Accounting Principles & Fundamental Accounting Assumptions
MEANING AND NATURE OF ACCOUNTING PRINCIPLES
Accounting Principles refers to the rules or guidelines adopted for recording and reporting of business transactions, in order to bring uniformity in the preparation and the presentation of financial statements.
The term ‘principle has been defined by the American Institute of Certified Public Accountants (AICPA) as ‘A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice’.
The Accounting Principles have evolved over a long period of time on the basis of past experiences, usages, or customs by individuals and professional bodies and regulations by government agencies and have general acceptability among most accounting professionals.
These principles are classified into two categories:
1. Accounting Concepts:
Accounting Concepts refer to the necessary assumptions and ideas, which are fundamental to the accounting practice. These accounting assumptions or concepts must be followed as they provide the basic foundation for the accounting process. Accounting Concepts are the necessary assumptions, conditions, or postulates upon which the accounting is based.
2. Accounting Conventions:
Accounting conventions are the customs or traditions guiding the preparation of accounts. They are adopted to make financial statements clear and meaningful.
1. Accounting Entity or Business Entity Principle
According to this principle, a business is considered to be a separate and distinct entity from its owners.
- Accounting is always done from the point of view of the business and not its owners. So, all the business transactions are recorded from the point of view of the business and not from that of the owners.
- The personal transactions of the owner are kept separate from the business. For example, house, car, personal income, and expenditure of the proprietor must be kept separate from the business accounts.
- The proprietor or owner is treated as a creditor of the business to the extent of capital invested by him in the business. When the owner brings in some money as capital, it is treated as a liability of the business to the owner. Similarly, when he withdraws money from the business for his personal expenses (drawings), it is treated as a reduction of the owner’s capital and consequently a reduction in the liabilities of the business.
- This principle applies to all forms of business organizations, i.e., sole proprietorship, partnership, or a company.
2. Money Measurement Principle
According to this principle, only those transactions and events are recorded in the books of accounts that are capable of being expressed in terms of money,
- Suppose a business enterprise has 70,000 cash, 2 buildings, and 4 machines. These assets cannot be added and shown in the Financial Statements unless they are valued in terms of money and then added up together to know the worth of the business. So, money is the common denominator in which all transactions are recorded.
- This concept suffers from two major limitations:
(i) Qualitative transactions are not recorded, irrespective of their importance. For example, sincerity and quality of the employees or quality of the product are not recorded in the Financial Statements even though they are so crucial for the enterprise.
(ii) Money is considered to have static value as transactions are recorded at the value on the transaction date. However, the value of money does not remain the same over a period of time due to changes in the price level.
3. Accounting Period Principle
According to this principle, the economic life of an enterprise is split into periodic intervals (known as the accounting period) so that its performance is measured at a regular period.
- The accounts of an enterprise are maintained following the Going Concern Concept, which says that the business is intended to continue for an indefinite period of time. It means that the true results of the business operations can be ascertained only when the business is completely wound up.
- However, ascertainment of profit after a very long period will be of little use to the users of financial statements as they need accounting information at regular intervals for decision making.
- So, the life of a business is split into periodic intervals, which is known as the ‘Accounting Period”.
- An accounting period of one year is usually adopted for this purpose. In India, it generally starts on 1t day of April and ends on 31t of March next year.
- At the end of an accounting period:
- Profit and Loss Account is prepared to know the profit earned during the accounting year; and
- The Balance Sheet is prepared to know the financial position of the business at the end of the year.
4. Full Disclosure Principle
According to this principle, the financial statements should completely disclose all the significant information relating to the economic affairs of the enterprise.
- The disclosure can be done either in the financial statements or in the footnotes, like in the case of contingent liabilities (or Notes to Accounts in case of companies).
- Full Disclosure is not only a legal requirement, but it also makes the accounting system fair and transparent.
- As per the Companies Act, every company is required to disclose essential information in the financial statements.
- Incomplete information hampers the basic purpose of financial statements. So, all the material and relevant facts should be disclosed in the financial statements.
- Full Disclosure ensures that financial statements present a true and fair view of the profitability and financial position of the business to its various end-users.
