THEORETICAL FRAMEWORK

1.1 DEFINITION OF ACCOUNTING

Accounting is an art of recording, classifying and summarizing transactions and

events which are in part at least of financial character, in a significant manner
and in terms of money, and interpreting the results thereof.

1.2 TRANSACTIONS AND EVENTS

Transaction is used to mean ‘a business, performance of an act, an agreement’

while event is used to mean ‘a happening, as a consequence of transaction(s), a
result.’

Particulars ₹ ₹ Result
Goods sold 1,47,000 Transaction
Goods in hand 15,000 Event
1,62,000
(-) Goods purchased 1,15,000 Transaction
Shop Rent paid 5,000 (1,20,000) Transaction
Surplus 42,000 Event

Business Activities

Transaction: Business Event: Result of Both Transaction &

Activity Performed + Business Transaction = Event

Human Efforts + No Human Efforts = Both

Purchase, Sale, etc P&L, Closing bal., etc Purchase of FA on

B/S Date.
1.3 PROCEDURAL ASPECTS OF ACCOUNTING

On the basis of the above definitions, procedure of accounting can be basically

divided into two parts:

(i) Generating financial information and

(ii) Using the financial information.

1.4 GENERATING FINANCIAL INFORMATION

1. Recording – This is the basic function of accounting. All business transactions

of a financial character, as evidenced by some documents such as sales bill,
pass book, salary slip etc. are recorded in the books of account. Recording is
done in a book called “Journal.”

2. Classifying – Classification is concerned with the systematic analysis of the

recorded data, with a view to group transactions or entries of one nature at one
place so as to put information in compact and usable form. The book containing
classified information is called “Ledger”. This book contains on different pages,
individual account heads under which, all financial transactions of similar nature
are collected.

3. Summarising – It is concerned with the preparation and presentation of the

classified data in a manner useful to the internal as well as the external users
of financial statements. This process leads to the preparation of the financial
statements.
4. Analysing – The term ‘Analysis’ means methodical classification of the data
given in the financial statements. The figures given in the financial statements
will not help anyone unless they are in a simplified form.

5. Interpreting – This is the final function of accounting. It is concerned with

explaining the meaning and significance of the relationship as established by
the analysis of accounting data. The recorded financial data is analysed and
interpreted in a manner that will enable the end-users to make a meaningful
judgement about the financial condition and profitability of the business
operations.

6. Communicating – It is concerned with the transmission of summarised,

analysed and interpreted information to the end-users to enable them to make
rational decisions. This is done through preparation and distribution of
accounting reports, which include besides the usual profit and loss account and
the balance sheet, additional information in the form of accounting ratios,
graphs, diagrams, fund flow statements etc.

1.5 USING THE FINANCIAL INFORMATION

There are certain users of accounts. Earlier it was viewed that accounting is
meant for the proprietor or owner of the business, but changing social
relationships diluted the earlier thinking. It is now believed that besides the
owner or the management of the business enterprise, users of accounts include
the investors, employees, lenders, suppliers, customers, government and other
agencies and the public at large.
1.6 OBJECTIVES OF ACCOUNTING

The objectives of accounting can be given as follows:

1. Systematic recording of transactions – Basic objective of accounting is to

systematically record the financial aspects of business transactions i.e. book-
keeping.

2. Ascertainment of results of above recorded transactions – Accountant

prepares profit and loss account to know the results of business operations for
a particular period of time. If revenue exceed expenses then it is said that
business is running profitably but if expenses exceed revenue then it can be
said that business is running under loss.

3. Ascertainment of the financial position of the business – Businessman is

anxious to know that what he owes (liability) to the outsiders and what he owns
(assets) on a certain date. To know this, accountant prepares a financial
position statement popularly known as Balance Sheet. The balance sheet is a
statement of assets and liabilities of the business at a particular point of time
and helps in ascertaining the financial health of the business.

4. Providing information to the users for rational decision-making –

Accounting as a ‘language of business’ communicates the financial results of an
enterprise to various stakeholders by means of financial statements.
5. To know the solvency position – By preparing the balance sheet,
management not only reveals what is owned and owed by the enterprise, but
also it gives the information regarding concern’s ability to meet its liabilities in
the short run (liquidity position) and also in the long-run (solvency position) as
and when they fall due.

