doubtful debts,

Page 38: Accounting Principles and Concepts

• Following are the conservative practices adopted in accountancy

1)FA are shown are cost less depreciation.2)CA are shown at cost or market whichever is

less.3)Charging stock of medicines, stationery to profit

and loss account.4)Providing for doubtful debts and discount of


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2) Consistency

• The continuous application of the same accounting policy enables to compare results.

• Helps in preparing more reliable, comparable and dependable financial statements.

• Consistency does not mean inflexibility or forbidding introduction of improved accounting techniques.

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Consistency has to be followed in particular in respect of the following procedures

a)Calculation of Depreciationb)Valuation of materialc) Treatment of revenue and capital expenditureConsistency helps comparison of results. Once a

method or policy is adopted by the business it should be consistently followed.

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3) Materiality

• Materiality means the relative importance and is related to the convention of disclosure.

• Disclosure is necessary in financial accounts only for material facts.

• The cost of accounting a transaction should not be more than recording the transaction.

• What is material and what is not will be decided by individual judgement.

• materiality may differ from concern to concern and year to year.

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4) Full Disclousre

• All material facts should be disclosed in the final accounts.

• The object of disclosure is to make the financial statements more useful and to give less scope for misinterpretation.

• Significant events occurring after the end of the accounting year but before the preparation of balance sheet are to be disclosed.

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Important items requiring disclosure are as under :1) Contingent Liabilities2) Accounting methods and policies adopted by the

company.3) Changes in the method or policies of accounting and

their consequences on the profit.4) Items of non-recurring nature.5) Significant difference between the cost and market

value of stock.

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5) Objective Evidence