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MEANING OF ACCOUNTING THEORY

Accounting theory, a branch of accounting consisting of principles and methodologies for accounting, plays an important role in the foundation of prospective accounting professionals. It also helps them in performing various critical functions of management like planning, decision making,' controlling and analysing. For drawing meaningful conclusions by various users of accounting, the accounting information should be reliable as well as comparable. This would be possible only when the financial statements are based on accepted principles, policies and practices. And for this, it is necessary that assumptions, principles, modifying principles and accounting standards are thoroughly embedded in the roots of people engaged in accounting process.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

The expansion of business, separation of ownership from control and diversification of ownership, influences to develop such accounting techniques which should be based on some accepted principles and can be applied uniformly as guiding principles for financial reporting of a business enterprise. Keeping in view of the importance of accounting theory in the modem business environment, it becomes inevitable to develop certain rules and, principles that can generally be accepted by all persons involved in accounting. Interestingly, these rules are known by different terms such as principles, concepts, conventions, postulates, assumptions, modifying principles etc. Precisely, there is no difference, between the terms such as postulates, concepts, .principles etc. However, there are conflicting opinions on the usage of these terms. Terms which are called as postulates by some, are recognized as concepts and principles etc by some others. However in the succeeding paragraphs an attempt has been made to discuss these terms. An assumption or postulate is that which does not require any proof as they are self evident truths in accounting. These are the basic foundations in accounting process and without considering certain assumptions in accounting, financial statements cannot be prepared. Concepts are ideas or notion about the desirability and applicability of a particular method. Conventions are customs, based on the generally accepted practices. Conventions are also known as modifying principles. Concepts and conventions when combined together become principles. Thus, accounting principles are not man made; they have been evolved gradually, through an evolutionary process of combining concepts and conventions together. Since theory is needed to take any practical action, basic principles serve as a guide for that. Though these principles are not universal truths yet they are found to be pervasive in business entities.

in accounting.

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Instead of indulging ourselves into the semantics of these terms, it is rather more important to discuss their usage

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BUSINESS ENTITY ASSUMPITION (Separate Entity Concept)

According to this assumption , business is treated as an entity which is separate and distinct from its owners . It is further assumed that business has its own identity distinct from the owners, creditors, debtors, managers and others. In a sole proprietorship concern, the owner and the business enterprise both share the same legal existence but in accounting, however, they are treated as two different entities. Keeping in view of this assumption, business transactions are recorded in the books of accounts from the point of view of business enterprise and personal transactions of the owner are not included in the business transactions. Also, assets and liabilities of the owners are set aside in the preparation of financial statements of the business enterprise. Business entity assumption is applicable to all types of business organizations viz. sole proprietorship, partnership firms, companies etc. It should be noted that in case of companies, the legal relationship of company and its shareholders is also separate as against a sole proprietorship and partnership firms. Hence, in case of insolvency of proprietorship and partnership firms, the personal assets of such entities can be used for the purpose of business and vice versa. A leading case on this point viz Salomon v. Salomon & Co. is also referred to at every level. Keeping in view the importance of this assumption the following three points need consideration: (i) (ii) (iii) NEED In the preparation of financial statements of the business enterprise, business and the owner who constitute the business are treated as two separate entities, distinct from each other. If such an assumption is not considered, the operating financial results of a business enterprise cannot be obtained. A vague and confusing view would be drawn. It would be very difficult to distinguish the personal expenses and business expenses. To add further, a distinction between income of the business and income of the owner, which is a very crucial matter to determine the worthiness of business enterprise can not be drawn. LIMITATIONS Drawing a line of separation between the owner and the business is very thin in the case of sole proprietorship and partnership, but not so in the case of companies. Sometimes it becomes very difficult to differentiate between the personal expenses and business expenses. For example, use of personal car for the purpose of business or use of Business Transactions vs. Personal Transactions Business Assets & Liabilities vs. Personal Assets & Liabilities. Business Income and Personal Income.

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official phone for personal purposes etc.

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CASE STUDY-1 Mr., Prakash, a sole proprietor, introduces some cash as his capital in the business, Here, Mr. Prakash and the business which he owns are treated as two separate entities. One entity (i.e.Mr. Prakash) is giving money to another entity (i.e. Business). It is worth mentioning here that we should record the transactions in the books of accounts from the point of view of business. So in the business. The amount of capital is a liability because the business has to pay, back the amount of capital invested by Mr. Prakash. On the other hand. The amount of cash invested by Mr. Prakash is an asset for the business. The business can use this amount for the. Purpose of business. These shows. how the money introduced by the owner is treated as a liability for the business despite the fact that the business is owned by Mr. Prakash himself.

