FINANCIAL ACCOUNTING

BLOCK 1

UNIT-1

 DEFINITION OF ACCOUNTING:

“Accounting is the art of recording, classifying, and summarizing in a significant manner

and in terms of money; transactions and events which are, in part at least, of a financial

character, and interpreting the results thereof.”

 FEATURES OF FINANCIAL ACCOUNTING:

1) It is an art: Accounting is an art because it helps us in attaining our

objective of ascertaining the financial results by recording, classifying and

summarizing the business transactions.

2) It is an art of recording business transactions: Accounting is an art of

recording business transactions in the books of account in a systematic

manner. Recording is carried out in the book called ‘Journal’. A journal is

a chronological listing of the firm’s transactions including which amount

is debited and which amount is credited.

3) It records transactions of financial character: Accounting records only

those transactions and events which are of financial character.

4) It records transactions in terms of money: Accounting records the

transactions by expressing them in terms of money. For example, if a

business has 10 machines, 20 tons of raw material, 2 buildings, 20 tables

 and chairs, it is not possible to add them together or know which one is

more valuable unless they are expressed in terms of money.

5) It is an art of classifying business transactions: Classifying is the process

of grouping of transactions or entries of one nature at one place. This is

done by opening accounts in a book called ‘Ledger’, it contains all the

accounts of the business. The general ledger, sometimes known as the

nominal ledger, is the main accounting record of a business which uses

double-entry bookkeeping. It will usually include accounts for such items

as current assets, fixed assets, liabilities, revenue and expense items, gains

and losses. Each General Ledger is divided in two sections. The left hand

side lists debit transactions and the right hand side lists credit transactions.

6) It is the art of summarizing the business data: Summarizing is the art of

presenting the classified data (ledger) in a manner which is understandable

and useful to management and other interested parties. This involves

preparation of final accounts which include:

 Trial balance

 Trading and Profit and loss account

 Balance sheet

7) It is helpful in the analysis and interpretation of the results: The analysis of

accounting statements will help the management to judge the performance

of business operations and for preparing the future plans. The results of

the analysis and interpretation are communicated to the proprietor and

other interested parties such as creditors, investors, employees.

 FUNCTION OF ACCOUNTING:
1) Maintaining Systematic Records: Business transaction are properly recorded,

classified under appropriate accounts and summarized into financial statements—

income statement and the balance sheet.

2) Communicating the Financial Results: Accounting is used to communicate

financial information in respect of net profit (or loss), assets, liabilities etc., to the

interested parties.

3) Meeting Legal Needs: The provision of various laws such as companies Act,

Income tax and sales tax acts require the submission of various statements, i.e.,

annual accounts, income tax returns, returns for sales tax purpose and so on.

4) Protecting Business Assets: Accounting maintains proper record of various assets

and thus enables the management to exercise proper control over them with the

help of following information regarding them:

(a)How much is the balance of cash in hand and cash at bank?

(b)What is the position of inventories?

(c)How much money is owned by the customers?

(d)How much money is owing to the creditors?

(e)What is the position of various fixed assets and how these are being used?

5) Stewardship: In the case of limited companies, the management is

entrusted with the resources of the enterprise. The managers are expected to act

true trusted of the funds and the accounting helps them to achieve the same.
 6) Fixing Responsibility: Accounting helps in the computation of the profits of

different department of an enterprise. This would help in fixing the responsibility

of department heads.

7) Forecasting: Accounting enables to forecast the future performance and financial

position using past accounting information.

8) Measurement: It is the basic function of the accounting data to measure the past

performance in money term and disclose its current financial position.

9) Decision Making: Accounting provides the user the relevant data to enable them

make appropriate decision in respect of investment in the capital of the business

enterprise or to supply goods on credit or lend money etc.

10) Control: To identify the weakness of the operational system and review the steps

taken to check such weaknesses.

 ADVANTAGES OF ACCOUNTING:

1) Assistant to Management: Accounting is to ascertaining the financial results of

operation, also performs the significant function of providing information. The

information helps in planning, decision-making, and controlling.

