The rules and conventions of accounting are commonly referred to as the conceptual framework of accounting. As with any discipline or body of knowledge, some underlying theoretical structure is required if a logical and useful set off practices and proce-dures are to be developed for reaching the goals of the profession and for expanding knowledge in that field. Such a body of principles is needed to help answer new questions that arise. No profession can thrive in the absence of a theoretical frame-work. According to Hendriksen (1977), Accounting theory may be defined as logical reasoning in the form of a set of broad principles that (i) provide a general frame of reference by which accounting practice can be evaluated, and (ii) guide the develop-ment of new practices and procedures. Accounting theory may also be used to explain existing practices to obtain a better understanding of them. But the most important goal of accounting theory should be to provide a coherent set of logical principles that form the general frame of reference for the evaluation and development of sound accounting practices.
The American Institute of Certified Public Accountants (AICPA) discusses financial accounting theory and generally accepted accounting principles as follows:
Generally accepted accounting principles encompass the conventions, rules and procedures necessary to define accepted accounting practice at a particular timegenerally accepted accounting principles include not only broad guidelines of general application, but also detailed practices and procedures.
(Source: AICPA. Statements of the Accounting Principles Board No.4 "Basic Concept and Accounting Principles Underlying Financial Statement of Business Enter-prises", October, 1970, pp.54-55)
The word `principles' is used to mean a "general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice". You will note that this definition describes a principle as a general law or rule that is to be used as a guide to action. This implies that accounting principles do not prescribe exactly how each detailed event occurring in business should be recorded. Consequently, there are several matters in accounting practice that may differ from one company to another.
Accounting principles are man-made. They are accepted because they are believed to be useful. The general acceptance of an accounting principle (or for that matter any principle) usually depends on how well it meets the three criteria of relevance, objectivity, and feasibility. A principle is relevant to the extent that it results in meaningful or useful information to those who need to know about a certain business. A principle is objective to the extent that the information is not influenced by the personal bias or judgement of those who furnished it. Objectivity connotes reliability or. trustworthiness which also means that the correctness of-the information reported can be verified. A principle is feasible to the extent that it can be implemented without undue complexity or cost.
ACCOUNTING CONCEPTS
Business Entity Concept
In accounting we make a distinction between business and the owner. All the records are kept from the viewpoint of the business rather than from that of the owner. An enterprise is an economic unit separate and apart from the owner or owners. As such, transactions of the business and those of the owners should be accounted for and reported separately. In recording a transaction the important question is how does it affect the business? For example, if the owner of a shop were to take cash from the cash box for meeting certain personal expenditure, the accounts would show that cash had been reduced even though it does not make any difference to the owner himself. Similarly, if the owner puts cash into the business, he has a claim against the business for capital brought in.
This distinction can be easily maintained in the case of a limited company because a company has a legal entity (or personality) of its own. Like a natural person it can engage itself in economic activities of producing, owning, managing, storing, transfer-ring, lending, borrowing and consuming commodities and services. Distinction, however, is difficult in the case of partnership, and even more so in the case of one-man business. Nevertheless, accounting still maintains separation of business and owner. This implies that owner's personal and household expenses or obligations (e.g., expenditure on food, clothing, housing, entertainment, debts, mortgages, etc.) will not appear in the books of account. It may be clarified that it is only for accounting purposes that partnerships and sole proprietorships are treated as separate and apart from the owners though law does not make such distinction. A creditor would be justified in looking to both the business assets and the private estate of the owner for satisfaction of his claim. One reason for this distinction is to make it possible for the owners to have an account of the performance from those who manage the enterprise. The managers are entrusted with funds supplied by owners, banks and others; they are responsible for the proper use of the funds. The financial accounting reports are designed to show how well this responsibility has been discharged.
Money Measurement Concepts
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.
