ACCOUNTING CONCEPTS & PRICIPLES

ACCOUNTING CONVENTIONS, CONCEPTS & PRINCIPLES

In order to maintain proper accounting records and to prepare acceptable financial statements, there are several accounting conventions, concepts and principles which developed over the period of time. Some of these are followed by force of custom and practice while a number of them have been enforced through laws and accounting standards. All the accounting rules which developed during the long history of accounting subject may be referred to as conventions, concepts, assumptions, or Generally Accepted Accounting Principles (GAAP), and many to them have become part of International Accounting Standards (IAS) and also enforced by other laws.

All these concepts and principles are stated hereunder with their meanings and brief descriptions. Most of them relate to the preparation and presentation of financial statements, as the basic function of accounting is to provide information to the users of these statements and to enhance the usefulness of accounting data.

The most fundamental accounting concepts that must be followed are:

Fair Presentation
Financial Statements should be “Fairly Presented”, and additional disclosures should be made, beyond those required by IAS, when and where necessary, to achieve the objective of fair presentation. Notes to the Accounts are an example of the same. The financial statements should be presented in accordance with the stated accounting policies of the enterprise, in a manner which provides relevant, reliable, comparable and understandable information, to make it a fair presentation.

Going Concern
This fundamental concept of Going Concern allows for the assumption that the business entity has a reasonable expectation of continuing in business at a profit for an indefinite period of time. Any business enterprise, normally, is not set up for a specific period of time.

In other words, the business enterprise will continue in operational existence for a foreseeable future and this implies that all available information for a foreseeable future should be provided, and not only for the next twelve months.

Accruals and Matching Concept
The Accrual Basis of Accounting means that Assets, Liabilities, Equity, Income and Expenses are recognized when they occur and not when cash or its equivalent is received or paid.
So the related Matching Concept becomes relevant and it signifies that all the costs / expenses should be set off against the sales / revenues they have contributed to. In other words, all incomes and charges relating to the period to which the financial statements relate should be taken into account without regard to the date of receipt or payment.

Consistency
In order that the Concept of Comparability is properly followed the principle of Consistency will have to be adopted.

So it is assumed that the successive Profit and Loss Statements and the Balance Sheets of a business enterprise are based consistently on the same generally accepted accounting principles as previously chosen by the enterprise. A particular accounting method once adopted should not be changed from period to period.

Changes may be made, (presentation, classification, valuation) but the change and its impact on the financial statements must be clearly disclosed.

Some other fundamental accounting concepts are also stated below.

Materiality
The concept of materiality means that the information that is material should not be mixed up or aggregated with other items.
However, the determination of what is material and what is un-important requires the exercise of judgment.

If combining transactions could mislead the user of the financial statements, the amounts should be split out. So any financial information that is material should be mentioned in the financial statements – i.e. if considered of interest to the users of these statements.

An item is “material” if knowledge of the same might reasonably influence the decision of the user of financial statements.

Historical Cost Concept
Under this principle, all the values in respect of business transactions are based on the historical costs incurred.

Thus Financial Statements are prepared based on historical cost values, as their objective evidence exists and this makes them more reliable. This provides the basis for valuation of assets.

Money Measurement Concept
Accounting information has traditionally been related to recording only such events and transactions to which a monetary value can be attributed. Or in other words, all business transactions are recorded in terms of money, because it is the common factor in all business transactions.

Stable Monetary Unit or Stability of Currency
As diverse business transactions are expressed / recorded in terms of a common unit of measurement, namely the monetary unit, so the stability of monetary unit becomes very important. Transactions that happen over a period of time must reflect a single currency and exchange rate. This will allow one year’s set of accounts to be compared with another regardless of the rate of inflation. The effect of inflation or devaluation of currency is presented in a separate statement.

Business Entity / Accounting Entity Concept
This concept implies that a Business Enterprise is separate and distinct from the persons who supply the resources it uses.

In other words, the financial accounting information relates only to the activities of the Business Entity and not to the activities of its owner. The affairs of the business are separate from the non-business activities of its owners. The extent of application of this concept is different for different forms of business organizations.

