Q.

1 Discuss the following accounting concepts and

conventions and their applications while recording business
transactions and preparing financial statements.

1. Separate Entity Concept

Definition

“Business is different from its owner”

In accounting, a business entity is treated as a separate entity from the owner(s). It is

necessary to record the business transactions separately to distinguish it from the
owner's personal transactions.
This will often be an incorporated company, whose treatment as a separate accounting
entity is required by law.
There are many instances whereby the owner withdrew money from the business for
their personal use. This is actually a lending of money from the business to the owner
and should be recorded as such in the books of the business entity. On the other hand,
when the owner inject cash into the business to help easing tight cash flow situation
faced by the business entity, it is a lending of money from the owner to the business
and should also be recorded as such in the books of the business entity.

2. Realization Concept

Definitions

“In Accrual Base Accounting system the profit is made at the time when goods
are actually given to the customer”

"Revenues are recognized when goods and services are delivered and in an amount
that is reasonably certain to be realized" 

1. There are two important dimensions to this principle, i.e. when revenue is
recognized, and whether it is certain that all revenue will eventually be collected.
2. If the accountant believes that based on past experience only 90% of revenues will
be collected, then the accountant will create an "allowance for doubtful accounts".
For Example:
If “A” trader has sold goods to “B” costing Rs. 100000 on credit basis, he will
consider it as an income for the business however the amount is not yet received!
He will do the following entry
B’s Account 100000
To Sales 100000
Sales to Mr. B
It will increase the income side of the business.

3. Matching Concept
Definition

“The concept in accounting of recognizing expenses in the same accounting

period when the related revenues are recognized”

The matching concept is an accounting principle that requires the identification and
recording of expenses associated with revenue earned and recognized during the same
accounting period. Accordingly, under the matching concept the expenses of a
particular accounting period are the costs of the assets used to earn the revenue that is
recognized in that period. It follows, therefore, that when expenses in a period are
matched with the revenues generated for the same period, the result is the net income
or loss for that period.

4. Historical Cost concept

Definition

“The amount of money that was originally used to pay for an asset. A company
records assets on a balance sheet at historical cost, which often bears little
relation to the market value of the assets after they have been owned several
years. Also called original cost.”
In the Generally Accepted Accounting Principles, the original cost of an asset on a
balance sheet. Many assets, particularly illiquid assets, are recorded on a balance
sheet according to their historical cost. A notable exception to this rule is the
recording of marketable securities, which are recorded according to their market
value. The historical cost usually bears little or no relationship to the market value
after an asset has been held for several years.
According to generally Accepted Accounting principles A measure of value used
in accounting in which the price of an asset on the balance sheet is based on its
nominal or original cost when it was acquired by the company.

For Example

Based on the historical-cost principle, under GAAP, most assets held on the balance
sheet are to be recorded at their historical cost even if they have changed significantly
in value over time. For example, say the main headquarters of a company, which
includes the land and building, was bought for $100,000 in 1925, and its expected
market value today is $20 million. The asset is still recorded on the balance sheet at
$100,000. Not all assets are held at historical cost. For example, marketable securities
are held at market value on the balance sheet.

5. Convention of Conservatism
Definition

"Expected losses are losses but expected gains are not gains"

According to this convention all anticipated or. Probable losses are

Recorded as and when they occur and anticipated profits are not recorded.
Profit are recorded only when the same have been earned. In the same way
Stock at the end of the year is valued at the cost price or market price
Whichever is lower. A businessman values the stock at the price which is
Lower of the two on the basis of the convention of conservatism. He is
Recording probable loss before it actually occurs.
The convention of conservatism is a useful tool in situations of
uncertainty and doubt.
For Example

A businessman sells goods not only for cash but also on credit. When
Goods are sold on credit; the businessman has to collect money at a later
date. Sometimes the businessman is unable to collect the amount for goods
Sold on credit. This is a loss to the business out of the goods sold on credit
in a year. This loss is recorded in the books of accounts at the end of the
year. On the basis of experience, we earmark some amount for such purposes
and show such amounts as loss. Similarly, there may be some creditors who
may not claim money from us. But we do not earmark such likely gains. Let
us take one more example. A businessman is expecting a profit of Rs. 10,000
on the sale of a fixed asset. This possible profit will not be recorded until
s the actual sale of the fixed asset takes place. In the above situations,
Businessman takes decision that he will be recording only probable losses.

