| Accountancy NCERT Notes, Solutions and Extra Q & A (Class 11th & 12th) | |||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 11th | 12th | ||||||||||||||||||
Chapter 2 Theory Base Of Accounting Concepts, Solutions and Extra Q & A
The theory base of accounting establishes the fundamental rules and guidelines, known as Generally Accepted Accounting Principles (GAAP), to ensure financial statements are uniform, consistent, and comparable. This framework is crucial for providing reliable information to various users like investors, creditors, and management. It provides a standardized approach to recording, classifying, and reporting financial transactions, which builds trust and enables meaningful analysis and decision-making.
Core to GAAP are foundational concepts such as the Business Entity (business is separate from its owner), Going Concern (business will continue indefinitely), Money Measurement (only monetary transactions are recorded), and Dual Aspect (every transaction has two effects). These assumptions are supported by guiding principles like Consistency (using the same methods over time), Conservatism (providing for all losses but not anticipating profits), and Full Disclosure (revealing all material information).
The Matching Concept, which aligns expenses with the revenues they generate, underpins the Accrual Basis of accounting. This basis recognizes transactions when they occur, not when cash changes hands, providing a more accurate view of a firm’s performance. These principles collectively ensure that financial reports present a true and fair view of an enterprise's financial health.
Generally Accepted Accounting Principles (GAAP)
For this accounting information to be truly useful, it must possess two key qualities: reliability and comparability. To make accounting information meaningful, it is crucial that it is prepared following a standard set of rules and guidelines. This ensures that the financial statements of different enterprises can be compared, and the performance of the same enterprise can be analysed over different periods. This necessity gives rise to a proper theory base of accounting.
The Need for Principles and Consistency
Imagine a scenario where every business creates its own rules for recording financial transactions. One business might record an asset at its purchase price, while another might record it at its current market value. The resulting financial statements would be impossible to compare, rendering them almost useless for external analysis.
To avoid such chaos, the accounting profession has developed a standardized framework. This framework ensures:
Inter-firm Comparison: An investor can compare the profitability of two different companies (e.g., Tata Motors and Mahindra & Mahindra) because both are expected to follow the same set of accounting rules.
Inter-period Comparison: A manager can assess their own company's performance by comparing the current year's financial results with those of previous years. This is only meaningful if the accounting policies have been applied consistently.
This need for uniformity has led to the development of a common set of principles and concepts that serve as the bedrock of accounting.
What is GAAP?
Generally Accepted Accounting Principles (GAAP) refers to the common set of accounting principles, standards, and procedures that companies must follow when compiling their financial statements. GAAP is a combination of authoritative standards set by policy boards and the commonly accepted ways of recording and reporting accounting information.
The term ‘principle’ is defined by the American Institute of Certified Public Accountants (AICPA) as, ‘A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice’. The word 'generally' implies that these principles have broad acceptance and are followed by most accounting professionals.
For example, a core principle within GAAP is the historical cost principle. This rule states that assets should be recorded at their original purchase price. This brings objectivity to the process because the cost can be verified from purchase invoices or receipts, making the financial data more reliable and less subject to personal bias.
Evolution and Nature of GAAP
GAAP is not a static set of rules carved in stone. It is a dynamic framework that has evolved over a long period and continues to change in response to the business environment. Its development is influenced by:
Past Experiences and Customs: Practices that have proven to be useful and effective over time become accepted conventions.
Statements by Professional Bodies: In India, the Institute of Chartered Accountants of India (ICAI) is the regulatory body that issues Accounting Standards, which are a key part of GAAP.
Government Regulations: Laws such as the Companies Act, 2013, prescribe formats and disclosure requirements for financial statements.
Needs of Users: As the demands of investors and other stakeholders change, accounting principles are adapted to provide more relevant information.
Concepts vs. Conventions
The rules and guidelines under GAAP are often referred to by various names like principles, postulates, assumptions, concepts, and conventions. While they are often used interchangeably, there are subtle distinctions:
Concepts: These refer to the necessary assumptions and ideas which are fundamental to accounting practice. For example, the idea that a business is a separate entity from its owner is a 'concept'.
Conventions: These connote customs or traditions that guide the preparation of accounting statements. For instance, the practice of valuing stock at cost or market price, whichever is lower (Conservatism), is a 'convention'.
Instead of delving into the semantics, it is more practical to understand their application. For this reason, these fundamental ideas are collectively referred to as Basic Accounting Concepts.
Basic Accounting Concepts
The basic accounting concepts are the fundamental ideas or basic assumptions that provide the foundation for the theory and practice of financial accounting. They function as the broad working rules for all accounting activities, ensuring that financial information is prepared and presented in a logical and consistent manner. The important concepts are as follows:
Business Entity Concept
Money Measurement Concept
Going Concern Concept
Accounting Period Concept
Cost Concept
Dual Aspect Concept
Revenue Recognition (Realisation) Concept
Matching Concept
Full Disclosure Concept
Consistency Concept
Conservatism (Prudence) Concept
Materiality Concept
Objectivity Concept
Business Entity Concept
This concept establishes that a business is considered a separate and distinct entity from its owners. For accounting purposes, the financial affairs of the business are kept completely separate from the personal financial affairs of its owner(s).
Implications of the Concept
Capital as a Liability: When an owner invests money (capital) into the business, it is recorded as a liability of the business to the owner. This is because the business entity is seen as borrowing funds from the owner entity.
Drawings: When the owner withdraws money or goods for personal use (known as drawings), it is treated as a reduction of the owner's capital, thereby decreasing the business's liability to the owner.
Business Perspective: All accounting records are maintained from the point of view of the business, not the owner.
Separation of Assets: The personal assets and liabilities of the owner (e.g., personal car, home loan) are not included in the business's financial statements. A transaction is recorded in the business's books only if it affects the business's funds or assets directly.
Money Measurement Concept
This concept states that only those transactions and events that can be expressed and quantified in terms of money are recorded in the books of accounts.
Key Aspects of the Concept
Monetary Transactions: Events like the sale of goods, payment of rent, or receipt of interest are recorded because they have a clear monetary value.
Exclusion of Qualitative Aspects: Important but non-monetary factors, such as the skill of the management team, employee morale, or the brand reputation of a company, are not recorded because they cannot be objectively measured in monetary terms.
Common Unit of Measurement: All assets, liabilities, and transactions are recorded and reported in a common monetary unit (e.g., Indian Rupees, ₹). This allows for the aggregation of diverse items. For example, owning 2 acres of land, 10 office rooms, and 30 computers is meaningless as a sum of physical units. However, converting them to their monetary values (e.g., land worth ₹2 crore, building worth ₹1 crore, computers worth ₹15 lakh) allows them to be added up to find a total asset value of ₹3.15 crore.
Limitations of the Concept
A key limitation is the assumption that the value of money remains stable over time. Due to inflation, the purchasing power of money decreases. Adding the value of a building bought in 1995 for ₹2 crore to a plant bought in 2020 for ₹1 crore means adding monetary units of different real values, which may not present a true and fair view of the business's assets in today's terms.
Going Concern Concept
This fundamental concept assumes that a business entity will continue to operate indefinitely for a foreseeable future and is not expected to be liquidated or shut down. This assumption of continuity has significant implications for accounting.
Importance and Implications
Asset Valuation: It justifies recording fixed assets at their original cost and depreciating them over their useful lives, rather than at their immediate sale or liquidation value.
Depreciation: The concept allows the cost of an asset to be spread over the years it is expected to generate revenue. For example, if a machine costing ₹50,000 has a useful life of 5 years, the Going Concern concept justifies charging ₹10,000 as depreciation expense each year, rather than expensing the full ₹50,000 in the year of purchase.
Distinction between Expenditures: It provides the basis for distinguishing between capital expenditure (benefits multiple periods, treated as an asset) and revenue expenditure (benefits the current period, treated as an expense).
Accounting Period Concept
Since a business is assumed to have an indefinite life (Going Concern), it is impractical to wait until its closure to measure its performance. The Accounting Period Concept addresses this by stipulating that the life of a business should be divided into specific, shorter time intervals for preparing financial statements.
Key Features
These intervals are known as accounting periods.
Financial statements (Profit and Loss Account and Balance Sheet) are prepared at the end of each period to assess profitability and financial position.
This provides stakeholders with regular and timely information for decision-making.
The standard accounting period is typically one year (e.g., April 1st to March 31st in India).
Legislation like the Companies Act, 2013, and the Income Tax Act mandate annual reporting. However, interim financial statements can be prepared for shorter durations (e.g., quarterly or half-yearly), which is a common requirement for listed companies.
