Chapter 2

Nature of Financial Accounting Principles

LEARNING OBJECTIVES

At the end of the chapter, you will be able to understand

  1. Need and Meaning of Accounting Principles

  2. Meaning and Characteristic Features of Generally Accepted Accounting Principles (GAPP)

  3. Basic Accounting Concepts – Entity Concept, Money Measurement Concept, Going Concern Concept – Accounting Standard (AS)–1, Periodicity Concept, Cost Concept – Special Features, Realisation Concept, Matching Concept.

  4. Basic Accounting Conventions – Convention of Conservatism (Prudence), Convention of Consistency, Convention of Materiality and Convention of Disclosure

  5. Distinction Between Concepts and Conventions

OBJECTIVE 1: NEED AND MEANING OF ACCOUNTING PRINCIPLES

A uniform set of rules and guidelines must be necessary for any accountant to prepare the financial statements of an enterprise. If there are no standardised set of rules, then each accountant for each enterprise will prepare the financial statements in their own way which will result in unreliable, inconsistent and biased accounting information. Keeping in view of this, the accountants have developed certain rules and guidelines to be followed by each enterprise. These rules and guidelines are the outcome of constant hard work of accounting professionals over the years. Generally, such set of rules and guidelines are known as accounting principles.

OBJECTIVE 2: MEANING AND CHARACTERISTIC FEATURES OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAPP)

2.1 Meaning of GAPP

GAPP may be defined as “those rules of action or conduct, which are derived from experience and practice and when they prove useful, they become accepted as principles of accounting.” GAPP is a technical accounting term, which describes the basic rules, concepts, conventions and procedures that represent the accepted accounting principles at a particular time. According to the American Institute of Central Public Accountants (AICPA), the principles which have substantial authoritative support become a part of the generally accepted accounting principles. It further stated that, “generally accepted accounting principles incorporate the consensus at any time as to which economic resources and obligations should be recorded as assets and liabilities, which changes in them should be recorded, how the recorded assets and liabilities and changes in them should be measured, what information should be disclosed and how it should be disclosed and which financial statements should be prepared.” GAPP include accounting principles as well as procedures for applying these principles.

2.2 Salient Features of GAPP

As GAPP are ground rules for accounting, the salient characteristic features of accounting principles are highlighted as:

  • To ensure uniformity: Accounting principles have been formulated to ensure uniformity and easy understanding of the accounting information.
  • Not final statements: Accounting principles are generally not final statements. They are not static. Any change in government regulation or introduction of statutory legislation may affect the existing accounting principles. Hence, accounting principles will have to be modified in conformity with those changes.
  • Simple guidelines: Accounting principles are not laboratory tested principles. They are not discovered. They are man-made. They are derived from experience. They are simple guidelines.
  • GAPP depends on the following attributes:
    1. Relevance: A principle is relevant to the extent it results in information that is meaningful and useful to the user of accounting information.
    2. Objectivity: A principle is objective to the extent the accounting information is not influenced by personal bias or judgement of those who provide it. It also implies verifiability, which means that there is some way of ascertaining or checking the correctness of the information reported.
    3. Feasibility: A principle is feasible to the extent it can be implemented without much complexity or cost.

Generally, all the above three features are found in accounting principles. In some cases, sacrifice of one principle in favour of other principle may become necessary. In some cases, an optimum balance of all the three is struck for adopting a particular rule as an accounting principle. These features often contradict with each other. In applying new principles, it is essential to achieve a trade-off between relevance on one hand and objectivity and feasibility on the other.

OBJECTIVE 3: BASIC ACCOUNTING CONCEPTS

Basically, an accounting concept is an opinion. Accounting concept is the base for evolving a set of rules and guidelines to record business transactions. It is a recognised presumption that business in an accounting entity, separate from its owners, is a sole proprietorship, or partnership firm or limited companies (private as well as public). Accounting concept is not subject to any proof because it is only an opinion based on the assumption. Despite the fact that accounting concept is not a fact, its role in the preparation of financial statements or any accounting process is well recognised by the accountants.

The factors that determine the evolution of accounting concepts are:

  1. New inventions, improvement in technology, increasing business activities, proliferation of multinational companies as an impact of globalisation – all necessitate new kind of varied transactions. Hence, new accounting concepts have to be developed to combat with such innovations in technology. Accounting concepts are ever changing in nature.
  2. New accounting concepts have to be devised keeping pace with the changes in legal, socioeconomic environments.

In general, while recording business transactions, business entity concept and historical cost concept have been taken as basic concepts. There are some more basic accounting concepts that are being observed while preparing the financial statements. They are:

  1. Entity or business entity or accounting entity concept.
  2. Money measurement concept.
  3. Going concern concept.
  4. Accounting period concept.
  5. Cost concept.
  6. Realisation concept.
  7. Accrual concept.
  8. Matching concept.

