Read this article to learn about the principles of accounting!
1. Accounting Entity (Separate Entity Concept):
According to this principle, business is treated as an entity which is separate and distinct from its owners. It is further assumed that business has its own identity distinct from the owners, creditors, debtors, managers and others.
In a sole proprietorship concern, the owner and the business enterprise both share the same legal existence but in accounting, however, they are treated as two different entities. Keeping in view of this assumption, business transactions are recorded in the books of accounts from the point of view of business enterprise and personal transactions of the owner are not included in the business transactions. Also, assets and liabilities of the owners are set aside in the preparation of financial statements of the business enterprise.
Business entity assumption is applicable to all types of business organizations viz. sole proprietorship, partnership firms, companies etc. It should be noted that in case of companies, the legal relationship of company and its shareholders is also separate as against a sole proprietorship and partnership firms.
Hence, in case of insolvency of proprietorship and partnership firms, the personal assets of such entities can be used for the purpose of business and vice versa.
A leading case on this point viz., Salomon v. Salomon & Co. is also referred to at every level.
Keeping in view the importance of this assumption the following three points need consideration:
(i) Business Transactions vs. Personal Transactions
(ii) Business Assets & Liabilities vs. Personal Assets & Liabilities.
(iii) Business Income and Personal Income.
In the preparation of financial statements of the business enterprise, business and the owner who constitute the business are treated as two separate entities, distinct from each other, if such assumption is not considered, the operating financial results of a business enterprise cannot be obtained.
A vague and confusing view would be drawn. It would be very difficult to distinguish the personal expenses and business expenses. To add further, a distinction between income of the business and income of the owner, which is a very crucial matter to determine the worthiness of business enterprise can not be drawn.
Drawing a line of separation between the owner and the business is very thin in the case of sole proprietorship and partnership, but not so in the case of companies. Sometimes it becomes very difficult to differentiate between the personal expenses and business expenses. For example, use of personal car for the purpose of business or use of official phone for personal purposes etc.
2. Money Measurement (Monetary Unit Concept):
This assumption distinguishes between the qualitative and quantitative aspect of a transaction. According to the money measurement concept, a fact or a transaction will be recorded in the accounting books only if the effect of such a situation or transaction can be computed in monetary terms.
If such is not the case, no fact should be recorded irrespective it was very important and could affect the financial results of the business enterprise. For instance, adverse impact on sales due to lack of coordination between the sales team and production team cannot be recorded in the books of accounts, however, the loss of goods by fire can be recorded in the books.
(i) Common unit for recording business transactions:
Money Measurement concept plays a vital role in accounting, because critical decisions viz. fixing the selling price of product, paying dividend to the shareholders, payment of salary and wages to the staff etc. depend upon the value of an item and not the quantity or appearance of an item.
(ii) Judging the financial position of business enterprise:
Recording transaction in terms of money helps in fulfilling the objectives of accounting i.e. ascertaining the profitability and or solvency of the business enterprise.
(i) Ignore Qualitative Aspects:
Money measurements underline the fact that in accounting only those events, happenings or transactions can be recorded which can be measured in terms of money only. However, there are certain facts which, though important for judging the financial position of the business enterprise, cannot find place in the books of accounts because they cannot be measured in terms of money. For example, an efficient manager is not recorded as an asset or a dishonest employee is never recorded as a liability for a business. This is the biggest limitation of money measurement concept.
(ii) Ignores Price level Changes:
Another limitation is associated with the purchasing power, the primary characteristic of the monetary unit. Since the transactions are recorded at their money value on the date of occurrence, it ignores subsequent changes in the money value. In other words, money measurement ignores the impact of price level changes by not considering the inflationary movements into account.
3. Accounting Period (Periodic Concept):
Accounting period is usually a period of one year and that year can be a financial year, a calendar year or any year of 12 months. However, for tax purposes, the accounting period should be a financial year i.e., a year starting from 1stApril to 31st March. The accounting period not only helps in the maintenance of accounting records and ascertainment of actual profit or loss but also in ascertaining the true and fair view of the financial position of the enterprise and also communicating the business information to the intended users.