The Basic Accounting Equation reflects the Accounting Entity Concept. The equation relates to the independent Economic Unit.

Dual Aspect Concept or Duality
This concept means that there are two aspects of accounting (double-side effect of each business transaction), one represented by the assets of the business and the other by rights/claims against them, and that these two aspects are always equal.

Also known as Duality Concept, this is generally expressed as the Dual Effect of each transaction. Double entry system is the name given to the method of recording business transactions for the Dual Aspect Concept.

Realization
The principle of Realization (or Revenue Recognition) implies that a transaction should be recognized when the event from which the transaction stems has taken place, e.g. Sale on credit is recorded or recognized when the sale is made (goods delivered) and invoice raised for the Customer, without waiting until the sale amount is received.

Accounting Period or Time Interval Concept
For accounting purposes, the lifetime of the business is divided into arbitrary periods of fixed length, usually one year.

The Financial Statements are normally prepared at the end of each arbitrary period, (or at specified time intervals) normally referred to as the Accounting Period.

Prudence / Conservatism
Accountants should always err on the side of caution (or should always be on the side of safety) in their estimates and valuations. So accountants are expected to be professionally conservative.

This is called the concept of Prudence, which requires that such method or procedure should be preferred for preparing financial statements which yield lesser amount of net profit or asset value. The concept advocates “anticipate no profits and provide for all losses”.

FINANCIAL STATEMENTS

FINANCIAL STATEMENTS

The principal Financial Statements are:
Balance Sheet
Income Statement (or Profit and Loss Statement)

However, the complete set of Accounting Reports also includes:
Cash Flow Statement
Statement of Owner’s Equity / Statement of Retained Earnings

Financial Statements are the end product of the whole accounting process. The purpose / objective of financial statements is to provide information about the financial position, performance, and changes in financial position of the business enterprise.

BALANCE SHEET is a financial statement which shows at a specific date the financial position of the business enterprise. It shows in an organized manner the financial data in three main sections i.e. Assets, Liabilities and Owner’s Equity at a given date. It reflects the Accounting Equation.

INCOME STATEMENT OR PROFIT AND LOSS STATEMENT shows profitability of the business enterprise over a period of time say preceding year. It provides details of Revenues/Incomes/Gains and Costs/Expenses/Losses of the business enterprise for a time interval or period of time, and the resulting Net Profit or Net Loss. By matching the revenues against expenses, it shows the net result of operations for a period.

CASH FLOW STATEMENT explains changes in cash and cash equivalents (i.e. receipts / generation / inflow and payments / utilization / outflow) of the business enterprise. It reports about the Cash Flow related to its operating, investing and financing activities.

STATEMENT OF OWNER’S EQUITY / RETAINED EARNINGS explains the changes in the amount of owner’s equity / retained earnings over the same period of time.

As the information / figures in the above financial statements are much in summarized form, these are also supported by Notes to the Accounts or Notes to the Financial Statements, giving further details and explanations. That is why these Notes are also considered an integral part of Financial Statements.

ACCRUAL & CASH-BASIS SYSTEMS

ACCRUAL AND CASH-BASIS SYSTEMS

The business enterprises may keep their account books (i.e. may records their business transactions) in one of the two ways.

ACCRUAL SYSTEM of accounting means that expenses and revenues are recognized in the period they occur, regardless of whether a cash transaction has occurred or not (i.e. payment has been made or not, amount has been received or not). This method matches revenues of the period with the expenses of the same period.

CASH BASIS SYSTEM of accounting means that revenues are recorded only when amounts have been received and expenses are recorded when payments are made. Under this method, revenues and expenses of the same period may not match.

Generally Accepted Accounting Principles (GAAP) requires that all the public companies (business enterprises) have to use Accrual System of Accounting.

BOOK-KEEPING & BOOKS OF ACCOUNT

BOOK-KEEPING AND BOOKS OF ACCOUNT

Book-keeping and Accounting are not the same, although two are closely related.

Generally, book-keeping means recording of business data (transactions) in a prescribed manner. So in a way, it includes the functions of Recording and Classifying of transactions.

