Accounting Policies & Procedures
By Asok Nadhani
4.1
Accounting Policies
Irrespective of extent of
standardization, diversity in accounting policies is unavoidable for two major
reasons.
(i)
Accounting standards cannot (and do not) cover all possible
areas of accounting. An enterprise may adopt any reasonable accounting policies
in areas not covered by a standard.
(ii)
The accounting standards therefore permit more than
one policies, even in areas covered by it. Differences in accounting policies
lead to differences in reported information, even if underlying transactions
are same.
4.2
Areas of Different Accounting Policies
The following
are examples of the areas in which different accounting policies may be adopted
by different enterprises:
· Methods of
depreciation, depletion and amortization.
· Treatment of
expenditure during construction.
· Conversion or
transaction of foreign currency items.
· Valuation of
inventories.
· Treatment of
goodwill.
· Valuation of
investments.
· Treatment of
retirement benefits.
· Treatment of
contingent liabilities.
· Recognition of
profit on long term contracts.
· Valuation of
fixed assets.
4.3
Selection of Accounting Policies
The main considerations in
the selection of accounting policies are:-
(i)
Prudence: Due to uncertainty
of future events, Probable losses are provided for as a matter of conservatism.
(ii)
Substance over form: The accounting treatment and presentation in
financial statements of transactions should be in accordance to their substance
& financial reality of transaction and not merely by the legal form.
(iii) Materiality: Financial statements
should disclose all material items, knowledge of which might influence the
decisions of the user of the financial statements.
4.4 Change of Accounting Policies
A change in
accounting policies may be made in the following conditions:
a)
Adoption of different accounting policies is
required by statute or for compliance with an Accounting Standard.
b)
It is considered that change would result in more
appropriate presentation of financial statement.
4.5 Disclosure of Accounting Policy
All significant
Accounting Policies adopted in preparation & presentation of financial
statements should be disclosed.
a)
The principle of consistency requires use of same
accounting policies for similar transactions consistently in all accounting
periods. In case of a change in accounting policy, required disclosures to be
made.
b)
Any change in the accounting policies, which has a
material effect in the current period or expected to have a material effect in
a later period, should be disclosed.
4.6
Valuation Principles
There are several methods
of valuation of assets & liabilities, such as:-
1.
Historical Cost: Under this
principle, assets are recorded at cash (or cash equivalent) paid, or the fair
value of other consideration given to acquire them at the time of their
acquisition. Similarly, liabilities are recorded at the amount of cash received
or expected to receive in near future.
Example: An asset was purchased for Rs.19,00,000, so this is the historical cost
of the asset.
In case of tax payment, until the income is earned, tax payable amount
can not be determined. In such case, the tax liability is determined on the
basis of historical cost i.e. the estimated income amount will be historical
cost.
2.
Current Cost: Under this
valuation principle, assets are carried at the amount of cash or cash equivalent,
which have to be paid now to acquire 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.
Example: A liability is due to a creditor for Rs.5,000. So Rs.5,000 is
historical cost. Now the creditor informs that he will allow 6% discount on
instant cash payment. Thus the current cost of the liability will be [5,000-(6%
on 5,000) i.e.(5,000 – 300)= Rs.4,700.
3.
Realizable
Value: Under this principle, assets are carried out at the amount of cash or
cash equivalent that could currently be obtained by selling the assets. Similarly,
liabilities are carried out at the present value of future net cash out flows,
that are expected to be required, to settle the liabilities.
Example: An asset was purchased for Rs.15,00,000
3 years ago. Now its written down
value is Rs.10,00,000. It can correctly sell at Rs.13,00,000, and selling expense would be Rs. 2,000. Its
realizable value is (13,00,000 – 2,000)= Rs.12,98,000.
4.
Present Value: Under this
principle, assets are valued at present value of future net cash flows
generated by the assets. Similarly liabilities are carried at present value or
future net cash outflow to settle the liability.
Assets are carried at present value of future net cash flows generated
by the concerned assets in the normal course of business. Liabilities are
carried at present value of future net cash flows that are expected to be
required to settle the liability in the normal course of business.
Example: At the discount rate of 10%, present value of Re.1 after
1st year will be = 1/ (1+0.10)1 =0.909
2nd year will be = 1/ ((1+0.10) 2 =0.826 so on.