As per the Going Concern Concept, the business will continue its operations indefinitely i.e. for a fairly long period. Actual success or failure of a business enterprise is determined at the time of its final closure or when it ceases to operate the business permanently. But knowing the reasons for its success or failure at that point of time would hardly be of any use for the owners, management, financial institutions and other users because it’s no use crying over spilt milk.
For ascertaining the information about the profitability and feasibility of the business, users of accounting information cannot wait till indefinite period. Keeping this in view, the whole indefinite accounting period is divided into parts, known as accounting periods. Financial statements showing the financial results for those periods are prepared.
In this way, management has enough time to take corrective and preventive measures. This would ease out the problems of both the proprietor and the various users of accounting information by timely evaluating the financial results in each accounting period.
Accounting period assumption facilitates the management to take timely action for remedial and corrective measures. It saves the business entity from going into liquidation because timely information facilitates the management in taking remedial measures. As per the statutory requirements of SEBI and Companies Act, 1956, accounting period assumes more importance.
Accordingly, annual reports are to be prepared and submitted to the shareholders. Similarly, as per Income Tax Act, taxes on income shall be calculated on annual basis and that too on the basis of financial year. Companies whose shares are not listed on stock exchange are required to publish their financial position quarterly.
Despite the significance of this assumption, it is not free from the following shortcomings:
(i) Identification of accounting year is difficult:
As per the accounting period assumption, business transactions are identified and recorded on the basis of that particular accounting period. However, in real life there are so many transactions which relate to more than one accounting period. Sometimes, it becomes very difficult to identify and establish to which accounting year such transactions relate. For example, deferred revenue expenditure or payment for the purchase of fixed assets.
(ii) Misleading results when different accounting methods are adopted:
Another limitation of accounting period arises when entities follow different accounting methods for recording of depreciation or stock valuation in different accounting periods. In those circumstances, results from comparisons of different accounting periods would be misleading.
4. Full Disclosure Principle (Full Disclosure Concept):
The principle of full disclosure directs a business enterprise towards disclosing the full, fair and sufficient information. Since one of the primary objectives of accounting is to communicate with the intended users, full disclosure in the financial statements and accompanying footnotes acts as a means of communicating all relevant, material and reliable information to them. Stated differently, no information of substance should be concealed in the financial statements. The users here can be both internal and external.
For instance, top level management requires information for planning, for which it requires internal papers like production reports, cash budget report etc. Similarly, external users like banks, creditors etc have to rely on financial statements as the source of information.
In this connection, certain regulatory authorities have made innumerable strict clauses for the disclosure of essential information through financial statements and reports. For example, Security Exchange Board of India (SEBI) has made it compulsory for certain types of companies to annex Corporate Governance Report in the annual report showing their financial results.
Similarly, Companies Act has made it compulsory for all the companies to use the formats provided by it for the preparation of Profit and Loss Account and Balance Sheet, including complete details regarding the items to be included and their placement including the contents of foot notes.
This shows that disclosure of all material facts is compulsory but it does not imply that even those figures which are irrelevant are to be included in financial statements. It just requires all the material information i.e. any fact or figure which has the capacity of altering the decisions of users, associated with the enterprise, and must be conveyed in an organized and reliable manner.
Information contained in the financial statements is used by various users such as investors, management, lenders, creditors and others for taking various decisions pertaining to them. In this context it becomes more important to disclose all material facts relating to the financial performance of a business enterprise fully in their financial statements and their accompanying footnotes to enable them to take decisions about profitability and financial soundness about the business enterprise.
The limitations of full disclosure are as under:
(i) Historical in nature:
The information contained in the financial statements is historical in nature and reflects the past position of business organization.
(ii) Records only monetary transactions:
The information which can be measured in terms of money can be recorded in accounting. A lot of transactions, though important and have a significant impact on the working of enterprise, do not find place in books of accounts as they are non-financial in nature. For example, in-effective control prevailing in the organization, inefficient employees, market conditions, change of government policies etc.
