Accounting concepts and conventions

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Information about Accounting concepts and conventions
Business & Mgmt

Published on March 6, 2014

Author: faltufocat


Accounting Concepts and Conventions

Introduction  Concepts are essential ideas that permit the identification and classification of phenomena or other ideas  A concept must state all that the given class includes and all that it excludes  Formed primarily by observation and established through agreement

• The American Institute of Certified Public Accountants have defined the accounting principle as, “a general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice”. • It may be noted that the definition describes the accounting principle as a general law or rule that is to be used as a guide to action.

• “Rules governing the foundation of accounting actions and the principles derived from them have arisen from common experiences, historical precedent, statements by individuals and professional bodies and regulation of governmental agencies”. • Accounting principles, rules of conduct and action are described by various terms such as concepts, conventions, doctrines, tenets, assumptions, axioms, postulates, etc

• The term “concept” is used to connote accounting postulates i.e. necessary assumptions or conditions upon which accounting is based. • The term convention is used to signify customs or traditions as a guide to the preparation of accounting statements.

ACCOUNTING CONCEPTS  Business Entity  the entity is separate and distinct from the owners and the entity is liable to the owner  Hence, in a limited liability company, the enterprise is liable to the owner (shareholder) based on the proportion of the capital investment (share capital) made by the latter  Going Concern  entities have a life of infinite duration, unless facts are known that indicate otherwise  the basis of valuation of resources is influenced more by their future utility to the business entity than by their current market valuation

• Money Measurement Concept – Accounting records only those transactions which can be expressed in monetary terms. – The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprise can be expressed and measured in a much better way.

 Matching – Determining the profits after charging the expenses of a period with the revenues earned in the same period  Realization – Determines the point of time when revenue and hence returns (or profits) can be recognized objectively, unbiased, and with certainty.

• Cost Concept – All transactions are expressed in terms of money, i.e. money is considered the common unit of measurement. The common economic value of assets and liabilities is expressed in monetary terms rather than in terms of any other physical dimension.

• Dual Aspect – This is the basic concept of accounting. According to this concept every business transaction has a dual effect. For example, if A starts a business with a capital of Rs 1 lakh, there are two aspects of the transactions. • On the one hand, the business has an asset of Rs 1 lakh. • On the Other hand, business has to pay Rs 1 lakh to the owner.

• The properties owned by a business enterprise are referred to as assets and the rights or claims to the various parties against the assets are referred to as equities. • The relationship between the two may be expressed in the form of an equation as follows:Liabilities = Assets Liabilities may be subdivided into two principal types: the rights of creditors and the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called capital. Expansion of the equation to give recognition to the two types of equities results in the following which is known as the accounting equation: Liabilities + Capital = Assets

• It is customary to place `liabilities’ before `capital’ because creditors have priority in the repayment of their claims as compared to that of owners. • Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to the other side of the equation as: Capital = Assets – Liabilities All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation.

• This is well explained with the help of the following series of examples (i) Mr. A commenced business with a capital of Rs.3,000: The result of this transaction is that the business, being a separate entity, gets cash-asset of Rs.30,000 and has to pay to Mr. Rs.30,000 his capital. This transaction can be expressed in the form of the equation as follows: Capital = Assets (A ) (Cash) 30,000 30,000

(ii) Purchased furniture for Rs.5,000: • The effect of this transaction is that cash is reduced by Rs.5,000 and a new asset viz. furniture worth Rs.5,000 comes in thereby rendering no change in the total assets of the business. • The equation after this transaction will be: Capital = Assets A Cash + Furniture 30,000 25,000+ 5,000

(iii) Borrowed Rs.20,000 from Mr. G • As a result of this transaction both the sides of the equation increase by Rs.20,000; cash balance is increased and a liability to Mr.G is created. • The equation will appear as follows: Liabilities + Capital = Assets Creditors (G) + A Cash + Furniture 20,000 +30,000 45,000 + 5,000

(iv) Purchased goods for cash Rs.30,000. This transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. cash is reduced by Rs.30,000 and a new asset viz. stock worth Rs.30,000 comes in. The equation after this transaction will be as follows:Liabilities + Capital = Asset Creditors(G) + A Cash + Stock + Furniture 20,000+ 30,000 15,000 +30,000+ 5,000

• Accounting Period Concept – According to this concept, the life of business is divided into appropriate segments for studying the results shown by the business after each segment. – This is because the life of business is considered indefinite and it is necessary to know the business situation after a appropriates interval.

Accounting Conventions • • • • Conservatism Full disclosure Consistency Materiality

Basis of Preparing Accounting • Cash Basis of Accounting • Accrual Basis of Accounting

Steps in The Accounting Cycle Analyze source documents. Journalize transactions in the general journal. Post entries to the accounts in the general ledger. Prepare a trial balance. Prepare financial statements.

THE ACCOUNTING PROCESS • During the accounting period the accountant records transactions as and when they occur. • At the end of each accounting period the accountant summarises the information recorded and prepares the Trial Balance to ensure that the double entry system has been maintained.

Thus the accounting process consists of three major parts: (i) the recording of business transactions during that period; (ii) the summarizing of information at the end of the period, and (iii) the reporting and interpreting of the summary information

• The transactions that takes place in a business enterprise during a specific period may effect increases and decreases in assets, liabilities, capital, revenue and expense items. • To make upto-date information available when needed and to be able to prepare timely periodic financial statements, it is necessary to maintain a separate record for each item.

• An account is a statement wherein information relating to an item or a group of similar items are accumulated. The simplest form of an account has three parts: – a title which gives the name of the item recorded in the account – a space for recording increases in the amount of the item, and – a space for recording decreases in the amount of the item. This form of an account is known as a `T’ account because of its similarity to letter T.

