ACCOUNTING PRINCIPLES/ CONVENTIONS

Have marked bearing on preparation of income statement and balance sheet

 Cross border investment and requires financial information that is comparable for business around the world. International Accounting Standards Board (IASB) is committed to developing a single set of accounting standards that will eventually be acceptable worldwide. IASBs standards are known as International Financial Reporting Standards (IFRS) or International Accounting Standards (IAS). IFRS and US GAAP are the two different accounting systems. They differ in terms of the detail, quality of application and acceptability across nations.

GAAP
Generally Accepted Accounting Principles are a collection of standards, pronouncements, opinions, interpretations, and practice guidelines. Various professional and quasi-statutory bodies set the accounting principles. For example in the US, the Financial Accounting Standards Board (FASB), the SEC, and the American Institute of Certified Public Accountants (AICPA) set GAAP. In India, the Institute of Chartered Accountants of India (ICAI) provides technical resources and operational mechanism for developing accounting standards issued by the Government. Many institutions including SEBI and RBI, would influence Indian GAAP.

 IMPORTANT PRINCIPLES OF ACCOUNTING

MONEY MEASUREMENT CONCEPT

Accounting records incorporate only those facts about a business firm, which can be expressed in monetary terms It means that financial statements do not provide all information about the business. For example, competition in the market

GOING CONCERN CONCEPT

Implies that the firm will continue to operate in the foreseeable future. Implication is that assets are not shown at their realizable market value or liquidation value

COST CONCEPT
Accounting system aims at reporting fair and objective information Since the cost of an asset is usually fair and objective, historical cost values (acquisition cost) from actual transactions are commonly reported in financial statements. Prevents arbitrary manipulation by an interested management. Makes possible more accurate determination of profit or loss when the asset is finally disposed of. But individual assets do not reflect current values In other words, historical cost values are compromise between reliability and relevance

Exceptions to historical cost measurement

Although cost may be used for Inventory, the use of cost or market price, whichever is the lower of the two, is the common rule. Marketable securities are also customarily valued at the lower of cost-or-market value. Marketable securities are temporary investments held as a support to cash in order to meet emergencies or unknown future needs. Some assets are subject to lowering of value but not due to market price fluctuations. For example, plant and machinery tend to wear out. Similarly, receivables are subject to bad debt loss. Allowances for decreases in value of this sort is made by a deduction from cost.

MATERIALITY
Magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it possible that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. Avoiding unwanted disclosures

CONSERVATIVE CONCEPT
Reporting the least optimistic view when faced with uncertainty in measurement Gains are not recognized until they are realized whereas losses are recognized immediately. That is, conservatism results in recognizing income-decreasing events immediately, even if there is no transaction to back it up (e.g. inventory write-downs). But the effect of an income-increasing event is delayed until realized. For example, stocks of finished goods is valued at the cost or the market price whichever is lower Advantages: Provides an additional margin of safety, particularly for creditors A sign of superior earnings quality But reduces the relevance of accounting information

CONSISTENCY
Should be a consistency of accounting treatment of items (e.g. depreciation methods, inventory valuation methods, etc)

ACCOUNTING PERIOD CONCEPT

Income statements should be prepared at periodic intervals for purposes such as performance evaluation and determination of taxes Time span period conventionally is one year But as per the companies act, businesses are required to produce interim accounts Many firms produce monthly or quarterly accounts

ACCRUAL CONCEPT
Revenues are recognized when earned and expenses when incurred, regardless of the receipt or payment of cash. For example, accrued interest income uncollected income that has not matured but has been earned. Accrued expenses include interest accrued on bonds, wages accrued, and taxes accrued. Separation of revenue and expense recognition from cash flows.

 Accrual basis implies the calculation of not only of accrued income and expense, but also of deferred income and expense. Deferred income is income which is received, or for which another has become liable, before it has been earned. For example, a bank that discounts its customers bills. It is an unearned discount shown as a liability in the sense that bank still owes its customer for the portion of service it will have to render up to the date the bill comes due. Deferred expense is an expense paid for or for which the business owes before the service or goods have been received. They are called prepaid expenses.

REVENUE RECOGNITION
Revenues are recognized when both earned and either realized or realizable Revenues are earned when the company delivers its products or services Revenues are realized when cash is acquired for products or services delivered. Revenues are realizable when the company receives an asset for products or services delivered (e.g. receivables) that is convertible to cash

Revenue Recognition Criteria

Earning activities creating revenue are substantially complete, and no significant effort is necessary to complete the transaction. Risk of ownership in sales is effectively assessed to the buyer. Revenue and the associated expense are measured or estimated with reasonable accuracy. Revenue recognized normally yields an increase in cash, receivables, or securities. Under certain conditions it yields an increase in inventories or other assets, or a decrease in liabilities. Revenue transaction is at arms length with an independent party(ies) (not with controlled parties) Revenue transaction is not subject to revocation (such as a right of return)

MATCHING
Expenses are to be matched with their corresponding revenues Expenses that arise in production of a product or service, called product costs are recognized when the product or service is delivered Period costs (e.g. administrative expenses) are recognized in the period they occur, which is not necessarily when cash outflows occur.

Accrual Accounting Vs Cash flow Accounting

Accruals are the sum of accounting adjustments that make net income different from net cash flow. They include those that affect income when there is no cash flow impact (e.g. credit sales) and those that isolate cash flow effects from income (e.g. asset purchases). Because of double entry, accruals affect the balance sheet by either increasing or decreasing asset or liability accounts by an equal amount.

 An accrual that increases (decreases) income will also either increase (decrease) an asset or decrease (increase) a liability. Short-term accrualsRelated to working capital items Long-term accruals Depreciation and amortization. Long term accruals arise from capitalization. Asset capitalization is the process of deferring costs incurred in the current period whose benefits are expected in future periods. Costs of fixed assets are allocated over their benefit periods and make up a large part of long-term accruals.

 Advantages of Cash flow Accounting: Cash flows are easy to understand and compute There is something tangible and certain about cash flows. Cash flows are more reliable than accruals. Accrual numbers are less concrete than cash flows as they depend on certain assumptions. Accrual accounting is subject to accounting distortions.

Advantages of Accrual Accounting

Most business transactions are on credit. Further, companies invest a large amounts of funds in assets, the benefits of which occur over many future periods. In these scenarios, cash flow accounting fails to provide a real picture of financial condition and performance of a business. Accrual accounting aims to inform users about the consequences of business activities for a companys future cash flows.

 Accrual accounting reduces timing and matching problems. Timing problem refers to cash flows that do not occur contemporaneously with the business activities yielding the cash flows. E.g. a sale occurs in the first quarter, but cash from sale occurs in the next quarter. Matching problem refers to cash inflows and cash outflows that occur from business activities but are not matched with in time with each other (e.g. fees received from consulting that are not linked in time to wages paid to consultants working on the project).

 Accrual accounting produces a balance sheet that more accurately reflects the level of resources available to the company to generate future cash flows. Accrual accounting is more relevant than cash flows Business value can be determined by using accrual accounting figures. Net income = Operating cash flows + Accruals Difference between income and cash flows is mainly timing and, thus over long horizons, income and operating cash flows tend to converge.