3.1 Entity Concept

For accounting purposes, the business is treated as a unit or entity, apart from its owners. The proprietor of a business enterprise is always considered to be separate and distinct from the business. According to this concept (i.e., business as an entity), all the transactions of the business are recorded in the books of the business. Each business entity is treated as a separate distinct unit and accounting process is carried on and as such all personal transactions affecting the proprietors are not to be taken into account. As per the business as an entity concept, even the proprietor (owner) of business enterprise is observed as a creditor to the extent of his capital contributions. Thus, capital is a liability like any other liability and the amount is due to proprietor, that is, the enterprise owes to the proprietor. This concept, as a separate legal entity, is specifically applicable to joint stock companies.

But, in some form of organisations, accounting entity is not necessarily a separate legal entity. Take the case of sole proprietorship, where a sole trader cannot separate his business assets and liabilities from those of his personal assets and liabilities. Legally speaking, a sole trader’s liability is “unlimited,” which means his business liability can be met with his personal assets. Law allows to recover debts occur in business from his personal resources. The same is the case of partnership firms. A partnership firm is not a legal entity. As per the Partnership Act, all the partners are jointly and severally liable for firm’s debts. But in companies registered under the Companies Act (public limited companies), this legal entity concept is recognised because the shareholders (real owners of the company) are not liable for the company’s debt. Liability is limited to the extent of their amount they invested in shares of their particular company. But, it is important to be noted at this juncture, that is, for accounting purposes, the principle of business entity is observed. Even though the legal provisions stipulate and treat the sole trader and his business as one unit, the accounting principles treat them as two different units as business and personal. Hence, in business enterprises, whichever type it belongs to, that is, sole proprietorship, partnership firms or joint stock companies, the separate entity concept is taken into consideration. Even the separate entity is not recognised by law in some form of organisations, as explained above, for accounting purpose the separate entity concept is always to be taken as base. One should understand in this context that the concepts of legal and business activities are not compatible with each other.

The “entity concept” reveals:

  1. Personal transactions of the owners are not at all recorded. Only business transactions are to be recorded.
  2. Net result (profit/loss) is related to the business.
  3. The capital is treated as a liability of the business, which it has to owe to its owners.
  4. This concept may be applied to the whole enterprise as one single unit or to different departments of the enterprise.

3.2 Money Measurement Concept

The money measurement concept highlights the fact that in accounting, all transactions of any type of enterprise are recorded in terms of money. According to this concept, transactions, which cannot be expressed in terms of money, are not recorded in the books of account. They assume that money is a stable unit of measurement which means same value of money for all times is taken into consideration.

This concept suffers from a serious limitation. According to this concept, a transaction is recorded at its money value on the date of the transaction. It fails to recognise the frequent changes in the money value. For example, a land (measuring 1,000 sq. mtrs.) was purchased for Rs 1,00,000 in 1990 and another transaction of purchase of a land (same extent, same location) for Rs 2,00,000 in 2000 were recorded at Rs 1,00,000 and Rs 2,00,000 respectively. But, the worth of land purchased in 1990 is more in real terms than the one that was purchased in 2000, though it is recorded as Rs 2,00,000.

Both these transactions are shown in today’s Balance Sheet, that is, 2010 at the rate on which they were purchased. Its worth will be several times higher today. This is due to the fact of rising prices and change in the value of money. Money as a unit of measurement is not stable or constant forever. In accounting this important factor, that is, change in the value of money is ignored.

Another drawback in the usage of this concept is that it does not take into consideration of non-monetary transactions. It ignores all the other facts and events that affect the enterprises. For example, quality of the products marketed, working conditions of employees, sales policy and such facts and events, which cannot be recorded in terms of money, are ignored. Under such circumstances, this concept affects the true usefulness of accounting records. Consequently, this affects the management decisions and overall efficiency of the management

Despite the above illustrated limitations, the importance of the usage of money measurement concept cannot be underestimated. The financial statements prepared at the end of the accounting period show the operating results (after all necessary adjustments – additions and deductions) in a summarised form. To make necessary adjustments, that is, for addition or subtraction a common unit of measurement is needed. Here, it is in terms of money. In the absence of a common measurement unit, that is, in terms of money, any information will be valueless.

Example: A business has a land of 1000 sq. mtrs., building with 10 rooms and one conference hall, 100 chairs, 150 fans, 5 tonnes of raw materials, 10 air conditioners and so on. If they are expressed like this without any common measurement unit their value as exist cannot be assessed and if any purchase or sale from these items also cannot be quantified.