DEBIT CREDIT • The left-hand side of any account is called the debit side and the right-hand side is called the credit side. • Amounts entered on the left hand side of an account, regardless of the title of the account are called debits and the amounts entered on the right hand side of an account are called credits. • To debit (Dr) an account means to make an entry on the left-hand side of an account and to credit (Cr) an account means to make an entry on the right-hand side.

• The words debit and credit have no other meaning in accounting, though in common parlance, debit has a negative connotation, while credit has a positive connotation. • Double entry system of recording business transactions is universally followed. In this system for each transaction the debit amount must equal the credit amount.

Ledger Account T-Account Format Account Name Debit Credit

The T-Account Increases to the T-account are recorded on one side of the Taccount, and decreases are recorded on the other side. Account Name Debit Credit

The T-Account The side which increases and the side which decreases is determined by the type of account. Account Name Debit Credit

What Are Debits and Credits? • Tools used for recording transactions – Debit (DR) – Credit (CR) • Debit refers to the LEFT and Credit to the RIGHT side of the T-Account Account Name LEFT DEBIT SIDE RIGHT CREDIT SIDE

Rules of Debit and Credit • Transactions in accounts are recorded on the basis of rules of debit and credit. For this purpose business transactions can be classified into three categories:– Transactions relating to persons – Transactions relating to properties and assets – Transactions relating to income and expenses On this basis, it becomes necessary for business to keep account of:  Each person with whom it deals – PERSONAL ACCOUNTS  Each property or asset which the business owns- REAL ACCOUNTS  Each item of income or expense- NOMINAL ACCOUNTS

PERSONAL ACCOUNTS • Natural Personal Accounts • Artificial Personal Accounts • Representative Personal Accounts Rule: DEBIT THE RECIVER CREDIT THE GIVER

Example • Cash paid to Ramesh – Since rule of Personal Account is DEBIT THE RECEIVER. In this example, Ramesh is Receiver, so his account will be debited. • Cash Received from Mr. G – Since rule of personal account is CREDIT THE GIVER, Mr. G account will be credited.

REAL ACCOUNTS • Accounts that belongs to assets, property ad equipments are called Real accounts. – Tangible Real Account – Intangible Real Account • Rule DEBIT WHAT COMES IN CREDIT WHAT GOES OUT

Example • Machine purchased for cash – In this transaction, there are two accounts Machine and Cash both are assets . – By applying rule of Real account “ Debit What comes in”, Credit What goes out” – In this transaction Machine is coming in the Business, so Machine account will be debited and Cash is going out of business, thus Cash Account will be credit with the rule that Credit What Goes Out.

Nominal Accounts • Nominal account include accounts of all expenses, losses, income and gains. • Rent, lighting, insurance, dividend, salary are example of nominal Account. Rule – DEBIT ALL EXPENSES AND LOSSES – CREDIT ALL INCOME AND GAINS • Important point to note here is that both Real and Nominal Accounts come in the category of Impersonal Account accounts. When any prefix or suffix is added to a Nominal Account, it becomes a Personal Account

Few examples NOMINAL ACCOUNT PERSONAL ACCOUNT Rent Account Rent Prepaid account, Outstanding rent account Interest Account Outstanding interest account, Interest received in advance account, Prepaid interest account Salary Account Outstanding salaries account, Prepaid salaries account Insurance account Outstanding insurance account, Prepared insurance account Commission account Outstanding commission account, prepaid commission account

Class Exercise • • • • • • • • • • From the following transactions identify the nature of account and also state which account should be debited and which should be credited:Rent paid Interest Received Paid to Suresh Lighting Dividend received Telephone charges paid Machinery sold Furniture purchased Goods purchased Goods Sold

Balance Sheet Model A = L + C

Balance Sheet Model Debits and credits affect the Balance Sheet Model as follows: A = L + C ASSETS Debit for Increase Credit for Decrease LIABILITIES Debit for Credit for Decrease Increase Capital Debit for Credit for Decrease Increase

“A L O R E” Acronym Particular Debit Credit A (ssets) + - L (iabilities) - + O (wners' equity) - + R (evenues) - + E (xpenses) + -

2-42 Recording Transactions  Initially, all transactions are recorded in the General Journal.  Each transaction always affects at least two different accounts.  One account has a debit effect.  The second account has a credit effect.  This methodology was named “double entry” accounting by whom? F.L. Pacioli

2-43 General Journal Page GENERAL JOURNAL Page: Date Description PR Debit Credit

2-44 Journal Entries Example 1 On January 1, 2013, ABC Company started business with a cash of Rs INR1,00,000. Prepare the appropriate general journal entry for the above transaction.

2-45 Journal Entries Solution 1  Two accounts are affected:  Cash is increased by Rs 1,00,000.  ABC owe Rs 1,00,00 to owner and this become capital.

2-46 Journal Entries Solution 1  Two accounts are affected:  Cash is increased by Rs 1,00,000.  Capital is created by Rs 1,00,000. Description PR Debit

2-47 Journal Entries Example 2 On January 15, 2013, ABC Company purchases a motor vehicle for Rs19,500 cash. Prepare the appropriate journal entry for the above transaction.

2-48 Journal Entries Solution 2  Two accounts are affected:  Vehicle is increased by Rs19,500.  Cash is decreased by Rs19,500.

2-49 Journal Entries Solution 2  Two accounts are affected:  Trucks is increased by Rs19,500.  Cash is decreased by Rs19,500. GENERAL JOURNAL 1 Page: Date Description 15-Jan Motor Car Cash (Being purchase of truck) PR Debit 150 100 Credit 19,500 19,500

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