Thoery Base of Accounting

Basic Accounting Concepts-

BASIC ASSUMPTION OF ACCOUNTING

• BUSINESS ENTITY ASSUMPTION

From the accounting point of view every business enterprise is an entity separate and distinct from its proprietor(s)/owner(s). The accounting system gives information only about the business and not its owner(s).

• ACCOUNTING PERIOD ASSUMPTION

Those who are interested in the operating results of business obviously cannot wait till the end. The requirements of these parties therefore force the accountant to report for the changes in the wealth of a firm for short time periods. These time periods in actual, practice vary, though a year is the most common interval as a result of established business practice, tradition and government requirements. Some firms adopt calendar year, some others financial year of the government.

Financial year starts from 1^st April and ends on 31^st March.

• ASSUMPTIONS OF MONEY MEASUREMENT

In accounting, only those facts which can be expressed in terms of money are recorded. As money is accepted not only as a medium of exchange but also as a store of value, it has a very important advantage since a number of widely different assets and equities can be expressed in terms of a common denominator. Without this adding heterogeneous factors like five buildings, ten machines, six trucks will not have much meaning.

• GOING CONCERN ASSUMPTION

Accounting assumes that the business (an accounting entity) will continue to operate for a long time in the future unless there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, as continuing in operation, at least in the foreseeable future. The owners have no intention nor have they the necessity to wind up or liquidate its operations.

This assumption provides a basis for the application of cost in accounting for assets.

• DUAL ASPECT PRINCIPLE

This is a basic concept of accounting. According to this concept every business transaction has a two-fold effect. In commercial context it is a famous dictum that "every receiver is also a giver and every giver is also a receiver".

Every business transaction involves two aspects:

1. the receiving aspect, and (ii) the giving aspect

If complete record of transactions is to be made, it would be necessary to record both the aspects in books of account. This principle is the cose of double enuy book-keeping and if this is strictly followed, it is called 'Double Entry System of Book-keeping'.

This equality is called 'balance sheet equation' or 'accounting equation'. It is stated as under : Liabilities (Equities) = Assets

or

Capital + Outside Liabilities = Assets

The term 'assets' denotes the resources (property) owned by the business while the term 'equities' denotes the claims of various parties against the business assets.

 Equities are of two types: (i) owners' equity, and (ii) outsiders' equity.

Owners' equity called capital is the claim of the owners against the assets of the business. Outsiders' equity called liabilities is the claim of outside parties like creditors, bank, etc. against the assets of the business.

Thus, all assets of the business are claimed either by the owners or by the outsiders. Hence, the total assets of a business will always be equal to its liabilities.

• REVENUE RECOGNITION PRINCIPLE

The Revenue recognition principle states that revenue shall be recognized once the underlying goods or services associated with the revenue have been delivered or rendered, respectively. Thus, revenue can only be recognized after it has been earned or its due.

• HISTORICAL COST PRINCIPLE

According to the historical record concept, we record only those transactions which have actually taken place and not those which may take place (future transactions). It is because accounting record presupposes that the transactions are to be identified and objectively evidenced. This is possible only in the case of past (actually happened) transactions.

• MATCHING PRINCIPLE

This is also called 'Matching of Costs against Revenues Concept'. To work out profit or loss of an accounting year, it is necessary to bring together all revenues and costs pertaining to that accounting year. In other words, expenses incurred in an accounting year should be matched with the revenues earned during that year. The crux of the problem, therefore, is that appropriate costs must be matched against appropriate revenues.

• OBJECTIVITY PRINCIPLE

The term objectivity refers to being free from bias or free from subjectivity. Accounting measurements are to be unbiased and verifiable independently. For this purpose, all accounting transactions should be evidenced and supported by documents such as invoices, receipts, cash memos, etc. These supporting documents (vouchers) form the basis for making entries in [he books of account and for their verification by auditors afterward.

• CONVENTION OF FULL DISCLOSURE

Financial statements are the basic means of communicating financial information to all interested parties. These statements are the only source for assessing the performance of the enterprise for investors, lenders, suppliers, and others. Therefore, financial statements and their accompanying foot-notes should completely disclose all relevant information of a material nature which relate to the profit and loss and the financial position of the business. This enables the users of the financial statements to make correct assessment about the profitability and financial soundness of the enterprise. It is therefore necessary that the disclosure should be full, fair and adequate.