1.7 FUNCTIONS OF ACCOUNTING

The main functions of accounting are as follows:

(a) Measurement: Accounting measures past performance of the business

entity and depicts its current financial position.

(b) Forecasting: Accounting helps in forecasting future performance and

financial position of the enterprise using past data and analysing trends.

(c) Decision-making: Accounting provides relevant information to the users of

accounts to aid rational decision-making.

(d) Comparison & Evaluation: Accounting assesses performance achieved in

relation to targets and discloses information regarding accounting policies and
contingent liabilities which play an important role in predicting, comparing and
evaluating the financial results.

(e) Control: Accounting also identities weaknesses of the operational system

and provides feedbacks regarding effectiveness of measures adopted to check
such weaknesses.

(f) Government Regulation and Taxation: Accounting provides necessary

information to the government to exercise control on the entity as well as in
collection of tax revenues.

1.8 BOOK-KEEPING

Book-keeping is an activity concerned with the recording of financial data

relating to business operations in a significant and orderly manner. It covers
procedural aspects of accounting work and embraces record keeping function.
Obviously, book-keeping procedures are governed by the end product, the
financial statements.
1.9 OBJECTIVES OF BOOK-KEEPING

1. Complete Recording of Transactions – It is concerned with complete and

permanent record of all transactions in a systematic and logical manner to show
its financial effect on the business.

2. Ascertainment of Financial Effect on the Business – It is concerned with

the combined effect of all the transactions made during the accounting period
upon the financial position of the business as a whole.

1.10 DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

S.No. Book Keeping Accounting

1 It is a process concerned with It is a process concerned with
recording of transactions. summarising of the recorded
transactions.
2 It constitutes as a base for It is considered as a language of
accounting. the business.
3 Financial statements do not form Financial statements are prepared
part of this process. in this process on the basis of
book-keeping records.
4 Managerial decisions cannot be Management takes decisions on the
taken with the help of these basis of
records. these records.
5 There is no sub-eld of book- It has several sub-elds like
keeping. financial accounting, management
accounting etc.
6 Financial position of the business Financial position of the business is
cannot be ascertained through ascertained on the basis of the
book-keeping records. accounting reports.
Relationship of Accounting, Book-keeping and Accountancy can be
depicted in the following chart as
ACCOUNTANCY

ACCOUNTING

BOOK

KEEPING

1.11 SUB-FIELDS OF ACCOUNTING

The various sub-elds of accounting are:

(i) Financial Accounting – It covers the preparation and interpretation of

financial statements and communication to the users of accounts. It is
historical in nature as it records transactions which had already been occurred.

(ii) Management Accounting – It is concerned with internal reporting to the

managers of a business unit. To discharge the functions of stewardship,
planning, control and decision- making, the management needs variety of
information. A very important component of the management accounting is cost
accounting which deals with cost ascertainment and cost control.

(iii) Cost Accounting –The process of accounting for cost which begins with the
recording of income and expenditure or the bases on which they are calculated
and ends with the preparation of periodical statements and reports for
ascertaining and controlling costs.

(iv) Social Responsibility Accounting – Social responsibility accounting is

concerned with accounting for social costs incurred by the enterprise and social
benefits created.

(v) Human Resource Accounting – Human resource accounting is an attempt to

identify, quantify and report investments made in human resources of an
organisation that are not presently accounted for under conventional accounting
practice.
1.12 USERS OF ACCOUNTING INFORMATION

Generally users of accounts are classified into two categories, (a) internal users
and (b) external users.

(i) Investors: They provide risk capital to the business. They need information
to assess whether to buy, hold or sell their investment. Also they are
interested to know the ability of the business to survive, prosper and to pay
dividend.

(ii) Employees: Growth of the employees is directly related to the growth of

the organisation and therefore, they are interested to know the stability,
continuity and growth of the enterprise and its ability to provide remuneration,
retirement and other benefits and to enhance employment opportunities.

(iii) Lenders: They are interested to know whether their loan-principal and
interest will be paid back when due.

(iv) Suppliers and Creditors: They are also interested to know the ability of
the enterprise to pay their dues, that helps them to decide the credit policy
for the relevant concern, rates to be charged and so on.

(v) Customers: Customers are also concerned with the stability and
profitability of the enterprise because their functioning is more or less
dependent on the supply of goods.