Suppose, if the same is expressed in terms of money, that is, a land of Rs 1,00,000 (1000 sq. mtrs.); building worth Rs 50,00,000 (with 10 rooms and a conference hall); 100 chairs each at Rs 250; 10 air conditioners each at Rs 20,000, then the total value as exist is easily ascertained. At the time of any addition by way of purchase or deduction by way of sale can be adjusted with the existing items.

Hence, this concept increases the value of the state of affairs of a business enterprise in its true sense. The use of money measurement concept has become inevitable and indispensable.

3.3 Going Concern Concept

This going concern concept assumes that the enterprise will continue to exist for a number of years (indefinite) in future. As Accounting Standards (AS)–1, going concern concept is a fundamental accounting assumption underlying the preparation of financial statements. While dealing with the disclosure of accounting policies, AS–1 stipulates “the enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations.” Construction activities is a typical example. Once the construction of the specified project is completed, the business comes to an end. On the other hand, certain business enterprises that are engaged in automobile, consumable goods exist for over a century. It will continue its operations in the foreseeable future. This going concern concept is followed in the valuation of assets. If this is not followed, AS–1 requires the disclosure of fact with reason.

Advantages

  1. The going concern concept facilitates the classification of assets and liabilities as short-term and long-term.
  2. This concept is a boon to investors. They may not be in anxiety on the life of the enterprise. Having assured of the longevity of the business entities, investors returns is also assured.
  3. Assets are depreciated on the basis of expected life, not on the basis of market value. This facilitates the allocation of the cost of the asset over the expected life of the asset. Thereby it dispenses with the periodic consideration of market value. This concept is in accordance within that of the accounting principle that “depreciation is a process of allocation, not of valuation.”
  4. This going concern concept facilitates the task of accounting professionals to record the value of fixed assets at cost rather than to follow “value-in-use” approach. Market price is ignored. This is for the treatment of the fixed assets.
  5. For current assets, they are valued at lower of cost or market value.

Disadvantages

  1. When financial statements are prepared in the going concern concept, and the required formulations regarding the publication of reports and statements are completed, some enterprises may wind up (liquidate) their business. In such situation this may mislead the user, the net result will lead to chaos and confusion.
  2. Unsecured creditors will be put in too much hardship due to such misleading financial information.
  3. Furthermore, future cannot be predicted and unforeseen events cannot be controlled in advance.

3.4 Periodicity Concept (Accounting Period Concept)

The net income of the business, really speaking, can be measured correctly by computing the assets of the business existing at the time of its commencement with those existing at the time of its liquidation (wind up). As per the going concern concept, the life of the business is indefinite. In that case, one has to wait for a very long period to know the results of his business. The preparing and reporting of the net results of the business at the end of the life is not at all useful to its users. Not even corrective measures can be taken by the owners after liquidation takes place. Each and every user of financial statements are much interested to know “how things are going” at frequent intervals. Hence, the accounting professionals have developed this concept – the periodicity concept.

A shorter and convenient time is chosen for the measurement of income and reporting the same at specified intervals. Usually, twelve months period is followed for the purpose of preparing and reporting financial statements. This time interval is known as accounting period and that is the reason for calling this as “Accounting Period Concept.” The generally adopted accounting period is calendar year, that is, from Jan 1 to Dec 31 or it may be a financial year, which starts from Apr 1 and ends on Mar 31, of the following year. Now-a-days, financial accounts are prepared and reported at shorter intervals of half yearly, quarterly or even a month. Such accounts are termed as interim accounts. Interim accounts, which are less than half yearly are mainly intended for internal use. Half yearly accounts are reported in papers as part of listing requirements. In general, such interim accounts are not subject to audit.

Periodicity concept also depends on the type of business. There are some kinds of businesses, which are called “continuing profit seeking enterprises.” These type of business enterprises continue indefinitely. In such cases, accounting and reporting has to be carried out periodically.

Advantages

  1. Financial information is available to its users at specified intervals.
  2. By periodical evaluation, correct measures are taken at an appropriate time.
  3. It serves as a useful and reliable information to statutory and regulatory authorities.

Disadvantages

  1. Usually, the business transactions spread to more than one accounting period.
  2. Allocating the cost to a particular accounting period is difficult and arbitrary.
  3. This concept overrides the different bases and other accounting concepts resulting in defective and deceptive financial statements.

3.5 Cost Concepts

According to the cost concept, the asset is recorded at the price paid to acquire it, that is, at cost (not market value) and this cost is the basis for all subsequent accounting for the asset. This is also called as historical cost because the acquisition cost, which is taken as a basis, relates to the past.

In case, if nothing is paid for acquiring the asset as per this concept, it will not be recorded in the books of accounts as an asset. In this context, it is appropriate to quote, “thus the knowledge and skill, that is built up as the business, operates a team work that grows up within the organisation, a favourable location that becomes of increasing importance as time goes by, a good reputation with its customers, none of these appears as an asset in the accounts of the company.”

