Various Accounting Concepts

Welcome Friends, you are welcome to learnvern. I am Anshu Sachan.

In the last session we saw, Importance of Accounting. That is what are the benefits related to accounting. And also about how you can utilise the accounts in your business. In today’s topic we will be learning about, when we are writing an account then what are the accounting principles that would be used at that time. About what are the things that you need to remember when you are writing the account.

The first thing is matching Concepts. Friends I have already told you that whenever you are writing an account, then at that time you need to decide, for which accounting period are you writing the account for. Right. You should know the starting point, the starting period, and your ending period. Generally in our India, there are two things. There is a calendar year and a financial year. The calendar year is from January to December. The financial year is from April to March. In India we have taxation, the government collects tax from the individuals, Income Tax, that is from April to March. So, the business usually matches their accounting year to the financial year for taxation reasons. That is from April to March. Now we have decided that I want to write the account. From the period of April 2020 to March 2021. Okay.

According to matching concepts, the account that you are writing for the accounting period. During that same period, you need to record the transactions for the same period. As I have decided a period of April 2020 to March 2021. So anything related to that like, income, expense, assets and the liabilities, all the transactions, that are related to the business. And also the accounting transaction that involves a monetary value, those will be the only transaction that I will book. That was a matching concept. You only need to book the transaction, only for the same accounting period. The future transaction would be booked in the future. If a transaction is of April 2021, then the transaction would be booked in April 2021, and not right now. Okay, so this was a matching concept. Same thing for the income and expenses. Now you might ask why it is required? Look, we are making the account because we want to look at the profit for that particular year, to check if we have it or not. I also need to check the position of my business for that particular duration. Are you getting me? So, if I am making a profit and loss for the date of 31st March 2021. Then the expenses in that account should only be there from 2020 and 2021. If I were to book the expenses of April, then I would not be able to get a proper profit. Okay.

If you want proper profit and accurate positioning, then you need to follow the matching concept. Okay. This was all about matching concepts. Clear!

The second one is revenue recognition. Recognize means, when would you accept that it is your income now. If I have provided a service, then is the revenue made, should I book it now? I have received the money for the service that I have provided. Should I book the revenue of the income? It doesn't happen like that. What happens is, you need to recognise the revenue, when you think that this is your legal right. When you think that you can take money from the individual. It is a legal right and there is no doubt that I would not be receiving the money. There is no doubt related to that, and this is my revenue.

For instance, suppose you are providing a 12 month long service. Then in the middle you have your year end, its 31st March 2021 now. Okay. I have already provided the service for three months, but I have not yet received the money. I have also not also made an invoice as I promised the service for 12 months. So the invoice that will be made for the 12 months together. So should I not book the income? It's not like that. You have provided the service for 12 months. That is January, February and March. Now there is no doubt that you would not be getting the money. Okay. It is your legal right, as you have already provided the service. So if you do not get some part of the payment then you can also go to the court. As I have already provided the service for three months. So the person in front is bound to pay you the money. This is called revenue earned. This is the revenue that you have made and earned, but is yet to be recognized or realised. I have earned it but I am yet to receive the payment, so I can book the transaction, as it is my legal right.

I have provided the service, what if the company had paid advance for the 12 months of the service. The service is for 12 months, and the payment for the 12 month service has been paid, but you have only provided the service for 3 months only. Then you cannot recognise the payment for all 12 months. Okay. How much revenue can you recognize? Of only 3 months. In short, there is a line for recognizing the revenue, it is after the revenue is earned. And also when you have a legal right to that. When there is no doubt that you would not receive the money. Then at that time you can recognize the revenue. That was the revenue recognition concept.

The third thing is prudence. What is prudence? It is that you should never overstate your income or assets. Which is an assumption, that I would be getting a certain amount in future. You should not recognize it in advance. Okay. When you receive it in the future, in actuality, then at that time you would recognize it. There is also a second part of prudence. It is that you should never overstate your liabilities and also your expenses. What is overstatement? It is like if your expense is 500 and you book it as 1000. You should book it for 500 only.

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But when we talk about it in future. I might be incurring a loss of X amount in future. Like I have a court case for 600 but if I lose that case then I might need to pay 50 thousand. Now what happens is. The loss of the future, you can recognize it now. I had said earlier, you can not recognise the income, but can recognize the loss. Okay. So the payment that you need to make in future, make a provision for it right now.

As you might have heard about taxation. Provision for Taxation. How do we make the account? We make it from April to March. Then when do we file the return of the tax? It is usually during September. That is in the future. But we do the provision for it in advance. As this is the taxation that I need to pay, so provide for it. This was prudence.