Cost Concept (Historical Cost Concept)
This concept requires that all assets be recorded in the books of accounts at their original acquisition cost. This cost includes not only the purchase price but also all expenses incurred to bring the asset to its location and make it ready for use.
Application and Rationale
For instance, the total cost of a newly purchased plant would be its purchase price plus costs for transportation, installation, and initial repairs.
This acquisition cost is known as historical cost and serves as the basis for all subsequent accounting for the asset, including the calculation of depreciation.
The recorded cost does not change over time, even if the market value of the asset increases or decreases.
The main advantage of this concept is its objectivity, as the purchase cost can be verified from documents like invoices. This makes the records reliable and free from bias.
The primary limitation is that historical cost may not reflect the asset's true worth, especially during periods of high inflation. This can lead to undervalued assets on the balance sheet and what are known as 'hidden profits'.
Dual Aspect Concept
This is the fundamental principle of accounting and forms the basis of the double-entry system. It states that every business transaction has a dual or two-fold effect, affecting at least two accounts in opposite directions.
The Accounting Equation
For every 'debit', there must be a corresponding and equal 'credit'. This two-fold effect is captured by the fundamental Accounting Equation:
$Assets = Liabilities + Capital$
This equation signifies that the total assets of a business are always equal to the total claims against those assets, which are the claims of outsiders (Liabilities) and the claims of the owner (Capital or Owner's Equity).
Examples of the Dual Effect
Ram invests ₹50,00,000 cash: Assets (Cash) increase by ₹50,00,000, and Capital increases by ₹50,00,000.
Buys goods for ₹10,00,000 cash: Assets (Stock) increase by ₹10,00,000, and Assets (Cash) decrease by ₹10,00,000. The total assets remain unchanged.
Buys a machine on credit for ₹30,00,000: Assets (Machinery) increase by ₹30,00,000, and Liabilities (Creditors) increase by ₹30,00,000.
Every transaction maintains the balance of this equation, ensuring the arithmetical accuracy of the records.
Revenue Recognition (Realisation) Concept
This concept dictates when revenue should be recorded in the books. Revenue is the gross inflow of economic benefits (cash, receivables) from the ordinary activities of an enterprise.
Point of Realisation
The general rule is that revenue is considered realised (and should be recorded) when the legal right to receive it arises, not necessarily when the cash is received.
For sale of goods: Revenue is recognised when ownership of the goods is transferred to the buyer (i.e., when the sale is made), even if it's a credit sale.
For rendering of services: Revenue is recognised when the service has been provided to the customer.
For other incomes (rent, interest, etc.): Revenue is recognised on a time basis. For example, rent for March is considered revenue for the financial year ending in March, even if it is received in April.
Exceptions: For long-term construction projects, revenue may be recognised proportionally based on the stage of completion. For hire purchase sales, revenue may be recognised as instalments are collected.
Matching Concept
This concept is crucial for determining accurate profit or loss. It states that to ascertain the profit for a period, the expenses incurred in that period must be matched against the revenues earned in that same period.
Core Principle
It works in conjunction with the Revenue Recognition and Accounting Period concepts.
Expenses are recognised not when cash is paid, but when they are incurred to generate revenue. For example, the salary for March is an expense for March, even if it is paid in April.
Depreciation on a machine is an expense that is matched against the revenues the machine helps to generate over its useful life.
When calculating profit from sales, the cost of goods sold (the cost of only those goods that were sold) is matched against the sales revenue, not the total cost of all goods purchased during the period. The cost of unsold goods (closing stock) is carried forward as an asset.
Full Disclosure Concept
This concept requires that financial statements and their accompanying notes should disclose all material and relevant information concerning the financial performance and position of an enterprise.
Purpose and Scope
The goal is to provide a full, fair, and adequate understanding of the company's affairs to enable users to make well-informed decisions.
An item is 'material' if its knowledge could influence a user's decision.
Disclosure is not limited to the figures in the statements but also includes footnotes explaining significant accounting policies (e.g., depreciation method), contingent liabilities (e.g., a pending lawsuit), and other crucial information.
Regulatory bodies like the Companies Act and SEBI in India mandate specific disclosures to ensure a 'true and fair view' is presented.
Consistency Concept
This concept states that the accounting policies and practices adopted by a business should be applied consistently from one accounting period to the next. This ensures that financial statements are comparable over time.
Importance of Consistency
Consistency is essential for both inter-period (comparing a company's results over several years) and inter-firm (comparing one company to another) analysis.
If a company frequently changes its method of valuing inventory or calculating depreciation, its profit figures would not be comparable, and it would be difficult to assess performance trends.
Consistency does not mean rigidity. A change in policy is allowed if required by law or an accounting standard, or if it results in a more appropriate presentation. However, the nature, reason, and financial effect of such a change must be fully disclosed.
Conservatism (Prudence) Concept
This concept advocates for a cautious approach when recording transactions, especially under uncertainty. Its guiding principle is: "Anticipate no profit, but provide for all possible losses."
Application of the Concept
This aims to prevent the overstatement of assets and profits.
Examples of application:
- Valuing closing stock at the lower of its cost or market value. A potential loss is recognised immediately, but a potential gain is ignored until realised.
- Creating a provision for doubtful debts to account for potential losses from customers who might not pay.
- Writing off intangible assets like goodwill if their value appears impaired.
While prudence is important, excessive conservatism can lead to the creation of 'secret reserves' (hidden profits) and should be avoided as it can distort the financial statements.
Materiality Concept
This concept states that accounting should focus on material facts and that insignificant items can be treated in the most convenient way. An item is considered material if its knowledge could influence the economic decisions of users.
Determining Materiality
Materiality depends on the amount and nature of the item in the context of the business. What is material for a small firm may be immaterial for a large corporation.
For example, the cost of a stapler, though technically an asset, is an immaterial amount. Therefore, it is treated as an expense in the year of purchase rather than being capitalised and depreciated over its life. This is done for convenience.
This concept allows accountants to disregard strict adherence to principles for trivial items, while ensuring that all significant information is properly disclosed.
Objectivity Concept
This concept requires that accounting transactions be recorded in an objective manner, free from the personal bias of the accountant or management. The recording should be based on verifiable evidence.
Ensuring Objectivity
Objectivity is achieved by ensuring that each transaction is supported by a verifiable source document, such as a purchase invoice, sales receipt, or bank statement.
These documents provide independent evidence of the transaction and its value, allowing for audit and verification.
The Historical Cost Concept supports objectivity because the purchase cost of an asset can be verified from documents, whereas its market value is often subjective and difficult to verify.
Objectivity enhances the reliability and trustworthiness of financial statements.
Systems Of Accounting
The systems of recording transactions in the books of accounts are generally classified into two types. The choice of system depends on the size and nature of the business and the level of detail required in the financial records.
Double Entry System
The Double Entry System is a scientific and complete method of accounting that is based on the fundamental Dual Aspect Concept. This concept, as discussed earlier, states that every transaction has two effects: a receiving of a benefit and a giving of a benefit.
Core Principle
The basic principle of the double entry system is that for every transaction, there are two entries: a debit in one or more accounts and a corresponding and equal credit in one or more other accounts. The total amount of debits must always equal the total amount of credits for every transaction.
For example, if a business purchases furniture worth ₹50,000 for cash:
- The 'Furniture' account (an asset) increases, so it is debited with ₹50,000.
- The 'Cash' account (also an asset) decreases, so it is credited with ₹50,000.
Features and Advantages
Complete and Scientific: It is considered a complete system because it records both aspects of every transaction, providing a full picture of how each event impacts the business's financial position.
Accuracy and Reliability: The system is highly accurate and more reliable. The arithmetical accuracy of the records can be verified by preparing a Trial Balance, which checks if total debits equal total credits.
Minimizes Frauds: Since a complete record of all changes in assets and liabilities is maintained, the possibilities of frauds and misappropriations are significantly minimized.
Universal Applicability: The double entry system is robust and can be implemented by all types of organizations, from small proprietorships to large multinational corporations.
Single Entry System
The Single Entry System is not a complete or scientific system for maintaining financial records. It is often described as an incomplete double entry system or simply a "lack of a system" because it does not consistently follow the dual aspect principle for all transactions.
Core Principle and Features
There is no rigid set of rules. For some transactions, both aspects might be recorded, while for others, only one aspect is recorded, and some may be ignored altogether.
Incomplete Records: Typically, only personal accounts (of debtors and creditors) and a Cash Book are maintained. Impersonal accounts like assets, liabilities, expenses, and revenues are often not kept.
Lack of Uniformity: The method of recording is not uniform and can vary from business to business, depending on their needs.