(vi) Government and their agencies: They regulate the functioning of business
enterprises for public good, allocate scarce resources among competing
enterprises, control prices, charge excise duties and taxes, and so they have
continued interest in the business enterprise.

(vii) Public: The public at large is interested in the functioning of the

enterprise because it may make a substantial contribution to the local economy
in many ways including the number of people employed and their patronage to
local suppliers.

(viii) Management: Management as whole is also interested in the accounts for

various managerial decisions. On the basis of the accounts, management
determines the effects of their various decisions on the functioning of the
organisation. This helps them to make further managerial decisions.
1.13 RELATIONSHIP OF ACCOUNTING WITH OTHER DISCIPLINES

(a) Accounting and Economics: Economics is viewed as a science of rational

decision-making about the use of scarce resources.

Accounting is viewed as a system, which provides data to the users to permit

informed judgement and decisions. Some non-accounting data are also relevant
for decision-making.

Accountants got the ideas of value, income and capital maintenance from
economists, but brushed suitably to make them usable in practical
circumstances. Accountants developed the valuation, measurement and decision-
making techniques which may owe to the economic theorems for origin.

(b) Accounting and Statistics: In accounts, all values are important individually
because they relate to business transactions. As against this, statistics is
concerned with the typical value, behaviour or trend over a period of time or
the degree of variation over a series of observations.

Accounting records generally take a short-term view of events and are

connected to a year while statistical analysis is more useful if a longer view is
taken for the purpose.

In accountancy, a number of financial and other ratios are based on statistical

methods, which help in averaging them over a period of time. Several accounting
and financial calculations are based on statistical formulae.

(c) Accounting and Mathematics: Knowledge of arithmetic and algebra is a

pre-requisite for accounting computations and measurements. Calculations of
interest and annuity are the examples of such fundamental uses. While
computing depreciation, finding out installments in hire-purchase and
instalments payment transactions, calculating amount to be set aside for
repayment of loan and replacement of assets and calculating lease rentals,
mathematical techniques are frequently used. Accounting data are also
presented in ratio form.
(d) Accounting and Law: An economic entity operates within a legal
environment. All transactions with suppliers and customers are governed by the
Contract Act, the Sale of Goods Act, the Negotiable Instruments Act, etc. The
entity itself is created and controlled by laws. For example, a company is
created by the Companies Act and also controlled by Companies Act.

Similarly, every country has a set of economic, scale and labour laws.
Transactions and events are always guided by laws of the land. Very often the
accounting system to be followed has been prescribed by the law. For example,
the Companies Act has prescribed the format of financial statements for
companies.

(e) Accounting and Management: Accountants are well placed in the

management and play a key role in the management team. A large portion of
accounting information is prepared for management decision-making.In the
management team, an accountant is in a better position to understand and use
such data. In other words, since an accountant plays an active role in
management, he understands the data requirements. So the accounting system
can be moulded to serve the management purpose.

1.14 LIMITATIONS OF ACCOUNTING

1. The Balance sheet cannot reflect the value of certain factors like loyalty and
skill of the personnel which may be the most valuable asset of an enterprise
these days.

2. Balance Sheet shows the position of the business on the day of its
preparation and not on the future date while the users of the accounts are
interested in knowing the position of the business in the near future and also in
long run and not for the past date.

3. Accounting ignores changes in some money factors like inflation etc.

4. There are occasions when accounting principles conflict with each other.

5. Certain accounting estimates depend on the personal judgement of the

accountant, e.g., provision for doubtful debts, method of depreciation adopted,
recording certain expenditure as revenue expenditure or capital expenditure,
selection of method of valuation of inventories and the list is quite long.

6. Financial statements consider those assets which can be expressed in

monetary terms. Human resources although the very important asset of the
enterprise are not shown in the balance sheet.

7. Different accounting policies for the treatment of same item adds to the
probability of manipulations.

1.15 ROLE OF ACCOUNTANT IN THE SOCIETY (Areas of Services)

(i) Maintenance of Books of Accounts: An accountant is able to maintain a

systematic record of financial transactions in order to establish the net result
of the transactions entered into during a period and to state the financial
position of the concern as at a particular date.

(ii) Audit

(iii) Internal Audit: It is a management tool whereby an internal auditor

thoroughly examines the accounting transactions and also the system, according
to which these have been recorded with a view to ensure the management that
the accounts are being properly maintained and the system contains adequate
safeguards to check any leakage of revenue or misappropriation of property or
assets and the operations have been carried out in conformity with the plans of
management.

