Accounting – Concepts and Conventions

NATURE OF FINANCIAL STATEMENT The data exhibited by financial statements are affected by a)Recorded facts b)Accounting Concepts, Conventions & Principles c)Personal Judgment 1)Recorded Facts: The term recorded facts means the data used for preparing financial statements are taken from accounting record which are facts. i. e. Cash in Hand: Actual cash is recorded Amount due from debtor: Actual to be recorded Amount due to creditor: Actual to be recorded Thus the financial statement do not disclose such facts which may be reality, which are not recorded. For ex. : L/Bldg. urchased are shown at cost price in the Accounting Books But market value which in reality may be different is not stated because it is not recorded in Books of A/c. 2)Accounting concepts & conventions & principle: The Dictionary meaning is â€Å"Fundamental truth implying uniformity of Applicability everywhere. † However when applied in Financial Statement Analysis, it gives different meaning in different conc epts & so it is rarely used as a fundamental accounting truth. Accounting Principles are those rules of Action which are adopted by the Accountant universally in recording transaction.Different professional bodies like Australian Society of Account (i. e. Institute of Chartered Accountant in Australia) The Institute of Chartered Accountant in England & Wales. The American Institute of certified public accountant have made recommendation on accounting principles in the recent year. Accounting principles have been developed over the years from experience, usage & necessity. They are judged on the General Acceptability rather than Universal Acceptability to the user of financial statement hence they are called as General Accepted Accounting Principles (G. A. A. P. )According principles can be broadly classified into two categories: A. Accounting concepts B. Accounting Conventions Accounting Principles Accounting conceptsAccounting Conventions a)Entity Concepta)Disclosure b)Going Concer n Conceptb)Materiality c)Accounting period conceptc)Consistency d)Money Measurement Conceptd)Conservatism e)Cost Concept f)Cost Attach Concept g)Dual Aspect Concept h)Accrual concept i)Periodic Matching of cost and Revenue Concept j)Realisation Concept k)Verifiable Objective Evidence Concept ACCOUNTING CONCEPTS: They are the necessary assumptions or conditions upon which accounting is based.Accounting concepts are postulates, assumptions or conditions upon which accounting is based. They are developed to convey the same meaning to all people. Some of the important concept are given as follows: 1. Entity Concept: For accounting purposes- the ‘business’ is treated as a separate entity from the proprietor (s). It may sound to be absurd that one sell goods to himself, but all transactions are recorded in the books of the business as per this point of view. This concept helps in keeping private affairs of the proprietor away from the business affairs. Thus if a proprietor in vests Rs. ,00,000/- in the business, it is deemed that the proprietor has given Rs. 1,00,000/- to the ‘business’ and it is shown as a ‘liability’ in the books of business. (because business has to ultimately repay it to the proprietor). Similarly, if the proprietor withdraws Rs. 10,000/- from the business, it is charged to him. This concept is applicable to all forms of business organizations. Although in the eyes of Law a Sole trader and his business or the partner and their business are one and the same, for accounting purposes they are regarded as separate entities. It is the ‘business’ with which we are concerned. . Going Concern Concept (Continuity of Activity): It is assumed that the business concern will continue for a fairly long time, unless and until it has entered into a state of liquidation. 3. Accounting Period Concept: Although the ‘going concern’ concept stresses the continuing nature of the business enterprise, it i s customary to divide its life into chapters known as ‘Accounting Periods. ’ An accounting period is the interval of time at the end of which the income statement and financial position statement (balance sheet) are prepared to know the result and resources of the business.Although shorter periods are frequently adopted for purposes of comparative studies, the normal accounting period is twelve months. This is because though the life of the business is considered to be indefinite, the measurement of income and studying the financial position of the business after a very long period would not help in taking timely corrective steps or to enable periodic distributions of income to proprietor (s) with reasonable safety. Therefore, it is necessary for the concern to ‘stop’ at regular intervals and ‘see back’ how it is faring. 4.Money Measurement Concept : In accounting everything is recorded in terms of money. Events or transaction which cannot be e xpressed in terms of money are not recorded in the books of accounts, even if they are very important or useful for the business. Purchase and sale of goods, payment of expenses and receipt of income are monetary transactions which find place in accounting etc. Death of an executive, resignation of a manager are the events which cannot be expressed in money and so are not to be recorded in Book’s of A/c. 5. Cost Concept (Objectivity Concept): As per cost concept: )an asset is ordinarily recorded at the price paid to acquire it i. e. at its cost, and b)this cost is the basis for all subsequent accounting for the asset. For example, if a plot of land is purchased for Rs. 1,00,000/- it is recorded in the books of at Rs. 1,00,000/- and even if its market value at the time of preparation of final accounts is Rs. 2,00,000/- or Rs. 60,000/- it will not be considered. Thus the balance sheet on a particular date does not ordinarily indicate what the asset could be sold for. The cost c oncept does not mean that the asset will always be shown at cost.It only means that cost becomes the basis for all subsequent accounting for the asset. Thus the assets recorded by the process of depreciation. Cost concept brings objectivity in the preparation and presentation of financial statements. It implies that the figures shown in the accounting records should be based on objective evidence and not on the subjective views of a person. 