ACCOUNTING NOTES

Essential Features of Accounting Principles:

Accounting Principles are acceptable if they satisfy the following norms:

Usefulness: A principle will be relevant only if it satisfies the needs of

those who use it. The accounting principles should be able to provide
useful information to its users otherwise it will not serve the purpose.

Objective: A principle will be said to be objective if it is based on facts

and figures. There should not be a scope for personal bias. If the principle
can be influenced by the personal bias of users, it will not be objective, and
its usefulness will be limited.

Feasibility: The accounting principles should be practicable. The

principles should be easy to use otherwise their utility will be limited.

Principles of Accounting can be classified into two kinds:

 Accounting Concepts
 Accounting Conventions
Accounting Concepts
The

1) Substance over Form:

Substance over form is an accounting concept which means that the
economic substance of transactions and events must be recorded in the
financial statements rather than just their legal form to present a true and
fair view of the affairs of the entity.

In other words, Substance over form in accounting refers to a concept that

transactions recorded in the financial statements and accompanying
disclosures of a company must reflect their economic substance rather
than their legal form.
Importance
The principle of Substance over legal form is central to the faithful
representation and reliability of information contained in the financial
statements. By placing the responsibility on the preparers of the financial
statements to actively consider the economic reality of transactions and
events to be reflected in the financial statements, it will be more difficult for
the preparers to justify the accounting of transactions in a manner that does
fairly reflect the substance of the situation. However, the principle of
substance over form has so far not been recognized by IASB or FASB as a
distinct principle in their respective frameworks due to the difficulty of
defining it separately from other accounting principles
particularly reliability and faithful representation.

Explanation, Use and Application

Usually, the legal form of a transaction is frequently descriptive of its
economic substance, so no problem arises. In some cases when the two
differ and both give different results. Examples include assets held on
finance lease and hire purchase which are treated as non-current assets,
although they are not in the legal ownership of the business .

Example
A sell a machine to B for $20000 and at the same time agrees to buy it
back in 1 years’ time for $21800. The machine remains on A’s premises
and A continues to use and to insure the machine. These related
transactions are likely to arouse some suspicion. What is going on here? In
legal terms, following the first transaction, B is clearly the owner of the
machine. However, the substance of the transaction is that A retains the
risks and rewards of ownership, and effectively, has taken out a loan for a
year at an interest rate of 9%.

2) Consistency
The concept of consistency means that accounting methods once adopted
must be applied consistently in future. Also, same methods and techniques
must be used for similar situations. It implies that a business must refrain
from changing its accounting policy unless on reasonable grounds. If for
any valid reasons the accounting policy is changed, a business must
disclose the nature of change, the reasons for the change and its effects on
the items of financial statements.

Consistency concept is important because of the need for comparability,

that is, it enables investors and other users of financial statements to easily
and correctly compare the financial statements of a company.

Example
Company A has been using declining balance depreciation method
for its IT equipment. According to consistency concept it should
continue to use declining balance depreciation method in respect of
its IT equipment in the following periods. If the company wants to
change it to another depreciation method, say for example
the straight line method, it must provide in its financial report, the
reason(s) for the change, the nature of the change and the effects of
the change on items such as accumulated depreciation.

3) Full Disclosure
The full disclosure principle states that all information should be included
in an entity's financial statements that would affect a reader's
understanding of those statements. The interpretation of this principle is
highly judgmental, since the amount of information that can be provided
is potentially massive. To reduce the amount of disclosure, it is
customary to only disclose information about events that are likely to
have a material impact on the entity's financial position or financial
results.
Explanation
Full disclosure principle requires the management of any business
organization to give full disclosure of all the material and important
information that may affect the investor’s understanding of that
organizations financial statement. Management must decide what all
business-related information should be known to investors.

Example

There is a company named Clothing incorporation that deals with the

manufacturing of clothes. There was another firm named Lavish fabrics
who is the main customer of Clothing Information. In the year 2019,
Lavish fabrics found another supplier who provides more better-quality
products, so the management of Lavish fabrics decided to switch all
their buying to that new vendor thereby cancelling all the upcoming
orders that were pending with Clothing Incorporation. Now this news will
have a great impact on the investor’s decision as the result of this
cancellation the major revenue of the clothing incorporation will be lost
so this is material information that the clothing incorporation must
disclose in the notes of financial statements.

Importance

The Full Disclosure Principle is important because it provides the investor

with all material facts about a business in which he wishes to invest his
money. So, because of Full Disclosure Principle, it is ensured that the
business organizations are not misleading any group of investors by
providing only the positive information to them.

Full Disclosure Principle is also important because it reduces the chance of

getting the financial statements manipulated. As if there was no such
principle then the potential businesses will show only the information that
will make their business to look stronger and growing than it is.

4) Conservatism

Conservatism principle is the accounting principle that concern about the

reliability of Financial Statements of an entity. The conservatism principle
provides guidance to accountants on how to records and recognizes the
uncertainty outcome of revenues, expenses, assets, and liabilities
in financial statements.

In other words, Conservatism Principle is a concept in accounting under

GAAP which recognizes and records expenses and liabilities-certain or
uncertain, as soon as possible but recognizes revenues and assets when
they are assured of being received. It gives clear guidance in documenting
cases of uncertainty and estimates.

Example

Suppose an asset owned by an entity like inventory was bought for $120
but can now buy for $50. Then the company must immediately write
down the value of the asset to $50, i.e., the lower the cost of the market.
But if the inventory was bought for $120 and now costs the company $150,
it must still be shown as $120 on the books. The gain is only recorded
when the inventory or the asset is sold.

