Account 6 Marks Question

Consistency: This concept states that accounting principles and methods should remain consistent from one year to another. These should not be changed from year to year, in order to enable the management to compare the Profit & Loss Account and Balance Sheet of the different periods and draw important conclusions about the working of the enterprise. If a firm adopts different accounting principles in two accounting periods, the profits of current period will not be comparable with the profits of the preceding period. For example, a firm can choose any one of the several methods of depreciation, i.e., straight line method, written down value method or any other method. But it is expected that the method once chosen will be followed consistently year after year. Likewise, the method of stock valuation or making provision for likely bad debts should remain consistent with the previous years otherwise the decisions taken on the basis of accounts will be misleading.

Materiality: This Convention is an exception to the convention of full disclosure. According to this convention, items having an insignificant effect or being irrelevant to the user need not be disclosed. These unimportant items are either left out or merged with other items, otherwise accounting statements will be unnecessarily overburdened.
(AAA) defines the term materiality as under:-
“An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor.''

Conservatism: According to this convention, all anticipated losses should be recorded in the books of accounts, but all anticipated or unrealized gains should be ignored. In other words, conservatism is the policy of playing safe. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty. Likewise, when there are different alternatives for recording a transaction, the one having least favourable immediate effect on profits or capital should be adopted. Following are the examples of the application of the principle of conservatism:

1. Closing stock is valued at cost price or realisable value whichever is less.
2. Provision for doubtful debts is created in anticipation of actual bad-debts.
3. Joint life insurance policy is shown only at surrender value as against the arnount paid.
4. Provision for a pending law suit against the firm, which may either be decided . in its favour.

Full Disclosure: This Convention requires that all significant information relating to the economic affairs of the enterprise should be completely disclosed. In other words, there should be a sufficient disclosure of information which is of material interest to the users of the financial statements such as proprietors, present and potential creditors, investors and others. The principle is so important that the Companies Act makes ample provisions for the disclosure of essential information in the financial statements of a Company.

Convention of prudence: According to this convention, all anticipated losses should be recorded in the books of accounts, but all anticipated or unrealized gains should be ignored. In other words, conservatism is the policy of playing safe. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty. Likewise, when there are different alternatives for recording a transaction, the one having least favourable immediate effect on profits or capital should be adopted. Following are the examples of the application of the principle of conservatism:

1. Closing stock is valued at cost price or realisable value whichever is less.
2. Provision for doubtful debts is created in anticipation of actual bad-debts.
3. Joint life insurance policy is shown only at surrender value as against the arnount paid.
4. Provision for a pending law suit against the firm, which may either be decided in its favour.

Money Management Concept: Only those transactions and events are recorded in accounting which are capable of being expressed in terms of money. An event, even though it may be very important for the business, will not be recorded in the books of the business unless its effect can be measured in terms of money with a fair degree of accuracy. For example, accounting does not record a quarrel between the production manager and sales manager; it does not report that a strike is beginning and it does not reveal that a competitor has placed a better product in the market. These facts or happenings cannot be expressed in money terms and thus are not recorded in the books.

According to this concept, every business transaction is recorded as having a dual aspect. In other words, every transaction affects atleast two accounts. If one account is debited, any other account must be credited. The system of recording transactions based on this principle is called as ‘Double Entry System'. It is because of this concept that the two sides of the Balance Sheet are always equal and the following accounting equations will always hold good at any point of time:
Assets = Liabilities + Capital
OR
Capital = Assets - Liabilities