6. Cost-attach Concept: This concept is also known as ‘cost-merge’ concept. In order to produce an article it is necessary to purchase raw-material, process it and convert into finished article.This calls for the services of other factors of production and therefore, there are several other costs like labour cost, power and other overhead expenses. These cost have a capacity to ‘merge’ or ‘attach’ when they are brought together. Thus the proportionate raw-material costs, labour costs, and other overheads are added together to obtain product cost so as to increase the utility of cost data. 7. Dual Aspect Concept: This is the basic concept of accounting. As per this concept, every business transaction has a dual effect. 8.Accrual Concept: The accrual concept implies recording of revenues and expenses of a particular accounting period, whether they are received / paid in cash or not. Under cash system of accounting, the revenues and expenses are recorded only if they are actually received / paid in cash irrespective of the accounting period to which they belong. But under accrual method, the revenues and expenses relating to that particular accounting period only are considered. 9. Periodic Matching of Cost and Revenue Concept : This concept is based on the accounting period concept.Making profit is the most important objective that keeps the proprietor engaged in business activities. That is why most of the accountant’s time is spent in evolving techniques for measuring the profit /profitability of the concern. To ascertain the profit made during a period, it is necessary to match ‘revenues’ of the period with the ‘expenses’ of that period. Income (profit) earned by the business during a period can be measured only when the revenue earned during the period is compared with the expenditure incurred to earn that revenue. The question when the payment was made / received is irrelevant.Therefore, as per this concept adjustments are made for all outstanding expenses, prepaid expenses, accrued incomes, unearned incomes etc. 10. Realisation Concept : According to this concept profit should be accounted for only when it is actually realized. Revenue is recognized only when sale is effected or the services are rendered. Sale is considered to be made when the property in goods passes to the buyer and he is legally liable to pay. However, in order to recognize revenue, receipt of cash is not essential. Even credit sale results in realization as it creates a efinite asset called ‘Account Receivable’. However, there are certain exceptions to the concept: like in case of contract accounts, hire purchase etc. Similarly incomes like commission, interest, rent etc. are shown in Profit and Loss Account on accrual basis though they may not be realised in cash on the date of preparing accounts. 11. Verifiable Objective Evidence Concept : According to this concept all accounting transactions should be evidenced and supported by objective documents. These documents include invoices, contracts, correspondence, vouchers, bill, pass books, cheque books etc. uch supporting documents provide the basis for making accounting entries and for verification by the auditors later on. This concept also has its limitations. for example, it is difficult to verify internal allocation of costs to accounting periods. 2. ACCOUNTING CONVENTIONS: Conventions are the customs or traditions or usage which guide of accounting statements. They a re adapted to make financial statements clear and meaningful. 1. Convention of Disclosure: This means that the accounts must be honestly prepared and they must disclose all material information.The accounting reports should disclose full and fair information to the proprietors, creditors, investors and others. This conventions is specially significant in case of big business like Joint Stock Company where there is divorce between the owners and the managers. However, it does not mean that all information or information of any kind is to be included in accounting statements. The term ‘disclosure’ only implies that there must be a sufficient disclosure of informations which is of material interest to proprietors, present and potential creditors and investors. 2.Conventions of Materiality: The accountant should attach importance to material details and ignore insignificant details. If this is not done accounts will be overburdened with minute details. As per the American A ccounting Association, â€Å"an item should be regarded as material, if there is a reason to believe that knowledge of it would influence the decision of informed investor. † Therefore, keeping the convention of materiality in view, unimportant items are either left out or merged with other items. Some items are shown as foot notes like, contingent liabilities, market value of investment etc.However, an item may be material for one purpose but immaterial for another, material for one concern but immaterial for another, or material for one year but immaterial for next year. 3. Convention of Consistency: The comparison of one accounting period with the other is possible only when the convention of consistency is followed. It means accounting from one accounting period to another. For example, a company may adopt straight line method, written down value method, or any other method of providing depreciation on fixed assets. But it is expected that the company follows a particular method of depreciation consistently.Similarly, if stock is valued at ‘cost or market price whichever is less,’ this principle should be followed every year. Any change from one method to another would lead to inconsistency. However, consistency does not mean non-flexibility. It should permit introduction of improved techniques of accounting. 