(iii) Window Dressing and Personal bias:
Sometimes, events are measured on the basis of estimates. In those cases, judgment of the person who is estimating the events plays a vital role in accounting. For example, estimating the useful life of the asset for calculating of depreciation. So we can say window dressing and personal bias of an individual influence the personal judgments.
5. Materiality (Materiality Concept):
As per full disclosure concept each and every aspect related to business enterprise should be fully disclosed in the financial statements but sometimes it is not possible to disclose all the information. In this context materiality requires that accounting should focus on material facts and efforts should not be wasted in presenting the facts which are not so important or immaterial.
In this connection one important question arises -What is material? It may happen that one fact is material for someone but not for others and vice versa. If any fact or figure has the capacity of changing or varying the decision of any intended users viz., owner, management, creditors etc., it is said to be a material fact.
Hence, the immaterial items are to be merged with other items. Irrelevant items can sometimes be left out from recording. But the decision whether the transaction fact or figure is material or not should be taken with due care and utmost diligence. In this connection one should put oneself in other’s shoes and try to understand how relevant that information for one is.
For instance, variation in the amount of profits of two consecutive years due to change in depreciation policy, inventory valuation, abnormal circumstances like lockouts, earthquake etc. are material. However, decrease in sales due to less demand is irrelevant.
Material information in the financial statements helps the intended users to take decision relating to their interest. Containing only material information in the financial statements does not overburden the financial statements.
The major limitation of this principle is that there is no consistency about the meaning of material. Sometimes it may happen that one fact is material for someone but immaterial for others and vice versa.
6. Prudence (Conservatism):
The convention of conservatism, also known as prudence, is based on the policy of ‘playing safe’. Accordingly, all anticipated profits should be ignored but all anticipated losses should be accounted for. The convention requires that profits in anticipation should not be recorded but losses in anticipation should immediately be recorded even if there is a very remote possibility of occurrence of such losses.
This convention is based on the rule that “anticipate no profits but provide for all possible losses.” Thus, a cautious approach should be adopted in ascertaining the income of the business entity with the objective that profits of the enterprise in no case be overstated. The overstatement of profits may lead to distribution of excess dividend, resultant reduction in capital of the business enterprise.
When there is more than one equally acceptable method available, the method which is nearer to conservative approach should be adopted. It is because of this that conservatism is also called prudence principle so that the rational application of the same could be possible in circumstances of uncertainty and doubt.
In the same parlance, business entities are required to:
(i) Value stock at cost or realizable value whichever is lower;
(ii) Create provision for doubtful debts;
(iii) Create provision for discount on debtors;
(iv) Ignore the provision for discount on creditors;
(v) Create investment fluctuation reserve;
(vi) Show the joint life policy at its surrender value on the asset side of the balance sheet;
(vii) Write off intangible assets like goodwill, trademark, and patents as early as possible.
The convention of conservatism is a pessimist approach in accounting, but for dealing with the uncertainties it is a must. In this way interests of lenders and creditors are also protected by not distributing fictitious profits as dividends.
(i) Inconsistent with the principle of consistency:
Convention of conservatism leads to inconsistency in the sense that while adopting the methods which would have least effect on overstatement of profits and assets, sometimes in two successive years the business entities have to adopt two different methods of accounting. For example, in one year stock is valued at cost price (being less than the realizable value) and in the next year stock is valued at market price (being less than the cost price).
(ii) Creates secret reserves:
Too much of conservatism might lead to misinterpretation and result in creation of secret reserves which goes against the principle of full disclosure.
It is reminded again that the tool of principle of conservatism should be used in the most cautious and rational manner.
7. Cost Concept (Historical Cost):
This principle assumes the importance in the field of accounting in the sense that monetary values of items are recorded in the books of accounts as per this concept. As per cost concept, all assets are required to be recorded in the books of accounts at their original cost.
In other words, the assets are recorded at their purchase price which comprises cost of acquisition and all expenditure incurred for making the asset ready to use such as amount spent on its transportation, installation etc.
