CHAPTER 3: THEORY BASE OF ACCOUNTING ( ACCOUNTING PRINCIPLES) Continued...

CHAPTER 3 

THEORY BASE OF ACCOUNTING,ACCOUNTING STANDARDS, IFRS AND GST

LEARNING OUTCOMES:

INTRODUCTION

ACCOUNTING PRINCIPLES:

1.BUSINESS ENTITY PRINCIPLE

2. MONEY MEASUREMENT PRINCIPLE 

3. ACCOUNTING PERIOD PRINCIPLE 

4. COST CONCEPT OF HISTORICAL COST PRINCIPLE 

5. DUAL ASPECT OR DUALITY PRINCIPLE 

6. REVENUE RECOGNITION PRINCIPLE 

7. MATCHING PRINCIPLE

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INTRODUCTION, BUSINESS ENTITY PRINCIPLE

INTRODUCTION

As discussed earlier : Accounting Principles are man made, are not rigid and act as a guide for accounting and are generally accepted.
There are 11 ACCOUNTING PRINCIPLES.
Let's take Each of them, one by one.
The first one to start with is a very IMPORTANT PRINCIPLE :  

1. BUSINESS ENTITY or ACCOUNTING ENTITY PRINCIPLE:

 According to this principle, business is considered to be a separate and distinct entity from its owners. Accounting is always done from the point of view of the business and not its owners. So, all the business transactions are recorded from the point of view of the business and not from that of the owners.
• The personal transactions of the owner are kept separate from the business. For example, house, car, personal income and expenditure of the proprietor must be kept separate from the business accounts. 

• The proprietor or owner is treated as a creditor of the business to the extent of capital invested by him in the business. When the owner brings in some money as capital, it is treated as liability of the business to the owner. Similarly, when he withdraws money from the business for his personal expenses (drawings), it is treated as reduction of the owner's capital and consequently a reduction in the liabilities of the business.

• This principle applies to all forms of business organisations, i.e. sole proprietorship, partnership or company. 

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MONEY MEASUREMENT, ACCOUNTING PERIOD PRINCIPLE

2. MONEY MEASUREMENT PRINCIPLE: 

According to this principle only those transactions and events are recorded in the books of accounts which are capable of being expressed in terms of money. 

• Suppose a business enterprise has ₹ 70000 cash, two buildings, and 4 machines. These assets cannot be added and shown in the Financial Statements unless they are valued in terms of money and then added up together to know the worth of the business. So, money is the common denominator in which all transactions are recorded. 

• This concept suffers from two major limitations:

i. Qualitative transactions are not recorded, irrespective of their importance. For example, sincerity and quality of the employees or quality of the product are not recorded in the Financial Statements even though they are so crucial for the enterprise.

ii.  Money is considered to have static value as transactions are recorded at value on transaction date. However, value of money does not remain same over a period of time due to change in the price level.

3. ACCOUNTING PERIOD PRINCIPLE:

According to this principle, the economic life of an enterprise is split into periodic intervals (known as accounting period) so that its performance is measured at regular period. 

• The accounts of an enterprise are maintained following the Going Concern Concept, which says that the business is intended to continue for an indefinite period of time. It means that the true results of the business operations can be ascertained only when the business is completely wound up. 

• However, ascertainment of profit after a very long period will be of little use to the users of financial statement as they need accounting information at regular intervals for decision making.

•  So, life of a business is split into periodic intervals, which is known as accounting period 'Accounting Period'.

•  Accounting period  of one year is usually adopted for this purpose. In India, it generally starts on first day of April and ends on 31st of March next year. 

•  At the end of an accounting period:

#  Profit and loss account is prepared to know the profit earned during the accounting year and 
# Balance sheet is prepared to know the financial position of the business at the end of the year .