5) Prudence

Business transactions and other events are sometimes uncertain and

presenting them in financial statements requires making estimates. Making
estimates involves exercise of judgement. Use of judgement requires
prudence. Prudence is a key accounting principle which ensures that
assets and income are not overstated, and liabilities and expenses are not
understated. At the same time, it does not allow deliberate understatement
of assets and income and overstatement of liabilities and expenses.
Prudence is critical to achieve neutrality which is one of the preconditions
of faithful representation.

Importance

Prudence concept (otherwise the principle of conservatism) is

a fundamental accounting concept, increasing the reliability of numerical
data presented in company reports, consisting in the obligation to register
expenses and other liabilities as quickly as possible, while revenues only in
situations where there is certainty about their implementation or a
guarantee appears.

Capital Receipts

Capital receipts are the income received by the company which is non-
recurring in nature. They are part of the financing and investing activities
rather than operating activities. The capital receipts either reduces an asset
or increases a liability. The receipts can be generated from the following
sources:
  Issue of Shares
 The issue of debt instruments such as debentures.
 Loan taken from a bank or financial institution.
 Government grants.
 Insurance Claim.
 Additional capital introduced by the proprietor.

Revenue Receipts
Revenue Receipts are the receipts which arise through the core business
activities. These receipts are a part of normal business operations that is
why they occur again and again however its benefit can be enjoyed only in
the current accounting year as its effect is short term. The income received
from the day-to-day activities of business includes all the operations that
bring cash into the business like.

 Revenue generated from the sale of inventory

 Services Rendered
 Discount Received from the creditors or suppliers
 Sale of waste material/scrap.
 Interest Received
 Receipt in the form of dividend
 Rent Received

Key Differences Between Capital Receipt and Revenue

Receipt
The following points explain the difference between capital receipt and
revenue receipt in detail:

1. Receipts generated from investing and financing activities are capital

receipts, on the other hand, receipts from operating activities are
revenue receipt.
2. Capital Receipts do not frequently occur, as it is non-recurring and
irregular. But revenue receipts occur again and again, i.e. they are
recurring and regular.
3. The benefit of capital receipt can be enjoyed in more than one year,
but the benefit of revenue receipt can be enjoyed only in the current
year.
4. Capital Receipts appears on the liabilities side of the Balance Sheet
whereas Revenue Receipts appears on the credit side of the Profit
and Loss Account as income for the financial year.
5. The capital receipt is received in exchange for the source of income.
Unlike revenue received which is a substitution of income.
6. Capital receipt either decreases the value of an asset or increases
the value of liability, but revenue receipt neither increases nor
decreases the value of asset or liability.
Users of Accounting Information:

 Internal User
 External User

Internal User:  Management – Organization’s internal management

includes all junior and senior business managers.

They use it for

1. Budgeting, forecasting, analysis & take important financial decisions.

2. Investment decisions, identification of warning and opportunity signals.

3. Taking informed & evaluated decisions.

4. Compliance with all statutory, regulatory, and any other external body.

Owners/Partners – Owners are the legal stakeholders of the business and

the ultimate signing authority.

They use it for

1. Tracking their investment and monitoring their return on investment.

2. Observing their capital invested and evaluating its upward or downward move.

 3. Keeping an eye on the overall well-being of the business.

Employees – Full-time & part-time workers. They are essentially on the

company’s payroll.

They use it for

1. Checking the overall financial health of the company as it affects their remuneration and job
security.

2. Decision making in case of shares-based payment such as ESOPs offered by the employers.

3. Examining if the employer is depositing all required funds to the appropriate authorities such
as the provident fund, 401(k), etc. 
External Users of Accounting Information – (Secondary)

Following are the secondary users of accounting information:

1. Investors – They may be current investors, minority stakeholder,

potential future investors, etc.

They use it for

1. Checking how the management is utilizing the equity invested in the business.

2. Decisions related to an increase in investment or to divest from the business.

3. Analyzing their present investment in the business or the overall financial health
in case of a potential investor.

Lenders – Banks and Non-banking financial companies which provide

loans in the form of cash or credit are termed as lenders.

They use it for

1. Evaluation of short-term and long-term financial stability of a business.

2. An insight into the liquidity, profitability, etc. with the help of ratio analysis 
 3. Assessment of the creditworthiness with the help of financial ratios and scrutiny
of the three main financial statements in accounting

Regulatory and Tax Authorities – Regulatory bodies such as the stock

exchange & authorities include the govt. along with various statutory and
tax departments.

They use it for

1. To keep a check and ensure that the firm is following all required accounting
principles, standards, rules & regulations.

2. The ultimate intent is to protect business integrity & safeguard investors. 

3. Tax department as one of the users of accounting information assures accurate

tax calculation by the companies.

Customers – Are buyers of goods or services and may exist at any stage
of a business cycle. They may be producers, manufacturers, retailers, etc.
 They use it for

1. Checking the continuous inflow of stock and the pace of overall production.

2. Assessing the financial position of its suppliers which is essential to maintain a

stable source of supply.

Suppliers – Are the sellers of goods and services.

They use it for

1. Inspecting the credibility of their customers by evaluating their repayment ability.

2. Setting up a credit limit & payment terms with their customers.

Public – The general public is also among users of accounting information.

They are keen to know the financial health of a business to get a fair idea
of the firm’s niche market, business environment, and economic
atmosphere of the country.