5. Materiality Principle
According to this principle, all relatively relevant items, the knowledge of which might influence the decision of the users of the financial statements, should be disclosed in the financial statements.
- As per this Materiality, only those items should be disclosed that have a significant effect or are relevant to the user. So, this principle is contradictory to the Full Disclosure principle.
- An item that is significant for one enterprise, maybe insignificant for another enterprise. For example, tools costing 5,000 is material for small car workshop, but for a large enterprise, like Tata Motors, it may be insignificant.
- So, whether an item is material or not will depend on its nature arid/or amount.
6. Prudence or Conservatism Principle
According to this principle, all prospective losses should be recorded in the books of accounts, but all anticipated profits should be ignored.
- Due to this principle, provision is made for all known liabilities and losses, even though their amount cannot be determined with certainty, For example, provision for doubtful debts is made in anticipation of actual bad debts. Similarly, the closing stock is valued at a lower cost or net realizable value.
- This principle aims to ensure that the Financial Statements present a true and fair view of the state of affairs of the business and does not exhibit a better picture than what actually is.
Drawbacks of Conservatism Principle
(i) It may lead to the creation of Secret Reserves: The creation of too many provisions, like creating excess provision for doubtful debts or charging excessive depreciation, may lead to the creation of secret reserves.
(ii) It may lead to an overstatement of liabilities: Conservatism provides for all the anticipated expenses and losses but does not record anticipated revenues. So, it may result in the overstatement of liabilities. So, this principle should be carefully applied so that the results depicted by the Financial Statements are not distorted.
7. Cost Concept or Historical Cost Principle
According to this principle, an asset is recorded in the books at the price paid to acquire it and cost becomes the basis for its accounting in the subsequent accounting periods.
- The asset is recorded at cost at the time of its acquisition and is reduced year after year by charging depreciation based on the useful life of that asset rather than its market value. So, an asset is shown in the Balance Sheet at its book value, i.e. cost less depreciation.
- If nothing is paid to acquire an asset, then the same will not be recorded as an asset.
- Since the acquisition cost of an asset relates to the past, it is referred to as ‘Historical Cost’.
- This principle brings Objectivity in the preparation of financial statements as the cost price paid for the purchase of assets is verifiable from the cost records. So, the information stated in the financial statements is not influenced by personal bias or judgments.
Drawbacks of Cost Principle
- It ignores the recording of assets for which nothing in monetary terms is paid. For example, a good brand name, favorable location, technological knowledge, etc. will remain unrecorded even though these are valuable assets.
- It results in inflated or understated profit during inflation as depreciation is charged on the basis of historical cost and not on the basis of market value.
8. Matching Principle
According to this principle, expenses incurred in an accounting period should be matched with the revenues recognized in that period.
- Profit earned by a business during a period can be correctly measured only when the revenue earned during the period is matched with the expenditure incurred to earn that revenue. Such matching of revenue with expenses is based on the accrual system of accounting.
- Following are the points that should be kept in mind for matching cost with revenue:
(a) When an item of revenue is included in the Profit and Loss Account, then all the expenses incurred, whether paid or not, should be shown as expenses in the Profit and Loss Account. It means, if there is any outstanding expense, then will be shown in the Profit and Loss Account.
(b) If an expense is paid during an accounting period, but revenue related to it will be earned in the following period, then such expense will be shown as an expense only next year and not this year. For example, Prepaid Insurance. Such prepaid expense is shown as an asset in the Balance Sheet.
(c) In the same manner, if revenue is received, but against it services will be rendered next year, then revenue will be also recognized in the next year and will be shown as a liability in the Balance Sheet. For example, unearned salary.
9. Dual Aspect or Duality Principle
According to this principle, every business transaction has two aspects, a debit and a credit of equal amount.
- In other words, for every debit, there is a credit of equal amount in one or more accounts and vice-versa. The system of recording transactions based on this principle is termed as ‘Double Entry System’.
- Because of this principle, the Balance Sheet has two sides: The assets side and the Liabilities side and both are always equal to each other under all circumstances.
- For example, suppose Rachit starts a business by investing 4,00,000 in cash and takes a loan of 1,00,000 from the bank.