(iv) Taxation: An accountant can handle taxation matters of a business or a

person and he can represent that business or person before the tax authorities
and settle the tax liability under the statute prevailing.

He can also assist in avoiding or reducing tax burden by proper planning of tax
affairs.

(v) Management Accounting and Consultancy Services: Management

accountant performs an advisory function. He is largely responsible for internal
reporting to the management for planning and controlling current operations,
decision-making on special matters and for formulating long-range plans.
(vi) Financial Advice: Many people need help and guidance in planning their
personal financial affairs. An accountant who knows about finances, taxation
and family problems is well placed to give such advice.

(a) Investments: An accountant can explain the significance of the formidable

documents which shareholders receive from companies and help in making
decisions relating to their investments.

(b) Insurance: An accountant can provide information to his clients on various

insurance policies and helps in choosing appropriate policy.

(c) Business Expansion: As businesses grow in size and complexity and mergers
are being considered, accountants are in the forefront in interpreting accounts,
making suggestions as to the form of schemes and the fairness of proposals
considering cost and financial consequences and generally advising their clients.

(d) Investigations: Financial investigations are required for a variety of

purposes. Examples are:

(i) To ascertain the financial position of a business, for the information of

interested parties in connection with an issue of capital, the purchase or sale of
the business or a reconstruction or amalgamation.

(ii) To help the management to decide whether it is cheaper to manufacture an

article or to buy out.

(iii) To ascertain why profits have fallen.

(iv) To achieve greater efficiency in management.

(v) To ascertain whether fraud has occurred and if so, its nature and extent
and to make suggestions which will help to prevent a recurrence.

(vi) To value businesses and shares in private companies for purposes such as
purchase, sale, estate duty or wealth tax etc.

(e) Pension schemes: Specialist advice from actuaries, insurance agents or

insurance company is needed before launching or amending a provident fund or
pension scheme in a business. But before making a final decision, an accountant
has to be consulted. Later on, his help may be needed for managing the scheme
or obtaining tax relief.
(vii) Other Services

(a) Secretarial Work

(b) Share Registration Work

(c) Company Formation

(d) Receiverships, Liquidations, etc

(e) Arbitrations

(f) As regards the Cost Accounts

(g) Accountant and Information Services

 ACCOUNTING CONCEPTS
❖ Accounting concepts define the assumptions on the basis of which
financial statements of a business entity are prepared.
❖ Concepts are those basic assumptions and condition which form the basis
upon which the accountancy has been laid.

BUSINESS ENTITY CONCEPT

This concept assumes that, for accounting purposes, the business enterprise
and its owners are two separate independent entities. Thus, the business and
personal transactions of its owner are separate. For example, when the owner
invests money in the business, it is recorded as liability of the business to the
owner. Similarly, when the owner takes away from the business cash/goods for
his/her personal use, it is not treated as business expense.

MONEY MEASUREMENT CONCEPT

This concept assumes that all business transactions must be in terms of money,
that is in the currency of a country. In our country such transactions are in
terms of rupees. For example, sale of goods worth Rs.200000, Rent Paid
Rs.10000 etc. are expressed in terms of money, and so they are recorded in the
books of accounts.

GOING CONCERN CONCEPT

This concept states that a business firm will continue to carry on its activities
for an indefinite period of time. Simply stated, it means that every business
entity has continuity of life. Thus, it will not be dissolved in the near future.
This is an important assumption of accounting, as it provides a basis for showing
the value of assets in the balance sheet.

ACCOUNTING PERIOD CONCEPT

All the transactions are recorded in the books of accounts on the assumption
that profits on these transactions are to be ascertained for a specified period.
This is known as accounting period concept. Thus, this concept requires that a
balance sheet and profit and loss account should be prepared at regular
intervals. This is necessary for different purposes like, calculation of profit,
ascertaining financial position, tax computation etc.
ACCOUNTING COST CONCEPT
It states that all assets are recorded in the books of accounts at their
purchase price, which includes cost of acquisition, transportation and
installation and not at its market price. It means that fixed assets like building,
plant and machinery, furniture, etc are recorded in the books of accounts at a
price paid for them.