Unreliable: The accounts maintained under this system are incomplete and unsystematic. It is very difficult to check their accuracy, and financial statements prepared from these records are not considered reliable.
Suitability: Despite its drawbacks, it is often used by very small business firms (like sole traders or small partnership firms) because it is simple, less expensive to maintain, and flexible.
Comparison: Double Entry vs. Single Entry System
| Basis of Difference | Double Entry System | Single Entry System |
|---|---|---|
| Governing Principle | Based on the Dual Aspect Concept. | No fixed principle; follows no set rules. |
| Aspects Recorded | Both debit and credit aspects of every transaction are recorded. | For some transactions both aspects are recorded, for others only one, and some are not recorded at all. |
| Accounts Maintained | Maintains all types of accounts: Personal, Real, and Nominal. | Generally, only Personal accounts and a Cash Book are maintained. |
| Trial Balance | A Trial Balance can be prepared to check arithmetical accuracy. | A Trial Balance cannot be prepared. |
| Reliability | Highly reliable, scientific, and systematic. | Unreliable, unscientific, and unsystematic. |
| Financial Position | Profit/Loss and a true financial position (Balance Sheet) can be accurately determined. | Only an estimate of profit or loss can be made; a proper Balance Sheet cannot be prepared. |
| Suitability | Suitable for all types of businesses, regardless of size. | Suitable only for very small businesses or sole traders. |
Basis Of Accounting
The basis of accounting refers to the timing of the recognition of revenue and costs in the books of accounts. It determines at which point in time the financial effects of transactions and events should be recorded. The choice of basis significantly impacts the reported profit and the financial position of an enterprise. There are two broad approaches to accounting.
Cash Basis of Accounting
Under the Cash Basis, financial transactions are recorded in the books of accounts only when cash is actually received or paid. The timing of when revenue is earned or when an expense is incurred is ignored. The focus is solely on the movement of cash.
Recognition Rules
Revenue Recognition: Revenue is recognised only when cash is received from customers, regardless of when the sale was made or the service was rendered.
Expense Recognition: Expenses are recognised only when cash is paid, regardless of when the benefit of the expense was consumed.
Example
Let's say a business sells goods on credit for ₹10,000 in March 2024 and receives the payment in April 2024. Under the cash basis, this revenue of ₹10,000 would be recorded in April 2024, not in March 2024 when the sale occurred.
Similarly, if the business pays its office rent for December 2023 (₹20,000) in January 2024, the expense would be recorded in January 2024, not in December 2023 when the rent was due.
Advantages and Disadvantages
Advantage: It is simple to use and understand, as it directly tracks the cash flow of the business.
Disadvantage: It is fundamentally incompatible with the Matching Concept. By not matching the revenues of a period with the expenses incurred to earn them, it fails to provide a true and fair view of the profit or loss. Profit is simply calculated as the difference between total cash receipts and total cash payments for a period, which can be misleading.
Due to its limitations, the cash basis is generally not considered appropriate for most business enterprises. However, it may be used by non-profit organizations or certain professionals like doctors and lawyers who primarily operate on a cash basis.
Accrual Basis of Accounting
Under the Accrual Basis, the financial effects of transactions and events are recognised in the period in which they occur or are earned/incurred, irrespective of when cash is actually received or paid. This basis focuses on the substance of the transaction rather than just the cash flow.
Recognition Rules
Revenue Recognition: Revenue is recognised when it is earned (i.e., when the legal right to receive it arises). For example, when goods are sold or services are rendered.
Expense Recognition: Expenses are recognised when they are incurred to generate revenue, not when they are paid.
Example
Using the same example, if a business sells goods on credit for ₹10,000 in March 2024, the revenue is recognised in March 2024 itself, because that is when it was earned.
Similarly, the rent expense for December 2023 (₹20,000) is recorded as an expense in December 2023, when the premises were used, even if the cash payment is made in January 2024.
Advantages and Disadvantages
Advantage: This basis is fully consistent with the Matching Concept. It provides a much more accurate and realistic picture of the profitability and financial position of a business for a specific period.
Disadvantage: It is more complex than the cash basis as it requires accounting for outstanding expenses (accrued expenses) and outstanding incomes (accrued incomes).
The accrual basis is the standard, more appropriate, and widely used basis of accounting under GAAP for most business entities as it gives a true and fair view of financial performance.
Summary of Differences: Cash Basis vs. Accrual Basis
| Basis of Difference | Cash Basis of Accounting | Accrual Basis of Accounting |
|---|---|---|
| Timing of Revenue Recognition | When cash is received. | When revenue is earned. |
| Timing of Expense Recognition | When cash is paid. | When expense is incurred. |
| Matching Principle | Not followed. Revenues and expenses are not matched. | Followed. Expenses are matched with the revenues they generate. |
| Determination of Profit/Loss | Calculated as the difference between cash receipts and cash payments. Can be misleading. | Calculated by matching revenues and expenses for the period. Provides a true and fair view. |
| Complexity | Simple and easy to maintain. | More complex due to adjustments for accruals and prepayments. |
| Acceptance under GAAP | Not generally accepted for most businesses. | The standard and accepted method for most businesses. |
Accounting Standards
Accounting Standards are a set of formal, written policy documents issued by an expert accounting body or government authority. They establish the principles and procedures for recognising, measuring, treating, presenting, and disclosing accounting transactions and events in the financial statements. In essence, they are the authoritative rules that govern the preparation of financial reports.
In India, the primary professional body responsible for issuing accounting standards is the Institute of Chartered Accountants of India (ICAI). The main objective of these standards is to bring uniformity and consistency to accounting practices, thereby enhancing the reliability and comparability of financial statements for all users.
Need For Accounting Standards
Accounting information serves a diverse group of users, from investors and creditors to management and government agencies. For this information to be useful, it must be consistent and comparable. In the absence of standards, businesses could use different methods to account for similar transactions, leading to confusion and mistrust.
Key Reasons for the Need
To Limit Alternatives: For many transactions, there can be multiple acceptable accounting treatments. For example, depreciation can be calculated using the Straight-Line Method or the Written-Down Value Method. Accounting standards limit these alternatives or prescribe specific conditions under which a particular method can be used, ensuring more uniformity.
To Mandate Disclosures: Standards often require the disclosure of crucial information that may not be legally mandated but is vital for users. For example, disclosing the details of a major lawsuit against the company (a contingent liability) is essential for an investor to assess risk.
To Facilitate Comparability: When all companies in an industry follow the same standards, it becomes possible to compare their performance and financial position (inter-firm comparison). It also allows for the analysis of a single company's performance over several years (intra-firm comparison).
To Enhance Credibility: Adherence to a standardized set of rules enhances the credibility and transparency of financial reporting, building confidence among stakeholders.
Benefits Of Accounting Standards
The implementation of accounting standards offers significant advantages to the business community and the economy as a whole.
Eliminates Variations: Standards reduce the range of acceptable accounting treatments for transactions. This harmonizes accounting policies and practices, leading to more consistent financial statements that are easier to understand and analyse.
Requires Additional Disclosures: Standards may call for disclosures beyond what is required by law. This provides users with useful information about contingent liabilities, accounting policies, and other relevant facts, leading to greater transparency.
Facilitates Comparability: By ensuring that similar transactions are accounted for in a similar manner across different companies and over different periods, standards make financial statements highly comparable. This is the cornerstone of effective financial analysis.
Improves Reliability and Credibility: Financial statements prepared in accordance with established standards are perceived as more reliable and trustworthy by investors, lenders, and other stakeholders.
Limitations Of Accounting Standards
Despite their benefits, accounting standards are not without limitations.
Difficulty in Choosing Among Alternatives: In some cases, standards may permit a choice between different methods. This requires professional judgment, and different accountants might make different choices, slightly reducing comparability.
Rigidity: Standards are designed to apply to a wide range of situations, which can make them rigid. A standard might not provide the best solution for a novel or unique business transaction, thus limiting flexibility.
Cannot Override Law (Statute): Accounting standards must be framed within the ambit of the prevailing laws of the country. If there is a conflict between an accounting standard and a law (e.g., the Companies Act), the law will prevail. The standard cannot override the statute.
Applicability Of Accounting Standards
In India, Accounting Standards issued by the ICAI are generally applicable to all enterprises engaged in commercial, industrial, or business activities. This broad applicability covers a wide range of organizational forms:
- Sole proprietorship units
- Partnership firms
- Companies (both public and private)
- Societies
- Trusts
- Hindu Undivided Families (HUFs)
- Association of Persons (AOPs)
- Cooperative Societies
Only purely charitable organisations that do not have any commercial, industrial, or business activities are typically exempted from their application.
