BASIC CONCEPTS RELATING TO FINAL ACCOUNTS

6.2 BASIC CONCEPTS RELATING TO FINAL ACCOUNTS

You know that accounting concepts are broad working rules adopted by the accounting profession as guides for recording and reporting the affairs and activities of the business. In Unit 1 you learnt about the concepts to be observed at the recording stage. Let us now discuss the concepts which are to be observed at the reporting stage i.e., at the time of preparing the final accounts. These concepts are:

1 Going Concern Concept
2 Accounting Period Concept
3 Matching Concept
4 Conservatism Concept
5 Consistency Concept
6 Full Disclosure Concept
7 Materiality Concept

Let us take them up one by one.

6.2..1 Going Concern Concept

Normally the business is started with the intention of continuing it indefinitely or at least for the foreseeable future. The investors lend money and the creditors supply goods and services with the expectation that the enterprise would continue for long. Unless there is a strong evidence to the contrary, the enterprise is normally viewed as a going (continuing) concern. Hence, financial statements are prepared a going concern basis and not on liquidation (closure) basis.

Certain expenses like rent, repairs, etc., give benefit for a short period, say less than one year. But the benefit of some other expenditure like purchase of a building, machinery etc., is spread over a longer period. If the benefit of an expenditure is limited to one accounting year it is fully charged to the Profit and Loss Account of that year. But, if the benefit of an expenditure is available for a number of accounting years, it must be spread over a number of years. Hence, only a portion of such expenditure is charged to the Profit and Loss Account every year. The balance is shown in the Balance Sheet as an asset. Let us take an example, suppose a firm purchased a delivery van for Rs. 60,000 and its expected life is 10 years. It means the business will use the van for a period of 10 years. So, the accountant has to spread the cost of the van over 10 years. He would charge Rs. 6,000 (1110 of its cost) every year to the Profit and Loss Account in the form of depreciation, and show the balance in the Balance Sheet as an asset. This is based on the assumption that the business will continue for an indefinite period and the asset will be used for its expected life. Thus this concept is regarded as the basic assumption in accounting according to which the fixed assets are valued at historical cost less depreciation and not at its realisable value.

6.2.2 Accounting Period Concept

You know the going concern concept assumes that the business will continue for a long period, almost indefinitely. But, the businessmen cannot postpone the preparation of financial statements indefinitely. Therefore, he prepares them periodically to find out the profit or loss and financial position of the business. This 1 will also enable other interested parties such s owners, investors, creditors, tax authorities to make periodic assessment of its performance. So, the life of the business enterprise is divided into what are called 'accounting ' periods', Profit and loss and the financial position the end of each such accounting period is regularly assessed. Conventionally, duration of the accounting period is twelve months. It is called an 'accounting year'. Accounting year cap be a calendar year i.e., January 1 to December 31 or any other period of twelve months, say, April 1 to March 31 or Dewali to IDewali.

Normally, the final accounts are prepared at the end of each accounting year. The Profit and Loss Account is prepared for the year so as to ascertain the profit earned or loss incurred during that year, and the Balance Sheet is prepared as on that date. However, for internal management purposes, accounts can be prepared even for shorter periods, say monthly, quarterly or half yearly.

6.2.3 Matching Concept

This is 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. For this purpose, first we have to recognise the inflows (revenues) during an accounting period and the costs incurred in securing those inflows. Then, the sum of the costs should be deducted from the sum of the revenues to arrive at the net result of that period. Let us now understand how to recognise the revenues and costs i11 relation to an accounting period. For this purpose, the following rules are followed.

The Timing of Revenue Recognition

Revenue is recognized in the period in which it is earned or realised. The revenue recognition is primarily based on realization principle which clearly states that in identifying revenues with a specific period one must look to the time of various transactions rather than cash inflow. Thus,

i)      In case of the sale of goods (or services) revenue is regarded as realised when sales actllally take place and not when cash is received. In other words, credit sales are treated as revenue when sales are made and not when money is received from the debtors.

ii)       Income such as rent, interest, commission, etc. are recognized on a time basis. The revenue from such items is taken to the Profit and Loss Account of the year during which it is earned. Let us assume that the business purchased some government securities on October 1, 1987 for Rs. 20,000 carrying interest at 12 per cent. The interest is payable half yearly on April 1 and October 1 every year. The first instalment of interest (Rs. 1,200) is received on April 1, 1988. The Profit and Loss Account is being prepared for the year 1987 (January 1, 1987 to December 31, 1987). The interest amounting to Rs. 600 earned during October 1 to December 31 must be shown as the income from interest on investment in the Profit and Loss Account for 1987 though the amount has not been received in 1987.