2) Replacement of Memory: No businessman can remember everything about his

business since memory has limitations. It is necessary to record transaction in the

books of account promptly .This will obviate the necessity of remembering the

various transactions since no need; the record will furnish the necessary

information.
 3) Comparative Study: A systematic record will enable a businessman to compare

one year’s results those of other years and locate significant factors leading to the

change, if any.

4) Settlement of Tax Liability: If accounts are maintained properly, they will be of

great assistance when the firm is assessed to income tax or sales tax.

5) Evidence in court: Systematic record of transaction is often treated by the courts

as good evidence.

6) Sale of Business: If someone desires to sell his business, the accounts maintained

by him will enable the ascertainment of the proper purchase price.

7) Assistance to an Insolvent Person: In case one becomes insolvent, one has to

explain many things about the past. Proper accounting helps him to do that.

 LIMITATIONS OF ACCOUNTING:

1) Does not Provide Timely Information: It is not a limitation when high powered

software applications like Hi-tech Financial Accounting are used to keep online

and concurrent accounts where the balance sheet is made available almost

instantaneously. However, manual accounting does have this shortcoming.

Financial accounting is designed to supply information in the form of statements

(Balance Sheet and Profit and Loss Account) for a period normally one year. So

the information is, at best, of historical interest and only 'post-mortem' analysis of

the past can be conducted. The business requires timely information at frequent

intervals to enable the management to plan and take corrective action.

2) Ignores Important Non-Monetary Information: Financial accounting does not

consider those transactions of non- monetary in nature. For example, extent of

competition faced by the business, technical innovations possessed by the

business, loyalty and efficiency of the employees; changes in the value of money

etc. are the important matters in which management of the business is highly

interested but accounting is not tailored to take note of such matters. Thus any

user of financial information is, naturally, deprived of vital information which is

of non-monetary character. In modern times good accounting software with MIS

and CRM can be most useful to overcome this limitation partially.

3) Does not Provide Detailed Analysis: The information supplied by the financial

accounting is in reality aggregates of the financial transactions during the course

of the year. Of course, it enables to study the overall results of the business the

information is required regarding the cost, revenue and profit of each product but

financial accounting does not provide such detailed information product- wise.

For example, if business has earned a total profit of say, $ 5, 00,000 during the

accounting year and it sells three products namely petrol, diesel and mobile oil

and wants to know profit earned by each product financial accounting is not likely

to help him unless he uses a computerized accounting system capable of handling

such complex queries. Many reports in a computer accounting software like Hi-

tech Financial Accounting which are explained with graphs and customized

reports as per need of the business overcome this limitation.

4) Does not disclose the Present Value of the Business: In financial accounting the

position of the business as on a particular date is shown by a statement known as

 'Balance Sheet'. In Balance Sheet the assets are shown on the basis of "Continuing

Entity Concept. Thus it is presumed that business has relatively longer life and

will continue to exist indefinitely, hence the asset values are 'going concern

values.' The 'realized value' of each asset if sold to-day can't be known by

studying the balance sheet. Financial accounting permits alternative treatments

Accounting is based on concepts and it follows “generally accepted principles"

but there exist more than one principle for the treatment of any one item. This

permits alternative treatments with in the framework of generally accepted

principles. For example, the closing stock of a business may be valued by anyone

of the following methods: FIFO (First-in- First-out), LIFO (Last-in-First-out),

Average Price, Standard Price etc., but the results are not comparable.

 DIFFERENTIATE BETWEEN FINANACIAL ACCOUNTING &

MANAGEMENT ACCOUNTING:

FINANACIAL ACCOUNTING MANAGEMENT ACCOUNTING

1. Financial accounting is concerned with 1. Management accounting is the art

recording the transactions of financial presenting the accounting information in

character, summarizing and interpreting such a way as to assist management in the

them and communicating the results to the creation of the policy and in the day to day

users. operation of the undertaking.

2. It is externally oriented 2. It is internally oriented.

3. It is compulsory. 3. It is not compulsory.

4. It is historic oriented. 4. It is future oriented.

5. It is highly aggregated. 5. It is very specific.

6. It emphasis objectivity i.e profits and 6. It emphasis on relevance.

loses.