International Financial Reporting Standards (IFRS)
In today's globalized economy, companies operate and raise capital across international borders. This created a need for a single, high-quality set of global accounting standards to overcome the challenges posed by different national accounting rules. This has led to the development of International Financial Reporting Standards (IFRS), issued by the International Accounting Standards Board (IASB).
Need For IFRS
To Avoid Manipulation and Errors: A globally accepted framework reduces the scope for companies to manipulate financial figures and ensures a consistent approach to recognition, measurement, and presentation.
To Promote Global Harmonisation: IFRS acts as a common accounting language, making financial statements from different countries understandable and comparable, thus promoting uniformity.
To Facilitate Global Investment: When companies use a single set of standards, it becomes easier and less costly for investors to analyse and compare investment opportunities across borders. This contributes to the free flow of global capital.
IFRS in the Indian Context: Ind AS
India has committed to converging with IFRS. In this process, the Ministry of Corporate Affairs (MCA) has notified a set of standards known as Indian Accounting Standards (Ind AS). These standards are largely based on IFRS but include certain "carve-outs" or modifications to make them suitable for the Indian economic and legal environment. The goal of Ind AS is to be as close to IFRS as possible while addressing specific national needs.
The introduction of Ind AS has led to the phasing out of the older Accounting Standards (AS) for many companies, particularly larger and listed ones. A comparative list of Ind AS and the older AS is provided below:
| Ind AS Title | Existing AS Title |
|---|---|
| Ind AS 1: Presentation of Financial Statements | AS 1: Disclosure of accounting policies |
| Ind AS 2: Inventories | AS 2: Valuation of inventories |
| Ind AS 7: Statement of Cash Flows | AS 3: Cash flow statements |
| Ind AS 8: Accounting Policies, Changes in Accounting Estimates and Errors | AS 5: Net profit or loss for the period, prior period items and changes in accounting policies |
| Ind AS 10: Events after the Reporting Period | AS 4: Contingencies and events occurring after the balance sheet date |
| Ind AS 11: Construction Contracts (Superseded by Ind AS 115) | AS 7: Construction contracts |
| Ind AS 12: Income Taxes | AS 22: Accounting for taxes on income |
| Ind AS 16: Property, Plant and Equipment | AS 10: Property, Plant and Equipment (revised) / AS 6: Depreciation accounting (withdrawn) |
| Ind AS 17: Leases (Superseded by Ind AS 116) | AS 19: Leases |
| Ind AS 18: Revenue (Superseded by Ind AS 115) | AS 9: Revenue recognition |
| Ind AS 19: Employee Benefits | AS 15: Employee Benefits |
| Ind AS 20: Accounting for Government Grants and Disclosure of Government Assistance | AS 12: Accounting for government grants |
| Ind AS 21: The Effects of Changes in Foreign Exchange Rates | AS 11: The effects of changes in foreign exchange rates |
| Ind AS 23: Borrowing Costs | AS 16: Borrowing Costs |
| Ind AS 24: Related Party Disclosures | AS 18: Related Party Disclosures |
| Ind AS 27: Separate Financial Statements | AS 21: Consolidated Financial Statements (related) |
| Ind AS 28: Investments in Associates and Joint Ventures | AS 23: Accounting for Investment in Associates in Consolidated Financial Statements |
| Ind AS 32: Financial Instruments: Presentation | AS 31: Financial Instruments: Presentation |
| Ind AS 33: Earnings Per Share | AS 20: Earnings Per Share |
| Ind AS 34: Interim Financial Reporting | AS 25: Interim Financial Reporting |
| Ind AS 36: Impairment of Assets | AS 28: Impairment of Assets |
| Ind AS 37: Provisions, Contingent Liabilities and Contingent Assets | AS 29: Provisions, Contingent Liabilities and Contingent Assets |
| Ind AS 38: Intangible Assets | AS 26: Intangible Assets |
| Ind AS 40: Investment Property | AS 13: Accounting for Investments (related) |
| Ind AS 101: First-time Adoption of Indian Accounting Standards | --- |
| Ind AS 102: Share-based Payment | Guidance Note on Employee Share-based Payments |
| Ind AS 103: Business Combinations | AS 14: Accounting for Amalgamations |
| Ind AS 105: Non-current Assets Held for Sale and Discontinued Operations | AS 24: Discontinuing Operations |
| Ind AS 108: Operating Segments | AS 17: Segment Reporting |
Goods And Services Tax (GST)
Goods and Services Tax (GST) is a comprehensive, multi-stage, destination-based indirect tax that has replaced many indirect taxes in India. The core idea behind GST is to create a unified market under the motto "One Country, One Tax".
It is levied at every stage of the supply chain, from manufacturing to final consumption. A crucial feature of GST is the system of Input Tax Credit (ITC), which allows businesses to claim credit for the taxes they paid on their inputs (purchases). This mechanism ensures that tax is levied only on the value added at each stage, and the ultimate tax burden is borne by the final consumer. This eliminates the cascading effect (tax on tax) of the previous tax regime.
GST is a destination-based tax, meaning the tax revenue accrues to the taxing authority of the state where the goods or services are finally consumed (the place of supply), not the state where they are produced.
The Dual GST Model and its Components
India has adopted a Dual GST model, which is consistent with its federal structure. Under this model, both the Central Government and the State Governments have the power to simultaneously levy and collect tax on a common base of goods and services.
The Dual GST framework has three main components:
CGST (Central Goods and Services Tax): This tax is levied by the Central Government on intra-state supplies of goods and services (i.e., transactions occurring within the same state). The revenue collected under CGST goes to the Central Government. It has subsumed previous central taxes like Central Excise Duty, Service Tax, Central Sales Tax, etc.
SGST (State Goods and Services Tax): This tax is levied by the respective State Government on intra-state supplies. The revenue collected under SGST goes to that State Government. It has subsumed state taxes like Value Added Tax (VAT), Entertainment Tax, Luxury Tax, Entry Tax, etc.
IGST (Integrated Goods and Services Tax): This tax is levied and administered by the Central Government on all inter-state supplies of goods and services (i.e., transactions between two different states) and on imports into India. IGST is levied to ensure that credit flows seamlessly from one state to another. The revenue collected is later apportioned between the Centre and the destination state as per the rules laid down by the GST Council.
Examples of GST Application
Intra-State Sale: A dealer in Punjab sells goods worth ₹10,000 to another dealer within Punjab. If the applicable GST rate is 18%, the invoice will show CGST @ 9% (₹900) and SGST @ 9% (₹900). The total price will be ₹11,800. Here, ₹900 goes to the Central Government and ₹900 goes to the Punjab Government.
Inter-State Sale: A manufacturer in Madhya Pradesh sells goods worth ₹1,00,000 to a dealer in Rajasthan. As this is an inter-state transaction, IGST will be levied. If the rate is 18%, the invoice will show IGST @ 18% (₹18,000). This amount is collected by the Central Government, which will later pass on the share to Rajasthan (the destination state).
Key Characteristics and Advantages of GST
Characteristics of Goods and Services Tax
Common Law and Procedure: It establishes a single, uniform law and procedure for indirect taxation across India.
Destination-Based Consumption Tax: The tax is levied at the final point of consumption, and the revenue accrues to the consuming state.
Comprehensive Levy: GST is applicable on both goods and services, unifying them under one tax system.
Value Addition Tax: With the benefit of Input Tax Credit (ITC), GST is effectively a tax only on the value added at each stage of the supply chain.
Simplified Rate Structure: It aims for a minimal number of tax rates, though in practice, there are several slabs.
Elimination of Cascading Effect: The ITC mechanism ensures there is no 'tax on tax', making the system more efficient.
Subsumption of Multiple Taxes: It has replaced a host of central and state indirect taxes, simplifying the tax structure significantly.
Advantages of GST
Abolition of Multiple Taxes: It has replaced the complex and fragmented web of central and state indirect taxes with a single, unified tax.
Wider Tax Base and Increased Revenue: By bringing more businesses into the formal economy, GST has widened the tax base, leading to increased revenue for both the Centre and the States.
Reduced Administrative Cost: A simplified and unified tax structure reduces administrative costs for the government.
Increased Voluntary Compliance: The online, technology-driven compliance process and the incentive of ITC have encouraged higher voluntary compliance.
Boosts Manufacturing and Distribution: By removing inter-state tax barriers and streamlining logistics, GST has made supply chains more efficient and reduced the cost of production.
Promotes Economic Efficiency: GST is neutral to business models, structures, and geographical locations, thereby promoting economic efficiency.
Enhances International Competitiveness: The reduction in the overall tax burden on goods and services makes Indian products more competitive in the international market, which helps in boosting exports.
