THEORY BASE OF ACCOUNTING

Accounting Principles

1. Accounting Entity. / Business Entity :

An entity has a separate existence from its owner. According to this principle, business is treated as an entity, which is separate and distinct from its owner. Therefore business transactions are recorded; analyzed and financial statements are prepared from the business point of view and not of the owner.

• The owner is treated as a creditor (liability) for his investment in the business, as if the firm has borrowed from its owner instead of the outside parties.
• Interest on capital is treated as expense like any other business expense.
• His private expenses are treated as drawings leadings to reduction in capital.
• This concept is applicable to all forms of business organizations - sole proprietorship, partnership or a company.

2. Money Measurement Principle :

According to this principle, only those
transactions that are measured in money or can be translated in term of money are recorded in the books of accounts of the enterprises.

• Money means the currency of a country.
• Money is a common measuring unit for recording and reporting business transactions.

Example : purchases cost ϕ 15,000 will be recorded in the books of accounts but the good human relationship within organization will not be recorded.

Limitations :

1. it ignores qualitative aspects e.g. efficient human resources (Assets), satisfied customers (Assets) and dishonest employee (liabilities)
2. Self-generated goodwill not recorded.
3. Value of money (currency) is not stable.

• The facts which cannot be expressed in money cannot be recorded.
• To make accounting records simple, relevant, understandable and homogeneous, facts are expressed in a common unit of measurement - money.

3. Accounting Period Principle :

According to this principle, the whole indefinite life of an enterprise is divided into part, known as accounting period. Accounting period is defined as interval of time, at the end of which the profit and loss account and balance sheet are prepared. So the performance is measured at regular intervals and decision can be taken at the appropriate time. This interval may be quarterly, half-yearly and one year. Accounting period is usually a period of one year and that year may be financial year or calendar year.

Relevance :

1. As per SEBI and Companies Act Annual reports are to be prepared and submitted to registrar annually.
2. As per income tax law, tax on income is calculated on annual basis from 1st April to 31st March (Financial Year)
3. Accounting period concept is responsible for the preparation of income statement on accrual basis as distinguished from cash basis of accounting.

4. Full Disclosure Principle :

According to this principle, apart from legal requirements all significant and material information relating to the economic affairs of the entity should be completely disclosed in its financial statement and accompanying footnotes.

Disclosure of material information will result in better understanding of users, so, they take good and sound decision from the information. E.g. footnotes such as :

1. Contingent liabilities in respect to a claim of a very big amount against the business are pending in a court of law.
2. Change in the method of providing depreciation.
3. Market value of investment.

Disclosure of all material facts is compulsory but is does not imply that even those figures which are irrelevant are to be included in financial statements.

5. Materiality Principle :

According to this principle, only those items or information should be disclosed that have material effect and relevant to the users. So, item having an insignificant effect or being irrelevant to user need not be disclosed
separately, these may be merged with other item.

If the knowledge of any information may effect the decision of a user of account, is termed as material information.

It should be noted that an item material for one enterprise may not be material for another enterprise. E.g. an item of expenses ϕ 50,000 is material for an enterprise having turnover of ϕ 1,50,000 but it is not material for an enterprise having turnover of ϕ 100 crore.

The nature of transaction should be taken into consideration for materiality of information. E.g. a difference of ϕ 200 in the valuation of stock may be immaterial but the difference of ϕ 50 in cash could be termed as material.

6. Prudence/ conservatism Principle :

According to this principle, profit in anticipation should not be recorded but loss in anticipation should immediately be recorded. The objective of this principle is profit of the enterprise in no case overstated.

When there are different equally acceptable alternative methods are available, the method which having least favourable immediate effect on profit should be adopted. e.g.

1. Valuation of stock at cost or realizable values whichever is lower.
2. Provision for doubtful debts and Provision for discount on debtor is made.
3. Ignore provision for discount on creditors.