Tuesday, September 04, 2012

Theory and Base of Accounting

Generally Accepted Accounting Principles
Generally Accepted Accounting Principles are the rules and concepts which have been accepted by accounting community for sound accounting practice. 
Their usefulness depends on ‘general acceptability’ rather than ‘individual acceptability’ of accounting concepts.  They (GAAP) have been formalised on the basis of usage, reason and experience.  As stated by the American Institute of certified Public Accountant (AICPA)-
“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 recorded; when these changes should be recorded; how the recorded assets and liabilities and changes in them should be measured, what information should disclosed and how they should be disclosed and how they should be disclosed and which formal statements should be prepared.”
 Thus Generally Accepted Accounting Principles (GAAP) comprises a set of rules, concept and guidelines used in preparing financial accounting reports.
Essential features of Accounting Principles
(i)      Man made: Accounting principles are man made. They are not tested in a laboratory.
(ii)    Objectivity: It means accounting principles must be based on facts and free from personal bias or judgment of the individuals who prepares the statements.
(iii)   Usefulness/relevance: Accounting principles must be relevant and useful to the person who is using financial statements.
(iv)  Feasibility: The accounting principles should be practicable or feasible.
(v)    Axiom: It denotes a statement of truth which cannot be questioned by anyone.

Accounting concepts:
The term ‘concept’ is used to denote accounting postulates, i.e., basic assumptions or conditions upon which the accounting structure is based. The following are the common accounting concepts adopted by many business concerns.
                           i.      Business Entity Concept
                         ii.      Money Measurement Concept
                        iii.      Going Concern Concept
                       iv.      Dual Aspect Concept
                         v.      Periodicity Concept
                       vi.      Historical Cost Concept
                      vii.      Matching Concept
                    viii.      Realisation Concept
                       ix.      Accrual Concept

i) Business Entity Concept: Business entity concept implies that the business unit is separate and distinct from the persons who provide the required capital to it. This concept can be expressed through an accounting equation, viz., Assets = Liabilities + Capital. The equation clearly shows that the business itself owns the assets and in turn owes to various claimants.
ii) Money Measurement Concept: According to this concept, only those events and transactions are recorded in accounts which can be expressed in terms of money. Facts, events and transactions which cannot be expressed in monetary terms are not recorded in accounting. Hence, the accounting does not give a complete picture of all the transactions of a business unit.
iii) Going Concern Concept: Under this concept, the transactions are recorded assuming that the business will exist for a longer period of time. Keeping this in view, the suppliers and other companies enter into business transactions with the business unit. This assumption supports the concept of valuing the assets at historical cost or replacement cost.
iv) Dual Aspect Concept: According to this basic concept of accounting, every transaction has a two-fold aspect, Viz., 1.giving certain benefits and 2. Receiving certain benefits. The basic principle of double entry system is that every debit has a corresponding and equal amount of credit. This is the underlying assumption of this concept. The accounting equation viz., Assets = Capital + Liabilities or Capital = Assets – Liabilities, will further clarify this concept, i.e., at any point of time the total assets of the business unit are equal to its total liabilities.
V) Periodicity Concept: Under this concept, the life of the business is segmented into different periods and accordingly the result of each period is ascertained. Though the business is assumed to be continuing in future, the measurement of income and studying the financial position of the business for a shorter and definite period will help in taking corrective steps at the appropriate time. Each segmented period is called “accounting period” and the same is normally a year.
vi) Historical Cost Concept: According to this concept, the transactions are recorded in the books of account with the respective amounts involved. For example, if an asset is purchases, it is entered in the accounting record at the price paid to acquire the same and that cost is considered to be the base for all future accounting.
vii) Matching Concept: The essence of the matching concept lies in the view that all costs which are associated to a particular period should be compared with the revenues associated to the same period to obtain the net income of the business.
viii) Realisation Concept: This concept assumes or recognizes revenue when a sale is made. Sale is considered to be complete when the ownership and property are transferred from the seller to the buyer and the consideration is paid in full.
ix) Accrual Concept: According to this concept the revenue is recognized on its realization and not on its actual receipt. Similarly the costs are recognized when they are incurred and not when payment is made. This assumption makes it necessary to give certain adjustments in the preparation of income statement regarding revenues and costs.