NCERT Questions Solution
Test Your Understanding - I
Choose the Correct Answer
Question 1. During the life-time of an entity accounting produce financial statements in accordance with which basic accounting concept:
(a) Conservation
(b) Matching
(c) Accounting period
(d) None of the above
Answer:
(c) Accounting period
Reasoning: The Accounting Period Concept states that the entire life of a business enterprise is divided into smaller, specific time intervals for the purpose of preparing financial statements. This is done to ascertain the profit or loss and the financial position of the business at regular intervals.
While a business is assumed to be a going concern (lasting indefinitely), its stakeholders (like owners, investors, government) need periodic reports to make decisions. These periods are usually a financial year (in India, from April 1st to March 31st). Therefore, producing financial statements periodically during the entity's lifetime is a direct application of the Accounting Period concept.
The other options are incorrect because:
- Matching Concept deals with matching the expenses of a period with the revenues of that same period.
- Conservation (or Prudence) suggests that accountants should not anticipate profits but must provide for all possible losses.
Question 2. When information about two different enterprises have been prepared presented in a similar manner the information exhibits the characteristic of:
(a) Verifiability
(b) Relevance
(c) Reliability
(d) None of the above
Answer:
(d) None of the above
Reasoning: The qualitative characteristic being described is Comparability. Comparability is the quality of information that enables users to identify similarities and differences between two sets of economic phenomena. When financial information of two different enterprises is prepared and presented in a similar manner (i.e., using consistent accounting policies), it becomes comparable.
Since 'Comparability' is not provided as an option, the correct choice is (d) None of the above.
The given options are not the primary characteristic described:
- Verifiability means that different knowledgeable and independent observers could reach a consensus that a particular depiction is a faithful representation.
- Relevance implies that the information is capable of making a difference in the decisions of users.
- Reliability (or Faithful Representation) means the information is complete, neutral, and free from error.
Question 3. A concept that a business enterprise will not be sold or liquidated in the near future is known as :
(a) Going concern
(b) Economic entity
(c) Monetary unit
(d) None of the above
Answer:
(a) Going concern
Reasoning: The Going Concern Concept is the fundamental accounting assumption that a business enterprise will continue its operations for the foreseeable future and will not be forced to liquidate or halt its operations. This is a core assumption that justifies many accounting practices, such as:
- Depreciating fixed assets over their useful economic lives rather than their immediate sale value.
- Classifying assets and liabilities into 'current' and 'non-current' categories.
- Recording prepaid expenses as assets.
The other concepts are different:
- Economic Entity Concept treats the business as separate from its owners.
- Monetary Unit Concept assumes that all business transactions are recorded in terms of a common monetary unit (like the Indian Rupee $\textsf{₹ }$).
Question 4. The primary qualities that make accounting information useful for decision-making are :
(a) Relevance and freedom from bias
(b) Reliability and comparability
(c) Comparability and consistency
(d) None of the above
Answer:
(b) Reliability and comparability
Reasoning: To be useful for decision-making, accounting information must possess several key qualitative characteristics. While modern accounting frameworks categorise these into "fundamental" (Relevance, Faithful Representation) and "enhancing" (Comparability, Verifiability, Timeliness, Understandability) characteristics, traditionally, the four principal qualities are considered to be Reliability, Relevance, Understandability, and Comparability.
Let's analyze the options based on this widely accepted framework in Commerce education:
- Reliability: This is a cornerstone quality. Information is reliable when it is free from material error and bias and can be depended upon by users to represent faithfully what it purports to represent. It ensures the trustworthiness of the data.
- Comparability: This quality enables users to identify and understand similarities in, and differences among, items. Information is most useful when it can be compared with similar information from other companies or from previous periods of the same company. This is essential for analysis and decision-making.
The pair in option (b) combines two distinct and crucial primary qualities that make accounting information useful. Let's see why the other options are less appropriate:
- (a) 'Relevance and freedom from bias': While both are important, "freedom from bias" (neutrality) is a key component that contributes to the overall quality of Reliability. This option pairs a primary quality with a sub-component of another.
- (c) 'Comparability and consistency': Consistency is a means to achieve comparability. An entity must consistently apply its accounting policies from one period to the next to ensure that the financial statements are comparable. Therefore, they are not two distinct primary qualities.
Thus, the combination of Reliability (ensuring the information is trustworthy) and Comparability (ensuring the information can be used for analysis against benchmarks) represents the best choice among the given options for primary qualities that make accounting information useful for decision-making.
Test Your Understanding - II
Fill in the correct word:
Question 1. Recognition of expenses in the same period as associated revenues is called _______________concept.
Answer:
Matching
Explanation: The Matching Concept is a fundamental principle of accrual accounting. It mandates that the expenses incurred to generate revenue should be recorded in the same accounting period as the revenue itself. This allows for a more accurate calculation of a period's net income by offsetting the revenues with the costs required to earn them.
Question 2. The accounting concept that refers to the tendency of accountants to resolve uncertainty and doubt in favour of understating assets and revenues and overstating liabilities and expenses is known as _______________.
Answer:
Prudence (or Conservatism)
Explanation: The Prudence Concept (also known as the Conservatism Concept) guides accountants to exercise caution when dealing with uncertainty. It means that they should not anticipate or record potential gains or profits, but they should make provisions for all known liabilities and possible losses. This ensures that the financial statements present a realistic and not overly optimistic view of the company's financial health.
Question 3. Revenue is generally recongnised at the point of sale denotes the concept of _______________.
Answer:
Revenue Recognition
Explanation: The Revenue Recognition Concept provides guidelines on when revenue should be recorded in the books of accounts. The principle states that revenue should be recognized when it is realized or realizable and it is earned. For the sale of goods, this is generally considered to be the point of sale, when the legal title and risks and rewards of ownership are transferred from the seller to the buyer.
Question 4. The _______________concept requires that the same accounting method should be used from one accounting period to the next.
Answer:
Consistency
Explanation: The Consistency Concept states that once an accounting principle or method (like the method of depreciation or inventory valuation) is adopted, it should be followed consistently from one period to another. This ensures that the financial statements of different periods are comparable, allowing users to track performance and trends over time. Any change in method must be disclosed and its effects explained.
Question 5. The_______________concept requires that accounting transaction should be free from the bias of accountants and others.
Answer:
Objectivity
Explanation: The Objectivity Concept requires that all accounting transactions recorded must be based on factual, verifiable evidence and not on the personal opinions or biases of the accountant or management. This is typically achieved by relying on source documents like cash memos, invoices, and bank statements. This ensures that the financial statements are reliable and trustworthy.
Do it yourself (Page No. 40)
Question. State how the GST rates will be applicable if CGST is 9%, SGST is 9% and IGST 18% in each of the following situation:
- Goods worth ₹ 10,000 is sold by a Manufacturer 1 in Maharashtra to a Dealer A in Maharastra.
- Dealer A sell goods worth ₹ 25,000 to Dealer B in Gujarat.
- Dealer B sell goods to Sunita in Gujarat worth ₹ 30,000.
- Sunita sell goods to Ravindra in Rajasthan worth ₹ 65,000.
Answer:
Under the Goods and Services Tax (GST) regime in India, the type of tax levied depends on whether the transaction is an Intra-State (within the same state) or an Inter-State (between two different states) supply.
- For an Intra-State supply, CGST (Central GST) and SGST (State GST) are charged.
- For an Inter-State supply, only IGST (Integrated GST) is charged, where the IGST rate is generally the sum of the CGST and SGST rates.
Based on this, the GST applicability for each situation is as follows:
1. Goods worth $\textsf{₹ } \ 10,000$ is sold by a Manufacturer 1 in Maharashtra to a Dealer A in Maharashtra.
This is an Intra-State supply as the transaction occurs within the state of Maharashtra. Therefore, both CGST and SGST will be applicable.
CGST to be charged: $9\% \ of \ \textsf{₹ } \ 10,000 = \textsf{₹ } \ 900$
SGST to be charged: $9\% \ of \ \textsf{₹ } \ 10,000 = \textsf{₹ } \ 900$
Total GST collected will be $\textsf{₹ } \ 1,800$.
2. Dealer A sells goods worth $\textsf{₹ } \ 25,000$ to Dealer B in Gujarat.
This is an Inter-State supply as the goods are moving from Maharashtra (Dealer A) to Gujarat (Dealer B). Therefore, IGST will be applicable.
IGST to be charged: $18\% \ of \ \textsf{₹ } \ 25,000 = \textsf{₹ } \ 4,500$
3. Dealer B sells goods to Sunita in Gujarat worth $\textsf{₹ } \ 30,000$.
This is an Intra-State supply as the transaction occurs within the state of Gujarat. Therefore, both CGST and SGST will be applicable.