Not only the assets are recorded at their cost price, the underlying principle also serves as the base for all subsequent accounting for the assets. For example, any short term, long term capital gain or depreciation would be calculated on the cost price. As such, if nothing is paid to acquire the asset that will not be recorded in the Balance Sheet.
(i) This concept provides greater objectivity and greater feasibility because assets are recorded at their cost price and not at their market value so chances of manipulation and window dressing in accounts are remote.
(ii) Delay in preparation of financial statement is avoided because assets are shown at their cost price. In contrast, many times it is not even possible to work out market values for certain assets as the values of those assets change frequently in the market. For example, land and buildings, computers, software etc. Consequently, financial statements preparation can get delayed a lot.
(iii) This concept strengthens the assumption of going concern in the sense that going concern assumes that the business will operate its activities till indefinite period of time. So there is no need at all to use current values of the assets.
Whether the business is adhering to the historical concept or not, a proper note should be given in the accounting policies and annexed at the end of their financial statements.
The biggest limitations of this principle are:
(i) The true worth of the business is not shown in the books of accounts and the business may hide gains had those assets been shown at their market values.
(ii) Assets for which no amount is paid cannot be recorded in the books of accounts. For example, reputation or goodwill of the business enterprise.
(iii) A balance sheet prepared on the basis of cost concept does not indicate the price at which the assets could be sold, as against a relevant balance sheet prepared on the basis of market value.
Keeping in view the above, accounting information based on historical cost is not much useful to its users, creditors and financial institution in particular and management in general because the parties interested in the business e.g. prospective customers, investors, lenders, suppliers etc. are interested in determining what the business is worth in today’s date rather than its worth based on past data.
8. Matching Principle (Matching Concept):
The matching principle facilitates to ascertain the amount of profit or loss incurred in a particular period by deducting the related expenses from the revenue recognized during that period. Accordingly, all expenses incurred by the business entity during an accounting period should be matched with the revenue recognized during the same period.
Similar to revenue recognition, expenses should not be recognized at the time when cash is actually paid. Instead it should be recognized when an asset or service has been used to earn the revenue. For example, expenses such as salaries of employees, electricity charges, etc. should be recognized on the basis of the period instead of payment of those expenses.
Thus, recognized expenses to earn the recognized revenue, should only be recorded in the income statement of a particular period. In this parlance, total cost of fixed assets is allocated over the useful life of that asset as depreciation and charged to revenue.
Similarly, when a heavy amount is paid for advertisement, benefit for which would be derived for 5 years, the whole amount shall not be treated as expense in the year in which the amount is paid. Rather, on the basis of benefits likely to be received from such expense it should be properly allocated over the 5 years.
Following examples would further illustrate the concept of matching principle:
1. In case of prepaid insurance, a part of insurance related to the next accounting period should be shown on the asset side of the Balance Sheet of the current year which would be ultimately shown as expense in the later years.
2. If the amount of revenue is received this year but service against that is yet to be rendered then this will be shown as a liability in the Balance Sheet because the business is under an obligation to deliver the services in future.
3. An asset destroyed by fire. It will be charged against profit for the year only to the extent not recoverable from insurance i.e., book value less insurance claim admitted by the insurance company.
It is helpful in measuring the income (profit) for the given period by relating expenses to the associated revenues. The matching principle facilitates to ascertain the amount of profit or loss incurred in a particular period by deducting the related expenses from the revenue recognized during that period.
The limitations of the matching concept are as under:
(i) It does not take inflationary pressure into consideration. This principle fails to take inflationary pressures into account. For example, machinery purchased originally for Rs. 1, 00,000 in the year 2003 might be worth more than many times after some years. But depreciation is charged every year on the original cost only.
(ii) Sometimes it is very difficult to estimate the actual benefits received and the benefits likely to be received in future periods. In that case proper allocation of expenses related to the current year and future years would be a difficult task. For example, amount paid for advertisement.
Above all, matching principle constitutes one of the most crucial concepts in accounting and should be understood thoroughly before recording transactions in the books of accounts.