On the other hand, Accounting is primarily concerned with the design of the system of records, the preparation of reports based on the recorded data and the interpretation of the reports. So in a way it includes the functions of Summarizing and Interpreting, in addition to the designing of the system.

This also means that Book-keeping provides a basis for the real Accounting function.

BOOKS OF ACCOUNT

JOURNAL
Once you have analyzed the business transaction, you have to record it in the books of accounts. Writing of transaction in the books is called Recording or Journalizing. The first book where it is recorded is called the journal. That is why it is considered as the Book of Prime Entry, also as the Book of Original Entry.

A journal is a book in which business transactions are written in accounting terms in chronological order (as they occur i.e. date wise). The journal has a specific format and the transaction is written based on the rules of Debit and Credit, along with a brief description of the transaction.

You may have one journal for all types of transactions or you may divide it in different types of journals depending upon the number of transactions, like a Sales Journal, Purchase Journal, Cash Payment Journal, Cash Receipt Journal, and General Journal (for remaining types of transactions).


M/S AMJAD TRADING CORPORATION

JOURNAL for the month of February, 2010
---------------------------------------------------------------------------------
(Date)(V.No.)(Details.............)(Post Ref.)(Debit...)(Credit...)
---------------------------------------------------------------------------------



LEDGER
As against Journal, which is a record of transactions in chronological order related to various elements (Account Heads or Titles), a Ledger is the record of same transactions in a classified manner i.e. all transactions related to one element (Account Head) are recorded (posted) on the page specified for that element, again in chronological order.

So the transactions recorded in Journal are posted to Ledger where each element (Account Head) is allocated a specific space (pages) for this purpose. A Ledger therefore provides information related to one element at a single place.

A Ledger is a book that contains all the elements (account heads) within an organizational accounting system. It is collection of all the ledger accounts. You may call each element as a Ledger Account. You may have all the ledger accounts in one Ledger Book or you may divide it like the Journal and have a sub-ledger for customers (Accounts Receivable), a sub-ledger for vendors (Accounts Payable), a Fixed Assets Ledger and all other ledger accounts in General Ledger. (But then you will have a Control Account in General Ledger for each sub-ledger divided by you.

The standard format of Ledger page is given below.


M/S AMJAD TRADING CORPORATION

LEDGER ACCOUNT OF -----------------------------------------------------
--------------------------------------------------------------------------------
(Date)(V.No.)(Details........)(Post Ref.)(Debit)(Credit)(Dr/Cr)(Balance)
--------------------------------------------------------------------------------

RULES OF DEBIT AND CREDIT

RULES OF DEBIT AND CREDIT

DEBIT is another name for the Left-hand side of all types of accounts.
CREDIT is another name for the Right-hand side of all types of accounts.

Whether you make a T account or follow the standard format of Ledger Account the Debit amounts will be written on the left side and Credit amounts will be written on the right side.

As the normal balance of an account is usually:
DEBIT for Asset Accounts
CREDIT for Liability Accounts
CREDIT for Equity Accounts
CREDIT for Revenue / Sale Accounts
DEBIT for Expense / Cost Accounts

Therefore,
A Debit Entry in Asset Account signifies INCREASE
A Debit Entry in Liability Account signifies DECREASE
A Debit Entry in Equity Account signifies DECREASE
A Debit Entry in Revenue Account signifies DECREASE
A Debit Entry in Expense Account signifies INCREASE

And accordingly,
A Credit Entry in Asset Account signifies DECREASE
A Credit Entry in Liability Account signifies INCREASE
A Credit Entry in Equity Account signifies INCREASE
A Credit Entry in Revenue Account signifies INCREASE
A Credit Entry in Expense Account signifies DECREASE

In other words, we may also say, that in case a business transaction has an effect of increase in an asset account, then the amount should be placed to its Debit side (Left-hand side). Accordingly, follow the above mentioned rules for other types of accounts.

For any business transaction, minimum two accounts are affected, so you must Debit one account and Credit one account.

The above rules for Debit and Credit can also be understood in another way.