CGST to be charged: $9\% \ of \ \textsf{₹ } \ 30,000 = \textsf{₹ } \ 2,700$
SGST to be charged: $9\% \ of \ \textsf{₹ } \ 30,000 = \textsf{₹ } \ 2,700$
Total GST collected will be $\textsf{₹ } \ 5,400$.
4. Sunita sells goods to Ravindra in Rajasthan worth $\textsf{₹ } \ 65,000$.
This is an Inter-State supply as the goods are moving from Gujarat (Sunita) to Rajasthan (Ravindra). Therefore, IGST will be applicable.
IGST to be charged: $18\% \ of \ \textsf{₹ } \ 65,000 = \textsf{₹ } \ 11,700$
Short Answers
Question 1. Why is it necessary for accountants to assume that business entity will remain a going concern?
Answer:
The Going Concern concept is the fundamental accounting assumption that a business entity will continue to operate for the foreseeable future, without any intention or necessity of liquidation or ceasing its trading operations. It is necessary for accountants to make this assumption for several crucial reasons:
1. Valuation of Assets: The going concern assumption allows assets to be valued at their original cost less accumulated depreciation (i.e., book value) rather than their current resale or liquidation value. This is because assets are held for generating future revenues, not for immediate sale. Without this assumption, all assets would have to be valued at their scrap or net realizable value, which is not useful for assessing ongoing performance.
2. Classification of Assets and Liabilities: This concept is the basis for classifying assets and liabilities into current (to be realized or settled within one year) and non-current (to be realized or settled after one year). If a business is not a going concern, this distinction becomes meaningless as all assets and liabilities would need to be settled in the near future.
3. Recording of Deferred Revenue and Prepaid Expenses: It justifies carrying forward prepaid expenses (like prepaid insurance) and deferred revenue expenditure as assets in the balance sheet, as their benefits are expected to be received in future accounting periods.
In essence, the going concern assumption provides a stable and consistent basis for preparing financial statements that reflect the earning capacity and ongoing financial health of a business, which is far more relevant for most users (like investors and creditors) than a liquidation-based statement.
Question 2. When should revenue be recognised? Are there exceptions to the general rule?
Answer:
The Revenue Recognition Principle dictates that revenue should be recognised in the period in which it is earned, regardless of when the cash is received. In India, this is guided by Indian Accounting Standard (Ind AS) 115, 'Revenue from Contracts with Customers'.
Generally, revenue is considered earned and should be recognised when the entity has satisfied its performance obligation by transferring the promised goods or services to the customer. For the sale of goods, this is typically at the point of sale, i.e., when the legal ownership and the significant risks and rewards associated with the goods are transferred to the buyer. For rendering of services, revenue is recognised over the period the service is provided.
Yes, there are exceptions to this general rule, especially for contracts with unique characteristics. Some key exceptions include:
1. Long-term Construction Contracts: For projects that span multiple years (e.g., building a dam or a highway), it would be misleading to recognise revenue only upon completion. Instead, revenue is recognised using the Percentage of Completion Method, where revenue is recognised in proportion to the work completed during each accounting period.
2. Hire Purchase and Installment Sales: Due to the higher risk of non-payment, the profit is not fully recognised at the time of sale. Instead, it is recognised in proportion to the cash collected in each installment over the hire purchase term.
3. Production of Precious Metals or Agricultural Produce: In industries like gold mining or agriculture, where there is a ready and assured market at a determined price, revenue can be recognised at the point of production or harvest itself, even before a formal sale has taken place.
Question 3. What is the basic accounting equation?
Answer:
The basic accounting equation is the foundation of the double-entry system of accounting. It represents the relationship between the assets, liabilities, and owner's equity of a business. The equation is:
$Assets = Liabilities + Capital \ (or \ Equity)$
This equation can also be expressed as:
$Assets - Liabilities = Capital \ (or \ Equity)$
Where:
- Assets: These are the economic resources owned by the business that have future economic value. Examples include Cash, Machinery, Buildings, and Debtors.
- Liabilities: These are the financial obligations or debts of the business to external parties (outsiders). Examples include Creditors, Bank Loans, and Bills Payable.
- Capital (or Equity): This represents the owner's claim on the assets of the business. It is the residual amount left after deducting liabilities from assets.
The equation signifies that the total resources of a firm (Assets) are financed either by outsiders (Liabilities) or by the owners (Capital). At any point in time, the equation must remain in balance, forming the basis of the Balance Sheet.
Question 4. The realisation 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:
a. dispatched
b. invoiced
c. delivered
d. paid for
Give reasons for your answer.
Answer:
The correct answer is (b) invoiced.
Reasoning:
The Realisation Concept (or Revenue Recognition Principle) states that revenue should be recognised when the legal right to receive it arises. In practice, the sales transaction is recorded in the books of accounts when an invoice is generated and sent to the customer.
The invoice serves as the primary source document and legal evidence that the seller has fulfilled their performance obligation (which usually involves dispatching or delivering the goods) and now has a legal claim to receive money from the buyer. The act of invoicing is the trigger that leads to the accounting entry for recording the sale.
Let's analyse the other options:
- (a) Dispatched / (c) Delivered: While dispatch and delivery are crucial physical events that signify the transfer of risks and rewards, the accounting entry to include the amount in the 'sales figure' is made when the invoice is raised, which typically happens concurrently with or immediately after dispatch.
- (d) Paid for: This relates to cash basis accounting. Under the accrual basis of accounting (which is standard practice), revenue is recognised when it is earned, not when cash is received. A credit sale is included in the sales figure long before it is paid for.
Therefore, for the specific purpose of including a transaction in the "sales figure", the point of invoicing is the most practical and widely used trigger in accounting systems.
Question 5. Complete the following worksheet:
(i) 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 ___________ concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the ___________ concept.
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the ___________ concept.
(iv) The ___________ concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.
(v) 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 ___________.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the ___________.
(vii) 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 ___________ concept.
Answer:
(i) 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 (or Prudence) concept.
Explanation: The principle of conservatism states that accountants should anticipate and provide for all possible losses, but should not anticipate any future profits. Creating a 'Provision for Doubtful Debts' for debtors who might not pay is a direct application of this concept. It ensures that assets (debtors) and profits are not overstated.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the Business Entity concept.
Explanation: This concept treats the business as a separate entity from its owner(s). The owner's personal transactions are kept separate from the business's transactions. For this reason, the owner's investment in the business is treated as 'Capital', which is a liability of the business to the owner.
(iii) Everything a firm owns, it also owes out to somebody. This co-incidence is explained by the Dual Aspect concept.
Explanation: This is the foundation of double-entry accounting. It states that every transaction has two aspects: a debit and a credit. This leads to the fundamental accounting equation: Assets = Liabilities + Capital. The statement means that all the assets of the firm are financed either by the owners (Capital) or by outsiders (Liabilities).
(iv) The Consistency concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.
Explanation: This concept requires that the accounting methods and practices adopted by a firm should be applied consistently from one period to another. This ensures that the financial statements of different years are comparable, allowing users to analyse performance trends accurately. If methods were changed arbitrarily, the resulting profit figures would not be comparable.
(v) 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 (or Prudence) concept.
Explanation: Following the principle of conservatism ("do not anticipate profits"), an increase in the market value of stock is an unrealised gain and is therefore ignored. However, if the market value of the stock were to fall below its cost, this potential loss would be recorded immediately. This is why inventory is valued at 'cost or market price, whichever is lower'.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the Realisation concept.
Explanation: The revenue recognition (or realisation) concept states that revenue should only be recognised when the legal right to receive it arises, which is typically when goods have been delivered or services have been rendered. Simply receiving an order does not constitute a sale, as the transaction is not yet complete.
(vii) 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.
Explanation: This concept states that only those transactions and events that can be measured and expressed in monetary terms are recorded in the books of accounts. Qualitative aspects like the skill of management, employee morale, or brand reputation, while important for the business, cannot be objectively quantified in money and are therefore excluded from the primary financial statements.
Long Answers
Question 1. ‘The accounting concepts and accounting standards are generally referred to as the essence of financial accounting’. Comment.
Answer:
The statement, "The accounting concepts and accounting standards are generally referred to as the essence of financial accounting," is absolutely correct. They form the very foundation and framework upon which the entire structure of financial reporting is built. Without them, financial accounting would be a chaotic, subjective, and incomparable collection of data.
The role of each component can be understood as follows:
Accounting Concepts (The 'Why'):
Accounting concepts are the fundamental assumptions or postulates that provide the logical basis for accounting practices. They are the underlying principles that guide how transactions are recorded and reported. They answer the question, "Why do we account for things in a certain way?". Key concepts include:
- Business Entity Concept: Separates the business from the owner, allowing for objective recording of transactions.