9. Dual Aspect (Accounting Equation Concept):
As the name suggests, duality deals with double effect. This aspect provides the basis for recording all business transactions in the books of accounts, so it is regarded as one of the basic principles of accounting. According to this principle, every business transaction has a two fold effect.
For instance, contribution of capital by the owner increases the assets of the business enterprise in the form of cash and at the same time it increases the owner’s claim on the business. Thus, it also becomes a liability for the business enterprise.
It is worth mentioning that basically, the dual aspect arises because of the business entity concept. As it proposes the owner and the business to be two distinct entities for accounting purposes, every transaction will have a double effect. Every giver is a taker and every taker is a giver.
For instance, if a business purchases building on loan, it would have two effects, one of increasing the fixed assets and second of increasing the outsider’s claim. Similar examples on the duality aspect can be observed in numerous forms. The duality aspect can be expressed in terms of an equation, known as accounting equation.
There are three main variables or elements in any accounting equation viz:
(ii) Liabilities and
(iii) Capital (Owner’s Equity).
These three elements are shown in the accounting equation as:
Assets = Liabilities + Capital
The above equation shows that the assets of a business enterprise are equal to the total claims viz. claims of owner and claims of outsiders.
Duality aspect provides the basis for recording all business transactions in the books of accounts, so it is regarded as one of the basic principles of accounting. According to this principle, every business transaction has a two fold effect.
This aspect establishes the relationship of business transaction in monetary terms. There are certain facts, which though important for judging the financial position of the business enterprise, cannot find a place in the books of accounts because they cannot be measured in terms of money. For example, an efficient manager is not recorded as an asset or a dishonest employee is never recorded as a liability for a business.
10. Revenue Recognition (Realisation Concept):
Recognising the revenue means recording the income in the income statement, prepared for a particular period. The revenue recognition facilitates to recognize the revenue, which should be included in the income statement.
Stated in other words, the answers to two basic questions viz:
(i) What should be termed as revenue and
(ii) When that revenue is treated as realized, have been answered by this concept.
The term revenue means and includes gross inflow of cash or other consideration arising from the sale of goods, rendering services and by use of resources of enterprise by others such as yielding interests, royalties and dividend etc. Revenues are assumed to be realized at that point of time at which goods have been sold and/or services have been rendered to the customers and a legal right to receive the revenue arises.
As per revenue recognition concept, events and conditions are recorded in the books of accounts as and when they occur, rather than in the period of their receipt or payment. Accordingly, revenue earned during the year is to be recorded as against the revenue received during the year.
From the above, we can say that revenue is realised when goods sold and/or services rendered by a business enterprise are transferred to the customer either for cash or for an acceptance to receive in future. In other words recognition of revenue has nothing to do with the actual receipt of cash or receipt of an order to supply goods. For example, a manufacturing house produces units of goods in January, 2006, which were to be supplied in April, 2006.
In this case, the revenue will be considered in April, 2006 when the actual sale takes place. In case of extraction business, revenue is recognized the moment when natural resources (like coal from mines) are extracted out from mines. It only means that the revenue is realized, when either cash is received or a legal obligation is assumed by the customer to pay a certain sum in future.
When all transactions are settled in cash, revenue can be recognized immediately. However, this is not so in practical life. Many times, goods and services are sold or purchased on credit basis.
Revenue recognition concept facilitates to recognize the revenue to be considered in the income statement for any particular year. The concept prevents the management from giving wrong information about the income, which is yet to be earned, to the various users of accounting information.
The main limitations of revenue recognition concept are as under:
(i) It fails to recognize the revenue in case of contracts for long-term projects. For example, contract for construction of Metro Rail Project which takes 10-15 years to complete. In this case, should we consider the whole amount of contract as revenue on the date of completion of the project or on the date of entering into contract? As per Income Tax rules, for each year, revenue is considered on the basis of the part of the contract completed during that year.
(ii) In the case of goods sold on the basis of hire purchase system, the amount collected in each year as installment is treated as the revenue realized during that particular year instead of total selling price.