• CONVENTION  OF MATERIALITY

This concept is closely related to the Full Disclosure Concept. Full disclosure does not mean that everything should be disclosed. It only means that all relevant and material information must be disclosed. Materiality primarily relates to the relevance and reliability of information. An item is considered material if there is a reasonable expectation that the knowledge of it would influence the decision of the users of the financial statements. All such material information should be disclosed through the financial statements and the accompanying notes.

• CONVENTION OF CONSERVATISM

This is also known as Prudence Concept. This concept tries to ensure that all uncertainties and risks inherent in business are adequately provided for. Accountants generally prefer understatement of assets or revenues, and overstatement of liabilities or costs. This is in accordance with the traditional view which states anticipate no profits but anticipate all losses'. In other words, you should account for profits only when they are actually realised. But in case of losses you should take into account even those losses which may be a remote possibility

• CONVENTION OF CONSISTENCY

The principle of consistency means 'conformity from period to period with unchanging policies and procedures'. It means that accounting method adopted should not be changed from year to year.

If this principle of consistency is not followed, the accounting information about an enterprise cannot be usefully compared with similar information about other enterprises and so also within the same enterprise for some other period. Consistent use of the same methods and bases from one period to another, enhances the utility of the financial statement.

TYPES OF CONSISTENCY:

1.  VERTICAL CONSISTENCY ( Same Organisation)

It occurs when fixed assets have been shown at cost price and in the interrelated income statement depreciation has also been charged on the historical cost of the assets.

1.  HORIZONTAL  CONSISTENCY  (Time basis)

This consistency is to be found between financial statements of one entity from period to period.

1.  DIMENSIONAL CONSISTENCY  (Two organisations in the same  trade)

This consistency is to be found between financial statements of one entity from period to period.

Therefore, as per this convention the same accounting methods should be adopted every year in preparing financial statements.

 

Generally Accepted Accounting Principles-

Generally accepted accounting principles are usually developed by professional accounting bodies like American Institute of Certified Public Accountants (AICPA) and Institute of Chartered Accountants of India(ICAI). In developing such principles, however, the accounting profession has to reflect the realities of social, economic, legal and political environment in which it operates.

Systems of Accounting

There are two systems of accounting includes-

a). Single entry system

b). Double entry system

A method of writing every transaction in two accounts is known as double entry # system of accounting. Out of these two accounts, one account is given debit and , another accoubt is given credit of an equal amount. Thus, under double entry system for every debit there will be a corresponding credit and vice-versa.

This is considered as the most scientific system that records both aspects of each transaction.

For better understanding of double entry system one has to bear in mind the following factors which are common to every business.

 i) Every business unit deals with a number of persons or firms. Therefore, the personal firms must be recorded in separate category of accounts called personal accounts.

ii) The business concern needs to deal with and/or maintain some assets like cash, stock, furniture, etc. An accountant must keep the detailed record of such accounts which are classified as real or property accounts.

 iii) It is common for every business to have certain resources of income and similarly certain expenses must be incurred to run the business. Therefore, a detailed account of each expense and income is to be recorded in the books of account. Such accounts are known as nominal or fictitious accounts.

BASES OF ACCOUNTING

There are two bases of accounting: (i) cash basis, and (ii) accrual basis. These are explained below:

(i) Cash Basis of Accounting

In this system, the accounting entries are made on the basis of cash received or cash paid. In other words, transactions are recorded only when cash is received or paid. The incomes earned but not yet received (accrued income) or the expenses incurred but not yet paid (expenses outstanding) are completely ignored while preparing the final accounts.

(ii) Accrual Basis of Accounting

Accrual accounting is also called ‘Mercantile System of Accounting’. It recognises that buying, selling and all other operations of an enterprise during a period may not coincide with the period during which the related cash receipts and cash payments take place.

 

REVENUE RECOGNITION

Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.