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COST PRINCIPLE, DUAL ASPECT PRINCIPLE

4. COST CONCEPT OR HISTORICAL COST PRINCIPLE:

According to this principle, an asset is recorded in the books or at the price paid to acquire it and cost becomes the basis for its accounting in the subsequent accounting period.

•  Asset is recorded at cost at the time of its acquisition and is reduced year after year by charging depreciation based on useful life of that asset rather than its market value. So, an asset is shown in the Balance sheet at its book value, that is cost less depreciation.

•  If nothing is paid to acquire an asset, then the same will not be recorded as an asset. 

•  Since the acquisition cost of an asset relates to the past, it is referred to as 'Historical  Cost'

•   This principle brings Objectivity in the preparation of financial statements as cost price paid for the purchase of asset verifiable from the cost records. So, the information stated in the financial statements is not influenced by personal bias or judgements

.
Drawbacks of Cost Principle:

1. It  ignores recording of assets for which nothing in monetary terms is paid. For example good brand name, favourable location, technological knowledge, etc,  will remain unrecorded even though there these are valuable asset. 

2.  It results in inflated or understated profit during inflation as depreciation is charged on the basis of historical cost and not on the basis of market value.

5. DUAL ASPECT OR DUALITY PRINCIPLE: 

According to this principle, every business transaction has two aspects, debit and credit of equal amount. 

• In other words, for every debit, there is a credit of equal amount in one or more accounts and vice versa. The system of recording transactions based on this principle is termed as Double Entry System. 

• Because of this principle, Balance Sheet has two sides:  Assets side and Liabilities side and both are always equal to each other under all circumstances. 

• For example,

 suppose Ankit starts a business by investing ₹ 500000 in cash and takes a loan of ₹ 100000 from the bank.
#  Now, the assets (cash) in the business will increase by ₹ 6 lakh (= 5 lakh plus one lakh).
# At the same time, it will increase owner's equity or capital by ₹ 500000  and
# Claims of outsiders, that is liabilities will increase by ₹ 100000
#  Now, this transaction can be expressed as:

Assets(cash) = Claim of outsiders (bank loan) + Owner's Equity (Capital)
6 lakh = 1 lakh + 5 lakh 

• This fundamental equation will always remain good in all situations.

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REVENUE RECOGNITION, MATCHING PRINCIPLE

6. REVENUE RECOGNITION PRINCIPLE:  

According to this principle, revenue must be recognised when a transaction has been entered into and the obligation to receive its payment has been established. 

• It is very important to decide the point of time when revenue can be assumed to have been recognised. As revenue recognised is only considered for computation of profit.

•  Example: 

 Suppose a firm sells goods in January 2019 but received the amount in March 2019. As per the principle of revenue recognition revenue from this sale should be recognised in January 2019 itself as the legal obligation to pay the amount has been established on this date. However, if the firm has received only an advance in January 2019 for sale of goods in April 2019, then revenue from this sale shall be recognised in April 2019.

7. MATCHING PRINCIPLE: 

According to this principle expenses incurred in accounting period should be matched with the revenues recognised in that period. 

•  Profit earned by a business during a period can be correctly measured only when the revenue earned during the period is matched with the expenditure incurred to earn that revenue. Such matching  of revenue with expenses is based on accrual system of accounting. 

•  Following are the points that should be kept in mind for matching cost with revenue:

# When an item of revenue is included in Profit and Loss Account, then all the expenses incurred, whether paid or not, should be shown as expenses in the Profit and Loss Account. It means, if there is any outstanding then it will be shown in the Profit and Loss Account. 

# If an expense is paid during an accounting period, but revenue related to it will be earned in the following period, then such expense will be shown as an expense only next year and not this year. For example, prepaid insurance. Such prepaid expense is shown as an asset in the Balance Sheet.

• In the same manner, if a revenue received, but against it services will be rendered next year, then revenue will be also recognised in the next year and will be shown as a liability in the Balance Sheet. For example, unearned salary.

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CONCLUDING NOTES