7. Financial accounting reports contain 7.Management accounting reports contains

Information which can be translated or information of both financial or non-

expressed in money only. financial nature such as physical quantities

of stock, output, turnover, etc.

 END-USERS OF ACCOUNTING INFORMATION:

I) INTERNAL USERS

1) Owners: Owners contribute capital in the business and thus are always exposed to

risk. In view of the risk involved, the owners are always interested in knowing the

profit earned or loss suffered by the business besides the safety of the capital

invested by them. In small medium sized enterprises, owners generally exercise

direct control on the affairs and thus always possess the information as to profit

and financial position. But in large sized enterprises, owners do not exercise direct

control and are dependent on the managers for financial information.

2) Management: Businesses are managed by professional managers who are in direct

control. Management has the responsibility to not only safeguard the owner’s

investment but also to increase its value by managing the business efficiently so

that it earns the maximum profit. The management makes extensive use of

accounting information to arrive at informed decisions such as determination of

selling price, cost controls and reduction, investment into new projects etc.

II) EXTERNAL USERS

1) Banks and Financial Institutions: Bankers and financial institutions are an

essential part of any business as they provide loans to the businesses. It is natural

that the banks and financial institutions will watch the performance of the

business to know, whether it is making progress as projected to ensure the safety

and recovery of the loan advanced. Banks and financial institutions assess the

position of a company from an analysis of their accounting information.

2) Investors and Potential Investors: Investment involves risk and also the investors

do not have direct control over the business affairs. Therefore, they rely on the

accounting information available to them and seek answers to the questions such

as-what is the earning capacity of the enterprise and how safe is their investment?

3) Creditors: Creditors are those parties who supply goods or services on credit. It is

a common business practice that a large amount of supplier’s remains invested in

credit sales. Before granting credit, creditors satisfy themselves about the credit

worthiness of the business. The financial statements help them immensely in

making such an assessment.

4) Government and its Authorities: The government makes use of financial

statements to compile national income amounts and other information’s. The

information is so available to it enables them to take policy decisions.

Government levies various taxes such as Excise Duty, VAT, Service Tax and

Income Tax. These government authorities assess the correct tax dues from an

analysis of financial statements.

5) Employees and Workers: Employees and workers are entitled to bonus at the year

end besides the salary and wages taken every month. Bonus is directly linked to
 the profit earned by an enterprise. Therefore, the employees and workers are

interested in financial statements. Besides, the financial statements also reflect

whether the enterprise has deposited its dues into the Provident Fund and

Employees’ State Insurance, etc or not.

6) Researchers: Financial statements are of immense use to the researchers

undertaking research in topical areas like accounting theory and business

practices. Stock brokers also carry out research on financial statements to assess

the future profitability and as a result assess what should be the value of the share.

 BRANCHES OF ACCOUNTING:

Financial accounting: it is concerned with recording financial transactions, summarizing

& interpreting them & communicating the results to users.

Cost accounting: it ascertains the cost of products manufactured or services rendered &

help the management in decision making (say price fixation) & exercising controls.

Management accounting: it is concerned with generating accounting information relating

to funds, costs, profits, etc., as it enables the management in decision making.

 DIFFERENCE BETWEEN BOOK-KEEPING AND ACCOUNTING:

BASIS Book-Keeping Accounting

Definition Book-keeping is recording Accounting is the art of

of financial data and is recording, classifying, and
actually a part of summarizing in an
accounting. significant manner and in
terms of money and
interpreting the results
thereof.
Nature It is concerned with It is concerned with
identifying financial summarizing the recorded
transactions, recording and transactions, interpreting
classifying them. and communicating the
results.
Objectives The objectives of book- The objectives of
keeping are to maintain accounting are to ascertain
systematic records of net results of operation and
financial transactions. financial position and to
communicate information to
the interested parties.
Relation Book-keeping is the basis Accounting begins where
for accounting. the book-keeping ends.
Special skills Book-keeping is mechanical Accounting requires special
in nature and thus does not skills and ability to analyze
require any special skills. and interpret.

