Theory Base of Accounting
Basic Accounting Concepts, Principles & StandardsThe Going Concern concept assumes the business will continue operations for the foreseeable future. This is necessary because it justifies spreading the cost of fixed assets over their useful life (Depreciation) rather than charging the full cost in the year of purchase. It also allows for the recording of long-term liabilities and assets at cost rather than market liquidation values.
2. When should revenue be recognised? Are there exceptions?Revenue should generally be recognized when the right to receive it is established, typically at the point of sale (legal transfer of ownership) or when services are rendered.
Exceptions:
• Construction Contracts: Recognized on percentage of completion.
• Hire Purchase: Recognized when installments are received.
• Mining: Recognized at the point of production (valuation at market price).
The basic accounting equation is:
$$ \text{Assets} = \text{Liabilities} + \text{Capital} $$
This represents the Dual Aspect Concept, stating that every transaction affects at least two accounts and keeps the equation in balance.
In practice, (a) Dispatched or (b) Invoiced is commonly used. However, according to the Realisation Concept, revenue is recognized when the legal title to goods passes to the customer. This usually coincides with the dispatch and invoicing, as it establishes the customer’s legal obligation to pay.
Concepts and standards provide a unified framework and set of rules (GAAP) that ensure financial statements are reliable, comparable, and transparent. Without them, accounting would be subjective, making it impossible for investors or banks to compare different businesses.
3. Discuss the premise: ‘Do not anticipate profits but provide for all losses’.This refers to the Prudence / Conservatism concept. It serves as a safety guard, ensuring that the financial position of a business is not overstated. For example, closing stock is valued at cost or market price, whichever is lower, and provisions are made for doubtful debts.
4. What is matching concept? Why should it be followed?The Matching Concept states that expenses incurred in an accounting period should be matched with the revenues earned during that same period.
Importance: It ensures that the Profit and Loss account reflects the true profit or loss by including all related costs (like outstanding expenses or prepaid insurance) for the specific period.
Activity 1: Ruchica’s Mistakes
Ruchica violated several accounting principles which led to the banker’s distrust:
- Building Valuation: Violated the Cost Concept. Fixed assets must be recorded at historical cost, not current market value.
- Stock Valuation Change: Violated the Consistency Concept. Methods cannot be changed year-to-year to inflate profits.
- PC Purchase: Violated the Matching/Capital Expenditure rule. A computer is a fixed asset; only its annual depreciation should be charged to profit, not the whole ₹70,000.
Activity 2: The Legal Suit
The Accountant is Wrong.
Under the Prudence Concept, if a loss is probable and can be estimated, it must be recorded or at least disclosed as a contingent liability. Since it is “known that the judgment will be in favor of the customer,” the trader should provide for the estimated damages to show a true and fair view of the liabilities.