Another thing is Materiality Concept. The materiality differs from business to business. How much is the turnover of the business, the way a transaction is happening in a business. It differs in these regards. Now for me, from the months of April to March, I had some expenses for the postage, or courrier. Now if the expense of these courier services is lower than 500 rupees then include them in the generalised expense. Do not make a new head for that expense. Do not make a new ledger for that expense. It is just 500 rupees, make a general ledger and put that in it, and don’t show it separately. Now if that same transaction, if I am a small business and I want to know how much was my courier spending, then at that time what I will do is. I will set a line as if the expense is around 500 rupees, then it will be generalised and if the total expense reaches more than 500 rupees, then I will make a different head for the same. This was a materiality concept. Every business needs to decide according to themselves. If the expense is more than a certain amount, if the expense is more than 5 thousand or 10 thousand. Then I will capitalise it. Okay. And if it is less than that, then I will club it in revenue in profit and revenue.

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The next thing is Revenue Vs Capital Concept. The materiality concept and the revenue vs capital concepts are both interlinked. Okay. For instance you purchase a mobile worth 10,000. But your company is big or your business is big, and the expenses like these keep happening. Then at that time you have set a line, that of the expense is till 15 thousand, then it will be booked in the profit and loss account and do not categorise it in assets. Then what I will do is, I will book telephone expenses worth 10 thousand in the profit and loss account. Okay. But, in terms of materiality concept, my business is not that big, and I have decided that the expense till 5000. I will show it in a profit and loss account and if the expense is larger than 5 thousand then at that time I will capitalise it, and count it as an asset. Now what has happened here is. My phone is worth 10 thousand, I will be calculating it under assets. In the head of Computer and Equipment, I will show a mobile purchasing expense as 10 thousand rupees. Now it has become an asset for it, it is not my expense and it will be visible in my balance sheet. Are you understanding it?

For a certain business it can be an expense but for another business it becomes an asset. Who gets to decide that? The management decides it. Management decides the cutoff, whether it should be 5 thousand or 10 thousand. The recognition depends upon the management. How will it get decided? It depends upon the business transaction, the turnaround of your business, your turnover, and the frequency of it. Generally what we do is, we provide our workers with a phone worth 5 to 6 thousand. And this our expense, and every 2 years I would have to make this expense again. Now what I do is, I generalise it and put it in the profit and loss account. Okay. I will book the expense there itself. 

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This was our materiality concept, that there is a limit. If it is more than the threshold, then book it as an asset, make a separate head for it. Similar to this is, revenue vs capital concept, as I just talked about the 10 thousand rupees mobile. So for one, if I count it as an expense, then it would be my revenue expense. If I count it as an asset then it would be my capital asset. Understood?

The last thing that is there is called Current Vs Non Current. Now what this is, we all have some liabilities. Suppose we have taken a loan from the bank for a term of 5 years. Okay. I would be paying the loan back in a term of 5 years. Now you all know that, for repayment of the loan there are many instalments, there are also things called principles and interest income and interest expense, that you need to pay. Now suppose you took a loan of 5 lac, that you need to repay in 5 years. Now suppose, in the next one year, you need to pay one lakh rupees. And in the next 4 years you need to pay another 4 lacs. Okay. Now, in this the first 1 lakh portion is called current liability, that you need to pay in one year. The remaining amount of 4 lacs that you need to pay in next 4 years, that is called non current. You need to show this in non current.

But what is the difference that it makes? What if I show 5 lacs together. As I need to pay 5 lacs altogether. So why should I show that 1 lakh separately and the remaining 4 lacs separately. It would be better if I showed 5 lacs together. It does not happen like that. Why Do we bifurcate, do you know? If you would know, there is a thing called ratio analysis. Like what is the liquidity ratio, that shows how much liquidity you have. Now what happens is, when you bifurcate it based on current and noncurrent, then you will be able to estimate, in the next 12 months or 1 year, how much money you would be spending. Okay. Whenever a Bank gives a loan to you, then at that time it looks at this liquidity ratio. To see how much a person is earning and how much does he or she have to give out. What does the bank know from this? It understands the outflow and the inflow for this individual. How much it is earning as inflow and the outflow, as to how much money he needs to spend in a year. On the basis of this the bank decides how much loan should be provided to an individual. So this is called current vs non current. Okay. There are current assets and there are non current assets. They are both liabilities. Okay

If you have any queries and comments……

In the next topic we will be looking at various accounting terminologies.

Until then Thank You.