 ACCOUNTING CONCEPTS AND PRINCIPLES

Accounting principles may be defines as those rules of action or conduct which are

adopted by the accountant universally by recording accounting transactions. “They are a

body of doctrines commonly associated with the theory and procedures of accounting,

serving as an explanation of current practices and as a guide for selection of conventions

or procedures where alternatives exist.” These principles can be classified into two

categories:

1. Accounting Concepts

2. Accounting Conventions

Accounting Concepts: The term concept includes those basic assumption or condition

upon which the science of accounting is based. The following are the important

accounting concepts:

1. Separate Entity Concepts

2. Going Concern Concept

3. Accounting Period Concept

4. Money Measurement Concept

5. Cost Concept

6. Dual Aspect Concept

7. Periodic Matching of Cost and Revenue Concept

8. Realization Concept

Accounting Conventions: The term convention includes those customs or traditions

which guide the accountant while preparing accounting statements. The following are the

accounting conventions:

1. Convention of Conservatism

2. Convention of Full Disclosure

3. Convention of Consistency

4. Convention of Materiality
ACCOUNTING CONCEPTS

SEPARATE ENTITY CONCEPT

In accounting the separate entity concept treats a business as distinct and completely

separate from the owners. The business stands apart from other organizations as separate

economic unit. It is necessary to record the business transactions separately to distinguish

it from the owner's personal transactions. This concept is now extended to accounting for

various divisions of a firm in order to ascertain results for each division. The idea here is

that the financial transactions of one individual or a group of individuals must be kept

separate from any unrelated financial transactions of those same individuals or group.

The best example here concerns that of the sole trader or one man business: in this

situation you may have the sole trader taking money by way of 'drawings': money for his

own personal use. Despite it being his business and apparently his money, there are still

two aspects to the transaction: the business is 'giving' money and the individual is

'receiving' money. In contrast, there is no legal distinction between the sole trader and the

business, and the sole trader is liable for all of the debts of the business. So, the affairs of

the individuals behind a business must be kept separate from the affairs of the business

itself.

GOING CONCERN CONCEPT

According to this concept it is assumed that the business will continue for a fairly long

time to come. There is neither the intension nor the necessity to liquidate the particular

business venture in the foreseeable future. On account of this concept, the accountant

wile valuing the asset does not take into account the forced sales value of the assets.
Moreover, he charges the depreciation on fixed assets on the basis of their expected lives

rather than on the market values.

It should be noted that the ‘the going concern concept’ does not imply permanent

continuance of the enterprise. It rather presumes that the enterprise will continue in

operation long enough to charge against the income, the cost over fixed assets over the

useful lives, to amortize over appropriate period other cost which have been deferred

under the actual or matching concept, to pay liabilities when they become due and to

meet the contractual commitments. Moreover, the concept applies to the business as a

whole. When an enterprise liquidates a branch or one segment of its operation, the ability

of the enterprise to continue as a going concern is normally not impaired.

Circumstances under Which an Enterprise May Not be a Going Concern:

1. Relationship with Suppliers: In case a going concern is not in a position to take

advantage of cash discounts, has to pay interest for late payments, its shipment

stopped because of failure to meet terms of payment, or suppliers prepared to

supply the goods only on prepayment terms, it can be concluded that the concern

is having liquidity problems.

2. Turnovers Ratios: In case of turnover ratios in respect of receivable and

inventories are more unfavorable than those prevailing in the industry; the

enterprise is suffering from problems of liquidity.

3. Use of Short Term Funds For meeting Long Term Requirements: In case a

concern is required to use current assets to finance long term requirements

without the capacity or ability to refinance such requirements on a long term

basis, the concern s bound to suffer from liquidity problems.

 4. Pledging of Additional Assets to Secure Existing Debt: this shows that the

existing creditors are losing faith in the company on accounts of its vulnerable

financial problems.

5. Default on Loan Agreement: this shows that the firm is having difficulty in

repayments of loan.