DUAL ASPECT CONCEPT

Dual aspect is the foundation or basic principle of accounting. It provides the
very basis of recording business transactions in the books of accounts. This
concept assumes that every transaction has a dual effect, i.e. it affects two
accounts in their respective opposite sides. Thus, the duality concept is
commonly expressed in terms of fundamental accounting equation :

Assets = Liabilities + Capital

MATCHING CONCEPT
The matching concept states that the revenue and the expenses incurred to
earn the revenues must belong to the same accounting period. So once the
revenue is realised, the next step is to allocate it to the relevant accounting
period. This can be done with the help of accrual concept If the revenue is
more than the expenses, it is called profit. If the expenses are more than
revenue it is called loss. This is what exactly has been done by applying the
matching concept.

Significance

1. It guides how the expenses should be matched with revenue for

determining exact profit or loss for a particular period.

2. It is very helpful for the investors/shareholders to know the exact amount

of profit or loss of the business.

REALISATION CONCEPT
This concept states that revenue from any business transaction should be
included in the accounting records only when it is realised. The term realisation
means creation of legal right to receive money. Selling goods is realisation,
receiving order is not.
 ACCOUNTING CONVENTIONS
▪ Consistency
▪ Full Disclosure
▪ Materiality
▪ Conservatism

ACCOUNTING CONVENTION

An accounting convention refers to common practices which are universally

followed in recording and presenting accounting information of the business
entity. Conventions denote customs or traditions or usages which are in use
since long. To be clear, these are nothing but unwritten laws.

The accountants have to adopt the usage or customs, which are used as a guide
in the preparation of accounting reports and statements. These conventions are
also known as doctrine.

CONVENTION OF CONSISTENCY
The convention of consistency means that same accounting principles should be
used for preparing financial statements year after year. A meaningful
conclusion can be drawn from financial statements of the same enterprise when
there is comparison between them over a period of time.

CONVENTION OF FULL DISCLOSURE

Convention of full disclosure requires that all material and relevant facts
concerning financial statements should be fully disclosed. Full disclosure means
that there should be full, fair and adequate disclosure of accounting
information. Adequate means sufficient set of information to be disclosed. Fair
indicates an equitable treatment of users. Full refers to complete and detailed
presentation of information.

CONVENTION OF MATERIALITY
The convention of materiality states that, to make financial statements
meaningful, only material fact i.e. important and relevant information should be
supplied to the users of accounting information. The question that arises here
is what is a material fact. The materiality of a fact depends on its nature and
the amount involved. Material fact means the information of which will
influence the decision of its user.
CONVENTION OF CONSERVATISM
This convention is based on the principle that “Anticipate no profit, but provide
for all possible losses”.

This convention clearly states that profit should not be recorded until it is
realised. But if the business anticipates any loss in the near future provision
should be made in the books of accounts for the same.

For example, valuing closing stock at cost or market price whichever is lower,
creating provision for doubtful debts, discount on debtors, writing off
intangible assets like goodwill, patent, etc. The convention of conservatism is a
very useful tool in situation of uncertainty and doubts.

ACCOUNTING POLICIES
MEANING

Accounting Policies refer to specific accounting principles and methods of

applying these principles adopted by the enterprise in the preparation and
presentation of financial statements.

The areas wherein different accounting policies are frequently encountered can
be given as follows:

(1) Valuation of inventories;

(2) Valuation of investments.

SELECTION OF ACCOUNTING POLICIES

Accounting policy should be selected with due care after considering its effect
on the financial performance of the business enterprise from the angle of
various users of accounts.
Examples wherein selection from a set of accounting policies is made, can be
given as follows:

1. Inventories are valued at cost except for finished goods and by-products.
Finished goods are valued at lower of cost or market value and by-products are
valued at net realisable value.

2. Investments (long term) are valued at their acquisition cost.

CHANGE IN ACCOUNTING POLICIES

A change in accounting policies should be made in the following conditions:

(a) It is required by some statute or for compliance with an Accounting

Standard.

(b) Change would result in more appropriate presentation of financial

statement.

Change in accounting policy may have a material effect on the items of financial
statements. For example if cost formula used for inventory valuation is changed
from weighted average to FIFO. It is necessary to quantify the effect of
change on financial statement items like assets, liabilities, profit/loss.

The examples in this regard may be given as follows:

1. Omega Enterprises revised its accounting policy relating to valuation of

inventories to include applicable production overheads.

