Question.1)Explain the various accounting concepts and
examine the role of accounting concepts in the preparation of financial
statements.
Ans :
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There are the necessary assumptions or
conditions upon which accounting is based.Accounting concepts are postulates,
assumptions or conditions upon which accounting records and statement are
based. The various accounting concepts are as follows:
1. Entity Concept:
For accounting purpose the “business” is
treated as a separate entity from the proprietor(s). One can sell goods to
himself,, but all the transactions are recorded in the book of the business.
This concepts helps in keeping private affairs of the proprietor away from
the business affairs. E.g. If a proprietor invests Rs. 1,00,000/- in the
business, it is deemed that the proprietor has given Rs. 1,00,000/- to the
“business” and it is shown as a “liability” in the books of the business.
Similarly, if the proprietor withdraws Rs. 10,000/- from the business, it is
charged to them.
2. Dual Aspect Concept:
As per this concept, every business
transaction has a dual affect. For example, if Ram starts business with cash
Rs. 1,00,000/- there are two aspects of the transaction: “Asset Account” and
“Capital Account”. The business gets asset (cash) of Rs. 1,00,000/- and on
the other hand the business owes Rs. 1,00,000/- to Ram.
3. Going Business Concept (Continuity of
Activity):
It is assumed that the business concern
will continue for a fairly long time, unless and until has entered into a
state of liquidation. It is as per this assumption, that the accountant does
not take into account the forced sale values of assets while valuing them.
4. Money measurement concept:
As per this concept, in accounting
everything is recorded in terms of money. Events or transactions which cannot
be expressed in terms of money are not recorded in the books of accounts,
even if they are very important or useful for the business. Purchase and sale
of goods, payment of expenses and receipt of income are monetary transactions
which are recorded in the accounting books however events like death of an
executive, resignation of a manager are such events which cannot be expressed
in money.
5. Cost Concept (Objectivity Concept):
This concept does not recognize the
realizable value, the replacement value or the real worth of an asset. Thus,
as per the cost concept
a) as asset is ordinarily recorded at the
price paid to acquire it i.e. at its cost, and
b) this cost is the basis for all
subsequent accounting for the asset.
For example, if a machine is purchased for
Rs. 10,000/- it is recorded in the books at Rs. 10,000/- and even if its
market value at the time of the preparation of the final account is Rs.
20,000/- or Rs. 60,000/- the same will not considered.
6. Cost-Attach Concept:
This concept is also known as “cost-merge”
concept. When a finished good is produced from the raw material there are
certain process and costs which are involved like labor cost, power and other
overhead expenses. These costs have a capacity to “merge” or “attach” when
they are broughtr together.
7. Accounting Period Concept:
An accounting period is the interval of
time at the end of which the income statement and financial position
statement (balance sheet) are prepared to know the results and resources of
the business.
8. Accrual Concept:
The accrual system is a method whereby
revenue and expenses are identified with specific periods of time like a
month, half year or a year. It implies recording of revenues and expenses of
a particular accounting period, whether they are received/paid in cash or
not.
9. Period Matching of Cost and Revenue
Concept:
This concept is based on the period
concept. Making profit is the most important objective that keeps the
proprietor engaged in business activities. That is why most of the
accountant’s time is spent in evolving techniques for measuring the
profit/profitability of the concern. To ascertain the profit made during a
period, it is necessary to match “revenues” of the period with the “expenses”
of that period. Income (profit) earned by the business during a period is
compared with the expenditure incurred to earn the revenue.
10. Realization Concept:
According to this concept profit, should be
accounted for only when it is actually realized. Revenue is recognized only
when sale is affected or the services are rendered. However, in order to
recognize revenue, receipt of cash us not essential. Even credit sale results
in realization as it creates a definite asset called “Account Receivable”.
However there are certain exception to the concept like in case of contract
accounts, hire purchase etc. Similarly incomes like commission interest rent
etc. are shown in Profit and Loss A/c on accrual basis though they may not be
realized in cash on the date of preparing accounts.
11. Verifiable Objective Evidence Concept:
According to this concept all accounting
transactions should be evidenced and supported by objective documents. These
documents include invoices, contract, correspondence, vouchers, bills,
passbooks, cheque etc.
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Financial accountants produce financial
statements based on generally accepted accounting principles of a respective
country. In particular cases financial statements must be prepared according to
the International Financial Reporting Standards.
Financial accounting serves the following purposes:
Financial accounting serves the following purposes:
- producing
general purpose financial statements
- producing
information used by the management of a business entity for decision
making, planning and performance evaluation
- Producing
financial statements for meeting regulatory requirements.
- Solution
Accounting is the language used by businesses
to communicate their financial information and performance to interested
parties. Like every language accounting too has a set of concepts that it is
based on. Accounting has a set of twelve fundamental concepts that form the
basis of all accounting; these concepts are called the General Accepted
Accounting Principles (GAAP). These concepts explain the meaning of all the
figures that are found in the financial statements of a company.
In financial accounting, there are basic
concepts that govern the preparation of financial statements. Prudence is one
of several basic concepts used for that purpose. It suggests that assets
or revenue should not be overstated. On the flip side, liabilities and
expenses should not be understated either.
The aim of the prudence concept is toreflect
the least favourable position of a business. To those unfamiliar with
the concept, it might seem strange to want to do this. After all, a healthy
position can work in a business’ favour sometimes. This principle is important
in facilitating faithful representation – ensuring that financial statements do
not mislead or give false optimism to their various users. As such, the
prudence concept is a fundamental accounting principle, with the first
International Accounting Standard (IAS I) outlining its role.
- In
accounting, there are sometimes many routes to one result. For example,
you can value an asset according to Net Realisable Value or Replacement
Cost. Or you have different ways of evaluating stock and estimating
depreciation of an asset. In cases such as these, the prudence concept
suggests that the chosen method should provide the most conservative
result. This is seen in stock valuation, where stick is valued at cost and
not revenue potential.
- Where
expenses and liabilities are concerned, prudence suggests the opposite. A
liability or expenses need only be expected or anticipated to be
recorded. For instance, assume that a business has to pay insurance costs
at the end of the calendar year. However, if the financial statement is
prepared, it should take account of that expected expense. Organizations
should deal with devalued stock and debt servicing accordingly.
- This
fundamental principle also applies to handling of profit or losses.
A profit cannot be reported unless it is realized. For example,
assume that a business purchases an asset. Overnight, the asset value
soars; if the business sells the asset now, it would make a profit. However,
unless it actually sells the asset for a profit, it should not be
documented. In addition, profit should be in cash form (this makes it
determinable) and should also be reasonably certain (to avoid speculative
profits).
The prudence concept can conflict with other fundamental concepts – like the accruals basis of accounting. Accruals recognize transactions that have not yet been completed – like a hire purchase sale or prepaid expenses. In such cases, one principle (in this case, accruals) should prevail.
Prudence, along with other fundamental
principles, creates a sound platform for accounting. However, note that it is
no excuse for an organisation to withhold revenue or create hidden reserves.
After all, that conflicts with the principle of Fair Presentation
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