A liability of
Rs.10,000 is payable after 2 years. Its present value Rs.10,000 x .826 =
Rs.8,260.
4.7
Accounting Estimates
Financial Statements sometimes
require certain estimates to be made. Such estimate affects the balances of
assets and liabilities and their disclosure in financial statement.
It if the change in
accounting estimate has material effect, or expected to have material effect in
subsequent year, it should be disclosed. For example, estimates of useful life
of asset, provision for income tax, provision for bad debts etc. May vary from
actual, and should be disclosed in the financial statement.
4.8
Accounting Process or Cycle
Following are the steps of normal Accounting process or cycle -
-
First Process: Transactions are
recorded in books of original entries (like Journal).
-
Second Process: From the original books posting made in
ledger in various accounts. Each account is balanced at the end of a specified
period.
-
Third Process: Balance from
ledger (debit or credit) is transferred to a statement called Trial Balance.
The total of debit balances in Trial Balance should be equal to total of credit
balances. This statement forms the basis for preparation of Trading and Profit
& Loss A/c and Balance sheet.
-
Fourth Process: From Trial Balance,
balances of nominal accounts are transferred to Profit and Loss Account, while
remaining balances are transferred to Balance Sheet.
4.9 Double Entry System
The Double Entry System was
developed by Lucas Pacioli of Italy
Since one aspect of each
transaction is debited and other aspect is credited by equal amount, total of
all debits always tally to the total of all credits. It gives logical accuracy
of accounting records.
4.10 Classification of Account
An account represents a collection
of business transactions one place, relating to a particular head. Account may be broadly classifies as:
4.10.1 Personal Accounts: The accounts
which are related with real persons, artificial persons and representative
persons are called personal accounts. These may be of following types.
(i)
(a) Real or
natural person: For example Aamir’s A/c, Sourav’s Account.
(b) Proprietors A/c is represented by ‘Capital
account’ in respect of his investments in business, and by ‘drawings account’
for all that which he withdraws from business. So, capital account and drawings
account is also a sort of personal accounts.
(ii)
Artificial
persons’ accounts: Firms’ Account, Limited Companies Accounts, Banks
are known as artificial persons’ accounts.
(iii)
Representative
Account: All accounts representing outstanding expenses accrued or prepaid
incomes are representative accounts.
Rule for personal account: Debit
the receiver and Credit the giver.
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Example1: Cheque paid to Sourav of Rs.5,000.
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Sourav A/c
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Dr.
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5,000
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To BankA/c
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5,000
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Sourav, the receiver has been debited and Bank, the giver has been
credited. As the amount has been paid by cheque, the bank will be credited.
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Example3: Accrued Interest of Rs.400.
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Accrued Interest A/c
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Dr.
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400
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To Interest A/c
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400
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Accrued Interest A/c is a representative personal
account. It shows the amount earned but not yet received. When the amount will be received, the
Accrued Interest account will be credited and the cash account will be
debited.
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Example4: Prepaid Expense of Rs.400 has been paid.
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Prepaid Expense A/c
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Dr.
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400
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To Cash A/c
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400
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Prepaid expense is also a representative personal account.
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4.10.2 Real Accounts: Real Accounts represent
tangible assets (like Building, Furniture, Cash etc. as they have a physical
existence) and intangible assets (like trademarks and goodwill etc).
Rule
for real account: Debit what comes in, and Credit what goes out.
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Example: A Fixed asset is purchased for Rs.15,000.
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Fixed asset A/c
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Dr.
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15,000
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To Cash A/c
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15,000
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Fixed asset has been debited as it is coming into business. Cash has
been credited as it is going out.
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4.10.3 Nominal Accounts: Expenses and
income are called nominal accounts. (e.g. wages account, rent account etc).
Rule
for nominal account: Debit all losses and expenses and Credit all gains and
incomes.
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Example: Rent paid for Rs.1,500.
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Rent A/c
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Dr.
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1,500
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To Cash A/c
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1,500
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Rent has been debited as it is an expense.
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Example: Discount received for Rs.1,000.
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Cash A/c
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Dr.
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1,000
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To Discount Received A/c
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1,500
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Discount Received A/c is an
income so it has been credited.
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