ACCOUNTING AS A MEASUREMENT DISCIPLINE

MEANING OF MEASUREMENT

Measurement is vital aspect of accounting. Primarily transactions and events

are measured in terms of money. Any measurement discipline deals with three
basic elements of measurement viz., identification of objects and events to be
measured, selection of standard or scale to be used, and evaluation of
dimension of measurement standards or scale.

According to this definition, the three elements of measurement are:

(1) Identification of objects and events to be measured;

(2) Selection of standard or scale to be used;

(3) Evaluation of dimension of measurement standard or scale.

OBJECTS OR EVENTS TO BE MEASURED

Accounting essentially includes measurement of ‘information’. Decision makers

need past, present and future information. For external users, generally the
past information is communicated.

STANDARD OR SCALE OF MEASUREMENT

In accounting, money is the scale of measurement (see money measurement

concept), although now-adays quantitative information is also communicated
along with monetary information. Money as a measurement scale has no
universal denomination. It takes the shape of currency ruling in a country.

DIMENSION OF MEASUREMENT SCALE

An ideal measurement scale should be stable over time. Information of one year
measured in money terms may not be comparable with that of another year.
Suppose production and sales of a company in two different years are as
follows:

Looking at the monetary figures one may be glad for 8% sales growth. In fact
there was 10% production and sales decline. The growth envisaged through
monetary figures is only due to price change. Let us suppose further that the
cost of production for the above mentioned two years is as follows:

Take Gross profit = Sales – Cost of Production. Then in the first year profit
was Rs 1,00,000 while in the second year the profit was Rs 90,000. There was
10% decline in gross profit.

So money as a unit of measurement is not stable in the dimension. Thus

Accounting measures information mostly in money terms which is not a stable
scale having universal applicability and also not stable in dimension for
comparison over the time. So it is not an exact measurement discipline.
ACCOUNTING AS A MEASUREMENT DISCIPLINE

Accounting is meant for generating information suitable for users’ judgments

and decisions. But generation of such information is preceded by recording,
classifying and summarising data. By that process it measures performance of
the business entity by way of profit or loss and shows its financial position.
Thus measurement is an important part of accounting discipline.

Accounting profession earmarked three theorems namely going concern,

consistency and accrual as fundamental accounting assumptions, i.e. these
assumptions are taken for granted. Also while measuring, classifying,
summarising and also presenting, various policies are adopted. Recording,
classifying summarising and communication of information are also important
part of accounting, which do not fall within the purview of measurement
discipline. Therefore we cannot simply say that accounting is a measurement
discipline.

But in accounting money is the unit of measurement. So, let us take one thing
for granted that all transactions and events are to be recorded in terms of
money only. Quantitative information is also required in many cases but such
information is only supplementary to monetary information.

VALUATION PRINCIPLES

There are four generally accepted measurement bases or valuation principles.

These are:

(i) Historical Cost;

(ii) Current Cost;

(iii) Realizable Value;

(iv) Present Value.

(i) Historical Cost: It means acquisition price. For example, the businessman
paid Rs 7,00,000 to purchase the machine and spend Rs 1,00,000 on its
installation, its acquisition price including installation charges is Rs 8,00,000.
The historical cost of machine would be Rs 8,00,000. According to this base,
assets are recorded at an amount of cash or cash equivalent paid at the time of
acquisition. Liabilities are recorded at the amount of proceeds received in
exchange for the obligation.
When one Mr. X a businessman, takes Rs 5,00,000 loan from a bank @ 10%
interest p.a., it is to be recorded at the amount of proceeds received in
exchange for the obligation. Here the obligation is the repayment of loan as
well as payment of interest at an agreed rate i.e. 10%. Proceeds received are Rs
5,00,000 - it is historical cost of the transactions.

(ii) Current Cost: Current cost gives an alternative measurement base. Assets
are carried out at the amount of cash or cash equivalent that would have to be
paid if the same or an equivalent asset was acquired currently. Liabilities are
carried at the undiscounted amount of cash or cash equivalents that would be
required to settle the obligation currently. As on 1.1.2011 the bank
announces 1% prepayment penalty on the loan amount if it is paid within
15 days starting from that day. So as per current cost base, the machine
value is Rs 25,00,000 while the value of bank loan is Rs 5,05,000.