MONEY MEASUREMENT ASSUMPTION (Monetary Unit Concept)

This assumption distinguishes between the qualitative and quantitative aspect of a transaction. According to the money measurement concept , a fact or a transaction will be recorded in the accounting books only if the effect of such a situation or transaction can be computed in monetary terms. If such is not the case, no fact should be recorded irrespective it was very important and could affect the financial results of the business enterprise. For instance, adverse impact on sales due to lack of coordination between the sales team and production team cannot be recorded in the books of accounts, however, the Loss of goods by fire can be recorded in the books. NEED Money measurement concept plays a vital role in accounting, because critical decisions viz. fixing the selling price of product, paying dividend to. the shareholders, payment of salary and wages to the staff etc depend upon the value of an item and not the quantity Dr appearance of an item. LIMITATIONS Money measurements underline the fact that in accounting only those events, happenings or transactions can be recorded which can be measured in terms of money only. However, there are certain facts which, though important for judging the financial position of the business enterprise, cannot find place in the books of accounts because they cannot be measured in terms of money, For example, an efficient

business. This is the biggest limitation of money measurement concept.

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manager is not recorded as an asset or a dishonest employee is never recorded as a liability for a

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Another limitation is associated with the purchasing power, the primary characteristic of the monetary unit. Since the transactions are recorded at their money value on the date of occurrence, it ignores subsequent changes in the money value. In other words, money measurement ignores the impact of price level changes by not considering the inflationary movements into account.

CASE STUDY-2 th During 18 Century. Mr. A used to purchase gold@ Re.1 per kg during 19'h Century. Mr. B (grandson of Mr. A).used to purchase wheat @ Re.1 per kg during 20'h Century Mr. C (grandson of Mr. B). used to purchase salt @ 1 per kg. There are chances that Mr. D (grandson of Mr. C) could purchase only grass @ Re.1 per kg by the end of 21" Century. These transactions in the books of accounts are recorded at Re.1, But the items and their worth are different in different centuries. This is the biggest limitation of money measurement concept.

GOING CONCERN ASSUMPTION (Continuity of Activity Concept)

As the name suggests "Going Concern" means 'with the expectation of continuing indefinitely'. This concept underlines the assumption that the enterprise has neither any intention nor any necessity to close the business. The chances to cease to operate the business are too remote. Accounting is always done with a view that business entity will last for a long time. Accordingly, fixed assets are depreciated for a long time i.e. till their useful life. If this assumption is not considered, the whole cost of the fixed asset would be treated as an expense in the year in which that fixed asset is purchased. Based on Going Concern, the cost of the fixed asset is treated over the cost of the total years in which asset would give benefit from its usage: Deferred Advertising Expenditure is another example which is incurred in lump-sum and the benefits accrue indefinitely. Such expenditures are not charged in a single year's profits and are rather written off during the life of the business or the number of years we expect the likely benefits to accrue from it. Parties interested in the business will stay connected only when the longevity of the concern is assured. Otherwise they will be too scared to trust the continuity and availability of quality products. NEED

If the entrepreneur himself is doubtful of the longevity of the business enterprise, regular and increased

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The going concern assumption inspires and motivates the entrepreneurs to work with their full potential.

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earnings are doubtful because he will not plough back the profits into the business. He will not employ further capital in the business. Classification of long-term assets and current assets, long-term liabilities and current liabilities, long-term investments for obtaining higher rate of returns etc will not arise. The outsiders will not associate with the business for long-term contracts. In these circumstances, even the continuity of the business enterprise is doubtful not to speak of any expansion.

LIMITATIONS
Despite the significance of this assumption, it is not free from following shortcomings: Firstly, the financial statements are prepared on the assumption that the business will carry out its activities indefinitely i.e., for a long indefinite period. However, in many cases it can be seen that business enterprises close down their business activities after giving their financial statements. It only means that the results of the financial statements are misleading. Secondly, final position of the business can be known when the enterprise goes into liquidation. In that circumstance, there is hardly any use of such information.

CASE STUDY-3 During 2005-06, M/s Ram Industries purchases a fixed asset, say machinery costing Rs. 1,50,000. An asset is a bundle of services the enterprise will get for a long period from the usage of it. In this sense, the enterprise is actually buying the services of the machinery that the enterprise would receive over its estimated useful life. say 10 years. Is it fair to book the whole cost of machinery as an expense in the year 2005 itself? Certainly not. because the whole cost i.e. Rs. 1.50,000 would have not been consumed in the year 2005-06 itself. Instead it would give benefit for 10 years so the amount of total cost should be allocated in 10 accounting years and only a portion which is consumed during an accounting period shall be charged through revenue in that period. Contrary to this, the whole amount if charged to revenue would give misleading results. As the benefits from the usage of machinery would accrue for 10 years. so it is proper to distribute the whole cost in 10 parts and charge only a part in each accounting period to revenue.

