Questions for Practice
Short Answers
1. Why is it necessary for accountants to assume that business entity will remain a going concern?
Answer: It is necessary for accountants to assume that a business entity will remain a “going concern” because this assumption provides the basis for valuing assets in the balance sheet. It allows the business to charge only the consumed part of an asset as an expense from current revenue, carrying forward the remaining amount to future periods over the asset’s estimated life. Without this assumption, the entire cost of an asset would have to be expensed in the year of purchase, which would not accurately reflect the business’s financial position or performance. It assumes the firm will continue operations indefinitely and not be liquidated in the foreseeable future.
2. When should revenue be recognised? Are there exceptions to the general rule?
Answer: Revenue should generally be recognized when it is realized, meaning when a legal right to receive it arises. This typically happens when goods are sold or a service is rendered. For credit sales, revenue is recognized at the time of sale, not when the cash is received. Income like rent, commission, and interest is recognized on a time basis.
Exceptions to the general rule include:
Long-term contracts: For large construction work, revenue may be recognized proportionately based on the work certified.
Hire purchase sales: Revenue is recognized based on the installments collected.
3. What is the basic accounting equation?
Answer: The basic accounting equation, derived from the Dual Aspect Concept, is: Assets = Liabilities + Capital
4. The realisation concept determines when goods sent on credit to customers are to be included in the sales figure for the purpose of computing the profit or loss for the accounting period. Which of the following tends to be used in practice to determine when to include a transaction in the sales figure for the period. When the goods have been:
a. dispatched
b. invoiced
c. delivered
d. paid for
Give reasons for your answer.
Answer: The correct option is c. delivered.
Reason: According to the Revenue Recognition (Realisation) Concept, revenue is realized when a legal right to receive it arises, which generally occurs when the goods are sold or a service is rendered. Delivery signifies the transfer of ownership and the completion of the sale, creating the legal right to receive payment, regardless of when the cash is actually received. Dispatching or invoicing doesn’t necessarily mean the customer has received the goods and the sale is complete, and “paid for” refers to the cash basis, not the accrual basis required by the realization concept for revenue recognition.
5. Complete the following worksheet:
Answer: (i) If a firm believes that some of its debtors may ‘default’, it should act on this by making sure that all possible losses are recorded in the books. This is an example of the Conservatism concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the Business Entity concept.
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the Dual Aspect concept.
(iv) The Consistency concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.
(v) A firm may hold stock which is heavily in demand. Consequently, the market value of this stock may be increased. Normal accounting procedure is to ignore this because of the Conservatism (or Prudence) concept.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the Revenue Recognition (Realisation) concept.
(vii) The management of a firm is remarkably incompetent, but the firm’s accountants can not take this into account while preparing book of accounts because of Money Measurement concept.
Long Answers
1. ‘The accounting concepts and accounting standards are generally referred to as the essence of financial accounting’. Comment.
Answer: Accounting concepts and accounting standards are indeed considered the essence of financial accounting because they form its fundamental theory base, ensuring uniformity, consistency, reliability, and comparability of financial information.
Accounting Concepts (also called principles, conventions, postulates, assumptions) are the fundamental ideas or basic assumptions that underpin financial accounting theory and practice. They serve as broad working rules that guide how transactions are recorded and financial statements are prepared (e.g., Business Entity, Going Concern, Money Measurement, Dual Aspect, Revenue Recognition, Matching, Consistency, Conservatism, Materiality, Objectivity, Full Disclosure). These concepts ensure that financial reporting is based on a coherent and logical framework, allowing users to understand and trust the information. For instance, the Business Entity concept ensures that personal transactions of owners do not distort business financial statements, while the Going Concern concept allows for the rational allocation of asset costs over time.
Accounting Standards are written policy documents issued by authoritative bodies (like ICAI in India) that cover the recognition, measurement, treatment, presentation, and disclosure of accounting transactions in financial statements. They build upon the concepts by providing specific rules and guidelines, eliminating variations in accounting treatments and enhancing the comparability of financial statements across different periods and between different companies. They mandate disclosures that might not be legally required but are crucial for a true and fair view of the financial position.
Together, concepts provide the theoretical foundation, while standards provide the practical application guidelines, making financial statements meaningful, useful, and reliable for various stakeholders to make informed decisions. Without them, financial statements would be haphazard, incomparable, and potentially misleading.
2. Why is it important to adopt a consistent basis for the preparation of financial statements? Explain.
Answer: It is important to adopt a consistent basis for the preparation of financial statements due to the Consistency Concept. This concept states that accounting policies and practices should be uniform and consistent from one accounting period to another.
The importance lies in facilitating comparability:
Intra-company comparability: By consistently applying the same accounting methods (e.g., depreciation method, inventory valuation method), users can meaningfully compare a company’s financial performance and position over different accounting periods. Changes in policies would make profit figures and asset valuations incomparable, making it difficult to assess trends or management’s effectiveness.