For all REAL Accounts
Debit what Comes-in
Credit what Goes-out

For all PERSONAL Accounts
Debit the Benefit Receiver
Credit the Benefit Giver

For all NOMINAL Accounts
Debit all Expenses / Cost / Losses Accounts
Credit all Revenue / Sale / Income Accounts

DOUBLE-ENTRY ACCOUNTING

DOUBLE-ENTRY ACCOUNTING

Keeping in mind the basic accounting equation, we may say that each business transaction has two way effect (double effect) on the financial position of the business. In other words, a business transaction is recorded as a Debit entry in one account and a Credit entry in another account. So recording of the double effect of a transaction is called Double-entry Accounting.

Although the double entry system of accounting was prevalent even before the fifteenth century AD, it was described by an Italian mathematician in his book published in 1494 AD. The systems and procedures described in this book have since been further developed.

The basic accounting equation has been based upon this Double-entry system of Accounting.

Any business transaction will record the Debit as

Increase in Asset Account
Decrease in Liability Account
Decrease in Owner’s Equity Account
Increase in Expense Account
Decrease in Revenue Account

And the same transaction will record the Credit as

Decrease in another Asset Account
Increase in a Liability Account
Increase in Owner’s Equity Account
Decrease in an Expense Account
Increase in a Revenue Account

TYPES OF ACCOUNTS

CLASSIFICATION OF ACCOUNTS

One classification of accounts is done on the basis of Financial Statements.
Accordingly, there may be the following types of accounts.

1) BALANCE SHEET ACCOUNTS which include:

Assets Accounts
Current Assets Accounts
Non-current Assets Accounts

Liabilities Accounts
Current Liabilities Accounts
Non-current Liabilities Accounts

Owners’ Equity Accounts
Share Capital Accounts
Retained Earnings Account

2) PROFIT AND LOSS ACCOUNTS which include:

Revenue / Sale / Income Accounts

Expenses / Cost Accounts


Another classification of accounts is done on the basis of the nature of account.

1) REAL ACCOUNTS

All properties owned by the business are Real Accounts, like Fixed Assets of Buildings, Furniture, and Currents Assets of Stocks.

2) PERSONAL ACCOUNTS

All accounts related to Debtors (Receivable from parties) and Creditors (Payable to parties) and Drawings account of Owners are examples to Personal Accounts.

Therefore, all Balance Sheet Accounts are either Real Accounts or Personal Accounts. At the year end the balances in these accounts are carried forward to the next year.

3) NOMINAL ACCOUNTS or TEMPORARY ACCOUNTS

All Profit and Loss Accounts are temporary accounts and are called Nominal Accounts. On the one hand, these may be Revenue Accounts like Sales of Goods, Income from Services, Rent Income, Interest Income, and on the other hand, these may be Cost and Expense Accounts like Cost of Goods Sold, Salary Expense, Rent Expense, etc.

All these accounts are closed at the year end and the Net Result of all these accounts is transferred to Balance Sheet in the Owner’s Equity.

ACCOUNTING CYCLE

ACCOUNTING CYCLE

The sequence of activities that is performed for the accounting of a business transaction after it has occurred is commonly known as Accounting Cycle and the following processes are carried out for its completion.

To better understand the Accounting Cycle, it should be considered with reference to an accounting period, normally a month or a year.

Identify the transaction:
Identify the event as a transaction and generate the source document.

Analyze the transaction:
Determine the transaction amount, the Accounts affected and their Debits and Credits.

Journal Entries:
Record the transaction in a Journal, as a Debit and a Credit.

Posting to Ledger:
Transfer of Journal entries to appropriate accounts in the Ledger with cross reference.

Trial Balance:
Preparation of Trial Balance (Summary of Ledger Accounts) to verify the sum of Debits equals the sum of Credits.

Adjusting Entries:
Make adjusting entries for Accrued and Deferred items, record them in Journal and Post them to Accounts in the Ledger.

Adjusted Trial Balance:
Prepare another Trial Balance after recording the Adjusting entries.

Financial Statements:
Prepare all the Financial Statements.