ACCOUNTING PERIOD ASSUMPTION (Periodic Concept)

Accounting period is usually a period of one year and that year can be a financial year, a calendar year or
st st

accounting records and ascertainment of actual profit or loss but also in ascertaining the true and fair

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year starting from 1 April to 31 March. The accounting period not only helps in the maintenance of

any year of 12 months. However, for tax purposes, the accounting period should be a financial year i.e., a

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view of the financial position of the enterprise and also communicating the business information to the intended users. As per the Going Concern Concept, the business will continue its operations indefinitely i.e. for a fairly long period. Actual success or failure of a business enterprise is determined at the time of its final closure or when it ceases to operate the business permanently. But knowing the reasons for its success or failure at that point of time would hardly be of any use for the owners, management, financial institutions and other users because it's no use crying over spilt milk. For ascertaining the information about the profitability and feasibility of the business, users of accounting information cannot wait till indefinite period. Keeping this in view, the whole indefinite accounting period is divided into parts, known as accounting periods. Financial statements showing the financial results for those periods are prepared. In this way, management has enough time to take corrective and preventive measures. This would ease out the problems of both the proprietor and the various users of accounting information by timely evaluating the financial results in each accounting period. NEED Accounting period assumption facilitates the management to take timely action for remedial and corrective measures. It saves the business entity from going into liquidation because timely information facilitates the management in taking remedial measures. As per the statutory requirements of SEBI and Companies Act, 1956, accounting period assumes more importance. Accordingly, annual reports are to be prepared and submitted to the shareholders. Similarly, as per Income Tax Act, taxes on income shall be calculated on annual basis and that too on the basis of financial year. Companies whose shares are not listed on stock exchange are required to publish their financial position quarterly. LIMITATIONS Despite the significance of this assumption, it is not free from the following shortcomings: (i) Identification of accounting year is difficult

As per the accounting period assumption, business transactions are identified and recorded on the basis of that particular accounting period. However, in real life there are so many transactions which relate to more than one accounting period. Sometimes, it becomes very difficult to identify and establish to which accounting year such transactions relate. For example, deferred revenue expenditure or payment for the purchase of fixed assets. (ii) Misleading results when different accounting methods are adopted

Another limitation of accounting period arises when entities follow different accounting methods for recording of depreciation or stock valuation in different accounting periods. In those circumstances, results from comparisons of different accounting periods would be misleading.

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CASE STUDY-4 ABC Ltd was formed on 1.4.2000. 'Ram' (a prospective. investor), 'Mohan' (a lender), and 'Sohan' (a supplier) have to draft an opinion about the operational efficiency or solvency of the business enterprise. For this purpose they have to look for a reliable source of information. If any of the parties has the periodical data related to the profitability and operating activities of ABC Ltd. that would be the most sensible base for taking any decision. The question of period is important here because comparison of two successive cash flow statements explains the reasons for variations in the items of two periodic balance sheets and income statements. For example, balance sheets of 1.4.1979 and 1.4.2005 and income statements of the same period. would not serve any purpose. That is why a regular period is fixed for each business entity and financial statements are prepared accordingly. Such regular intervals are technically termed as 'Accounting Period'. In this connection regular annual report of ABC Ltd showing annual financial results helps Ram, Mohan and Sohan to take decisions related to their choice.

DUALITY (Dual Aspect Concept or Accounting Equation Concept)

As the name suggests, duality deals with double effect. This aspect provides the basis for recording all business transactions in the books of accounts, so it is regarded as one of the basic principles of accounting. According to this principle, every business transaction has a two fold effect . For instance, contribution of capital by the owner increases the assets of the business enterprise in the form of cash and at the same time it increases the owner's claim on the business. Thus, it also becomes a liability for the business enterprise. It is worth mentioning that basically, the dual aspect arises because of the business entity concept. As it proposes the owner and the business to be two distinct entities for accounting purposes, every transaction will have a double effect. Every giver is a taker and every taker is a giver. For instance, if a business purchases building on loan, it would have two effects, one of increasing the fixed assets and second of increasing the outsider's claim. Similar examples on the duality aspect can be observed in numerous forms. The duality aspect can be expressed in terms of an equation, known as accounting equation. There are three main variables or elements in any accounting equation viz. (i) Assets, (ii) Liabilities and (iii) Capital

Assets = Liabilities + Capital

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(Owner's Equity). These three elements are shown in the accounting equation as:

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The above equation shows that the assets of a business enterprise are equal to the total claims viz. claims of owner and claims of outsiders. Tutorial Note It is a golden rule that 'Accounting equation remains balanced all the time'; This is because of the reason that any change resulting from the business transaction also balances the same transaction Simultaneously.

NEED Duality aspect provides the basis for recording all business transactions in the books of accounts, so it is regarded as one of the basic principles of accounting. According to this principle, every business transaction has a twofold effect. LIMITATIONS This aspect establishes the relationship of business transaction in monetary terms. There are certain facts, which though important for judging the financial position of the business enterprise, cannot find a place in the books of accounts because they cannot be measured in terms of money. For example, an efficient manager is not recorded as an asset or a dishonest employee is never recorded as a liability for a business.