While money is probably the only practical common denominator and a yardstick, we must realise that this concept imposes two sever limitations. In the first place, there are several facts which, though vital to the business, cannot be recorded in the books of account because they cannot be expressed in money terms. For example, the state of health of the Managing Director of a company who has been the key contributor to the success of business is not recorded in the books. Similarly, the fact that the Production Manager and the Chief Internal Auditor are not on speaking terms, or that a strike is about to begin because labour is dissatisfied with the poor working condi-tions in the factory, or that a competitor has recently taken over the best customer, or that it has developed a better product and so on will not be recorded even though all these events are of great concern to the business.
From this standpoint, one could say that accounting does not give a complete account of the happenings in the business. You will appreciate that all these have a bearing on the future profitability of the company.
Secondly, use of money implies that a rupee today is of equal value to a rupee ten years back or ten years later. In other words, we assume stable or constant value of rupee. In the accounts, money is expressed in terms of its value at the time an event is recorded. Subsequent changes in the purchasing power of money do not affect this amount. You are perhaps aware that most economies today are in inflationary condi-tions with rising prices. The value of a rupee of 1980's has depreciated to an unbelievably low level in the 90s. Most accountants know fully well that purchasing power of rupee does change but very few recognise this fact in accounting books and make allowance for changing price level. This is so despite the fact that accounting profession has devoted considerable attention to this problem and numerous suggestions have been made to account for the effects of changes in the purchasing power of money. In fact, one of the major problem of accounting today is to find means of solving the measurement problem, that is, how to extend the quality and the coverage of meaningful information. It will be desirable to present in a supplementary analysis the effect of price level changes on the reported income of the business and the financial position.
Continuity Concept
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 enter-prise 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 is of considerable importance for it means that the business is viewed as a mechanism for adding value to resources it uses. The success of the business can be measured by the difference between output values (sales or revenues) and input values (expenses). Therefore, all unused resources can be reported at cost rather than at market values.
The assumption that the business is not expected to be liquidated in the foreseeable future, in fact, establishes the basis for many of the valuations and allocations in accounting. For example, depreciation (or amortisation) procedures rest upon this concept. It is this assumption which underlies the decision of investors to commit capital to enterprise. The concept holds that continuity of business activity is the reasonable expectation for the business unit for which the accounting function is being performed. Only on the basis of this assumption can the accounting process remain stable and achieve the objective of correctly recording and reporting on the capital invested, the efficiency of management, and the position of the enterprise as a going concern. Under this assumption neither higher current market values nor liquidation values are of particular importance in accounting. This assumption provides a basis for the application of cost in accounting for assets.
However, if the accountant has good reasons to believe that the business, or some part of it, is going to be liquidated or that it will cease to operate (say within a year or two), then the resources could be reported at their current values (or liquidation values).
Cost Concept
The resources (land, buildings, machinery, property rights, etc.) that a business owns are called assets. The money values that are assigned to assets are derived from the cost concept. This concept states that an asset is worth the price paid for or cost incurred to acquire it. Thus, assets are recorded at their original purchase price and this cost is the basis for all subsequent accounting for the assets. The assets shown on the financial statements do not necessarily indicate their present market worth (or market values). This is contrary to what is often believed by an uninformed person reading the statement or report. The term `book value' is used for amount shown in the accounting records.
In case of certain assets the accounting values and market values may be similar; cash is an obvious example. In general, the longer an asset has been owned by the company the lesser, are the chances that the accounting value will correspond to the market value.
The cost concept does not mead that all assets remain on the accounting records at their original cost for all time to come. The cost of an asset that has a long but limited life is systematically reduced during its life by a process called `depreciation' which will be discussed at some length in a subsequent unit. Suffice it to say at this point that deprecation is a process by which the cost of the asset is gradually reduced (or written off) by allocating a part of it to expense in each accounting period. This will have the effect of reducing the profit of each period. In charging depreciation the intention is not to change depreciation equal to the fall in the market value of the asset. As such, there is no relationship between depreciation and changes in market value of the assets. The purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost so as to bring it closer to the market value.
You must be wondering as to why assets are shown at cost even when there are wide differences between their costs and market values. The main argument is that the cost concept meets all the three basic criteria of relevance, objectivity and feasibility.
