Theory Base of Accounting

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Test Your Understanding – I
Choose the correct answer

  1. During the life-time of an entity accounting produce financial statements with which basic accounting concept:
    1. Conservation
    2. Matching
    3. Accounting period ✔
    4. None of the above
  2. When the information about two different enterprises have been prepared and presented in a similar manner the information exhibits the characteristic of:
    1. Verifiability
    2. Relevance
    3. Reliability
    4. None of the above ✔
  3. A concept that a business enterprise will not be sold or liquidated in the near future is known as:
    1. Going concern ✔
    2. Economic entity
    3. Monetary unit
    4. None of the above
  4. The primary qualities that make accounting information useful for decision-making are:
    1. Relevance and freedom from bias
    2. Reliability and comparability ✔
    3. Comparability and consistency
    4. None of the above
Test Your Understanding – II
Fill in the correct word:

  1. Recognition of expenses in the same period as associated revenues is called _________________ concept. (Matching)
  2. The accounting concept that refers to the tendency of accountants to sold uncertainty and doubt in favour of understating assets and revenues and overstating liabilities and expenses is known as _______________ (Conservatism)
  3. Revenue is generally recognized at the point of sale denotes the concept of ______________ (Revenue Realization)
  4. The _________________ concept requires that the same accounting method should be used from one accounting period to the next. (Consistency)
  5. The ________________ requires that accounting transaction should be free from the bias of accountants and others. (Objectivity)
Short Answer Questions
1. Why is it necessary for accountants to assume that the business entity will remain a going concern?
The accountants consider that the business entity is a going concern as it provides the basis for showing the value of the assets in the balance sheet.
This assumption will allow the business to charge only that part of the asset which has been consumed or used to earn the revenue from the revenues earned during a period. The rest of the asset will be carried forward to the next years, over the estimated life of the asset.





2. When should revenue be recognized? Are there exceptions to the general rule?
The right time to recognize the revenue is the the time when it is realized i.e. when the legal right receive the revenue arises. Ex: the moment the goods have been sold or services are rendered. Thus the credit sales will be considered as revenue even though the money is collected at a later point of time.
The exceptions to the revenue realization principle are:

  1. When goods are sold on hire purchase, the amount collected in installments is treated as realized.
  2. In case of contracts like construction work, which occur for long periods of time. In this case, the revenue is considered to be realized periodically in proportionate to the amount of contract work completed.
3. What is the basic accounting equation?
The basic accounting equation states that the assets of a business are always equal to the claims of the owners and the outsiders. The outsiders claim is referred to as Liability (creditors equity) and the owners’s claim is referred to as capital(owners’ equity).
It can be expressed as

Assets = Liabilities + Capital

Every transaction that happens will have a two-fold effect in such a way that the equality of the accounting equation is maintained on both the sides.

4. The realization concept determines when goods sent on credit to customers are to be included in the sales figure for the purpose of computing the profit or loss for the accounting period. Which of the following tends to be used in practice to determine when to include a transaction in the sales figure for the period. When the goods have been:

  1. dispatched
  2. invoiced
  3. delivered
  4. paid for

Give reasons for your answer.

The transaction is included in the sales figure for the period after preparing the invoice. This is due to the fact that immediately after preparing the invoice the customer acquires the legal right to own the goods.
5. Complete the following work sheet:

  1. If a firm believes that some of its debtors may ‘default’, it should act on this by making sure that all possible losses are recorded in the books. This is an example of the Conservatism/Prudence concept.
  2. The fact that a business is separate and distinguishable from its owner is best exemplified by the Business entity concept.
  3. Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the Dual aspect or Duality concept.
  4. The Consistency Concept concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.
  5. A firm may hold stock which is heavily in demand. Consequently, the market value of this stock may be increased. Normal accounting procedure is to ignore this because of the Conservatism.
  6. If a firm receives an order for goods, it would not be included in the sales figure owing to the Revenue recognition/Realization Concept.
  7. The management of a firm is remarkably incompetent, but the firms accountants can not take this into account while preparing book of accounts because of (Money measurement concept) concept.
Long Answers
‘The accounting concepts and accounting standards are generally referred to as the
essence of financial accounting’. Comment.
The accounting concepts and accounting standards are generally referred to as the essence of financial accounting due to the following reasons.

  1. Adherence to accounting standards and concepts will make the accounting information reliable and comparable.
  2. There are different accounting concepts covering all the accepts that need to be adhered while preparing the accounts. These include
    1. Accounting period
    2. Business Entity
    3. Conservatism
    4. Consistency
    5. Cost
    6. Dual Aspect(or duality)
    7. Full Disclosure
    8. Going concern
    9. Matching
    10. Materiality
    11. Money measurement
    12. Revenue recognition (realization)
    13. Objectivity
  3. They ensure that only that information which is financially relevant is recorded.
  4. They require that there should be uniformity in the accounting procedures what enables the comparability of inter-firm, intra-period reports.
  5. They provide guidance to the accountants regarding the information that is considered for accounting.
  6. They ensure that consistency is maintained and there by helping minimization of any errors arising out of ad-hoc accounting practices.
  7. Adherence to standards will help the understand-ability and thus make the decision making or planning process easy and accurate.
  8. Faster generation and communication of the uses who seek to have a peek into the financial position of the organization.
  9. Conformity to the standards will minimize errors and improve the productivity of the accountants.
  10. Conformity to the guidelines laid by the ICAI (Institute of Chartered Accountants of India)

Thus we can say that the accounting concepts and accounting standards form the essence of the accounting.