HISTORICAL COST (Cost Concept)

This principle assumes the importance in the field of accounting in the sense that monetary values of items are recorded in the books of accounts as per this concept. As per cost concept, all assets are required to be recorded in the books of accounts at their original cost. In other words, the assets are recorded at their purchase price which comprises cost of acquisition and all expenditure incurred for making the asset ready to use such as amount spent on its transportation, installation etc. Not only the assets are recorded at their cost price, the underlying principle also serves as the base for all subsequent accounting for the assets. For example, any short term, long term capital gain or depreciation would be calculated on the cost price. As such, if nothing is paid to acquire the asset that will not be recorded in the Balance Sheet. NEED (i) This concept provides greater objectivity and greater feasibility because assets are recorded at their

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remote.

cost price and not at their market value so chances of manipulation and window dressing in accounts are

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(ii) Delay in preparation of financial statement is avoided because assets are shown at their cost price. In contrast, many times it is not even possible to work out market values for certain assets as the values of those assets change frequently in the market. For example, land and buildings, computers, software etc. Consequently, financial statements preparation can get delayed a lot. (iii) This concept strengthens the assumption of going concern in the sense that going concern assumes that the business will operate its activities till indefinite period of time. So there is no need at all to use current values of the assets. Whether the business is adhering to the historical concept or not, a proper note should be given in the accounting policies and annexed at the end of their financial statements. LIMITATIONS The biggest limitations of this principle are: (i) The true worth of the business is not shown in the books of accounts and the business may hide gains had those assets been shown at their market values. (ii) Assets for which no amount is paid cannot be recorded in the books of accounts. For example, reputation or goodwill of the business enterprise. (iii) A balance sheet prepared on the basis of cost concept does not indicate the price at which the assets could be sold, as against a relevant balance sheet prepared on the basis of market value. Keeping in view the above, accounting information based on historical cost is not much useful to its users, creditors and financial institution in particular and management in general because the parties interested in the business e.g. prospective customers, investors, lenders, suppliers etc are interested in determining what the business is worth in today's date rather than its worth based on past data.

CASE STUDY-5 M/s Janaki Dass purchased a machinery for Rs.9, 70,000 for the business. In the books such machinery will be recorded at Rs. 9,70,000 throughout its life. irrespective of its market value. Any subsequent increase or decrease in the market value of the machinery should not be recorded in the books of accounts. It should be noted that the total cost of the machinery viz. Rs. 9. 70. 000 will be distributed to the useful life of the machinery each year as depreciation and the asset will appear at book value as against market value. Here book value means cost less depreciation.

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REVENUE RECOGNITION (Realisation Concept)

Recognising the revenue means recording the income in the income statement, prepared for a particular period. The revenue recognition facilitates to recognize the revenue, which should be included in the income statement. Stated in other words, the answers to two basic questions viz. (i) What should be termed as revenue and (ii) When that revenue is treated as realized, have been answered by this concept. The term revenue means and includes gross inflow of cash or other consideration arising from the sale of goods, rendering services and by use of resources of enterprise by others such as yielding interests, royalties and dividend etc. Revenues are assumed to be realized at that point of time at which goods have been sold and/or services have been rendered to the customers and a legal right to receive the revenue arises. As per revenue recognition concept, events and conditions are recorded In the books of accounts as and when they occur, rather than in the period of their receipt or payment. Accordingly, revenue earned during the year is to be recorded as against the revenue received during the year. From the above, we can say that revenue is realised when goods sold and/or services rendered by a business enterprise are transferred to the customer either for cash or for an acceptance to receive in future. In other words recognition of revenue has nothing to do with the actual receipt of cash or receipt of an order to supply goods. For example, a manufacturing house produces units of goods in January, 2006, which were to be supplied in April, 2006. In this case, the revenue will be considered in April, 2006 when the actual sale takes place. In case of extraction business, revenue is recognised the moment when natural resources (like coal from mines) is extracted out from mines. It only means that the revenue is realized, when either cash is received or a legal obligation is assumed by the customer to pay a certain sum in future. NEED When all transactions are settled in cash, revenue can be recognized immediately. However, this is not so in practical life. Many times, goods and services are sold or purchased on credit basis. Revenue recognition concept facilitates to recognize the revenue to be considered in the income statement for any particular year. The concept prevents the management from giving wrong information about the income, which is yet to be earned, to the various users of accounting information. LIMITATIONS The main limitations of revenue recognition concept are as under: (i) It fails to recognize the revenue in case of contracts for long-term projects. For example, contract for construction of Metro Rail Project which takes 10-15 years to complete. In this case, should we consider

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the whole amount of contract as revenue on the date of completion of the project or on the date of entering into contract? As per Income Tax rules, for each year, revenue is considered on the basis of the part of the contract completed during that year. (ii) In the case of goods sold on the basis of hire purchase system, the amount collected in each year as installment is treated as the revenue realized during that particular year instead of total selling price.