Features

  1. The acquisition cost of asset(s) is highly objective. Consequently, the net results of operations are free from subjectivity and personal bias.
  2. There is a high degree of verifiability in cost approach, as details of transactions can be verified with the respective source document.
  3. As market value of assets are constantly changing, the accounting professionals have to fine tune accounting in consonance with such changed market values, which is a cumbersome procedure.
  4. This is highly applicable to concerns where fixed assets are purchased for use in production and not for resale.
  5. Unrealised gains are ignored.
  6. This concept ignores the real value of the capital employed in the business as figures relating to this are not shown in the balance sheet.
  7. Items having no cost are ignored.
  8. Current assets are valued at cost price or market value whichever is lower, periodically. They differ from fixed assets when they are valued.
  9. Users of financial information need the present day worth of the business, whereas the balance sheet depicts the value of cost at which they are acquired. In this aspect, the final accounts do not reflect the true financial position of the enterprises. Strictly speaking, it misleads the investors.
  10. Another limitation arises in charging depreciation. The portion of assets, consumed during the accounting period is technically referred to as “expired cost.” This expired cost is charged as “depreciation” to the profit and loss account. The remaining part, that is, the unexpired cost is recorded in the balance sheet. To compute the expired cost is not an easy affair.

3.6 Realisation Concept

The essence of realisation concept is the timing of the revenue recognition. This concept of “revenue recognition” is explained in Chapter 9 – “Revenue Recognitions and Revenue Expenses” in Objective–8 – “Accounting Standards AS–9 Relating to Revenue Recognition.” Hence, instead of repeating once again, only salient features of this concept are explained as below. (Students have to refer these two chapters for detailed explanation on this concept.)

Realisation occurs when the following conditions are met with:

  1. All the business activities are completed. That means, all necessary costs are incurred and goods/services are kept in the completed form (ready for sale).
  2. Goods are transferred to the buyer for a price and are accepted by him.
  3. As there is a definite sale price, the amount of revenue is recognised definitely.
  4. There is a reasonable certainty that the said amount is received.
  5. Hence, sale of goods or provision and performance of service is the basis for revenue recognition.

3.7 The Accrual Concept

In accrual system of accounting, revenue is recognised when it is realised, that means when sale is complete or services are rendered, whether cash is received or not is immaterial. Similarly, costs (expenses) are recognised when they are incurred and not when paid. The date of transaction (sale/service/cost) is taken for accounting process and not the date of actual receipt of revenue or the date of actual payment for cost.

This system of accounting necessitates certain adjustments in the preparation of income statement. Regarding revenue, amount relating to other than the current accounting period is to be excluded and provision for revenue recognised but not received in cash is to be included. Similarly, regarding costs, provision is to be made for the costs incurred but not paid and the costs for the period other than the accounting period is to be excluded.

The salient features of this concept are explained as under:

  1. Matching principle is the associated concept, which computes the measurement of income by matching the expenses and the revenues.
  2. This system is contrary to the cash system of accounting.
  3. This method emphasises the principle that earning of a revenue and consumption of a revenue (expenses) can be accurately related to specific accounting period.
  4. Adjustments in the accounting process is additional work for accountants.

3.8 Matching Concepts

After revenue recognition, all costs (expenses) that were incurred to earn the revenue of the period will be charged against that revenue earning during that accounting period to determine the net income of the business enterprises. This is the main principle involved in this concept. To put it in simple terms, matching revenues against the related expenses is termed as matching concept. The revenues and expenses shown in a Profit and Loss Account must belong to the accounting period for which it is prepared. Because of this, sometimes the accrual concept is also called the matching concept. The revenue earned during an accounting period and costs incurred during the same accounting period is computed and the following standard equation is applied to determine the net income of a business enterprise.

 

π = ΣR − ΣE

 

where π = Profit
  ΣR = Sum of Revenues
  ΣE = Sum of Expenses (Costs Incurred)

Important aspects to be considered while applying the matching concept are:

 

  1. The revenues of a specified accounting period should be related to expenses directly associated in generating such revenues. This happens only in case such association is direct.

    Example: Association of sales revenue with the cost of goods sold. Mr Shekar buys 50 computers at Rs 30,000 each. He pays Rs 6,000 as carriage inward and Rs 9,000 for special package. He sells them for Rs 17,00,000

    Cost of Goods Sold is (50 × Rs 30,000) + Rs 6,000 + Rs 9,000 = Rs 15,15,000

    Sales: Rs 17,00,000 Profit: Rs 17,00,000 − Rs 15,15,000 = Rs 1,85,000

    Cost of Goods Sold: Rs 15,15,000 is directly associated with Rs 17,00,000 (sale)

    Hence, matching is adopted on accrual basis. Hence, the payments of cash for purchases and receipts of cash for sales is ignored. Thus, matching concept is possible only when the association is direct as shown in the example.