Revenue recognition is mainly concerned with the timing of recognition of revenue in the statement of profit and loss of an enterprise. The amount of revenue arising on a transaction is usually determined by agreement between the parties involved in the transaction. When uncertainties exist regarding the determination of the amount, or its associated costs, these uncertainties may influence the timing of revenue

Introduction of AS 9 Revenue Recognition

This standard was issued by ICAI in the year 1985 and in the initial years, it was re-commendatory for only Level I enterprises and but was made mandatory for all other enterprises from April 01, 1993. As per ICAI, “Enterprise means a company as defined in section 3 of the Companies Act, 1956”. Level I enterprises are those enterprises whose turnover for the immediately preceding accounting year exceeds 50 crores. The turnover here does not include other income and is applicable for holding as well as subsidiary companies.

Explanation

• Revenue recognition emphasizes on the timing of recognition of revenue in the statement of profit and loss of an enterprise
• The amount of revenue arising from a transaction is usually determined by an agreement between the parties involved in the transaction
• When uncertainties arise regarding the determination of the amount or its associated costs, these uncertainties may influence the timing of the revenue
   

Sale of Goods

A key criterion for determining when to recognise revenue from a transaction involving the sale of goods is that the seller has transferred the property in the goods to the buyer for a consideration. The transfer of property in goods, in most cases, results in or coincides with the transfer of significant risks and rewards of ownership to the buyer. However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership. Revenue in such situations is recognised at the time of transfer of significant risks and rewards of ownership to the buyer. Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the goods are at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes the parties may agree that the risk will pass at a time different from the time when ownership passes.

At certain stages in specific industries, such as when agricultural crops have been harvested or mineral ores have been extracted, performance may be substantially complete prior to the execution of the transaction generating revenue. In such cases when sale is assured under a forward contract or a government guarantee or where market exists and there is a negligible risk of failure to sell, the goods involved are often valued at net realisable value. Such amounts, while not revenue as defined in this Standard, are sometimes recognised in the statement of profit and loss and appropriately

Rendering of Services

Revenue from service transactions is usually recognised as the service is performed, either by the proportionate completion method or by the completed service contract method.

1. Proportionate completion method—Performance consists of the execution of more than one act. Revenue is recognised proportionately by reference to the performance of each act. The revenue recognised under this method would be determined on the basis of contract value, associated costs, number of acts or other suitable basis. For practical purposes, when services are provided by an indeterminate number of acts over a specific period of time, revenue is recognised on a straight line basis over the specific period unless there is evidence that some other method better represents the pattern of performance.
2. Completed service contract method—Performance consists of the execution of a single act. Alternatively, services are performed in more than a single act, and the services yet to be performed are so significant in relation to the transaction taken as a whole that performance cannot be deemed to have been completed until the execution of those acts. The completed service contract method is relevant to these patterns of performance and accordingly revenue is recognised when the sole or final act takes place and the service becomes chargeable.

The Use by Others of Enterprise Resources Yielding Interest, Royalties and Dividends

The use by others of such enterprise resources gives rise to:

•    interest—charges for the use of cash resources or amounts due to the enterprise;
•    Royalties—charges for the use of such assets as know-how, patents, trademarks and copyrights;
•    Dividends—rewards from the holding of investments in shares.

Interest accrues, in most circumstances, on the time basis determined by the amount outstanding and the rate applicable. Usually, discount or premium on debt securities held is treated as though it were accruing over the period to maturity.

Royalties accrue in accordance with the terms of the relevant agreement and are usually recognised on that basis unless, having regard to the substance of the transactions, it is more appropriate to recognise revenue on some other systematic and rational basis.

Dividends from investments in shares are not recognised in the statement of profit and loss until a right to receive payment is established.

When interest, royalties and dividends from foreign countries require exchange permission and uncertainty in remittance is anticipated, revenue recognition may need to be postponed.

Effect of Uncertainties on Revenue Recognition

Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.

Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g., for escalation of price, export incentives, interest etc., revenue recognition is postponed to the extent of uncertainty involved. In such cases, it may be appropriate to recognise revenue only when it is reasonably certain that the ultimate collection will be made. Where there is no uncertainty as to ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by installments.

When the uncertainty relating to collectability arises subsequent to the time of sale or the rendering of the service, it is more appropriate to make a separate provision to reflect the uncertainty rather than to adjust the amount of revenue originally recorded.

An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services or from the use by others of enterprise resources is reasonably determinable.

