(i) Every transaction has two fold aspects, i.e., one party giving the benefit and the other
receiving the benefit.
(ii) Every transaction is divided into two aspects, Debit and Credit.
One account is to be debited and the other account is to be credited.
(iii) Every debit must have its corresponding and equal credit.
Sunday, 29 May 2011
BASICS OF ACCOUNTING - DOUBLE ENTRY SYSTEM
It was in 1494 that Luca Pacioli the Italian mathematician, first published his comprehensive
treatise on the principles of Double Entry System. The use of principles of double entry system
made it possible to record not only cash but also all sorts of Mercantile transactions. It had
created a profound impact on auditing too, because it enhanced the duties of an auditor to a
considerable extent.
treatise on the principles of Double Entry System. The use of principles of double entry system
made it possible to record not only cash but also all sorts of Mercantile transactions. It had
created a profound impact on auditing too, because it enhanced the duties of an auditor to a
considerable extent.
ACCOUNTING CONVENTIONS - Convention of Conservatism
This is the policy of ‘playing safe’. It takes into consideration all prospective losses but
leaves all prospective profits. This accounting principle is given recognition in A.S. – 1 which
recommends the observance of prudence in the framing of accounting policies. “Uncertainties
inevitably surround many transactions. This should be recognised by exercising prudence in
financial statements. Prudence does not, however, justify the creation of secret or hidden
reserves”. Following are the examples of the application of the convention of conservatism :
(a) Making the provision for doubtful debts and discount on debtors in anticipation of
actual bad debts and discount,
(b) Valuing the stock in trade at market price or cost price whichever is less,
(c) Creating provision against fluctuation in the price of investments,
(d) Charging of small capital items, like crockery, to revenue,
(e) Adopting written-down-value method of depreciation as against straight-line
method. The written-down-value method of depreciaiton is more conservative in a
approach.
(f) Amortization of intangible assets like goodwill which has indefinite life,
(g) Showing joint life policy at surrender value as against the amount paid,
(h) Not providing for discount on creditors,
(i) Taking into consideration claims intimated but not accepted as a loss for calculating
profit for a general insurance company,
(j) Considering the loss relating to premium on the redemption of debentures when
they are issued at par or at discount but redeemable at premium, at the time of their
issue.
The principle of conservatism is applied :
(a) When there is an uncertainty inherent in the activity, e.g., uncertainty as to the useful
life of an asset, occurrence of loss, realization of income, remaining utility of an
asset, estimated liability.
(b) When there are two equally acceptable methods then the one which is more
conservative will be accepted.
(c) When there is judgement based on estimates and doubt exists as to which of the
several estimates is correct, the most conservative would be selected.
(d) When there is possibility of the occurrence of a loss or profit, losses will be considered
and profits will be overlooked.
This principle has effect on :
(a) Income statement. Here the principle results in lower net income than would
otherwise be the case.
(b) Balance sheet. When applied to the balance sheet, the conservative approach results
in understatement of assets and capital and overstatement of liabilities and provisions.
The principle of conservatism, however should be applied cautiously. If the principle is
stretched without reservations it results in the creation of secret reserves which is in direct
conflict with the doctrine of full disclosure. Since the main aim of published accounts is to
convey and not to conceal the information, the policy of secrecy is being abandoned in favour
of the modern and more logical policy of disclosure.
leaves all prospective profits. This accounting principle is given recognition in A.S. – 1 which
recommends the observance of prudence in the framing of accounting policies. “Uncertainties
inevitably surround many transactions. This should be recognised by exercising prudence in
financial statements. Prudence does not, however, justify the creation of secret or hidden
reserves”. Following are the examples of the application of the convention of conservatism :
(a) Making the provision for doubtful debts and discount on debtors in anticipation of
actual bad debts and discount,
(b) Valuing the stock in trade at market price or cost price whichever is less,
(c) Creating provision against fluctuation in the price of investments,
(d) Charging of small capital items, like crockery, to revenue,
(e) Adopting written-down-value method of depreciation as against straight-line
method. The written-down-value method of depreciaiton is more conservative in a
approach.