  2. There is a misconception that any net income earned should reflect as increase in cash balance. Such a matching concept may not be true in certain cases. For example, when a machinery worth Rs 5,00,000 is sold for Rs 4,00,000, there is an increase in cash resources to the extent of Rs 4,00,000. Really this will not result in an increase in the owner’s equity because the increase in cash is set off by decrease in asset (machinery). In this example, the owner’s equity is reduced by Rs 1,00,000, as the machinery is sold at a loss. To put in other way, the decrease of Rs 5,00,000 in the machinery is NOT MATCHED by an increase of the other asset (cash) to the same amount Rs 5,00,000. Owner’s equity is less by Rs 1,00,000.

    Net loss decreases owner’s equity (as illustrated in the above example) where net income will increase owner’s equity.

  3. If revenue is deferred, all elements of expenses related to such deferred revenue must also be deferred as per this matching concept approach. For example, heavy expenditure may be incurred on advertisement during a specific accounting year. The benefit due to that expenditure may last for some more years in the future. In such circumstances, it is not proper to match the entire cost of advertising against the revenue of that particular accounting year alone. The cost proportionate to the unexpired utility of advertisement must be carried forward to match against the revenue of subsequent years.

Features

  1. There is much difficulty in allocating costs to different accounting periods, if the matching concept is followed.
  2. Estimates are not made properly, which results in the accuracy of the profit ascertainment.
  3. It is not suitable for unexpected and non-trading revenues for which there are no corresponding expenses. For example subsidies from government, receipts by way of donations, interest on investments and the like.
  4. In cases, if a single expenditure benefits more than one unit, again difficulty arises to apportion the benefit relating to its cost.
OBJECTIVE 4: BASIC ACCOUNTING CONVENTIONS

Definition: An accounting convention is defined as, “a rule of practice, which has been sanctioned by general custom or usage. They are lamp posts to procedures employed in the collection, measurement and reporting of financial data.”

Accounting conventions has come into existence by common accounting practises. They are adopted by common consents. It may also be said that an accounting convention is a common procedure which is adopted by common agreement. It acts like a guide to select and apply the procedure.

Some accounting conventions are:

  • Conservatism (Prudence)
  • Consistency
  • Materiality
  • Disclosure

4.1 Convention of Conservatism (Prudence)

It is a policy of “playing safe.” Prudence also means early recognition of unfavourable events. Working rule relating to the convention of conservatism is – “Anticipate no gains but provide for all losses and if in doubt, write it off.” That means the accountant should not anticipate profit but he should make provision for all losses. In case of doubt, it should be written off or at least he should not indulge in over estimation. Unless the gain is actually realised, he should not record it. This accounting convention is recognised in AS–1, which strongly supports the observation of prudence in the framing of accounting policies. “Uncertainties, inevitably, surround many transactions. This should be recognised by exercising prudence in financial statements. Prudence does not, however, justify the creation of secret or hidden reserves.” In general, convention of conservatism affects the assets that are held for short term.

Following are some of the examples of the application of the convention of conservatism:

  1. Making provision for Doubtful Debts in anticipation of actual Bad Debts.
  2. Making provision for discount on Debtors in respect of discount.
  3. Valuing the Stock-in-hand at market price or cost price, whichever is lower.
  4. Creating Investment Fluctuation Reserve.
  5. Charging of small amount of capital expenditure like crockery to Revenue Expenses.
  6. Amortisation of intangible assets like Goodwill, Trade Marks, Copy Rights as early as possible.
  7. Applying Written-Down-Value (WDV) Method of depreciation as against Straight-Line Method. (WDV method is conservative approach.)
  8. Showing joint life policy at surrender value as an asset on the Balance Sheet.
  9. Taking into consideration claims, intimated but not accepted, as a loss for calculating profit for a general insurance company.
  10. Never providing discount on Creditors.
  11. Providing for the loss on issue of debentures, when the same are issued at par but redeemable at premium.

Circumstances

The principle of prudence is applied in the following circumstances:

  1. When there is uncertainty on the net results of income, that is, profit or loss, losses will be considered and profit will be ignored unless the actual result is profit.
  2. In case, if there are two equally acceptable methods to apply on accounting procedure, then preference is given to the conservative method.
  3. In case of estimation, to judge and select as to which of the several estimates is apt, the most conservative must be the natural choice of selection.
  4. When there is uncertainty inherent in the activity, for example, uncertainty as to the useful life of an asset, occurrence of accident, theft, fire, and so on, the principle of conservatism has to be applied.