MATCHING PRINCIPLE (Matching Concept)

The matching principle facilitates to ascertain the amount of profit Or loss incurred in a particular period by deducting the related expenses from the revenue recognized during that period. Accordingly, all expenses incurred by the business entity during an accounting period should be matched with the revenue recognized during the same period. Similar to revenue recognition, expenses should not be recognised at the time when cash is actual1y paid. Instead it should be recognized when an asset or service has been used to earn the revenue. For example, expenses such as salaries of employees, electricity charges, etc. should be recognized on the basis of the period instead of payment of those expenses. Thus, recognized expenses to earn the recognized revenue, should only be recorded in the income statement of a particular period. In this parlance, total cost of fixed assets is allocated over the useful life of that asset as depreciation and charged to revenue. Similarly, when a heavy amount is paid for advertisement, benefit for which would be derived for 5 years, the whole amount shall not be treated as expense in the year in which the amount is paid. Rather, on the basis of benefits likely to be received from such expense it should be properly allocated over the 5 years. Following examples would further illustrate the concept of matching principle: In case of prepaid insurance, a part of insurance related to the next accounting period should be shown on the asset side of the Balance Sheet of the current year which would be ultimately shown as expense in the later years . If the amount of revenue is received this year but service against that is yet to be rendered then this will be shown as a liability in the Balance Sheet because the business is under an obligation to deliver the services in future. An asset destroyed by fire. It will be charged against profit for the year only to the extent not recoverable from insurance i.e., book value less insurance claim admitted by the insurance company.

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NEED It is helpful in measuring the income (profit) for the given period by relating expenses to the associated revenues. The matching principle facilitates to ascertain the amount of profit or loss incurred in a particular period by deducting the related expenses from the revenue recognized during that period. LIMITATIONS The limitations of the matching concept are as under: (i) It does not take inflationary pressure into consideration. This principle fails to take inflationary pressures into account. For example, a machinery purchased originally for Rs. 1,00,000 in the year 2003 might be worth more than many times after some/years. But depreciation is charged every year on the original cost only. (ii) Sometimes it is very difficult to estimate the actual benefits received and the benefits likely to be received in future periods. In that case proper allocation of expenses related to the current year and future years would be a difficult task. For example, amount paid for advertisement. Above all, matching principle constitutes one of the most crucial concepts in accounting and should be understood thoroughly before recording transactions in the books of accounts.

CASE STUDY-6 During 2004-05 M/s Nanda Enterprises, purchased goods costing Rs. 2.00,000. During the aforesaid period it could sell only half of this at Rs. 1,50,000. During the year 2005-06 it had not purchased any goods but sold the remaining stock at Rs. 1,75,000. Does it mean that during the year 2004-05, M/s Nanda Enterprises had sustained a loss of Rs. 50,000 i.e., difference of total cost incurred on the purchase of goods (Rs. 2,00,000) and total receipts from the sale of goods during that period (Rs.l,50,OOO) and during 2005-06 it had generated a revenue of Rs. 1,75,000 as during 2005-06 it had not purchased any goods. Certainly not! Had the concept of matching revenue with the expenses not been known, it could have been so. The matching principle facilitates to ascertain the amount of profit or loss incurred during a particular period by deducting the related expenses from the revenue recognized during that period. Accordingly, for calculating profit or loss for the year 2004-05 we should not take the total cost of goods purchased but consider only the cost of those goods that have been sold during the year 2004-05. Thus, correct profit for the year 2004-05 is Rs. 50,000 being difference of half of total cost incurred on the purchases of goods (Rs. 1,00,000) and total revenue

75,000 being the difference between remaining half of cost incurred on the purchases of goods (Rs. 1,00,000) and total revenue realized from the goods sold during the year (Rs.1,75,000).

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realized from the goods sold during the year (Rs.l,50,OOO). Similarly, profit for the year 2005-06 is Rs.

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FULL DISCLOSURE PRINCIPLE (Full Disclosure Concept)

The principle of full disclosure directs a business enterprise towards disclosing the full, fair and sufficient information. Since one of the primary objectives of accounting is to communicate with the intended users, full disclosure in the financial statements and accompanying footnotes acts as a means of communicating all relevant, material and reliable information to them. Stated differently, no information of substance should be concealed in the financial statements. The users here can be both internal and external. For instance, top level management requires information for planning, for which it requires internal papers like production reports, cash budget report etc. Similarly, external users like banks, creditors etc have to rely on financial statements as the source of information. In this connection, certain regulatory authorities have made innumerable strict clauses for the disclosure of essential information through financial statements and reports. For example, Security Exchange Board of India (SEBI) has made it compulsory for certain types of companies to annex Corporate Governance Report in the annual report showing their financial results. Similarly, Companies Act has made it compulsory for all the companies to use the formats provided by it for the preparation of Profit and Loss Account and Balance Sheet, including complete details regarding the items to be included and their placement including the contents of foot notes. This shows that disclosure of all material facts is compulsory but it does not imply that even those figures which are irrelevant are to be included in financial statements. It just requires all the material information i.e. any fact or figure which has the capacity of altering the decisions of users, associated with the enterprise, must be conveyed in an organized and reliable manner. NEED Information contained in the financial statements is used by various users such as investors, management, lenders, creditors and others for taking various decisions pertaining to them. In this context it becomes more important to disclose all material facts relating to the financial performance of a business enterprise fully in their financial statements and their accompanying footnotes to enable them to take decisions about profitability and financial soundness about the business enterprise. LIMITATIONS The limitations of full disclosure are as under:

of business organization.