6. Convention of Materiality
Definition

“Only those transactions, important facts and items are shown which are useful
and material for the business”

For Example

A businessman is dealing in electrical items. He purchases bulbs, tube-

lights, electric wires etc. for his business. In buying these articles a larger
part of his capital is used. On the other hand, he also has to purchase pen,
pencil, paper etc. in which a smaller part of his capital is involved. He will
maintain record of all the items. But to maintain the details of every pen,
pencil or other stationery items is not considered of much significance. So
the items that are significantly important in recording the details are termed
as material facts. The items that are of less significance are immaterial facts.
In accounting, we distinguish between material and immaterial facts otherwise
Accounting information will be burdened with unimportant details.
7. Convention of full Disclosure
Definition

“In order to achieve the purpose of accounting, all the transactions of a business
and any change in accounting policies, methods and procedures are fully
recorded and presented in accounting. The convention of such presentation is
called full Disclosure Convention”

If there is a change in accounting methods of providing depreciation

on fixed assets, or in the methods of valuation of stock or in making provision
for doubtful debts, these should be clearly shown in the Balance Sheet by
way of notes. Similarly, we can say that all important facts are to be fully
disclosed, otherwise financial statements would be incomplete, unreliable and
misleading.
For Example
Suppose, you want to go to your doctor for your treatment, you are
advised to tell all the symptoms so that you can get the best possible treatment.
Similarly in accounting, financial disclosure means that all financial information
regarding business transactions must be given in full. Let us take the example
of business. The business provides financial information to various parties
like owners, creditors, lenders etc. The owners like to know about the financial
position of the business while the creditors would like to know the solvency
of the business. In the same way other parties would be interested in the
financial information according to their objectives. If the financial information
is complete, then only it is possible fortifièrent parties to use that information
in the beet manner. Similarly, another example could be claim of a very big
amount pending in a court of law against a business, any loan taken by
mortgage of any asset, writing of preliminary expenses, commission, etc.
should be properly brought to the notice of users of accounting information.

Q.2 Why do we make Adjustments? Is there any concept of

Accounting regarding Adjustments if so then discuss.
Ans:
Adjustments
The transactions which have not yet been journalized, appended to the trial balance
are what we call adjustments.

Thus we can say that Adjustments are transactions relating to the business which have
not been journalized by the end of the accounting period.

Why we make Adjustments

“Transactions after the Trial Balance Date”

Some of the reasons for the presence of such transactions are

• Transactions which do not occur in the normal course of business

There are a number of transactions relating to the business which do not occur in the
normal course of business. These transactions unless deliberately recorded do not get
into the books of accounts.

Examples for such transactions

i. Stock taken away by the proprietor for personal use

ii. Abnormal loss of stock

• Transactions which have to be recorded only towards the end

There are a number of transactions relating to the business which have to be recorded
only at the end of the accounting period. If the trial balance has been prepared before
all such transactions into consideration have been taken into consideration, then they
stay unrecorded in the books of accounts.
i. Depreciation on Assets

ii. Expenses - Outstanding/Prepaid

iii. Incomes - Outstanding/Pre-received

• Transactions relating to Error Rectifications

The agreement of a Trial Balance is not a conclusive proof of absence of errors in

accounting. Even in case where the trial balance agrees, there may still be errors
existing in the books of accounts.
These errors if identified subsequent to the preparation of the Trial Balance, need to
be rectified which needs journal entries to be passed for rectification