Its net impact on financial statements:

  1. Principle of conservatism, when applied, the profit and loss account will show lower net income.
  2. When the same principle is applied to Balance Sheet, there will be under statement of assets and capital and over statement of liabilities and provisions.

Criticism of convention of conservatism

  1. As income is understated due to excessive creation of provisions, depreciation and the like, investors get discouraged.
  2. True financial position cannot be understood from the financial statements prepared by adopting this principle exclusively.
  3. It will result in creation of secret reserves, which is contrary to the doctrine of disclosure.
  4. It is inherently inconsistent.
  5. Considering the overall picture, some takes complacent view and feels contended with the notion that ill effects of under estimation is better than over estimation.

It may be stated that any principle adopted in a moderate and optimum level, the results will be true and fair.

4.2 Convention of Consistency

The consistency convention principle implies that accounting practises and methods remain unchanged from one accounting period to another accounting period. To put it in other way, the same accounting methods will be followed for every year. This convention facilitates easy comparison of different financial statements. As per AS–1, consistency is a fundamental assumption and it is assumed that accounting policies are consistent from one period to another. Where this assumption is not followed, such fact should be disclosed with specific reason for not complying with this.

This consistency convention is the forerunner in choosing a particular method of accounting, when a number of alternative methods are available.

For example, there are several methods of valuation of inventories like First-In-First-Out (FIFO) Method, Last-In-First-Out (LIFO) Method, Weighted Average Method and so on. If one method is followed in one accounting year, say FIFO, in subsequent years also the same FIFO Method has to be followed for valuing the inventories. If there is any change in the method, it will affect the financial statements to a great extent. A change in the method of providing depreciation, making provision for doubtful debts, change from cash basis to accrual or mercantile basis are some of the examples where switching over from one method to other method is possible. It is to be noted that once a method is chosen, it has to be followed in the subsequent years also. Any change will result in unreliable financial statements to its users. No comparison is possible from such financial statements. Hence, consistency convention gains a high degree of significance in such contexts, as explained above.

Eric. L Kohler describes three types of consistencies:

Vertical Consistency: This consistency is maintained within the interrelated financial statement of the same date. “Interrelation” refers to the binding relationship among the constituents of the financial statements namely, Profit and Loss Account (Income Statement) and Balance Sheet. For example, vertical inconsistency will happen where an asset has been depreciated in one basis, say, Straight Line Method for Income Statement and on another basis, say, Written-Down-Value Method for the Balance Sheet.

Horizontal Consistency: This type of consistency is maintained between financial statements from one year to another year and subsequent years. This enables the comparison of performance of a business enterprise in one year with its performance in the next year.

Third Dimensional Consistency: This type of consistency enables the comparison of the performance of a business enterprise with the performance of another business enterprise in the same type of industry, and preferably on the same date.

One may think that in the context of ever changing social-economic environment that the convention follows a rigid and morbid approach without giving room for any flexibility and changes. However, a change is allowed but it has to be applied not frequently. Once a change in the accounting policy is adopted, as already stated, as AS–1, it should be disclosed in the final reports. Reason for such change is to be shown in such statements. Any effect on the financial provision of the enterprise, on account of a change in accounting procedure, has to be disclosed.

4.3 Convention of Materiality

Proliferation of financial information makes the task of accountants more difficult in deciding what information could be provided in the financial statements. His position is so delicate that he is not able to distinguish between material and immaterial information. Many definitions on this aspect leave it to the hands of accountants to decide themselves what should be included and what should not be included in the financial statements.

The American Accounting Association (AAA) defines the term materiality as – “An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor.”

Eric. L. Kohler has defined materiality as – “The characteristic attachment to a statement, fact, or item whereby its disclosure or the method of giving it expression would be likely to influence the judgement of a reasonable person.”

The convention of materiality emphasises “the relative importance of the information” to judge what is material and what is immaterial. Materiality acts as a guide for accounting professionals in deciding what should be disclosed in the financial statements of an enterprise.

Increase in the salary bill, loss of markets, fall in the value of stock are some of the examples of material financial information that should be disclosed in the financial statements. Now, any important material information has come to the notice (surfaced) after the date of the final statements, should also be disclosed.

It has to be observed that an item, material for one enterprise may be immaterial for another enterprise. For example, an item, raw material is an important item for manufacturing enterprises, whereas the same item may not be important for trading enterprises, which are interested in finished products only. Hence, the convention of materiality signifies the relative information.

Similarly, an item, material in one year may not be material in the next year. For example, an item, Bad Debts shown in the previous accounting periods, the same amount may not become important in the subsequent years.

Further, any insignificant amount is usually not recognised as an important item and treated as immaterial. But, if the aggregate value of such items and expenses exceed 1% of the total revenues of the company, a separate disclosure of items and expenses must be made according to the statutory provisions of the Companies Act.