Accounting Conventions:
Accounting conventions are common practices, which are followed in recording and presenting accounting information of a business. They are followed like customs in a society. The following conventions are to be followed to have a clear and meaningful information and data in accounting:
i) Consistency: The convention of consistency implies that the same accounting procedures should be used for similar items over periods. It is essential for clear and correct understanding and interpretation of the financial statements. It is also important for inter-period comparison.
ii) Full Disclosure: According to this principle, all accounting statements should be honestly prepared and all information of material interest to proprietors, creditors, investors, etc. should be disclosed in the accounting statements. Moreover, books of accounts should be prepared in such a way that they become reliable, informative and transparent.
iii) Conservatism or Prudence: This convention follows the policy of caution or playing safe. It takes into account” all possible losses but not the possible profits or gains”. The implication of this principle is to give a pessimistic view of the financial position of the business.
iv) Materiality: Materiality deals with the relative importance of accounting information. In order to make financial statements more meaningful and to economize costs, accountants should incorporate in the financial statements only that information which is material and useful to users. They should ignore insignificant details.

Accounting Standards are the policy documents or written statements issued, from time to time, by an apex expert accounting body in relation to various aspects of measurement, treatment and disclosure of accounting transactions for ensuring uniformity in accounting practices and reporting. These standards are prepared by Accounting Standard Board (ASB). Accounting Standards are formulated with a view to harmonise different accounting policies and practices in use in a country.
Objectives or Purposes of Accounting Standards:
The  whole  idea  of  accounting  standards  is  centered  around  harmonization   of   accounting  policies  and practices  followed  by  different  business  entities   so  that  the  diverse  accounting  practices  adopted  for   various  aspects   of  accounting  can be  standardized. Accounting   standards   standardizes diverse accounting policies   with a view to:
a.      To provide information to the users as to the basis on which the accounts have been prepared and the financial statements have been presented.
b.      To serve the statutory purpose of eliminating the impact of diverse accounting policies and practices and to ensure uniformity in accounting policies & practices, i.e., to harmonize the diverse accounting policies & practices which are in use the preparation & presentation of financial statements.
c.       To make the financial statements more meaningful and comparable and to make people place more reliance on financial statements prepared in conformity with the accounting standards.
d.      To guide the judgment of professional accountants in dealing with those items, which are to be followed consistently from year to year.
e.       To provide   a  set  of  standard  accounting  policies, valuation  norms  and  disclosure  requirements.

Procedure adopted in formulation of Accounting Standards:
The Institute of Chartered Accountants of India (ICAI), recognising the need to harmonise the diverse accounting policies and practices, constituted an Accounting Standards Board (ASB) on April 21, 1977. The main function of ASB is to formulate accounting standards so that such standards may be mandated by the Council of ICAI. While formulating the standards in India, ASB will take into consideration the applicable laws, customs, usages and business environment.
Following procedure will be adopted for formulating Accounting Standards:
a.      Identification of the broad areas by the ASB for formulating the Accounting Standards.
b.      Constitution of the study groups by the ASB for preparing the preliminary drafts of the proposed Accounting Standards.
c.       Consideration of the preliminary draft prepared by the study group by the ASB and revision, if any, of the draft on the basis of deliberations at the ASB.
d.      Circulation of the draft, so revised, among the Council members of the ICAI and 12 specified outside bodies such as Standing Conference of Public Enterprises (SCOPE), Indian Banks’ Association, Confederation of Indian Industry (CII), Securities and Exchange Board of India (SEBI), Comptroller and Auditor General of India (C& AG), and Department of Company Affairs, for comments.
e.       Meeting with the representatives of specified outside bodies to ascertain their views on the draft of the proposed Accounting Standard.
f.        Finalisation of the Exposure Draft of the proposed Accounting Standard on the basis of comments received and discussion with the representatives of specified outside bodies.
g.      Issuance of the Exposure Draft inviting public comments.
h.      Consideration of the comments received on the Exposure Draft and finalisation of the draft Accounting Standard by the ASB for submission to the Council of the ICAI for its consideration and approval for issuance.
i.         Consideration of the draft Accounting Standard by the Council of the Institute, and if found necessary, modification of the draft in consultation with the ASB.
j.        The Accounting Standard, so finalised, is issued under the authority of the Council.