Accrual Concept
The accrual concept makes a distinction between the receipt of cash and the right to receive it, and the payment of cash and the legal obligation to pay it. In actual busi-ness operations, the obligation to pay and the actual movement of cash may not coincide. The accrual concept recognises this distinction. In connection with the sale of goods, revenue may be received (i)before the right to receive arises, or(ii) after the right to receive has been created, The accrual concept provides a guideline to the accountant as to how he should treat the cash receipt and the rights related thereto. In the former case the receipt will not be recognised as the revenue of the period for the reason that the right to receive the same has not yet arisen. In the latter case the revenue will be recognised even though the amount is received in the subsequent period.
Similar treatment would be given to expenses incurred by the firm. Cash payments for expenses may be made before or after they are due for payment. Only those sums which are due and, payable would be treated as expenses. If a payment is made in advance (i.e. it does not belong to the accounting period in question) it will not be treated as an expense, and the person who received the cash will be treated as a debtor until his right to receive the cash has matured. Where an expense has-been incurred during the accounting period but no payment has been made, the expense must be recorded and the person to whom the payment should have-been made is shown as a creditor.
Concept of Conservatism
The concept of conservatism, also known as the concept of prudence, is often stated as "anticipate no profit, provide for all possible losses". This means an accountant should follow a cautious approach. He should record lowest possible value for assets and revenues, and the highest possible value for liabilities and expenses. According to this concept, revenues or gains should be recognised only when they are realised in the form of cash or assets (usually legally enforceable debts) the ultimate cash realisation of which can be assessed with reasonable certainity. Further, provision must be made for all known liabilities, expenses and losses whether the amount of these is known with certainty or is at best an estimate in the light of the information available. Probable losses in respect of all contingencies should also be provided for. A contingency is a condition or a situation, the ultimate outcome of which-gain or loss-cannot be determined accurately at present. It will be known only after the event has occurred (or has not occurred). For example, a customer has filed a suit for damage against the company in a court of law. Whether the judgement will be favourable or unfavorable to the company cannot be determined for sure. Hence, it will be prudent to provide for likely loss in the financial statements. As a consequence of the application of this concept, net assets are more likely to be understated than overstated, and income is more likely to be overstated than understated. Based on this concept is the widely advocated practice of valuing inventory (stock of goods left unsold) at cost or market price. whichever is lower. You will note that this convention, in a way, modifies the earlier cost concept. It should be stated that the logic of this convention has been under stress recently; it has been challenged by many writers on the ground that it stands in the way of fair determination of profit and the disclosure of true ad fair financial position of the business enterprise. The concept is not applied as strongly today as. it used to be in the past. In any case, conservatism must be applied rational Y as over-conservatism may result in misrepresentation.
Materiality Concept
There are many events in business which are trivial or insignificant in nature. The cost of recording and reporting such events will not be justified by the usefulness of the information derived. Materiality concept holds that items of small significance need not be given strict theoretically correct treatment. For example, a paper stapler costing Rs. 30 may last for three years. However, the effort involved in allocating its cost over the three-year period is not worth the benefrt than can be derived from this operation. Since the item obviously is immaterial when related to overall operations, the cost incurred on it may be treated as the expense of the period in which it is acquired. Some of the stationery purchased for office use in any accounting period may remain unused at the end of that period. In accounting, the amount spent on entire stationery would be treated as expense of the period in which the stationery was purchased, notwithstanding the fact that a small part of it still lies in stock. The value (or cost) of the stationery lying in stock would not be treated as an asset and carried forward as a resource to the next period. The accountant would regard the stock lying unused as immaterial. Hence, the entire amount spent on stationery would be taken as the expense of the period in which such expense was incurred.
Where to draw the line between material and immaterial events is a matter of judge-ment and common sense. There are no hard and fast rules in this respect. Whether a particular item or occurrence is material or not, should be determined by considering its relationship to other items and the surrounding circumstances. It is desirable to establish and follow uniform policies governing such matters.