As per AS–1, convention of materiality should govern the selection and application of accounting policies. Financial statements should disclose all items, which are material enough to affect evaluations or decisions. AS–5, in conformity with AS–1, stipulates as “all material information should be disclosed that is necessary to make the financial statements clear and understandable.”

4.4 Convention of Disclosure

The accounting convention of disclosure necessitates to prepare and present financial statements fairly by disclosing all material information therein. Disclosure may be defined as, “the communication of financial information about the activities of a business enterprise to the interested parties for facilitating their economic decisions.” It is a system of communication between the management and users of financial statements.

The convention of full disclosure that every financial statement should fully disclose “all pertinent information that has a bearing on the figures in the statements and that will make possible a reasonable interpretation of their meaning.” It should be important to note that no information of substance or interest to users especially investors will be concealed in presenting financial statements. Take for example, if the Balance Sheet shows Debtors at Rs 1,00,000, it is important to know how much Bad Debts are there and what percentage of provision is made for the Doubtful Debts and the like. If the same has been disclosed as Debtors 1,25,000, Provisions at Rs 25,000, then such disclosure leads the management to think why a provision @ 20% has been provided. Only prompt disclosures, without suppressing or omitting any item, facilitate proper decision making at the level of management and the other users also can know the true financial position of the entities.

There should be a sufficient disclosure of information, which is of material interest to various users of financial statements. In limited company form of enterprise there is divorce between Capital (contributed by shareholders who are the real owners) and the management. As the entire activities of such enterprises are entrusted with the management and with whom entire resources were entrusted, they owe to make a full disclosure to the shareholders (owners who have contributed the capital) and all the users of financial information. Sacher Committee Report on this aspect emphasises that – “Openness in company affairs is the best way to secure responsible behaviour.” Accounting Standards also require the disclosure of all significant accounting policies in the final reports. AS–1 exclusively deals this concept “disclosure.” Besides this, AS–5 deals with the information to be disclosed in financial statements. The concept of “disclosure” also covers the events occur after the Balance Sheet date and the date on which the financial statements are authorised for issue. The procedure of appending notes relating to items which are not shown in financial statements is followed now. In addition to these accounting standards, the Companies Act also enforces through its statutory provision to comply with. The requirements of Schedule VI affecting Balance Sheet and profit and loss of the company make available comprehensive information for various users. Thus, the convention of full disclosures has attained much significance in the accounting policies of business enterprises.

We have discussed so far, conventions and concepts as the important aspects influencing the nature of the financial accounting policies. Both the aspects differ from each other.

 

Differences Between Concepts and Conventions

Basis of Differences Concepts Conventions

1. Basis

A concept is based on the assumptions, which forms the foundation of accounting principles.

A convention is based on the general agreement.

2. Precedence

Accounting concept is preceded by the accounting conventions.

Accounting conventions are not followed by the accounting concepts.

3. Personal judgement

Personal judgement has no role in following the accounting concepts.

Personal judgement plays a major role in following the accounting conventions.

4. Internal inconsistency

Accounting concepts are not internally inconsistent.

Accounting conventions are internally inconsistent.

5. Uniformity in application

There is uniform application of accounting concepts in different organisations.

It is not so in accounting convention.

6. Legal status

Accounting concepts are generally established by the law.

Accounting conventions are established by the common accounting practises.

Summary

  • GAPP is a technical accounting term which describes the basic rules, concepts, conventions and procedures that represent the accepted accounting principles at a particular time.
  • GAPP depends on the attributes – Relevance, Objectivity and Feasibility.
  • Basic accounting concepts are Business Entity Concept, Historical Cost Concept, Money Measurement Concept, the Going Concern Concept, Accounting Period Concept, the Matching Concept, the Realisation Concept and the Accrual Concept.
  • Basic accounting conventions: a rule of practise, which has been sanctioned by general custom or usage. Conventions are the lamp posts to procedures employed in the collection, measurement and reporting of the financial data – some accounting are convention of Conservatism, Consistency, Materiality and Disclosure.
  • Distinction between concepts and conventions.

Key Terms

Accounting concept: Necessary assumptions on conditions upon which accounting system functions.

Accounting convention: It is a rule or an accepted method of accounting practise based on general consent or agreement.

Consistency: Conformity from period to period with unchanging policies and procedures.

Generally Accepted Accounting Principles (GAPP): A term which applies to the broad concepts or guidelines and detailed practises in accounting, including all the conventions, rules and procedures that make up accepted accounting practise, in general.

Entity Concept: The business establishment is regarded as a separate entity. It has a separate existence. The business is treated separately from that of the owner.

Going Concern Concept: Accounting is based on the assumption that the business firm has an indefinite period of existence.