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The information contained in the financial statements is historical in nature and reflects the past position

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(i)

Historical in nature

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(ii)

Records only monetary transactions

The information which can be measured in terms of money can be recorded in accounting. A lot of transactions, though important and have a significant impact on the working of enterprise, do not find place in books of accounts as they are non-financial in nature. For example, in-effective control prevailing in the organization, inefficient employees, market conditions, change of government policies etc. (iii) Window Dressing and Personal bias

Sometimes, events are measured on the basis of estimates. In those cases, judgment of the person who is estimating the events plays a vital role in accounting. For example, estimating the useful life of the asset for calculating of depreciation. So we can say window dressing and personal bias of an individual influence the personal judgments.

ACCRUAL CONCEPT
Accrual concept says that revenue is recognized when it is realized and expenses are recognized in that accounting period in which they facilitate to earn the revenue. In both the cases it should not be the criteria whether actual cash is received or not (in case of revenue) and actual cash is paid or not (in case of expenses). In this sense, a mere promise to pay is also considered revenue from the point of view of receiver and expense from the point of view of payer. NEED The basic objective of accrual concept is that earning of revenues and expenses (i.e., consumption of resources) can definitely be related to a particular accounting period, so revenue and expenses should be considered as earned and incurred respectively on accrual basis instead of cash basis. LIMITATIONS The main limitations of this concept are as under: (i) Allocation of revenue and expenses between different years on the basis of accrual is a time consuming process. (ii) In the case of goods sold on the basis of hire purchase system, the amount collected in each year as instalment is treated as the revenue realized during that particular year instead of total selling price.

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OBJECTIVITY PRINCIPLE (Verifiability&. Objectivity Evidence Concept)

This principle proposes that every accounting entry in the books should be verifiable against evidences like vouchers, cash memos, cheques etc. In other words, if there is a certain quantity of goods purchased, it should be verified against the cash memo for the quantity, quality and price mentioned therein. The evidence showing the validity of a business transaction should be objective enough. In other words, the evidence should state the facts as they are, without a bias towards either side. In addition, the supporting documents like invoices, memos, and cheques provide the basis for making accounting entries and for later audit of accounts. However, every accounting entry is not subject to verification; also the same is neither possible nor feasible. To sum up, it can be said that this principle holds that accounting should be free from personal bias. NEED The verifiability and objectivity in accounts support the thought that books and accounts show true and fair view of the business concern. This principle also serves as the base for adoption of Historical Cost, as assets are recorded at their cost price instead of market value and this cost price can be verified from the books of accounts. if those transactions are duly supported with. the' documentary evidences. LIMITATIONS Each and every transaction is not subject to verification because the same is neither possible nor feasible. The same voucher can be used for more than one purpose. For example, the same voucher for petrol can be used for different cars used by the business enterprise. It can be said that this principle holds, when the intention of the persons involved in accounting is not malafide and they are not pressurized by the owner and management.

MATERIALITY (Materiality Concept)

As per full disclosure concept each and every aspect related to business enterprise should be fully disclosed in the financial statements but sometimes it is not possible to disclose all the information. In this context materiality requires that accounting should focus on material facts and efforts should not be wasted in presenting the facts which are not so important or immaterial. In this connection one important question arises -What is material? It may happen that one fact is material for someone but not for others and vice versa. If any fact or figure has the capacity of changing or varying the decision of any intended users viz. owner, management, creditors etc. it is said to be a material fact. Hence, the immaterial items are to be merged with other items. Irrelevant items can

or not should be taken with due care and utmost diligence. In this connection one should put oneself in other's shoes and try to understand how relevant that information for one is. For instance, variation in

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sometimes be left out from recording. But the decision whether the transaction fact or figure is material

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CONCEPT & CONVENTIONS
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the amount of profits of two consecutive years due to change in depreciation policy, inventory valuation, abnormal circumstances like lockouts, earthquake etc. are material. However, decrease in sales due to less demand is irrelevant. NEED Material information in the financial statements helps the intended users to take decision relating to their interest. Containing only material information in the financial statements does not overburden the financial statements. LIMITATIONS The major limitation of this principle is that there is no consistency about the meaning of material. Sometimes it may happen that one fact is material for someone but immaterial for others and vice versa.