6. Recurring Operating losses: Such situations will ultimate leads to closing down

the business operations.

7. Commercial Insolvency: It is a situation where liabilities exceed the assets of the

business.

MONEY MEASUREMENT CONCEPT

The money measurement concept underlines the fact that in accounting, every recorded

event or transaction is measured in terms of money. Using this principle, a fact or a

happening which cannot be expressed in terms of money is not recorded in the

accounting books. One of the basic principles in accounting is "The Measuring Unit

principle: The unit of measure in accounting shall be the base money unit of the most

relevant currency. This principle also assumes the unit of measure is stable; that is,

changes in its general purchasing power are not considered sufficiently important to

require adjustments to the basic financial statements. e.g: Say if you are an investor who

is interested in purchasing over a company who own a factory. In the company’s

financial statement, do you think you are able to see such statistics like consumer price

index, number of loyal customers, industrial output, the factory’s productivity ratio,

factory staff turnover rate, number of shift, wastage % , and so on? The answer will be no

as this concept deals with resources and obligations that can be measured and quantified

into financial terms.

ACCOUNTING PERIOD CONCEPT

According to this concept, the lifespan of a business is divided into fixed period of time

(months, quarters, half-years or years) for which accounts are prepared.

In most cases an accounting period is a year. Note that the accounting year need not be

the same as the calendar year. For example, the accounting year for business X can be

from 1 June to 31 May, for business B from 1 September to 31 August or for business C

from 1 April to 31 March.

Accounts of the business are closed at a specific date every year and final accounts are

prepared (profits/ losses calculated)

COST CONCEPT

In general, cost means the amount of expenditure (actual or notional) incurred on, or

attributable to a given thing.

In Fact, the term cost cannot be exactly defined. Its interpretation depends upon the

following factors:

 The nature of business or industry

 The context in which it is used

In a business where selling and distribution expenses are quite nominal the cost of an

article may be calculated without considering the selling and distribution overheads. At

the same time, in a business where the nature of a product requires heavy selling and

distribution expenses, the calculation of cost without taking into account the selling and

distribution expenses may prove very costly to a business. The cost may be factory cost,

office cost, cost of sales and even an item of expense. For example, prime cost includes

expenditure on direct materials, direct labor and direct expenses. Money spent on
materials is termed as cost of materials just like money spent on labor is called cost of

labor and so on. Thus, the use of term cost without understanding the circumstances can

be misleading.

Different costs are found for different purposes. The work-in-progress is valued at factory

cost while stock of finished goods is valued at office cost. Numerous other examples can

be given to show that the term “cost” does not mean the same thing under all

circumstances and for all purposes. Many items of cost of production are handled in an

optional manner which may give different costs for the same product or job without

going against the accepted principles of cost accounting. Depreciation is one of such

items. Its amount varies in accordance with the method of depreciation being used.

However, endeavor should be, as far as possible, to obtain an accurate cost of a product

or service.

DUAL ASPECT CONCEPT

The dual aspect principle holds that every transaction entered into by an enterprise shall

have two aspects; if an event occurs, it is bound to have a two sided effect. This two sided

or double effect can be better understood if we remember the business entity concept

under which the enterprise is considered to be separate from its proprietor. When the

proprietor starts the business and invests money, the enterprise shall have that much

money but, also the enterprise shall owe that amount to the proprietor. One may,

therefore, say that the assets are equal to the owner’s equity or capital. Suppose further,

the enterprise borrows a sum of money; the amount of assets will increase but this will

mean that out of the total assets a certain sum of money is payable to outsiders called

creditors. It is also known as Double Entry Methodology.

Assets are the resources owned by a business

Liabilities are the rights of the creditors, which represent debts of the business

Owners Equity represents the rights of the owner

Thus, dual aspect concept implies

Sources of funds = Uses of Funds

Or

Owners Equity + Outside Liability = Assets

MATCHING CONCEPT

According this concept, the expenses incurred in an accounting period should be matched

with the recognized in that period. Ex., if revenue is recognized on all goods sold during

a period, cost of those goods sold should also be charged to that period. It is wrong

derecognized revenue on all sales, but charge expenses only on such sales as are collected

in cash till that period.