- Now, the assets (cash) in the business will increase by 5,00,000 (4,00,000 + 1,00,000).
- At the same time, it will increase the owner’s equity or capital by 5,00,000; and
- Claims of outsiders, i.e. liabilities will increase by 1,00,000.
- Now, this transaction can be expressed as Assets (Cash) = Claim of Outsiders (Bank Loan) + Owner’s Equity (Capital)
- This fundamental equation will always remain good in all situations.
10. Revenue Recognition Principle
According to this principle, revenue must be recognized when a transaction has been entered into and the obligation to receive its payment has been established.
- It is very important to decide the point of time when revenue can be assumed to have been recognized as revenue recognized is only considered for computation of profit.
- Example: Suppose a firm sells goods in January 2016 but receives the amount in March 2016. As per the principle of revenue recognition, revenue from this sale should be recognized in January 2016 itself as the legal obligation to pay the amount has been established on this date. However, if the firm had received only an advance in January 2016 for the sale of goods in April 2016, then revenue from this sale shall be recognized in April 2016.
11. Verifiable Objective Concept
According to this concept, all transactions should be recorded in an objective manner and they should be free from personal bias,
- It implies that all accounting transactions should be supported by documentary evidence or vouchers.
- These supporting documents include cash memos, invoices, bills, etc.
- For example, cash purchases of goods should be supported by a Cash Memo and credit purchases by an invoice.
Also Read: Meaning of Depreciation
FUNDAMENTAL ACCOUNTING ASSUMPTIONS
Fundamental Accounting Assumptions are the assumptions that are presumed to have been followed while preparing the book of accounts. If a firm does not follow any of the fundamental accounting assumptions, then the firm is required to disclose this fact together with the reason for not following them.
The three basic Accounting Assumptions are:
- Going Concern Assumption;
- Consistency Assumption; and
- Accrual Assumption.
1. Going Concern Assumption
According to this assumption, it is assumed that business shall continue for an indefinite period of time and there is neither any intention nor any necessity to close down the business or scale down its operations significantly.
- Business transactions are recorded from this point of view.
- On the basis of this assumption, fixed assets are recorded at their cost, and depreciation is charged on the basis of their expected lives rather than their market values.
- Going Concern concept facilitates the distinction between Current and Non-Current Assets, Long-term and Short-term liabilities, and Capital and Revenue Expenditure.
- It is also because of this assumption that outside parties enter into long-term contracts with the enterprise, give loans, and purchase debentures and shares of the enterprise. • This assumption is also known as ‘Continuity Assumption
2. Consistency Assumption
According to this assumption, accounting practices once selected and adopted, should be applied consistently year after year.
- This concept provides comparability to accounting data of the same enterprise over different time periods (known as an intra-firm comparison) and with other firms (known as an inter-firm comparison).
- Consistency eliminates personal bias and helps in achieving results that are comparable.
- This concept becomes particularly more important when two or more methods or alternative accounting practices are available and each one is equally acceptable. For example, out of the two methods of charging depreciation (Written Down Value Method and Straight Line Method), a firm can choose any one method. But, according to this assumption, it is expected that the method once chosen and applied should be applied consistently year after year.
- But, this concept does not mean that method or practice once adopted cannot be changed.
The method or practice may be changed if the Law or Accounting Standard requires it or if the change will result in a more meaningful presentation.
However, the nature and effect of the change of method and justification for the change must be clearly disclosed.
3. Accrual Assumption
According to the Accrual Assumption, revenue and expenses are recorded in the period in which they become due, rather than when they are received or paid.
- According to this assumption, a transaction is recorded in the books when it is entered into and not when the settlement takes place. It means:
- Revenue is recorded when sales are made or services are rendered, irrespective of the fact whether cash is received or not. For example, if a firm has sold goods on 27th June 2016 on 2 months credit, then the sale must be recorded on 27th June 2016, although the amount will be received in August.
- Similarly, expenses are recorded in the period in which they have become due rather than in the period in which they are paid.
- This concept recognizes the assets, liabilities, incomes, and expenses as and when transactions relating to it are entered into.
- To arrive at the correct profit or loss during an accounting period, all expenses and incomes be recorded on an accrual basis and not on a cash basis.