(iii) Realisable Value: Suppose Mr. X found that he can get Rs 20,00,000 if he
would sell the machine purchased, on 1.1.2000 paying Rs 7,00,000 and which
would cost Rs 25,00,000 in case he would buy it currently. Take also that Mr. X
found that he had no money to pay off the bank loan of Rs 5,00,000 currently.

As per realisable value, assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the assets in an orderly
disposal.

(iv) Present Value: Suppose we are talking as on 1.1.2011 - take it as time for
reference. Now think the machine purchased by Mr. X can work for another 10
years and is supposed to generate cash @ Rs 1,00,000 p.a. Also take that bank
loan of Rs 5,00,000 taken by Mr. X is to be repaid as on 31.12.2015. Annual
interest is Rs 90,000.

As per present value, an asset is carried at the present discounted value of the
future net cash inflows that the item is expected to generate in the normal
course of business. Liabilities are carried at the present discounted value of
future net cash outflows that are expected to be required to settle the
liabilities in the normal course of business.

Perhaps you know the compound interest rule: A = P (1+ i)n

A = Amount

P = Principal
i = interest / 100

n = Time

Suppose i = 20%, now what is the present value of Rs 1,00,000 to be received as

on 31.12.2011 (Take 1.1.2011 as the time of reference).

Total of all these present values is Rs 4,19,246. Since the machine purchased
by Mr. X will produce cash equivalent to Rs 4,19,246 in terms of present value,
it is to be valued at such amount as per present value measurement basis.

Applying this rule one can derive the present value of Rs 1,00,000 for 10 years
@ 20% p.a.

Similarly, the present value of bank loan is

= Rs 2,69,155 + Rs 2,00,939= Rs 4,70,094

Thus, we get the four measurements as on 1.1.2011:

The accounting system which we shall discuss in the remaining chapters is also
called historical cost accounting. However, this need not mean that one shall
follow only historical cost basis of accounting.

MEASUREMENT AND VALUATION

Value relates to the benefits to be derived from objects, abilities or ideas. To

the economist, value is the utility (i.e.; satisfaction) of an economic resource to
the person contemplating or enjoying its use. In accounting, to mean value of an
object, abilities or ideas, a monetary surrogate is used. That is to say, value is
measured in terms of money. Suppose, an individual purchased a car paying Rs
2,50,000. Its value lies in the satisfaction to be derived by that individual using
the car in future. Economists often use ordinal scale to indicate the level of
satisfaction. But accountants use only cardinal scales. If the value of car is
taken as Rs 2,50,000 it is only one type of value called acquisition cost or
historical cost. So value is indicated by measurement. In accounting the value is
always measured in terms of money.

ACCOUNTING ESTIMATES

There are certain items, which have not occurred therefore cannot be
measured using valuation principles still they are necessary to record in the
books of account, for example, provision for doubtful debts. For such items, we
need some value. In such a situation reasonable estimates based on the existing
situation and past experiences are made.

Therefore, the management makes various estimates and assumptions of

assets, liabilities, incomes and expenses as on the date of preparation of
financial statements. Such estimates are made in connection with the
computation of depreciation, amortisation and impairment losses as well as,
accruals, provisions and employee benefit obligations. Also estimates may be
required in determining the bad debts, useful life and residual value of an item
of plant and machinery and inventory obsolescence. The process of estimation
involves judgements based on the latest information available. An estimate may
require revision if changes occur regarding circumstances on which the
estimate was based, or as a result of new information, more experience or
subsequent developments. Change in accounting estimate means difference
arises between certain parameters estimated earlier and re-estimated during
the current period or actual result achieved during the current period.

Few examples of situations wherein accounting estimates are needed can be

given as follows:

(1) A company incurs expenditure of Rs 10,00,000 on development of patent.

Now the company has to estimate that for how many years the patent would
benefit the company. This estimation should be based on the latest information
and logical judgement.

(2) A company dealing in long-term construction contracts, uses percentage of

completion method for recognizing the revenue at the end of the accounting
year. Under this method the company has to make adequate provisions for
unseen contingencies, which can take place while executing the remaining
portion of the contract. Since provisioning for unseen contingencies requires
estimation, there may be excess or short provisioning, which is to be adjusted
in the period when it is recognised.

(3) Company has to provide for taxes which is also based on estimation as
there can be some interpretational differences on account of which tax
authorities may either accept the expenditure or refuse it. This will ultimately
lead to different tax liability.