This concept is basically an accrual concept since, it disregards the timing and the

amount of actual cash inflow or cash outflow and concentrates on the occurrence (i.e.

accrual) of revenue and expenses. This concept calls for adjustment to be made in respect

of prepaid expenses, outstanding expense, accrued revenue and unaccrued revenues.

Matching does not mean that expense must be identifiable with revenues. Expenses

charged to a period may or may not be related to the revenue recognized in that period,

e.g. cost of goods sold and commission too salesman are directly related to sales whereas

rent, interest, depreciation accruing with the passage of time and stock lost by fire are not
directly related to sales revenue yet, they are charged to the accounting period to which

they relate.

REVENUE CONCEPT

This principle is mainly concerned with the revenue being recognized in the Income

Statement of an enterprise. Revenue is the gross inflow of cash, receivables or other

consideration arising in the course of ordinary activities of an enterprise from the sale of

goods, rendering of services and use of enterprise resources by others yielding interests,

royalties and dividends. It excludes the amount collected on behalf of third parties such

as certain taxes. In an agencies relationship, the revenue is the amount of commission and

not the gross inflow of cash receivables or other considerations.

ACCOUNTING CONVENTIONS

The term convention includes those customs or traditions which guide the accountant

while preparing the accounting statements. Accounting conventions are the outcome of

account practices or principle being followed by the enterprises over a period of time.

Convention may undergo a change with time to bring about improvement in the quality

of account information. In short accounting convention is a common practice which is

universally followed in recording and presenting accounting information of business.

They are followed like customs in a society. As a society develops its own customs for its

day-do-day activities, so convention are develop by business to facilitate its recording In

the book of account. Conventions help in comparing accounting data of different business

unit or of the same unit of different business periods. The following are the important

accounting convention:
 1. Convention of conservatism.

2. Convention of full disclosure.

3. Convention of consistency.

4. Convention of materiality.

CONVENTION OF CONVERTISM

This concept emphasizes that profit should never be overstated or anticipated.

If a situation arises where there are two acceptable alternatives for reporting an item,

conservatism directs the accountant to choose the alternative that will result in less net

income and/or less asset amount. Conservatism helps the accountant to "break a tie." It

does not direct accountants to be conservative. Accountants are expected to be unbiased

and objective. Traditionally, accounting follows the rule "anticipate no profit and provide

for all possible losses.

For example: 1) Closing stock is valued at cost price or market price, whichever is lower.

The effect of the above is that in case market price has come down then provide for the

'anticipated loss' but if the market price has gone up then ignore the 'anticipated profits'.

Critics point out that conservation to an excess degree will result in the creation of secret

reserve. This will be quite contrary to the doctrine of disclosure. However, conservatism

to a reasonable degree may not come in for criticism.

2) Potential losses from lawsuits will be reported on the financial statements or in the

notes, but potential gains will not be reported. Also, an accountant may write inventory

down to an amount that is lower than the original cost, but will not write inventory up to

an amount higher than the original cost

CONVENTION OF FULL DISCLOSURE

According to this convention accounting reports should disclose fully and fairly the

information they purport to represent. They should be honestly prepared and sufficiently

disclose information which is of material interest to proprietors, present and potential

creditors and investors. The convention is gaining more importance because most of big

businesses are run by joint stock companies where ownership is divorced from

management. The companies act 1956 not only requires that income statement and

balance sheet of a company must give a true and fair view of the state of affairs of the

company but it also gives the prescribed forms in which these statements are to be

prepared. The practice of appending notes to the accounting statements (such as about

contingent liabilities or market value of investments) is in pursuant to the convention of

full disclosure.