The Timing of Cost Recognition

The matching principle holds that the expenses should be recognised in the same period as the associated revenues. Thus,

i)       Cost of goods have to be matched with their sales revenue. This means that while preparing the Profit aiid Loss Account for a particular year, you should not take the cost of goods produced during that year but consider oily the cost of goods that have actually been sold during that year. The cost of goods sold is arrived at by deducting the cost of closing stock from the cost of goods produced. You will learn about it in detail in Unit 7.

ii)      Expenses such as salaries, wages, interest, rent, insurance, etc., are recognised on time basis. In other words, they are related to the year in which the service is obtained or the expense is incurred, whether paid immediately or payable at a later date.

iii)     Costs like depreciation on fixed assets are also allocated over the periods during which the benefit is derived.

Thus, all revenues earned during an accounting year, whether received or not, and all costs incurred, whether paid or not have to be taken into account while preparing the Profit and Loss Account for the year. Similarly, any amount received or paid during the current year which actually relates to the previous year or the following accounting year, must be eliminated from the current year's revenues and costs. This gives rise to another aspect viz., the accrual basis of accounting about which you will learn later in .this unit.

The Matching Concept thus has the following implications for ascertaining of profit or loss during a particular period.

1.       We should ensure that costs should relate to the same accounting period as the revenues. For example, when we prepare the Profit and Loss Account for 1986, we shall take into account all those incomes that were earned during 1986, and similarly consider only those costs which were incurred in 1986 only. Any costs or incomes which relate to 1985 or 1987 shall be excluded

2.       We should ensure that all costs incurred during the accounting period (whether paid or not) and all revenues earned during that year (whether received or not) are bully taken into account.

3.       We should consider only those costs which relate to the revenue taken into account. That is why we consider only the cost of goods sold, and not the cost of goods produced during that period.

6.2.4 Conservatism Concept

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. That is why the closing stock is valued at cost price or market price whichever is lower. Provision for doubtful debts and provision for discounts on debtors are also made according to this concept. This reflects a generally pessimistic attitude of the accountants but it is regarded as the best way of dealing with uncertainty and protecting creditors against an unwarranted distribution of the. Firm’s assets as dividends.

6.2.5 Consistency Concept

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. For example, the principle of valuing closing stock at cost price or market price whichever is lower should be followed year after year. Similarly, if depreciation on fixed assets is provided on straight line basis, it should be followed consistently year after year. Consistency eliminates personal bias and helps in achieving comparable results.

If this principle of consistency is not followed, the accounting information about arm 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 statements.

However, consistency does not prohibit change. Desirable changes are always welcome. But such changes should be completely disclosed while presenting the financial statements.

6.2.6 Full Disclosure Concept

You know the financial statements are the basic means of communicating financial information to all interested parties. These statements are the only source for assessing the performance d the enterprise for investors, lenders, suppliers, and others. Therefore, financial statements and their accompanying footnotes 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.

6.2.7 Materiality Concept

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. For example, commission paid to sole selling agents, if any, should be disclosed separately in the Profit and Loss Account. Similarly, if there is a change in the method or rate of depreciation, this fact must be duly reported in the financial statements.

A strict adherence to accounting principles is not required for items of little significance or of non-material nature. For example, erasers, pencils, scales, etc., are used for a long period, but they are not treated as assets. They are treated as expenses. This does not affect the amount of profit or loss materially.

Similarly, while showing the amounts of various items in the financial statements, they can be approximated. Up to praise. Even if they are shown to the nearest rupee or hundreds, there may not be any material effect. For example, if an amount of Rs, 1, 45,923.28 is shown as Rs. 1, 45,923 or Rs. 1, 45,900 it does not make much difference for assessment of the performance of the enterprise.

However, there are no specific rules for ascertaining material or non-material items. It is just a matter qf personal judgment.