- Going Concern Concept: Assumes the business will continue indefinitely, justifying the depreciation of assets over time.
- Accrual Concept: Dictates that transactions are recorded when they occur, not when cash is exchanged, which is the basis for the matching principle.
- Money Measurement Concept: Provides a common unit of measure for all transactions.
These concepts are like the 'grammar' of accounting—they provide the basic rules and structure that everyone must follow to make sense of the information.
Accounting Standards (The 'How'):
While concepts provide the broad framework, accounting standards provide the specific, detailed, and authoritative rules for how to apply these concepts in practice. In India, these are the Indian Accounting Standards (Ind AS) issued by the Institute of Chartered Accountants of India (ICAI). They answer the question, "How do we specifically treat this transaction?". Examples include:
- Ind AS 16 (Property, Plant and Equipment): Prescribes how to account for fixed assets, including their recognition, measurement, and depreciation.
- Ind AS 2 (Inventories): Specifies the method for valuing inventory (cost or NRV, whichever is lower).
- Ind AS 115 (Revenue from Contracts with Customers): Provides detailed guidelines on when and how revenue should be recognised.
These standards are like the 'dictionary and style guide' of accounting—they provide precise definitions and prescribed formats to ensure that the language of accounting is applied uniformly.
In conclusion, concepts provide the theoretical foundation, while standards provide the practical application rules. Together, they are the essence of financial accounting because they work to ensure that financial statements are Relevant, Reliable, Consistent, Uniform, and Comparable across different companies and time periods, making them truly useful for stakeholders like investors, creditors, and the government.
Question 2. Why is it important to adopt a consistent basis for the preparation of financial statements? Explain.
Answer:
Adopting a consistent basis for the preparation of financial statements is crucial, and this importance is enshrined in the Consistency Concept of accounting. This concept states that once an entity has chosen a particular accounting method for a transaction, it should continue to use that same method for all similar transactions in the future, unless a change is justified.
The importance of adopting a consistent basis is multi-faceted:
1. Enables Meaningful Comparison (Comparability): This is the primary reason for consistency.
- Intra-firm Comparison: Consistency allows for a meaningful comparison of a company's financial performance and position over different accounting periods. For example, if a company uses the Straight-Line Method (SLM) for depreciation in one year and the Written-Down Value (WDV) method the next, the resulting profit figures would not be comparable, making it difficult to assess whether the company's performance has genuinely improved or declined.
- Inter-firm Comparison: It also facilitates the comparison of one firm with another in the same industry. If all firms use consistent policies, an analyst can more easily determine which firm is performing better.
2. Eliminates Personal Bias and Manipulation: If companies were allowed to change accounting methods arbitrarily, management could manipulate financial results to suit their needs. For instance, they might switch to an accounting method that inflates profit in a year they want to attract investors or secure a loan, and switch back to another method that reduces profit in a year they want to pay less tax. Consistency prevents such window dressing and ensures that profits reflect the operational reality, not accounting choices.
3. Enhances Reliability and Trust: When users of financial statements know that accounting policies are applied consistently, they can have greater confidence in the information. It lends credibility to the financial reporting process and assures stakeholders that the results are not arbitrary.
It is important to note that consistency does not mean that an accounting method can never be changed. A change is permissible if it is required by law, an accounting standard, or if the new method results in a more reliable and relevant presentation of the financial statements. However, in such cases, the fact of the change and its financial impact must be fully disclosed in the financial statements.
Question 3. Discuss the concept-based on the premise ‘do not anticipate profits but provide for all losses’.
Answer:
The concept based on the premise ‘do not anticipate profits but provide for all losses’ is the Prudence Concept, also widely known as the Conservatism Principle. It is a fundamental accounting concept that guides accountants to exercise caution and prudence when recording transactions where there is uncertainty. The objective is to ensure that financial statements present a realistic and not an overly optimistic picture of the firm's affairs.
The premise can be broken down into two distinct parts:
1. Do Not Anticipate Profits:
This part of the principle dictates that revenue and gains should only be recognised when they are actually realized or when there is a very high degree of certainty that they will be realized. It prevents companies from recording potential or expected profits that may never materialize.
Example: Suppose a company holds a piece of land purchased for $\textsf{₹ } \ 20,00,000$. Due to a new development project nearby, its market value has shot up to $\textsf{₹ } \ 35,00,000$. According to the prudence concept, the company cannot record this unrealized gain of $\textsf{₹ } \ 15,00,000$ in its books. The profit will only be recognised when the land is actually sold.
2. Provide for All Possible Losses:
Conversely, this part of the principle requires that all known liabilities and potential losses should be recognized and accounted for, even if their exact amount is uncertain and has to be estimated. This ensures that the financial statements are not understating liabilities or overstating the financial health of the business.
Example: A company has sold goods on credit and has total debtors of $\textsf{₹ } \ 5,00,000$. Based on past experience, the management anticipates that about 5% of the debtors might not pay. The prudence concept requires the company to create a 'Provision for Doubtful Debts' of $5\% \times \textsf{₹ } \ 5,00,000 = \textsf{₹ } \ 25,000$. This amount is treated as an expense in the current year, thereby reducing the reported profit and the value of debtors.
Another classic application of this principle is the valuation of closing stock at 'Cost or Net Realisable Value (NRV), whichever is lower'. If the cost is lower, no unrealized profit is booked. If NRV is lower, the anticipated loss is immediately recognized.
In essence, the Prudence Concept introduces a deliberate, cautious bias to financial reporting to safeguard the interests of stakeholders by ensuring that assets and profits are not overstated.
Question 4. What is matching concept? Why should a business concern follow this concept? Discuss.
Answer:
The Matching Concept is a fundamental principle of accrual accounting that dictates that the expenses incurred to generate revenue must be recognised in the same accounting period as the revenue itself. In simple terms, it involves matching the "efforts" (expenses) with the "accomplishments" (revenues). The focus is on the timing of the recognition of expenses, tying it directly to the revenue it helped earn, rather than when the expense was actually paid in cash.
A business concern should follow this concept for one primary and overarching reason: to determine the true and fair profit or loss for a specific accounting period.
The importance of following the Matching Concept can be discussed as follows:
1. Accurate Calculation of Periodic Profit: The main goal of preparing a Profit and Loss Account is to ascertain the net results of business operations during a period. If revenues for a year are accounted for, but some expenses that helped generate those revenues are postponed to the next year (simply because they were paid later), the profit for the current year would be overstated. Conversely, if expenses are prepaid, they should not be charged fully to the current period's profit. The matching concept ensures a correct income measurement.
Example: A company, 'Bharat Sales', makes total sales of $\textsf{₹ } \ 20,00,000$ in the financial year 2023-24. It pays its salesmen a commission of 5% on sales. The commission for sales made until February 2024 ($\textsf{₹ } \ 90,000$) was paid within the year. However, the commission for March 2024 sales ($\textsf{₹ } \ 10,000$) was paid in April 2024.
- Without Matching Concept: The company would record only $\textsf{₹ } \ 90,000$ as commission expense for 2023-24, as that was the amount paid. This would understate the true expense and overstate the profit.
- With Matching Concept: The company must recognise the full commission of $\textsf{₹ } \ 1,00,000$ as an expense for 2023-24, because this entire expense was incurred to generate the revenue of $\textsf{₹ } \ 20,00,000$. The unpaid $\textsf{₹ } \ 10,000$ is shown as an 'Outstanding Liability' in the Balance Sheet. This presents a fair view of the profitability.
2. Basis for Accrual Accounting: The matching concept is the bedrock of the accrual system. It gives rise to adjustments for outstanding expenses, prepaid expenses, accrued income, and income received in advance, ensuring that revenues and expenses are recognised in the appropriate period.
In conclusion, by systematically matching costs with revenues, the Matching Concept avoids distortion of periodic income and provides stakeholders with a more accurate and reliable picture of a company's operational efficiency and profitability for that period.
Question 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?
Answer:
The Money Measurement Concept is a fundamental accounting principle which states that only those business transactions and events that can be measured and expressed in terms of a monetary unit (like the Indian Rupee $\textsf{₹ }$, US Dollar $\$$, etc.) are recorded in the books of accounts. If a transaction or event cannot be quantified in monetary terms, it is not recorded in the financial statements, regardless of how important it might be to the business.
For example, a company would record the purchase of a machine for $\textsf{₹ } \ 5,00,000$ or payment of salaries of $\textsf{₹ } \ 80,000$. However, it would not record non-monetary events such as the superior skill of its management team, a strike by employees, the quality of its products, or a favourable market reputation, as these cannot be assigned a precise monetary value.