Historical Cost: It is an accounting concept under which an asset (resource or service) is recorded at cost (price actually paid for it). It is the acquisition cost. It is not the market price. Realisable values are ignored

Matching Concept: An attempt to match revenues against the appropriate expenses is referred to as the matching concept.

Prudence (Conservatism): As per this accounting convention, “anticipate no gains; but provide for all losses and if in doubt, write off.”

Periodicity Concept: According to this concept, financial statements are to be prepared periodically at regular intervals and to be reported about the progress of the business.

Reference

 

Anthony R.N. and J.S. Reece, “Accounting Principles,” Richard D. Irwin Inc.

A Objective-type Questions

 

I. State whether the following statements are True or False

  1. Accounting principles are judged on their general acceptability (subject to laws of the land) is the underlying concept of GAPP.
  2. Accounting principles are final statement.
  3. In all types of organisations, business is an accounting entity that separates from the owners.
  4. Different accounting concepts are independent of each other.
  5. GAPP manifest themselves through basic accounting concepts and accounting conventions.
  6. Accounting concepts are based on accounting conventions
  7. Accounting concepts are not internally inconsistent.
  8. The capital of the owner is treated as a creditor for his investment in business.
  9. The separate legal entity is recognised in law in the case of partnership firms.
  10. As per entity concept, income is the property of the business and not that of the owners.
  11. Money, the unit of measurement, has always a constant value.
  12. The going concern concept facilitates the classification of assets and liabilities into short term and long term.
  13. The accounting period concept necessitates the preparation of income statement on accrual basis.
  14. As per the cost concept, assets are always values at historical cost.
  15. Unexpired costs are not recorded in the balance sheet.
  16. Realisation of revenue occurs at the time of exchange of goods or services.
  17. Under accrual basis of accounting, revenue is recognised when the cash is received.
  18. The accrual concept can also be described as the matching concept.
  19. As per prudence convention, the accountants should anticipate profit and should not make provision for loss
  20. As per materiality convention, the accountants should disclose all information in the financial statements, irrespective of the nature of materiality.

Answers

 

  1. True

  2. False

  3. True

  4. False

  5. True

  6. False

  7. False

  8. True

  9. False

10. True

11. False

12. True

13. True

14. True

15. False

16. True

17. False

18. True

19. False

20. False

 

II. Fill in the blanks with suitable words

  1. In double entry accounting, all business transactions are marked as having __________ aspect.
  2. Accounting principles are only __________ based on usage, and experience over a period of years.
  3. Accounting concepts are not _________ forever.
  4. The separate legal entity is recognised by law in the case of a _______ form of business organisation.
  5. Though separate entity is not recognised by law in some types of organisations, the assumption of separate entity has to be followed in __________ types of business organisations.
  6. The capital of the business is considered as a __________ of the business to its owners.
  7. At cost or book value means cost ____________ depreciation.
  8. Periodicity concept emphasises _____________ period assumption.
  9. The cost concept is also referred at as ________ cost concept.
  10. __________ concept assumes that the business entity will continue its activities independently.
  11. The money measurement assumption which assumes that purchasing power of money is always __________.
  12. The realisation concept emphasises the timing of __________.
  13. The essence of accrual concept is that the earning of a revenue and consumption of expenses are related to a __________.
  14. Disclosure is the_________ and _________ of financial information to its users.
  15. Accounting records and statements must confirm to __________.

Answers

  1. dual
  2. guidelines
  3. static
  4. limited companies
  5. all
  6. liability
  7. less (or minus)
  8. accounting
  9. historical
  10. going concern
  11. stable
  12. revenue recognition
  13. specific accounting period
  14. communication and reporting
  15. GAPP

B Short Answer-type Questions

  1. Explain GAPP?
  2. Explain the meaning and significance of Entity Concept?
  3. Explain the meaning and significance of Money Measurement Concept?
  4. Explain the meaning and significance of Going Concern Concept?
  5. Explain the meaning and significance of Accounting Period Concept?
  6. Explain the meaning and significance of Cost Concept?
  7. Explain the meaning and significance of Realisation Concept?
  8. Explain the meaning and significance of Accrual Concept?
  9. Explain the meaning and significance of Matching Concept?
  10. What do you mean by Accounting Convention?
  11. Explain Convention of Consistency?
  12. Explain Convention of Conservatism?
  13. Explain Convention of Materiality?
  14. Explain Convention of Full Disclosure?

C Essay-type Questions

  1. “Revenue is recognised when a sales transaction is made or when services are rendered.” Do you agree with this statement? Give reasons for your answer with suitable illustrations, and exceptions, if any, to this statement.
  2. Explain the terms: “Accounting Concepts” and “Accounting Conventions.” Do you agree that both the terms represent the same meaning? Explain.
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