Suppose, you want to go to your doctor for 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 transaction

must be given in full. Let us take an example of business. The business provides financial

information to various parties like owners, creditors, lenders etc. The owners like to know

the financial position of the business while creditors 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 for different parties to use that information in the best manner. The convention

of full disclosure holds that “there should be complete and understandable reporting on

the financial statement of all significant information relating to the economic affairs of
the entity”. If there is a change in accounting method of providing depreciation on fixed

assets, or in the method of valuation of stock or in making provision for doubtful debts,

these should be clearly shown in the balance sheet by the 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. Therefore in order to achieve the purpose of

accounting policies, method and procedures are fully recorded and presented in

accounting. The convention of such presentation is called full disclosure convention.

COVENTION OF CONSISTENCY

The convention of consistency means that same accounting principles should be used for

preparing for financial statements for different periods. It enables the management to

draw important conclusions regarding the working of the concern over a longer period. It

allows a comparison in the performance of different periods. If different accounting

procedures and processes are used for preparing financial statements of different years

then the results will not be comparable because these will be based on different

postulates. The concept of consistency does not mean that no change should be made in

accounting procedures. There should always be a scope for improvement but the changes

should be notified in the statements. The impact of changes of procedures should be

clearly stated. It will enable the readers to analyze information according to new

procedures. In the absence of any information regarding the change, it will be presumed

that old methods have been used this time also. Whenever, consistency is not followed

this fact may be fully disclosed. For example, if a change in the method of charging

depreciation is made or a change is made in the method of allocating overhead expenses

to different products, a foot note to the financial statements should be given indicating the
extent of change. If possible, net monetary effect of these changes should also be given.

Consistency may be of three types:

Vertical consistency

Horizontal consistency

Dimensional consistency

The vertical consistency is maintained within interrelated financial statements of the

same period. If a change has been made in dealing with two aspects of the same

statement then it will be vertical inconsistency. For example, if one method of

depreciation is used while preparing profit and loss account and another method is

followed while preparing balance sheet, it will be a case of vertical inconsistency. When

figures of one financial year are compared with the figures of another financial year of

the same organization it will be a case of horizontal consistency. Third dimensional

consistency will arise when financial statements of two different organizations, in the

same industry, are compared.

CONVENTION OF MATERIALITY:

According to this convention the accountant should attach importance to material details

and ignore insignificant details. This is because otherwise accounting will be

unnecessarily overburdened with minute details. The question what constitutes a material

detail, is left to the discretion of the accountant. Moreover, an item may be material for

one purpose while immaterial for another. For example, while sending each debtor “a

statement of his account”, complete details up to paisa have to be given. However, when

a statement of outstanding debtors is prepared for sending to top management, figures

may be rounded to the nearest ten or hundred. The Companies Act also permits ignoring
of “paisa” wile preparing financial statements. Similarly, for tax purposes, the income

has to be rounded to nearest ten.

Thus, the term ‘materiality’ is a subjective term. The accountant should regard an item as

material if there is reason to believe that knowledge of it would influence the decision of

the informed investor.

It should be noted that accounting is a man-made art designed to help man in achieving

certain objectives. “The accounting principles, therefore, cannot be derived from or

proven by laws of nature. They are rather in the category of conventions or rules

developed by man from experience to fulfill the essential and useful needs and purposes

in establishing reliable financial and operating information control for business entities.

In this respect, they are similar to the principles of commercial and other social

disciplines.”

 ACCOUNTING STANDARDS

The Accounting Standards are set of guidelines, generally accepted accounting principles,

issued by the accounting body of the country such as the institute of chartered

accountants of India, that are followed for presenting and preparing of financial

statements .In other words, accounting standards are the norms of accounting policies and

practices to direct the treatment of transaction and events that ultimately transforms into

financial statements.

The concept of accounting standards is to bring uniformity in accounting practices and to

ensure transparency, consistency and compatibility .In other words, diverse accounting

practices are minimized to accept accounting practices so that credible financial

statements are prepared.

Nature of accounting standards:

1. Accounting Standards are guidelines providing the framework so that credible

financial statements can be prepared,

2. The objective of setting accounting standards is to bring uniformity in accounting

practices and to ensure transparency, consistency and compatibility.

3. The accounting standards are prepared keeping in view the business environment

and the law of the country. it therefore, naturally means that the guidelines shall

change with the change in business environment and the laws.