Consistency Concept
In practice, there are several ways to record an event or a transaction in the books of account. For example, the trade discount on raw material purchased may be deducted from the cost of goods and net amount entered in the books, or alternatively trade discount may be shown as the income with full cost of raw material purchased entered in the books. Similarly, there are several methods to charge depreciation (which is a decrease in the value of assets caused by wear and tear, and passage of time) on an asset or of valuing inventory. The consistency concept requires that once a company has decided on one method and has used it for some time, it should continue to follow the same method or procedure for all subsequent events of the same character unless it has a sound reason to do otherwise. If for valid reasons the company makes any departure from the method it has been following so far, then the effect of the change must be clearly stated in the financial statements in the year of change.
You will appreciate that much of the utility of accounting information lies in the fact that one could draw valid conclusions from the comparison of data drawn from financial statements of one year with data of the other year. Comparability is essential so that trends or differences may be identified and evaluated. Inconsistency in the application of accounting methods might significantly affect the reported profit and the financial position. Further, inconsistency also opens the door for manipulation of reported income and assets. The comparability of financial information depends largely upon the consistency with which a given class of events are handled in ac-counting records year after year.
Periodicity Concept
Although the results of operations of a specific enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off and liabilities paid off, the knowledge of the results periodically is also necessary. 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. But more and more firms are changing to the `natural' business year the end of which is marked by relatively lower or lowest volume of business activity in the twelve-month period. The custom of using twelve-month period is applied only for external reporting. The firms usually adopt a shorter span of interval, say one month or three months, for internal reporting purposes.
The allocation of long-term costs and the difficulties associated with this process directly stem from this concept. While matching the earnings and the cost of those earnings for any accounting period, all the revenues and all the costs relating to the yearn question have to be taken into account irrespective of whether or not they have been received in cash or paid cash. Despite the difficulties that arise in allocations and adjustments, short-term reports (i.e., yearly reports) are of such importance to owners, management, creditors, and other interested parties that the accountant has no option but to resolve such difficulties. Obviously, the utility of the periodic financial statements outweighs the difficulties.
Some other concepts e.g. Matching concept, Realisation concept and Dual Aspect concept are discussed in Units 4 and 5 and as such they have not been taken up here.
While going through all these concepts, probably you have developed a feeling that they come in conflict with each other. You are right. We illustrate this by considering. some of these concepts in the context of valuation of business properties. Suppose, a firm acquired a piece of land in 2000 fora price of Rs. 6,00,000. Factory premises were constructed in 2001 and operations commenced in 2002. The firm has been successful in achieving desired profit for the past year. The Balance Sheet ( a statement of assets and liabilities) for the year 2003 is being prepared and `Land' is required to be valued. The estimated current market price of this land is Rs. 60,00,000.
Should you recommend that the land be valued at Rs. 60 lakhs? The answer is `no' obviously. Land would be carried on the Balance Sheet at its original cost of Rs, 6,00,000 only. This decision is supported by several of the concepts discussed in this section. In the first place, the stability of purchasing power of money implied in the money measurement concept prevents us from recognising accretion in values as a result of changing price levels. Then, the realisation concept will not allow unrealised profits to be included as long as land is held by the company and not sold away. You may note that the continuity or going concern concept makes any possible market value of land irrelevant for balance sheet because the firm has to continue in business and land will be needed by it for its own use. In this connection, it could be argued that if land were shown on the balance sheet at its estimated current market value, the owner might decide to discontinue the business, sell the land and retire. The principle of objectivity is now introduced into the argument. It can be easily seen that in a situation like this the cost of acquisition of land at Rs. 6,00,000 in 2000 is the objective fact because it is based on a transaction that actually took place and this objective evidence is capable of being verified. In contrast, the estimate of current market value figure may be suspect. It raises many questions. Do you have a market quotation for an identical plot of land? Has a similar plot of land been sold recently and can we pick it up as verifiable evidence of the current market price? It may be said that even if market price for an identical plot of land is not available, estimates by an accredited valuer may be accepted as verifiable evidence of the market price. Further complications may be noticed if buildings and facilities have been erected on the plot of land. Is it possible to estimate the value of land without factory buildings and other facilities constructed on it? The answer is a flat `no' and the conservatism concept will then deter you from accepting an estimate of market value since it cannot be ascertained with reasonable accuracy.
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