Benefits and Limitations of Accounting Standard:
                Accounting  standard  seek to  describe the  accounting  principles, the valuation  techniques  and  the  methods  of  applying  the accounting  principles   in the  preparation  and  presentation of  financial  statements  so that  they  may  give  a true  and  fair   view  .

By setting the accounting standards, the accountant has following benefits:
a.       Standards  reduce  to a reasonable  extent or  eliminate  altogether  confusing   variations   in   the  accounting  treatments  used  to prepare  financial  statements.
b.      There are certain areas where important information is not statutorily required to be disclosed. standards may call for disclosure beyond that required by law.
c.       The  application   of  accounting standards  would ,to  a  limited  extent, facilitate  comparison  of  financial  statements  of  companies  situated in  different parts  of  the  world  and also of  different   companies  situated  in  the  same  country. However, it  should  be  noted  in  this  respect  that  differences in the institutions, traditions  and  legal  systems  from  one  country  to  another give rise  to  differences   in  accounting   standards  adopted  in  different  countries.

However, there are some limitations   of setting of accounting standards:
                (i)Alternative solution to certain   accounting problems may   each have   arguments to recommend them. Therefore, the choice between   different alternative   accounting   treatments may   become difficult.
                (ii)there may  be  a   trend  towards  rigidity  and  away  from  flexibility in   applying  the  accounting  standards.
                (iii)Accounting standards cannot override the statute. The  standards  are  required   to be  framed  within  the  ambit  of  prevailing  statutes.

AS 1
Disclosure of Accounting Policies
AS 2
Valuation of Inventories
AS 3
Cash Flow Statement
AS 4
Contingencies & Events occurring after Balance Sheet date
AS 5
Net profit or Loss for the Period, Prior period items & changes in accounting policies
AS 6
Depreciation Accounting
AS 7
Accounting for Construction Contracts
AS 8
Accounting for Research & Development
AS 9
Revenue Recognition
AS 10
Accounting for Fixed Assets
Accounting for effects in changes in Foreign Exchange Rates
AS 12
Accounting for Government Grants
AS 13
Accounting for Investments
AS 14
Accounting for Amalgamations
AS 15
Accounting for Retirement benefits in the Financial Statements of employers
AS 16
Borrowing Cost
AS 17
Segment Reporting
AS 18
Related Party Disclosure
AS 19
AS 20
Earnings Per Share
AS 21
Consolidated Financial Statements
AS 22
Accounting for taxes on income
AS 23
Accounting for Investments in Associates in consolidated financial statements
AS 24
Discontinuing Operations
AS 25
Interim Financial Reporting
AS 26
Intangible Assets
AS 27
Financial Reporting of Interests in Joint Ventures
AS 28
Impairment of Assets
AS 29
Provisions, Contingent Liabilities and Contingent assets
AS 30
Financial Instruments: Recognition and Measurement
AS 31
Financial Instruments: Presentation
AS 32
Financial Instruments: Disclosures

Methods of Accounting: Business transactions are recorded in two different ways.
                1. Single Entry    2. Double Entry
                1. Single Entry: It is incomplete system of recording business transactions. The business organization maintains only cash book and personal accounts of debtors and creditors. So the complete recording of transactions cannot be made and trail balance cannot be prepared.
                2. Double Entry: Double Entry is an accounting system that records the effects of transactions and other events in at least two accounts with equal debits and credits. Under this system all accounts i.e., Personal, real and nominal accounts are maintained. It is a complete system of recording business transactions.
Steps involved in Double entry system
                (a) Preparation of Journal: Journal is called the book of original entry. It records the effect of all transactions for the first time. Here the job of recording takes place.
                (b) Preparation of Ledger: Ledger is the collection of all accounts used by a business. Here the grouping of accounts is performed. Journal is posted to ledger.
                (c) Trial Balance preparation: Summarizing. It is a summary of ledge balances prepared in the form of a list.
                (d) Preparation of Final Account: At the end of the accounting period to know the achievements of the organization and its financial state of affairs, the final accounts are prepared.