(f) Amortization of intangible assets like goodwill which has indefinite life,
(g) Showing joint life policy at surrender value as against the amount paid,
(h) Not providing for discount on creditors,
(i) Taking into consideration claims intimated but not accepted as a loss for calculating
profit for a general insurance company,
(j) Considering the loss relating to premium on the redemption of debentures when
they are issued at par or at discount but redeemable at premium, at the time of their
issue.
The principle of conservatism is applied :
(a) When there is an uncertainty inherent in the activity, e.g., uncertainty as to the useful
life of an asset, occurrence of loss, realization of income, remaining utility of an
asset, estimated liability.
(b) When there are two equally acceptable methods then the one which is more
conservative will be accepted.
(c) When there is judgement based on estimates and doubt exists as to which of the
several estimates is correct, the most conservative would be selected.
(d) When there is possibility of the occurrence of a loss or profit, losses will be considered
and profits will be overlooked.
This principle has effect on :
(a) Income statement. Here the principle results in lower net income than would
otherwise be the case.
(b) Balance sheet. When applied to the balance sheet, the conservative approach results
in understatement of assets and capital and overstatement of liabilities and provisions.
The principle of conservatism, however should be applied cautiously. If the principle is
stretched without reservations it results in the creation of secret reserves which is in direct
conflict with the doctrine of full disclosure. Since the main aim of published accounts is to
convey and not to conceal the information, the policy of secrecy is being abandoned in favour
of the modern and more logical policy of disclosure.
ACCOUNTING CONVENTIONS - Convention of Consistency
In order to enable the management to draw important conclusions regarding the working
of a company over a number of years, it is but essential that accounting practices and methods
remain unchanged from one accounting period to another. The comparison for one accounting
period with that in the past is possible only when the convention of consistency is adhered to.
But the idea of consistency does not imply non-flexibility as not to permit the introduction of
improved techniques of accounting. According to A.S. – 1 consistency is a fundamental
assumption and it is assumed that accounting policies are consistent from one period to another.
Where this assumption is not followed, the fact should be disclosed together with reasons.
The principle of consistency plays its role particularly when alternative accounting method
is equally acceptable. For example, in applying the principle that fixed asset is depreicaied
over its useful life a company may adopt any of the several methods of depreciaiton, viz.,
written-down-value method, straight-line method, sinking fund method, annuity method, sumof-
years-digit method, unit-of-production method or any other method. But in keeping with
the convention of consistency it is expected that the company would consistently follow the
same method of depreciation which is chosen. Any change from one method to another would
result in inconsistency.
In the following cases, however, there is no inconsistency although apparently they make
look inconsistent :
(a) The application of principle for stock valuation ‘at cost or market price whichever is
lower’ will result in the valuation of stock sometimes at cost price and sometimes at
market price. But there is no inconsistency here because the shift from the cost to
market is only the application of the principle.
(b) Similarly, if investments are valued at cost or market price whichever is lower, it is
only an application of the principle
Kohler has talked about three types of consistencies :
(a) Vertical consistency. This consistency is maintained within the interrelated financial
statement of the same date. Vertical inconsistency will occur when an asset has been
depreciated on one basis for income statement and on another basis for balance
sheet.
(b) Horizontal consistency. This enables the comparison of performance of an organisation
in one year with its performance in the next year.
(c) Third dimensional consistency. This enables the comparison of the performance of one
organisation with the performance of other organisation in the same industry.
of a company over a number of years, it is but essential that accounting practices and methods
remain unchanged from one accounting period to another. The comparison for one accounting
period with that in the past is possible only when the convention of consistency is adhered to.
But the idea of consistency does not imply non-flexibility as not to permit the introduction of
improved techniques of accounting. According to A.S. – 1 consistency is a fundamental
assumption and it is assumed that accounting policies are consistent from one period to another.
Where this assumption is not followed, the fact should be disclosed together with reasons.