According to this concept, business is treated as a unit separate and distinct from its owners, creditors, managers and others. In other words, the owner of a business is always considered as distinct and separate from the business he owns. Business unit should have a completely separate set of books and we have to record business transactions from firm's point of view and not from the point of view of the proprietor. The proprietor is treated as a creditor of the business to the extent of capital invested by him in the business. The capital is treated as a liability of the firm because it is assumed that the firm has borrowed funds from its own proprietors instead of borrowing it from outside parties. It is for this reason that we also allow interest on capital and treat it as an expense of the business. Interest on capital reduces the profits of the firm and at the same time it increases the capital of the proprietor. Similarly, the amount withdrawn by the proprietor from the business for his personal use is treated as his drawings. Likewise, goods used from the stock of the business for business purposes are treated as the expenditure of the business but similar goods used by the proprietor for his personal use are treated as his drawings.
Because of the concept of separate entity, the proprietor's house, his personal investment in securities, his personal car and personal income and expenditure are kept separate from the accounts of the business entity. Also, if the proprietor has some other business entity doing another business, the records of that business should also be kept separate. In the absence of the concept of separate entity, the net profits and financial position of a business entity cannot be known. The concept of separate entity is applicable to all forms of business organisations, i.e., sole proprietorship, partnership or a company.

Accounting Concepts Accounting Concepts are the basic assumptions or fundamental propositions within which accounting operates. They are generally accepted accounting rules based on which transactions are recorded and financial statements are prepared. It is important to follow the accounting concepts because it enables the users of financial statements to understand them better and in the same manner.
Explain.

1. Matching Concept or Matching Principle An important objective of business is to determine profit periodically. It is necessary to match 'revenues of the period with the expenses' of that period to determine correct profit (or loss) for the accounting period. Profit earned by the 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. It is not relevant when the payment was made or received. Therefore, as per this concept, adjustments are made for all outstanding expenses and prepaid expenses. In brief, according to this concept, the expenses for an accounting period are matched against related revenues, rather than cash received and cash paid. This concept should be followed while preparing financial statements to have a true and fair view of the profitability and financial position of a business firm.
2. Revenue Recognition Concept According to the Revenue Recognition Concept, revenue is considered to have been realised when a transaction has been entered into and the obligation to receive the amount is established. It is to be noted that recognising revenue and receipt of an amount are two separate aspects. Let us take an example to understand it. An enterprise sells goods in February, 2018 and receives the amount in April, 2018. Revenue of this sales should be recognised in February, 2018, i.e., when the goods are sold because the legal obligation to receive the amount is established (upon sales) in February, 2018. Let us take another example. Suppose, an enterprise has received an advance in February, 2018 for the sales to be made in May, 2018, revenue shall be recognised in May, 2018, upon sales having been made because the legal obligation to receive the amount is established in May, 2018.

1. Money Measurement Concept: Only those transactions and events are recorded in accounting which are capable of being expressed in terms of money. An event, even though it may be very important for the business, will not be recorded in the books of the business unless its effect can be measured in terms of money with a fair degree of accuracy. For example, accounting does not record a quarrel between the production manager and sales manager; it does not report that a strike is beginning and it does not reveal that a competitor has placed a better product in the market. These facts or 'happenings cannot be expressed in money terms and thus are not recorded in the books.
2. Business Entity Concept: According to this concept, business is treated as a unit separate and distinct from its owners, creditors, managers and others. In other words, the owner of a business is always considered as distinct and separate from the business he owns. Business unit should have a completely separate set of books and we have to record business transactions from firm's point of view and not from the point of view of the proprietor. The proprietor is treated as a creditor of the business to the extent of capital invested by him in the business. The capital is treated as a liability of the firm because it is assumed that the firm has borrowed funds from its own proprietors instead of borrowing it from outside parties!). It is for this reason that we also allow interest on capital and treat it as an expense of the business. Interest on capital reduces the profits of the firm and at the same time it increases the capital of the proprietor. Similarly, the amount withdrawn by the proprietor from the business for his personal use is treated as his drawings. Likewise, goods used from the stock of the business for business purposes are treated as the expenditure of the business but similar goods used by the proprietor for his personal use are treated as his drawings.
3. Matching Concept: This concept is very important for correct determination of net profit. According to this concept, in determining the net profit from business operations, all costs which are applicable to revenue of the period should be charged against that revenue. Accordingly, for matching costs with revenue, first revenues should be recognised and then costs incurred for generating that revenue should be recognised.