Closing Entries:
Transfer the balances of Revenue and Expense Accounts to Owner’s Equity.

After-Closing Trial Balance:
A final trial balance is prepared after the Closing Entries.
(This will include only Balance Sheet Accounts)

FUNDAMENTAL ACCOUNTING EQUATION

FUNDAMENTAL ACCOUNTING EQUATION

The properties owned by a business are called ASSETS.
The rights to these properties are called EQUITIES.
Accounting deals with property and rights to property.

For every business enterprise, the sum of rights to the properties is equal to the sum of the properties owned by it.

This relationship can be expressed in form of an Accounting Equation.

ASSETS = EQUITIES

Or in simple words, if the business enterprise is not borrowing from outside sources and it is doing all its business in cash (no credit), then there will be no Liabilities and the above equation will stand true.

However, generally the business has to be carried out on credit basis and also sometimes the business enterprise may have to borrow funds from other sources. In that case the rights to properties (Equities) are divided into two principal types, which are The Rights of Creditors (Liabilities) and The Rights of Owners (Owner’s Equity).

So more logical Accounting Equation, which recognizes both types of Equities can be stated as follows.

ASSETS = LIABILITIES + OWNER’S EQUITY

Consequently, we may also express this equation as follows.

ASSETS – LIABILITIES = OWNER’S EQUITY

Here it is also notable that every business transaction can be stated in terms of its effect on the three basic elements of the accounting equation – Assets, Liabilities and Owner’s Equity.

Assets are resources (things that are owned by business).
Liabilities are obligations of the business (amounts that are owed by business).
Owner’s Equity is the amount left over after deduction of Liabilities from Assets

FORMS OF BUSINESS ORGANIZATION

FORMS OF BUSINESS ORGANIZATION

Accounting always applies to an Economic Organization or Economic Unit, whether Profit-making or Non-profit-making. Economic Units have business transactions that must be recorded, classified, summarized and interpreted. The accounting principles, as applicable to Economic Units for profit-making necessitate understanding of the forms of Business Enterprises which may be broadly of the following three types.

(These are differentiated on the basis of Ownership)

Sole Proprietorship
A business owned by one person is called Sole Proprietorship.

Partnership
An un-incorporated business owned by two or more persons, voluntarily acting as partners (co-owners) is called Partnership.

Limited Company / Corporation
A Company is a Legal Entity formed under the laws of the country (Companies Act or Companies Ordinance).
In other words, a Corporation is the only type of business organization recognized under the law as an entity separate from its owners.
The ownership in the Company is divided into shares owned by its shareholders and the owners of the Company are not personally liable for the debts of the business.
A company may be Private Limited Company or a Public Limited Company.


TYPES OF BUSINESS ORGANIZATION

The above stated forms of business organizations may carry out any of the following types of business.

TRADING (NON-INDUSTRIAL)
(Buying and Selling, Imports and Exports) (Products remaining the same)
(This also includes Retail and Wholesale Business)

MANUFACTURING (INDUSTRIAL)
(Industries) (Input products and Output products being different)
(This may also include Construction)

SERVICES
(Lawyers, Doctors, Consultants, Engineers)
(Professional and Business Services) (Provide services not goods)

Other examples are Leisure and Hospitality, Information, Financial Activities, Government, Education and Health Services, Transport, Warehousing, and Utilities, etc.

There may be combinations of the above as well.

WHAT IS ACCOUNTING

WHAT IS ACCOUNTING

Accounting is often characterized as “the language of business”.
Accounting is normally defined on the basis of functions that it performs.

DEFINITION OF ACCOUNTING

“Accounting has been described as 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.”

The above definition clearly indicates that Accounting provides the guidelines as to how the following processes will be performed.

RECORDING means putting the transactions and events to writing.

CLASSIFYING involves sorting all the transactions in an orderly and systematic manner.

SUMMARIZING means bringing the accounting data together in a form that further enhances their usefulness. This means preparation of periodical reports.

INTERPRETING includes analysis of the results of operations. This may be in the form of percentage analysis or ratios.