When such consideration is not determinable within reasonable limits, the recognition of revenue is postponed.

When recognition of revenue is postponed due to the effect of uncertainties, it is considered as revenue of the period in which it is properly recognised.

Main Principles

Revenue from sales or service transactions should be recognized when the requirements as to performance set out in paragraphs 11 and12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.

Explanation:

The amount of revenue from sales transactions (turnover) should be disclosed in the following manner on the face of the statement of profit and loss:

Turnover(Gross)    XX

Less: Excise Duty    XX

Turnover (Net)    XX

The amount of excise duty to be deducted from the turnover should be the total excise duty for the year except the excise duty related to the difference between the closing stock and opening stock. The excise duty related to the difference between the closing stock and opening stock should be recognised
Separately in the statement of profit and loss, with an explanatory note in the notes to accounts to explain the nature of the two amounts of excise duty.

In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:

(i)    the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
(ii)    no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.

In a transaction involving the rendering of services, performance should be measured either under the completed service contract method or under the proportionate completion method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists Revenue Recognition regarding the amount of the consideration that will be derived from rendering the service.

Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognised when no significant uncertainty as to measurability or collectability exists.

These revenues are recognised on the following bases:

(i)    Interest:    on a time proportion basis taking into account the amount
(ii)    Outstanding and the rate applicable.
(iii)    Royalties: on an accrual basis in accordance with the terms of the relevant agreement.

Disclosure

In addition to the disclosures required by Accounting Standard 1 on ‘Disclosure of Accounting Policies’ (AS 1), an enterprise should also disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties.

Illustrations

These illustrations do not form part of the Accounting Standard. Their purpose is to illustrate the application of the Standard to a number of commercial situations in an Endeavour to assist in clarifying application of the Standard.

A. Sale of Goods

1.    Delivery is delayed at buyer ’s request and buyer takes title and accepts billing Revenue should be recognised notwithstanding that physical delivery has not been completed so long as there is every expectation that delivery will be made. However, the item must be on hand, identified and ready for delivery to the buyer at the time the sale is recognised rather than there being simply an intention to acquire or manufacture the goods in time for delivery.

2.    Delivered subject to conditions

(a)    Installation and inspection i.e. goods are sold subject to installation, inspection etc. Revenue should normally not be recognised until the customer accepts delivery and installation and inspection are complete. In some cases, however, the installation process may be so simple in nature that it may be appropriate to recognise the sale notwithstanding that installation is not yet completed (e.g. installation of a factory-tested television receiver normally only requires unpacking and connecting of power and antennae).

(b) on approval :Revenue should not be recognised until the goods have been formally accepted by the buyer or the buyer has done an act adopting the transaction or the time period for rejection has elapsed or where no time has been fixed, a reasonable time has elapsed.

(c)    Guaranteed sales i.e. delivery is made giving the buyer an unlimited right of return Recognition of revenue in such circumstances will depend on the substance of the agreement. In the case of retail sales offering a guarantee of “money back if not completely satisfied” it may be appropriate to recognise the sale but to make a suitable provision for returns based on previous experience. In other cases, the substance of the agreement may amount to a sale on consignment, in which case it should be treated as indicated below.

(d)    Consignment sales i.e. a delivery is made whereby the recipient undertakes to sell the goods on behalf of the consignor Revenue should not be recognised until the goods are sold to a third party.

(e)    cash on delivery sales :Revenue should not be recognised until cash is received by the seller or his agent.

3.    Sales where the purchaser makes a series of installment payments to the seller, and the seller delivers the goods only when the final payment is received

Revenue from such sales should not be recognised until goods are delivered. However, when experience indicates that most such sales have been consummated, revenue may be recognised when a significant deposit is received.

4.    Special order and shipments i.e. where payment (or partial payment) is received for goods not presently held in stock e.g. the stock is still to be manufactured or is to be delivered directly to the customer from a third party

Revenue from such sales should not be recognised until goods are manufactured, identified and ready for delivery to the buyer by the third party.

5.    Sale/repurchase agreements i.e. where seller concurrently agrees to repurchase the same goods at a later date

For such transactions that are in substance a financing agreement, the resulting cash inflow is not revenue as defined and should not be recognised as revenue.