Advantages of Double Entry System
a)      Scientific system: This system is the only scientific system of recording business transactions. It helps to attain the objectives of accounting.
b)      Complete record of transactions: This system maintains a complete record of all business transactions.
c)       A check on the accuracy of accounts: By the use of this system the accuracy of accounting book can be established through Trail balance.
d)      Ascertainment of profit or loss: The profit earned or loss suffered during a period can be ascertained together with details by the preparation of Profit and Loss Account.
e)      Knowledge of the financial position of the business: The financial position of the firm can be ascertained at the end of each period, through the preparation of balance sheet.
Disadvantages of Double Entry System
a)      It requires expert knowledge: Book-keeping requires specialized knowledge, so it cannot be prepared by a layman.
b)      It is a very lengthy process: As it record transactions in two stage viz. journalizing and ledger posting, it requires a larger number of books.
c)       It is expensive: It is expensive because an expert is to be employed for this Purpose. It, therefore, involves additional expense.
d)      Errors of omission: If a transaction is omitted to be recorded in the books of accounts, it cannot be detected by double entry system because they do not affect a trial balance.

Merits of Single Entry System:-
(1) It is an easy and simple method of maintaining books of accounts.
(2) It is conventional and economical.
(3) It is less time consuming.

Demerits of Single Entry System:-
(1)It is not a scientific method of accounting because it does not record the two-fold aspect of each transaction.
(2)No trial balance can be prepared under Single Entry System.
(3)The arithmetical accuracy of the books cannot be checked in the absence of trial balance.
(4)In the absence of various checks, Fraud is more easily committed and it is very difficult to detect.
(5)In the absence of Real and nominal accounts the true financial position of the business cannot be ascertained.

Difference between Double Entry System and Single Entry System
Double Entry System
Single Entry System
Under this system, both aspect of each transaction are record.
Under this system, both aspect of each transaction are not recorded.
In this system, Personal, Real and Nominal accounts are kept fully.
In this system, only Personal Accounts are kept and Real and Nominal Accounts are ignored.
In this system, Cash book, General ledger, Debtors’ Ledger and Creditors’ Ledger are maintained.
In this system, only Debtors’ Ledger and creditors’ Ledger are kept. Cash book is also kept but personal transaction gets mixed up with business transaction.
Under this system, arithmetical accuracy can be checked by preparing Trial Balance at any moment of time.
Under this system, arithmetical accuracy cannot be checked because to Trial Balance can be prepared.
In this system, Trading, Profit and Loss Accounts and balance sheet can be prepared.
In this system, Trading, Profit And Loss Accounts and Balance sheet cannot be prepared.
For interpretation of financial statement, we can compute different ratios, if the accounts are maintained under this system.
Vital ratios cannot be computed, if the accounts are maintained under this system.
This system is scientific and follows certain rules.
This system is unscientific and does not follow any concrete rules.

BASES OF ACCOUNTING: There are three bases of accounting in common usage which are:
1. Cash basis
2. Accrual or Mercantile basis
3. Mixed or Hybrid basis.

Accounting on ‘Cash basis’: Under cash basis of accounting, entries are recorded only when cash is received or paid. No entry is passed when a payment or receipt becomes due. Government system of accounting is mostly on cash basis.
Accrual Basis of Accounting or Mercantile System: Under accrual basis of accounting, accounting entries are made on the basis of amounts having become due for payment or receipt. Incomes are credited to the period in which they are earned whether cash is received or not. Similarly, expenses and losses are detailed to the period in which, they are incurred, whether cash is paid or not. The profit or loss of any accounting period is the difference between incomes earned and expenses incurred, irrespective of cash payment or receipt.
Mixed or Hybrid Basis of Accounting: When certain items of revenue or expenditure are recorded in the books of account on cash basis and certain items on mercantile basis, the basis of accounting so employed is called ‘hybrid basis of accounting’. For example, a company may follow mercantile system of accounting in respect of its export business and cash basis for subsidies and duty drawbacks on exports to be received from government.