Inter-company comparability: While challenging due to different choices of methods, consistency within each company aids in understanding their individual performance over time, which is a prerequisite for any meaningful inter-firm comparison.
Consistency also helps eliminate personal bias in financial reporting and enhances the reliability of the information. While the Consistency Concept does not prohibit changes in accounting policies, it requires that any such changes be fully disclosed along with their probable effects on the financial results, ensuring transparency and enabling users to adjust their comparisons.
3. Discuss the concept-based on the premise ‘do not anticipate profits but provide for all losses’.
Answer: This premise describes the Conservatism Concept, also known as the Prudence Concept. This concept provides guidance for recording transactions by advocating a “playing safe” or cautious approach.
The core idea is:
Do not anticipate profits: This means that profits should not be recognized or recorded until they are actually realized (e.g., revenue from a sale is recognized only when the sale is complete, not when an order is received or goods are manufactured). Any potential future gains are ignored until they are certain to be received.
Provide for all losses: This means that all known or even remotely possible losses, irrespective of their certainty, must be provided for in the accounting records. If there’s a potential for a loss, it should be accounted for immediately.
Examples of its application:
Valuation of Closing Stock: Closing stock (inventory) is valued at cost or market value, whichever is lower. If the market value of stock falls below its cost, the loss is immediately recognized. However, if the market value increases, the gain is not recorded until the stock is actually sold.
Provision for Doubtful Debts: A provision is created for potential losses from debtors who may not pay their dues, even if the actual default has not yet occurred.
Writing off Intangible Assets: Intangible assets like goodwill are often written off over a conservative period.
The Conservatism Concept is intended to prevent overstating profits and assets, which could lead to actions like distributing dividends out of capital, thereby eroding the firm’s financial base. It aims to protect the interests of creditors and stakeholders by presenting a more realistic, albeit pessimistic, view of the firm’s financial health. However, an overly conservative approach can lead to “secret reserves” by deliberately underestimating assets, which is generally discouraged as it can mislead users.
4. What is matching concept? Why should a business concern follow this concept? Discuss.
Answer: The Matching Concept dictates that expenses incurred in an accounting period should be matched with the revenues earned during that same period. It is a fundamental principle of the accrual basis of accounting.
For example, if a company sells goods, the revenue from those sales is recognized when the sale occurs. Simultaneously, the cost of those specific goods (Cost of Goods Sold) and any expenses directly incurred to generate that revenue (e.g., sales commission, advertising for that period) should be recognized in the same period, regardless of when cash is paid or received. This ensures that the true profitability of operations for a given period is accurately determined.
Why a business concern should follow this concept:
Accurate Profit Determination: The primary reason for following the matching concept is to accurately ascertain the profit or loss made by the business during a specific accounting period. By matching only the expenses related to the revenue earned in that period, it provides a more precise measure of performance.
True and Fair View: It contributes to presenting a “true and fair view” of the business’s financial performance. If expenses and revenues were not matched, the profit figure could be distorted, leading to misinformed decisions by stakeholders.
Informed Decision Making: Users of financial statements (investors, creditors, management) rely on accurate profit figures for decision-making. The matching concept ensures that the income statement provides a reliable picture of operational efficiency and profitability.
Accrual Basis Foundation: It is a cornerstone of the accrual basis of accounting, which is generally considered superior to the cash basis because it reflects the economic events of a period rather than just cash movements.
Resource Allocation: By clearly linking expenses to the revenues they help generate, management can better understand the cost-effectiveness of various activities and make informed decisions about resource allocation.
In essence, the matching concept ensures that the efforts (expenses) are appropriately compared with the accomplishments (revenues) for a given period, leading to a meaningful and reliable measure of financial success.
5. What is the money measurement concept? Which one factor can make it difficult to compare the monetary values of one year with the monetary values of another year?
Answer: The Money Measurement Concept states that only transactions and happenings that can be expressed in monetary terms are recorded in the books of accounts. Qualitative aspects, such as the quality of management, the reputation of the company, or the efficiency of human resources, are not recorded because they cannot be measured in monetary units. All recorded transactions are expressed in the monetary units of the country (e.g., Rupees, Dollars).
The factor that can make it difficult to compare the monetary values of one year with the monetary values of another year, under the money measurement concept, is changes in the value of money due to inflation or deflation (i.e., changes in the purchasing power of money or price level changes).
Explanation: The money measurement concept assumes a stable monetary unit. However, in reality, the purchasing power of money changes over time due to inflation (money buys less) or deflation (money buys more). For example, an asset purchased for ₹1,00,000 ten years ago will be recorded at that historical cost. If a similar asset is purchased today for ₹2,00,000 due to inflation, the financial statements will show two assets of the same type but recorded at vastly different monetary values, making direct comparisons misleading. When comparing the profits or assets of one year to another, the monetary values are simply added or subtracted without adjusting for these changes in purchasing power, which can distort the true financial performance or position over time. This limitation means financial statements prepared under this concept may not always reflect a true and fair view in periods of significant price changes.