CONSISTENCY CONCEPT (Consistency Convention)

This concept proposes to keep the methodology, policies of the business consistent and unchanged, so as to draw conclusions and facilitate decision making. In policy formulation, it is necessary that both interfirm and inter-period (intra-firm) comparisons should be made. These comparisons can be possible when during the period of comparison; same methodology and policies are adopted by different entities. Hence, in order to enable the management to draw important conclusions on the operations of a company over a couple of years, it is necessary that the accounting practices and methods remain unchanged during all accounting periods in question. However, it should be noted that this concept should not be looked at as a method of no flexibility. It is worth mentioning here that discarding an old and inappropriate technique is always welcomed. Here, it is important to make a distinction between clauses and adjustments which appear as/being inconsistent but actually they are not. For instance, inventory is valued at cost or realizable value, whichever is lower. It might sound like an inconsistent clause but actually is not. Rather it is just an application of the Accounting Standards issued by Institute of Chartered Accountants of India. As against this, take a case of provision for doubtful debts. In one year the business enterprise has estimated doubtful debts on percentage basis and in the other year on age old basis. This seems absolutely fair in terms but is actually inconsistent. NEED Principle of consistency is equally important as a basic assumption of accounting because it helps in decision making function of the management. It also helps other users of accounting information to take

There are several accounting methods for different methods and it is not possible that the all the entities

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decisions related to their interest.

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in the same trade use the same techniques. For example, for valuation of stock, one entity may select First-in-First-out (FIFO) method and other entity- may select Last-in-First-out(LIFO) method. But in both the cases the results would be different. Business entities also switch over from one method to other very frequently. In those circumstances a meaningful conclusion cannot be drawn. To overcome the above limitations, it is necessary that any changes in the policy of the company or financial statements should be well informed to the users and the method once adopted by the entity should be followed by them atleast for some years so that trend of the operational efficiency can be evaluated.

PRUDENCE (CONSERVATISM)
The convention of conservatism, also known as prudence, is based on the policy of 'playing safe'. Accordingly, all anticipated profits should be ignored but all anticipated losses should be accounted for . The convention requires that profits in anticipation should not be recorded but losses in anticipation should immediately be recorded even if there is a very remote possibility of occurrence of such losses. This convention is based on the rule that "anticipate no profits but provide for all possible losses." Thus, a cautious approach should be adopted in ascertaining the income of the business entity with the objective that profits of the enterprise in no case be overstated. The overstatement of profits may lead to distribution of excess dividend, resultant reduction in capital of the business enterprise.' When there is more than one equally acceptable method available, the ( method which is nearer to conservative approach should be adopted. !tis because of this that conservatism is also called prudence principle so that the rational application of the same could be possible in circumstances of uncertainty and doubt. In the same parlance, business entities are required to: (i) (ii) (iii) (iv) (v) (vi) value stock at cost or realizable value whichever is lower; create provision for doubtful debts; create provision for discount on debtors; ignore the provision for discount on creditors; create investment fluctuation reserve; show the joint life policy at its surrender value on the asset side of the balance sheet; (vii) NEED The convention of conservatism is a pessimist approach in accounting, but for dealing with the write off intangible assets like goodwill, trademark, patents as early as possible.

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distributing fictitious profits as dividends.

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uncertainties it is a must. In this way interests of lenders and creditors are also protected by not

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LIMITATIONS (i) Inconsistent with the principle of consistency

Convention of conservatism leads to inconsistency in the sense that while adopting the methods which would have least effect on overstatement of profits and assets, sometimes in two successive years the business entities have to adopt two different methods of accounting. For example: in one year stock' is valued at cost price (being less than the realizable value) and in the next year stock is valued at market price (being less than the cost price). (ii) Creates secret reserves

Too much of conservatism might lead to misinterpretation and result in creation of secret reserves Which goes against the principle of full disclosure. It is reminded again that the tool of principle of conservatism should be used in the most cautious and rational manner.

CASE STUDY- 7 Four entrepreneurs viz. Mr. A, Mr. B, Mr. C and Mr. D were doing the business of manufacturing toys since 1998. Fortunately, they were close friends and were also residing in the same locality. During the year 2001, a likely loss of Rs. 5, 00, 000 on account of bad debts was foreseen in the businesses of both Mr. A and Mr. C. Similarly. as per market trend a likely gain of Rs. 5,00,000 on account of getting discount on creditors, was expected to be received both in the businesses of Mr. Band Mr. D during the year 2005. Now, we shall examine their approaches for treating the anticipated losses and gains and consequences thereof on their respective businesses. Mr. A was under the impression that as this loss was not a confirmed loss, so it ought not to be recorded in the books of accounts. Unfortunately, debtors of Rs. 5,00,000 proved bad in the year 2005 in the business of Mr. A As Mr. A had not created any provision for doubtful debts in any of the past years, so he was shocked and died of heart attack. Consequently, the business of Mr. A was shut down. Mr. B was the close neighbour of Mr. A and he was aware of the reasons for Mr. As death viz. non-creation of any provision for doubtful debt. Hence, he had created the provision for discount on creditors and showed this as an income in the year 2001. Thus, profits for the year 2001 of Mr. B were overstated by Rs. 5,00,000. In anticipation of this profit he had also undertaken some heavy liabilities to be paid sometime during 2005. Unfortunately, this discount was not given by the creditors and consequently incomes for the year 2005 were reduced by Rs. 5,00,000. Mr. B

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his business too was shut down.