The principle of consistency plays its role particularly when alternative accounting method
is equally acceptable. For example, in applying the principle that fixed asset is depreicaied
over its useful life a company may adopt any of the several methods of depreciaiton, viz.,
written-down-value method, straight-line method, sinking fund method, annuity method, sumof-
years-digit method, unit-of-production method or any other method. But in keeping with
the convention of consistency it is expected that the company would consistently follow the
same method of depreciation which is chosen. Any change from one method to another would
result in inconsistency.
In the following cases, however, there is no inconsistency although apparently they make
look inconsistent :
(a) The application of principle for stock valuation ‘at cost or market price whichever is
lower’ will result in the valuation of stock sometimes at cost price and sometimes at
market price. But there is no inconsistency here because the shift from the cost to
market is only the application of the principle.
(b) Similarly, if investments are valued at cost or market price whichever is lower, it is
only an application of the principle
Kohler has talked about three types of consistencies :
(a) Vertical consistency. This consistency is maintained within the interrelated financial
statement of the same date. Vertical inconsistency will occur when an asset has been
depreciated on one basis for income statement and on another basis for balance
sheet.
(b) Horizontal consistency. This enables the comparison of performance of an organisation
in one year with its performance in the next year.
(c) Third dimensional consistency. This enables the comparison of the performance of one
organisation with the performance of other organisation in the same industry.
ACCOUNTING CONVENTIONS - Convention of Materiality
The role of this convention cannot be over-emphasised in as much as accounting will be
unnecessarily overburdened with more details in case an accountant is not able to make an
objective distinction between material and immaterial matters. American Accounting
Association (AAA) defines the term materiality as under :
“An item should be regarded as material if there is reason to believe that knowledge of its
would influence the decision of informed investor”.
Kohler has defined materiality as under :
“The characteristic attaching to a statement, fact, or item whereby its disclosure or the
method of giving it expression would be likely to influence the judgement of a reasonable
person”.
Some of the examples of material financial information to be disclosed are likely fall in the
value of stocks, loss of markets due to competition or Government regulation, increase in wage
bill under recently concluded agreement, etc. It is now agreed that information known after
the date of balance sheet must also be disclosed.
Another example of materiality is the question of allocation of costs. An item of small
value may last for three years and technically its cost must be allocated to every one of the
three years. Since its value is small, it can be treated as the expense in the year of purchase.
Such a decision is in accordance with the principle of materiality. Likewise, unimportant items
can be either left out or merged with other items. Sometimes items are shown as footnotes or in
parentheses according to their relative importance.
It should be noted that an item material for one concern may be immaterial for another.
And similarly, an item material in one year may not be material in the next year.
As per A.S. – 1, materiality should govern the selection and application of accounting
policies. According to the consideration of materiality financial statement should disclose all
items which are material enough to affect evaluations or decisions.
unnecessarily overburdened with more details in case an accountant is not able to make an
objective distinction between material and immaterial matters. American Accounting
Association (AAA) defines the term materiality as under :
“An item should be regarded as material if there is reason to believe that knowledge of its
would influence the decision of informed investor”.
Kohler has defined materiality as under :
“The characteristic attaching to a statement, fact, or item whereby its disclosure or the
method of giving it expression would be likely to influence the judgement of a reasonable
person”.
Some of the examples of material financial information to be disclosed are likely fall in the
value of stocks, loss of markets due to competition or Government regulation, increase in wage
bill under recently concluded agreement, etc. It is now agreed that information known after
the date of balance sheet must also be disclosed.
Another example of materiality is the question of allocation of costs. An item of small
value may last for three years and technically its cost must be allocated to every one of the
three years. Since its value is small, it can be treated as the expense in the year of purchase.
Such a decision is in accordance with the principle of materiality. Likewise, unimportant items
can be either left out or merged with other items. Sometimes items are shown as footnotes or in
parentheses according to their relative importance.
It should be noted that an item material for one concern may be immaterial for another.
And similarly, an item material in one year may not be material in the next year.
As per A.S. – 1, materiality should govern the selection and application of accounting
policies. According to the consideration of materiality financial statement should disclose all
items which are material enough to affect evaluations or decisions.
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