4. Convention of Conservatism: It refers to the policy of ‘playing safe. ’ As per this convention all prospective losses are taken into consideration but not all prospective profits. In other words ‘anticipate no profit but provide for all possible losses’.However, this convention is being criticized on the ground that it goes not only against the convention of full disclosure but also against the concept of matching costs and revenues. It encourages creation of secret reserves by making excess provision for depreciation, bad and doubtful debts etc. The Income statement shows a lower net income and the Bal ance sheet overstates the liabilities and understates the assets. The convention of conservatism should be applied cautiously so that the results reported are not distorted. Some degree of conservatism is inevitable where objective data is not available.Following are the examples of application of conservatism: a)Making provision for doubtful debts and discount on debtors. b)Not providing for discount on creditors. c)Valuing stock in trade at cost or market price whichever is less. d)Creating provision against fluctuations in the price of investments. e)Showing Joint Life Policy at surrender value and not at the paid up amount. f)Amortization of intangible asset like goodwill which has indefinite life. ESSENTIAL QUALITIES OF FINANCIAL STATMENTS As stated earlier, the basic objective of financial statement is to provide information useful to the users of these statements.Different users like shareholders, investors, financial institutions, workers etc. are interested in financial sta tements with varying objectives. Generally, it is not possible for a firm to prepare these statements in such a form that may suit every interested user. However, such statements should possess at least the following essential qualities. 1. Relevance : Only these information should be disclosed in financial statements which are relevant to the objectives of the firm. The information is said to be relevant only when it influences decision of the users, while evaluating any event or correcting past evaluation.The conclusions drawn on the basis of irrelevant information would be misleading of no use. Therefore, the information irrelevant to the statements be avoided, otherwise it would be difficult to make a distinction between relevant and irrelevant information. 2. Understandability : The main objective of financial statements is to provide necessary information about the firm’s resources and performance. To fulfill this objectives, the information contained in these statement s should be clear, simple and lucid so that a person who is not well versed with the accounting terminology shall be able to understand without much difficulty.Hence, as far as possible, the form of financial statements should not be complex, and the terms used in these statements should be simple, in common language and non-technical. 3. Reliability and Accuracy : The information incorporated in financial statements should be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users. Reliability charges with the nature of information contained in the subject matter. Therefore, such information should be provided whose reliability can be verified. Reliability of financial statements also depends on the accuracy of accounts.Hence, to arrive at right conclusions, accuracy of the accounts is an essential quality. To be reliable*, information must (i) carry faithful representation of transactions, (ii) should be p resented in accordance with the substance and economic reality, and (iii) must be neutral, prudent and complete. 4. Comparability : Comparison is the essence of financial statement analysis. Comparable information will reveal relatively strong and weak point. Financial statement should be prepared in such a way that current year’s progress can be compared with that of previous year and inter-firm comparison is possible.To facilitate comparison, it would be more useful to provide with the financial statement of 5 to 10 years summary of important terms such as production in quantity, net sales, net profits, dividend paid, working capital etc. 5. Completeness : The information contained in the financial statements should be complete in al respects. It must be ensured that there is no possibility of any information being incomplete or doubtful. Therefore, full disclosure should be made of all significant information in a manner that is understandable and does not mislead creditor s, investors and others users. . Timeliness : Financial statements are prepared for a definite period of time. At the end of this period, they should be ready and submit to the parties concerned. If the statements are not prepared in time, they can not be properly used and the firm cannot formulate plans for future developments. In addition to the aforesaid qualities, financial statements be prepared easily, attention of the reader is automatically drawn and directed to most significant items and required data for the calculation of different ratios are also essential qualities.As American Accounting Association, has described, â€Å"every corporate statement should be based on accounting principles which are sufficiently uniform, objective and understood to justify opinions to the condition and progress of the business enterprise behind it. † LIMITATIONS OF FINANCIAL STATEMENTS The summary of accounts maintained by a business firm is presented in the form of financial statem ents. The amounts expressed in these statements are based on vouchers and accounting records.Hence, decisions based on these information are more true and logical. However, the conclusions drawn on the basis of these information cannot be treated as final and accurate, because there are certain limitations to the financial statements. One must, therefore, keep in view these limitations while studying the profit and loss account and balance sheet of the firm. Important and impact bearing limitations of financial statements are identified as below : 1. Lack of Precision 2. Lack of Exactness 3. Incomplete Information 4. Interim Reports . Hiding of Real Position or Window Dressing 6. Lack of Comparability 7. Historical Costs Analysis – To Analyse – to cut into pieces But only analyse – No – It means also Interpretation. Thus Financial Statement Analysis means â€Å"Analysis, comparisons and interpretation of Financial data to achieve the desired result† TOOLS OF FINANCIAL STATEMENT ANALYSIS 1. Comparative Statements 2. Common Size Statements The Essential Requirement is 3. Trend AnalysisVertical Financial Statement. 4. Ratio Analysis 5. Fund Flow Statement 6. Cash Flow Statement