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was not prepared for this reduction of income, he was also shocked and died of heart attack and

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CONCEPT & CONVENTIONS
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Mr. C was the immediate neighbour of Mr. B. and he was fully aware of various development relating to business of A and B. In view of this, Mr. C had created the provision for doubtful debts and showed this item in his income statement. Unfortunately, debtors of IRs. 5, 00, 000 proved bad in the year 2005 in the business of Mr. C. Mr. C has prepared himself For this loss, so he was not shocked and instead was able to take the loss in his stride. His business went on smoothly. was the immediate neighbour of Mr. C and he also had full knowledge of development relating to different aspects of business of Mr. A, Mr. Band Mr. C. Keeping the same in view, , Mr. D had not created the provision for discount on creditors and decided that such profits shall be considered only on the actual occurrence. Fortunately,' creditors allowed him a discount of Rs. 5, 00, 000. Consequently, his incomes for the year 2005 were increased by Rs. 5, 00, 000. This was the unexpected gain for him. He felt very happy and celebrated with great pomp and show. His business went on growing further. From the above, it can be concluded that features of Mr. C and Mr. D are acceptable and features of Mr. A and Mr. B should be avoided in the accounting practices .. So for a sound business practice, features of both Mr. C (do not anticipate for losses) and Mr. D (do not anticipate for profits) should be adopted which is also known as prudence. It is strongly recommended that in accounting, anticipated profits should be ignored but anticipated losses should be accounted for. as overstatement of profits and assets is more dangerous than the understatement. Similarly, understatement of losses and liabilities is more dangerous than no estimation.

TIMELINESS
This principle basically proposes to provide and update the various users in accounting with the relevant and recent financial and operational information about the business enterprise. Necessary steps should be taken to inform the relevant information to the different users in time. The relevant information should be regularly and timely made available to the interested parties. For example, issuing segment wise quarterly financial results b)' the companies is the step ahead in accounting to achieve the objectivity of this principle.

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ALGOL SCHOOL OF MANAGEMENT & TECHNOLOGY

CONCEPT & CONVENTIONS
V P SINGH 9899225022
NEED We know that accounting is the -process of identification, measurement,. recording and communicating economic events of an entity to all concerned. When at the time of recording data, details of the current year's sales are not furnished, the whole purpose of accounting i.e., to make the relevant information available to the users for their convenience is defeated, The information should be. regularly and timely made available to the interested parties. LIMITATIONS Information furnished without waiting for the audited results may mislead the users because in many cases it had happened that there was a huge difference in the before audited and after audited financial statements. Moreover, to save the time, audit observations of the auditor are concealed and not furnished to the users. In that case, the whole purpose of providing information to the users in time is defeated.'

SUBSTANCE OVER FORM

This principle, as the name suggests, complements materiality. It explains that even if a transaction, a fact or figure is not appropriate from a legal point of view but constitutes substance either money-wise or otherwise, it should find a place in the financial statements of the company . . For example, debentures issued as collateral security to a financial institution. Even if those debentures are not a part of assets of lending financial institution until the company fails to repay the amount of loan to the financial institutions; these debentures are shown as the assets by the financial institutions. Similar is the position in case of hire purchase transactions in which hire purchaser does not become the owner legally, even than that asset is shown in his balance sheet on the assets side. The main theme is that in these transactions the substance of the transaction is that the asset is immediately acquired by the hire purchaser and he has to pay the loan along with interest. NEED Transactions which are different from substance or fundamental commercial reality find place in the books of accounts due to this concept. LIMITATIONS When ownership is not transferred legally, recording assets in the books of accounts defeat the purpose of providing full information to the intended users. '

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ALGOL SCHOOL OF MANAGEMENT & TECHNOLOGY

CONCEPT & CONVENTIONS
V P SINGH 9899225022

VARIATIONS IN ACCOUNTING PRACTICES

Inspite of providing detailed clauses; guidelines and provisions for recording all kinds of financial data in accounting books of business, it sometimes does not seem to be enough. In other words, an exhaustive list of guidelines sti11 does not exist in the corporate world. This is so because inspite of being a part of the same industry, business entities follow different accounting practices. This is called variations in accounting practices. For instance, accounting treatment of contingent liability, depreciation, valuation of inventory is being dealt with differently by various business entities. Take another example. As a general practice, inventories are recorded .at cost price or net realisable value whichever is less but in case of agricultural products, crops are shown at contract price. support price or market price. Thus we can conclude by saying that sometimes existence of such a descriptive list of provisions and guidelines becomes immaterial and management is bound to follow the intercompany on inter-industry rules. NEED Sometimes, distinctiveness of a particular industry requires departure from some accounting principles because of their inapplicability in those types of industries. For example, valuation of gold at market price instead of cost price. LIMITATIONS It is very difficult to compare the profitability of two different entities if they belong to different industries. despite the fact that same amount of capital is invested in both the entities as different methodologies are adopted by those entities.

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