4. Accounting standards have been made flexible in the sense that where alternative

accounting practices are acceptable, an enterprise is free to adopt any form of

practice.

The institute of chartered accountants of India has so for pronounced 29 accounting

standards.

 ACCOUNTING IS NOT FULLY EXACT

Although most of the transactions are recorded on the basis of evidence such as sale or

purchase or receipt of cash, yet some estimates also be made for ascertaining profit or

loss. Examples of this are estimating the useful life of an asset, possible bad debts the

probable market price of the stock of goods, etc. people are bound to have different ideas

in respect of such things and the estimates will naturally differ from person to person.

This will also lead to a different amount of profit or loss being shown by different person.

Thus, the profit cannot be exact. The reasons are:

1) Influenced by Personal Judgments: Accounting is yet an exact science and

accountant has to exercise his personal judgment in respect of various items. For
example, it is extremely difficult to predict with any degree of accuracy the actual

useful life of an asset which is needed for calculating depreciation. The same is

true with the method of valuation of stock and making provision for doubtful

debts. Different person are bound to have different opinions in respect of such

things and hence it will result in ascertaining of different figure of profit or los of

a business by different persons. Hence the figure of profit cannot be taken exact

figure.

2) Incomplete Information: Accounting statements provide only the incomplete

information because the actual profit or loss of a business can be known only

when the business is closed down.

3) Omission of Qualitative Information: Accounts contain only that information

which can be expressed in term of money. Qualitative aspects of business units

are completely omitted from books as these can not be expressed in monetary

terms. Thus, changes in the management, reputation of business, cordial

management labour relations, firms ability to produce new products, efficiency of

management, etc. which have vital bearing on the profitability of firm are all

ignored because all of these are Qualitative nature.

4) Based On Historical Cost: Accounts are prepared on the basis of historical

cost and as such figures are given in financial statements do not the effect of

changes in price level. The assets remain undervalued in many cases particularly

in Land and Building, which are not helpful in estimating the true financial

position of the business.

 5) Window Dressing: Window dressing refers to the practice of manipulating

accounts, so that the financial statements may disclose a more favorable position

than the actual position. For example, the purchase made at the end of the year

may not be recorded or the closing stock may be overvalued. Hence cannot be

taken on the basis of such financial statements.

 DIFFERENCE BETWEEN ACCRUAL & CASH BASIS OF ACCOUNTING:

S. No. Basis Accrual Basis of Accounting Cash Basis of Accounting

1 Prepaid/ Under this, there may be Under this, there is no

outstanding prepaid/outstanding expense prepaid/outstanding

expenses/accrued/ and accrued/ unaccrued expense or accrued/

unaccrued income incomes in the balance sheet. unaccrued.

in balance sheet.

2 Higher/lower Income statement will show a Income statement will

income in case of relatively higher income. show lower income.

prepaid expenses

and accrued

income.
 3 Higher/lower Income statement will show a Income statement will

income in case of relatively lower income. show higher income.

outstanding

expenses and

unaccrued

income.

4 Recognition under This basis is recognized This basis is not

the companies act, under the companies act, recognized under the

1956. 1956. companies act, 1956.

5 Availability of Under this, an accountant has Under this an accountant

options to an options. has no option to make a

accountant to choice as such.

manipulate the

accounts.

 DIFFERENCE BETWEEN CASH DISCOUNT AND TRADE DISCOUNT:

Cash Discount Trade Discount

Is a reduction granted by supplier from the Is a reduction granted by supplier from the

invoice price in consideration of immediate list price of goods or services on business

or prompt payment consideration re: buying in bulk for goods

and longer period when in terms of services

As an incentive in credit management to Allowed to promote the sales

encourage prompt payment

Not shown in the supplier bill or invoice Shown by way of deduction in the invoice
 itself

Cash discount account is opened in the Trade discount account is not opened in the

ledger ledger

Allowed on payment of money Allowed on purchase of goods

It may vary with the time period within It may vary with the quantity of goods

which payment is received purchased or amount of purchases made