The one significant factor that can make it difficult to compare the monetary values of one year with the monetary values of another year is the change in the purchasing power of money due to inflation.
Explanation:
The Money Measurement Concept has an inherent limitation: it assumes that the value of the monetary unit is stable and constant over time. However, in reality, this is not true. Economies almost always experience inflation, which means the purchasing power of money decreases over time. A rupee today does not have the same value it had ten years ago.
This instability in the value of money makes historical cost accounting (which is based on this concept) less meaningful for comparison over time.
Example:
Suppose a company's Balance Sheet shows the following:
- Land purchased in 2013 for $\textsf{₹ } \ 10,00,000$.
- Building constructed in 2023 for $\textsf{₹ } \ 10,00,000$.
The books show two assets each valued at $\textsf{₹ } \ 10,00,000$, and the total value of these assets is recorded as $\textsf{₹ } \ 20,00,000$. However, adding the 2013 rupees to the 2023 rupees is like adding apples and oranges because their intrinsic value (purchasing power) is vastly different. The $\textsf{₹ } \ 10,00,000$ spent in 2013 represents a much larger economic sacrifice than the $\textsf{₹ } \ 10,00,000$ spent in 2023.
Therefore, comparing the asset values, sales figures, or profits of a company from different years without adjusting for the effects of inflation can be highly misleading and difficult.
Activity 1
Ruchica’s father is the sole proprietor of ‘Friends Gifts’, a firm engaged in the sale of gift items. In the process of preparing financial statements, the accountant of the firm Mr. Goyal fell ill and had to proceed on leave. Ruchica’s father was urgently in need of the statements as these had to be submitted to the bank, in pursuance of a loan of ₹ 5 lakh applied for the expansion of the business of the firm. Ruchica who is studying Accounting in her school, volunteered to complete the work. On scrutinising the accounts, the banker found that the value of building bought a few years back for ₹ 7 lakh has been shown in the books at ₹ 20 lakh, which is its present market value. Similarly, as compared to the last year, the method of valuation of stock was changed, resulting in value of goods to be about 15 per cent higher. Also, the whole amount of ₹ 70,000 spent on purchase of personal computer (expected life 5 years) during the year had been charged to the profits of the current year. The banker did not rely on the financial data provided by Ruchica. Advise Ruchica for the mistakes committed by her in the preparation of financial statements in the context of basic concepts in accounting.
Answer:
Dear Ruchica,
It is commendable that you stepped forward to help your father prepare the financial statements. The issues the banker raised are very common for students learning accounting, and they highlight the importance of certain fundamental accounting concepts. Financial statements must follow these concepts to be considered reliable and trustworthy, especially by external parties like banks.
Here is advice on the mistakes you committed, explained in the context of the basic accounting concepts that were violated:
1. Valuation of the Building at Market Price
Mistake: Showing the building at its present market value of $\textsf{₹ } \ 20,00,000$ instead of its original purchase price of $\textsf{₹ } \ 7,00,000$.
Concepts Violated:
- Historical Cost Concept: This principle requires that an asset must be recorded in the books of accounts at the price at which it was acquired. This cost is objective, verifiable, and serves as the basis for all future accounting (like depreciation). By using the market value, you replaced an objective fact with a subjective and fluctuating figure.
- Prudence Concept: This concept states that we should not anticipate profits but must provide for all possible losses. By increasing the value of the building, you have recorded an unrealized gain of $\textsf{₹ } \ 13,00,000$ ($\textsf{₹ } \ 20,00,000 - \textsf{₹ } \ 7,00,000$), which is a direct violation of this principle.
Correct Treatment: The building should be shown in the Balance Sheet at its historical cost of $\textsf{₹ } \ 7,00,000$, less any accumulated depreciation charged to date.
2. Changing the Method of Stock Valuation
Mistake: Using a different method for valuing stock compared to the previous year.
Concept Violated:
- Consistency Concept: This concept mandates that the accounting methods chosen by a firm should be applied consistently from one period to the next. This ensures that the financial statements are comparable over time. By changing the valuation method, you made it impossible for the banker to compare the firm's profitability and financial position of the current year with that of the previous year. The 15% increase in value could be misleading, as it might be due to the change in method rather than improved business performance.
Correct Treatment: You should have used the same method of stock valuation that was used in the previous year. A change is only allowed if it is required by law or an accounting standard, or if it results in a fairer presentation, and even then, it must be fully disclosed.
3. Treating the Purchase of a Computer as a Full Expense
Mistake: Charging the entire cost of the personal computer ($\textsf{₹ } \ 70,000$) to the profits of the current year.
Concepts Violated:
- Matching Concept: This principle requires that the cost of an asset be spread over its useful economic life to match the expense with the revenues it helps to generate in each period. The computer has an expected life of 5 years, meaning its benefit will be derived over 5 years. By expensing the full cost in one year, you have understated the current year's profit significantly and will overstate the profits of the next four years.
- Definition of an Asset: A computer is a resource with future economic benefit and should be classified as a Fixed Asset on the Balance Sheet, not as a revenue expense (like rent or salaries) that is consumed within the year.
Correct Treatment: The computer should be recorded as a Fixed Asset for $\textsf{₹ } \ 70,000$. An annual depreciation expense (e.g., $\textsf{₹ } \ 70,000 / 5 \ years = \textsf{₹ } \ 14,000$) should be charged to the Profit and Loss Account for each of the next five years.
Activity 2
A customer has filed a suit against a trader who has supplied poor quality goods to him. It is known that the court judgment will be in favour of the customer and the trader will be required to pay the damages. However, the amount of legal damages is not known with certainity. The accounting year has already been ended and the books are now finalised to ascertain true profit or loss. The accountant of the trader has advised him not to consider the expected loss on account of payment of legal damages because the amount is not certain and the final judgment of the court is not yet out. Do you think the accountant is right in his approach.
Answer:
No, the accountant is not right in his approach to completely ignore the expected loss. His advice violates several fundamental accounting principles and would result in financial statements that do not present a true and fair view of the business's financial position and performance.
The accountant's advice should be rejected based on the following accounting concepts and standards:
1. Violation of the Prudence (Conservatism) Concept
The most significant principle violated here is the Prudence Concept. This concept states that accountants should 'not anticipate profits but provide for all possible losses'. In this situation:
- It is known that the judgment will be against the trader. This means the loss is not just possible, but probable.
- By advising to ignore this probable loss, the accountant is failing to provide for it. This would lead to an overstatement of the current year's profit and an understatement of liabilities.
2. Violation of the Full Disclosure Concept
The Full Disclosure Concept requires that all material and relevant information that could influence the decision-making of the users of financial statements should be disclosed. A pending lawsuit with a probable negative outcome is a very material piece of information. Hiding this fact would be misleading to anyone reading the financial statements, such as a bank or an investor.
3. The Correct Treatment as per Indian Accounting Standards (Ind AS 37)
The specific guideline for this situation is provided by Indian Accounting Standard (Ind AS) 37 - 'Provisions, Contingent Liabilities and Contingent Assets'. According to this standard, a Provision should be created and recognised as an expense if three conditions are met:
- There is a present obligation (legal or constructive) as a result of a past event. (Condition Met: The sale of poor-quality goods is the past event creating a legal obligation).
- It is probable that an outflow of resources will be required to settle the obligation. (Condition Met: It is known the trader will have to pay damages).
- A reliable estimate can be made of the amount of the obligation. (This is the key issue).
The accountant's argument that the amount is "not certain" is a weak one. Ind AS 37 acknowledges that provisions often require estimation. The trader, in consultation with his lawyers, should make the best possible estimate of the damages based on the facts of the case, experience with similar cases, or other available information. This estimated amount should be recorded as a provision.
Journal Entry for Provision:
Journal Entries
| Date | Particulars | L.F. | Debit Amount (₹) | Credit Amount (₹) |
|---|---|---|---|---|
| Profit and Loss A/cDr. | XXXXX | |||
| To Provision for Legal Damages A/c | XXXXX | |||
| (Being provision made for expected legal damages based on best estimate) |
Alternate Solution (if an estimate cannot be made)
In the rare case that it is truly impossible to make any reliable estimate of the amount, a provision is not created. However, the situation cannot be ignored. Instead, it must be disclosed as a Contingent Liability in the notes to the financial statements. This disclosure must describe the nature of the lawsuit and explain why a reliable estimate of the financial effect cannot be made.
Conclusion: The accountant's advice to do nothing is incorrect. The correct professional approach is to either create a provision based on the best estimate or, at the very least, disclose the matter as a contingent liability.