11. Objectivity Principle (Verifiability & Objectivity Evidence Concept):
This principle proposes that every accounting entry in the books should be verifiable against evidences like vouchers, cash memos, cheques etc. In other words, if there is a certain quantity of goods purchased, it should be verified against the cash memo for the quantity, quality and price mentioned therein. The evidence showing the validity of a business transaction should be objective enough.
In other words, the evidence should state the facts as they are, without a bias towards either side. In addition, the supporting documents like invoices, memos, and cheques provide the basis for making accounting entries and for later audit of accounts. However, every accounting entry is not subject to verification; also the same is neither possible nor feasible, To sum up, it can be said that this principle holds that accounting should be free from personal bias.
The verifiability and objectivity in accounts support the thought that books and accounts show true and fair view of the business concern. This principle also serves as the base for adoption of Historical Cost, as assets are recorded at their cost price instead of market value and this cost price can be verified from the books of accounts, if those transactions are duly supported with the documentary evidences.
Each and every transaction is not subject to verification because the same is neither possible nor feasible. The same voucher can be used for more than one purpose. For example, the same voucher for petrol can be used for different cars used by the business enterprise.
It can be said that this principle holds, when the intention of the persons involved in accounting is not malafide and they are not pressurized by the owner and management.
This principle basically proposes to provide and update the various users in accounting with the relevant and recent financial and operational information about the business enterprise. Necessary steps should be taken to inform the relevant information to the different users in time.
The relevant information should be regularly and timely made available to the interested parties. For example, issuing segment wise quarterly financial results by the companies is the step ahead in accounting to achieve the objectivity of this principle.
We know that accounting is the process of identification, measurement, recording and communicating economic events of an entity to all concerned. When at the time of recording data, details of the current year’s sales are not furnished, the whole purpose of accounting i.e., to make the relevant information available to the users for their convenience is defeated. The information should be regularly and timely made available to the interested parties.
Information furnished without waiting for the audited results may mislead the users because in many cases it had happened that there was a huge difference in the before audited and after indicted financial statements. Moreover, to save the time, audit observations of the auditor are concealed and not furnished to the users. In that case, the whole purpose of providing information to the users in time is defeated.
13. Substance over Form:
This principle, as the name suggests, complements materiality. It explains that even if a transaction, a fact or figure is not appropriate from a legal point of view but constitutes substance either money-wise or otherwise, it should find a place in the financial statements of the company. For example, debentures issued as collateral security to a financial institution.
Even if those debentures are not a part of assets of lending financial institution until the company fails to repay the amount of loan to the financial institutions; these debentures are shown as the assets by the financial institutions. Similar is the position in case of hire purchase transactions in which hire purchaser does not become the owner legally, even than that asset is shown in his balance sheet on the assets side. The main theme is that in these transactions the substance of the transaction is that the asset is immediately acquired by the hire purchaser and he has to pay the loan along with interest.
Transactions which are different from substance or fundamental commercial reality find place in the books of accounts due to this concept.
14. Variations in Accounting Practices:
In-spite of providing detailed clauses, guidelines and provisions for recording all kinds of financial data in accounting books of business; it sometimes does not seem to be enough. In other words, an exhaustive list of guidelines still does not exist in the corporate world. This is so because in-spite of being a part of the same industry, business entities follows different accounting practices. This is called variations in accounting practices.
For instance, accounting treatment of contingent liability, depreciation, valuation of inventory is being dealt with differently by various business entities. Take another example. As a general practice, inventories are recorded at cost price or net realizable value whichever is less but in case of agricultural products, crops are shown at contract price, support price or market price. Thus we can conclude by saying that sometimes existence of such a descriptive list of provisions and guidelines becomes immaterial and management is bound to follow the intercompany on inter-industry rules.
Sometimes, distinctiveness of a particular industry requires departure from some accounting principles because of their inapplicability in those types of industries. For example, valuation of gold at market price instead of cost price.
It is very difficult to compare the profitability of two different entities if they belong to different industries, despite the fact that same amount of capital is invested in both the entities as different methodologies are adopted by those entities.