6.    Sales to intermediate parties i.e. where goods are sold to distributors, dealers or others for resale

Revenue from such sales can generally be recognised if significant risks of ownership have passed; however in some situations the buyer may in substance be an agent and in such cases the sale should be treated as a consignment sale.

7. Subscriptions for publications

Revenue received or billed should be deferred and recognised either on a straight line basis over time or, where the items delivered vary in value from period to period, revenue should be based on the sales value of the item delivered in relation to the total sales value of all items covered by the subscription.

8. Installment sales

When the consideration is receivable in installments, revenue attributable to the sales price exclusive of interest should be recognised at the date of sale.

The interest element should be recognised as revenue, proportionately to the unpaid balance due to the seller.

9. Trade discounts and volume rebates

Trade discounts and volume rebates received are not encompassed within the definition of revenue, since they represent a reduction of cost. Trade discounts and volume rebates given should be deducted in determining revenue.

B. Rendering of Services

1. Installation Fees

In cases where installation fees are other than incidental to the sale of a product, they should be recognised as revenue only when the equipment is installed and accepted by the customer.

2. Advertising and insurance agency commissions

Revenue should be recognised when the service is completed. For advertising agencies, media commissions will normally be recognised when the related advertisement or commercial appears before the public and the necessary intimation is received by the agency, as opposed to production commission, which will be recognised when the project is completed. Insurance agency commissions should be recognised on the effective commencement or renewal dates of the related policies.

3. Financial service commissions

A financial service may be rendered as a single act or may be provided over a period of time. Similarly, charges for such services may be made as a single amount or in stages over the period of the service or the life of the transaction to which it relates. Such charges may be settled in full when made or added to a loan or other account and settled in stages. The recognition of such revenue should therefore have regard to:

•    whether the service has been provided “once and for all” or is on a “continuing “basis;
•    the incidence of the costs relating to the service;
•    When the payment for the service will be received. In general, commissions charged for arranging or granting loan or other facilities should be recognised when a binding obligation has been entered into. Commitment, facility or loan management fees which relate to continuing obligations or services should normally be recognized over the life of the loan or facility having regard to the amount of the obligation outstanding, the nature of the services provided and the timing of the costs relating thereto.

4. Admission fees

Revenue from artistic performances, banquets and other special events should be recognised when the event takes place. When a subscription to a number of events is sold, the fee should be allocated to each event on a systematic and rational basis.

5. Tuition fees

Revenue should be recognised over the period of instruction.

6. Entrance and membership fees

Revenue recognition from these sources will depend on the nature of the services being provided. Entrance fee received is generally capitalized. If the membership fee permits only membership and all other services or products are paid for separately, or if there is a separate annual subscription, the fee should be recognised when received. If the membership fee entitles the member to services or publications to be provided during the year, it should be recognised on a systematic and rational basis having regard to the timing and nature of all services

C. Interest, royalties & dividends

The use by others of such enterprise resources gives rise to:

(i) Interest: Revenue is recognized on the time proportion basis after taking into account the amount outstanding and the rate applicable.

For Example: If the interest on FD is due on 30th June and 31st Dec. On 31st March when the books will be closed, though the interest for the period of Jan-March will be received in June, still we have to recognize the revenue in March itself.

(ii) Royalties: Royalty includes the charge for the use of patents, know-how, trademarks, and copyrights. Revenue has to be recognized on the basis of accrual basis and in accordance with the relevant agreement.

For Example: If the royalty is payable based on the number of copies of the book, then it has to be recognized on that basis only.

(iii) Dividends: Revenue has to be recognized when the owner’s right to receive payment is established. It is only certain when the company declare the dividends on the shares and the directors actually decide to pay the dividends to their shareholders.  

Difference between IND AS -18 & AS -9

AS 9 Revenue Recognition	IND AS 18
It is recognized at nominal value	It is recognized at fair value
This aspect is not covered in AS-9	IND AS – 18 also includes the exchange of goods and services with goods and services of similar and dissimilar nature (Barter Transactions are included in Ind AS-18)
Interest Income is recognized on time proportion basis	Interest Income is recognized using effective interest rate method
It recognizes revenue as per completed service method or percentage completion method	It only recognizes revenue as per percentage of completion method