Page No: 38
Questions for Practice
1. Why is it necessary for accountants to assume that business entity will remain a going concern?
It is necessary for accountants to assume that business entity will remain a going concern because
→ It helps in recording fixed assets at their original cost and depreciation is charged on these assets without reference to their market value. For example: if a machinery is purchased which would last for next 5 years, the cost of this machinery will be spread over the next 5 years for calculating the net profit or loss of each year. The full cost machinery would not be treated as an expense in the year of its purchase itself.
→ It is also because of this concept that outside parties enter into long-term contracts with the enterprise, give loans and purchase the debentures and shares of enterprise.
2. When should revenue be recognised? Are there exceptions to the general rule?
Revenue is recognised only when it is realised i.e., when a legal right to receive it arises. Thus credit sales are treated as revenue on the day sales are made and not when cash is received from the buyers. Similarly, rent for the month of March even if received in April month will be treated as revenue of the financial year ending 31st March.
There are two exceptions to this rule:
→ In case of sales on installment basis, only the amount collected in installments is treated as revenue.
→ In case of long-term construction contracts, proportionate amount of revenue, based on part of the contracted completed by the end of the financial year is treated as realised.
3. What is the basic accounting equation?
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:
(d) paid for
According to the realisation concept, revenue is recognised when a legal right to receive it arises. Therefore, when the goods are invoiced, it is treated as the transfer of ownership of goods from the seller to the buyer and hence the revenue is recognised.
5. Complete the following work sheet:
(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 ___________ concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the ___________ concept.
► business entity concept
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the ___________ concept.
► dual aspect
(iv) The ___________ 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 ___________.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the ___________.
► revenue recognition
(vii) The management of a firm is remarkably incompetent, but the firms accountants can not take this into account while preparing book of accounts because of ___________ concept.
► money measurement
1. ‘The accounting concepts and accounting standards are generally referred to as the essence of financial accounting’. Comment.
Financial accounting is concerned with the preparation of the financial statements and provides financial information to various accounting users. It is performed according to the basic accounting concepts like Business Entity, Money Measurement, Consistency, Conservatism, etc. These concepts allow various alternatives to treat the same transaction. For example, there are a number of methods available for calculating stock and depreciation, which can be followed by various firms. This leads to wrong interpretation of financial results by external users due to the problem of inconsistency and incomparability of financial results among different business entities. In order to mitigate inconsistency and incomparability and to bring uniformity in preparation of the financial statements, accounting standards are being issued in India by the Institute of Chartered Accountant of India. Accounting standards help in removing ambiguities and inconsistencies. Hence, accounting standards and accounting concepts are referred as the essence of financial accounting.
2. Why is it important to adopt a consistent basis for the preparation of financial statements? Explain.
It is important to adopt a consistent basis for the preparation of financial statements because it helps in comparability of financial statements. For Example: if a firm choose straight line method for showing depreciation but in the next accounting period switched over to written down method then the results of this year cannot be compared to that of the previous years. However, it does not mean that firm cannot changes its accounting policies. A better method, if available which will lead to better presentation and better understanding of the financial results, the firm may adopt but it must be stated clearly by way of footnotes to enable the users of the financial statements to be aware of the changes.
3. Discuss the concept-based on the premise ‘do not anticipate profits but provide for all losses’.
According to the Conservatism Principle, all anticipated loss should be recorded in books of accounts, but all anticipated gains should be ignored until they are recognized. For example, stock is valued at cost or market price, whichever is lower. If the market price is lower than the cost price, loss should be accounted; whereas, if the former is more than the latter, then this profit should not be recorded until unless the stock is sold. There are numerous provisions that are maintained based on the conservatism principle like, provision for discount to debtors, provision for doubtful bad debts, etc. This principle is based on the common sense and depicts pessimism. This also helps the business to deal uncertainty and unforeseen conditions.
4. What is matching concept? Why should a business concern follow this concept? Discuss?
Matching Concept states that all expenses incurred during the year, whether paid or not, and all revenues earned during the year, whether received or not, should be taken into account while determining the profit of that year. For Example: When some expense such as insurance premium is paid partly for the next year also, the part relating to next year will be shown as expense only next year not this year.
This concept is very important for correct determination of net profit. It is possible that in the same accounting period, the business may either pay or receive payments that may or may not belong to the same accounting period. This leads to either overcasting or under-casting of the profit or loss, which may not reveal the true efficiency of the business and its activities in the concerned accounting period. Similarly, there may be various expenditures like, purchase of machinery, buildings, etc. These expenditures are capital in nature and their benefits can be availed over a period of time. In such cases, only the depreciation of such assets is treated as an expense and should be taken into account for calculating profit or loss of the concerned year. Thus, it is very necessary for any business entity to follow the matching concept.
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?
Money Measurement Concept states that only those transactions and events are recorded in accounting which are capable of being expressed in terms of money. An event even though may very important for business, will not be recorded in the books of accounts unless its effect can be measured in terms of money. For Example: a business have 5 machines then this thing cannot be added up unless expressed in terms of money. In order to record this item, we must have to expressed it in monetary terms say Rs. 1,00,000. Thus, money measurement concept enables consistency in maintaining accounting records.