Why is it important to adopt a consistent basis for the preparation of financial
statements? Explain.
It is essential to follow consistent basis for the preparation of financial statements due to the following reasons.

  1. The users use the financial statements and make both intra-firm and inter-period comparisons and then draw conclusions. The comparisons are easier and accurate when the financial statements being compared are prepared using the same accounting principles and practices uniformly and consistently.
  2. If a firm adopts the declining balance depreciation method in one year and units of production depreciation method in another year, then the results will be inconsistent and hence will not be comparable.
  3. Adherence to consistency will help in comparing the results of two accounting periods comparable and from then the users can get an understanding of the financial performance of the enterprise.
  4. It is eliminates the personal bias and makes the reports comparable.
  5. It makes the comparisons among the financial results of two business entities meaningful.

However, consistency does not prohibit change in accounting policies. When it is necessary to adopt a change in the accounting policies or a better method is available, they can be adopted by fully disclosing them in the financial statements quoting their probable impact on the financial results of the business. This will help the user analyzing the financial statements to gauge the impact of the changes and interpret the results accordingly while drawing conclusions.

3. Discuss the concept-based on the premise ‘do not anticipate profits but provide for
all losses’.
The principle ‘do not anticipate profits but provide for all losses’ is in accordance with the conservatism (also called prudence) concept.

  1. It is the policy of playing safe.
  2. As per this concept a conscious approach should be adopted while computing the income so that the profits of the enterprise are not exaggerated.
  3. This principle prevents over calculation of the profits and there by prevents the distribution of dividend out of capital. If not adopted, this will lead to reduction inf the capital of the enterprise.
  4. The profits should be recorded only after realizing all the losses. As per this principles the losses which have a possibility of remote occurrence are considered as actually occurred.
  5. It reflects the pessimist attitude adopted by the accountants and is an important way of dealing with uncertainty and protecting the interests of the creditors against an unwanted distribution of firm’s assets.
  6. As per this principle, the following are adopted.
    1. The stocks are valued at the lowest of cost or market value.
    2. Provision is made for doubtful debts
    3. Discount is accounted on debtors
    4. Writing of intangible assets like goodwill, patents etc.
    5. Showing the stock value at cost price if the market value has gone down and not recording the gain until the stock is sold if the market value is gone up.
  7. When the value of the assets are deliberately underestimated it will lead to hidden profits, also called as secret reserves.
4. What is matching concept? Why should a business concern follow this concept?
Discuss.
The accounting concept as per which the expenses incurred in an accounting period should match with the revenue during that period is called as the matching concept. Thus the revenue and the expenses incurred to earn these revenues must belong to the same accounting period.
Thus all the revenues earned during an accounting year, whether received during that year or not and all costs incurred whether paid during that year or not should be taken into consideration while calculating the profit or loss for that year.

The business entity should follow the matching concept due to the following reasons:

  1. Matching concept ensures that the financial statements depict the exact financial state of the business entity.
  2. It avoids under-stating or over-stating the profit or loss by considering the expenses and revenues matching the accounting period.
  3. It allows the exact division of the revenues and expenses over multiple accounting periods. For instance, the expenses which span over a period of time like depreciation that spans over years etc are computed and recorded only to the extent that it is applicable for the accounting period under consideration.
  4. It ensures that though the transaction that belong to an accounting period occur in a different period, they’re recognized only in the period that they belong to. Thus the rent for February, though it is received in May, will be recorded as received in February. Similarly the expenses such as salary, rent are recognized in the period to which they relate to and not when they are actually paid.
5. What is the money measurement concept? Which one factor can make it difficult to
compare the monetary values of one year with the monetary values of another year?
The concept of money measurement states that only those transactions and happenings in a organization which can be expressed in terms of money should be considered for recording in the accounting books. For instance, transactions like sale of goods, payment of expenses or receipt of income are eligible to be recorded in the accounting book where as happenings like performance evaluation of employees, hiring of new employees, transfer of a manager to a different department should not be recorded in accounting books.
In addition to this the transactions should be recorded only in the monetary unit but not in physical units. For instance, smart phones purchased for the marketing department should be recorded as smart phones worth ₹ 4,00,000 but should not be recorded as 10 smart phones.
Factor that can make it difficult to compare the monetary values of one year with the monetary values of another year: Due to the fluctuation in prices the value of money will be different during different periods of time. Thus the worth of an asset costing Rs.1000 in the year 2000 might be 10 more times worthy today. Due to this fact when a machine purchased in 1995 for Rs.3 crore and a building purchased for Rs.5 crore in 2005, they represent heterogeneous values which can not be compared directly. Thus as the change in the value of money is not considered in the accounting books, the accounting data will not reflect the exact view of the affairs of an enterprise. This makes it difficult to compare the monetary value of one year with the monetary value of another year as it does not reflect the real value of money and we’re comparing two monetary values whose worth is different from what they are actually reflecting.

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You might also want to refer the following pages.

  1. Introduction to Accounting
  2. Recording of Transactions – I
  3. Recording of Transactions – II
  4. Bank Reconciliation Statement