Tag: Cash Flow

Calculating a fire insurance claim involves several steps to ensure that the policyholder is compensated fairly for the loss or damage caused by fire. The process includes assessing the loss, verifying policy coverage, applying relevant clauses, and finally calculating the claim amount.

Notification of Fire Incident

The first step after a fire occurs is for the insured to notify the insurer about the fire incident. Prompt notification is crucial as it initiates the claim process and allows the insurer to assess the damage as early as possible. Most insurance policies specify a timeline within which the fire incident must be reported.

Assessment of Loss

After the insurer has been notified, a loss assessor or surveyor is appointed to inspect the property and estimate the extent of damage caused by the fire. The surveyor assesses:

• The condition of the property before the fire.
• The extent of damage to stock, machinery, and other assets.
• The salvage value of any damaged goods or property. The assessment forms the basis of the claim, determining how much of the property has been destroyed or damaged.

Calculation of the Value of Stock or Assets Lost:

In the case of businesses, the value of the stock lost in the fire is calculated. The insured needs to provide details of the stock on hand before the fire occurred. This can be derived from:

• Stock registers or accounts.
• Invoices and purchase records.
• Valuation of finished goods and raw materials.

The valuation of assets or stock is often done at cost price or market value, depending on the terms of the policy. If the stock was insured at invoice price, any profit margin already added is also considered.

Application of Policy Coverage Limits:

Every fire insurance policy has a maximum coverage limit or sum insured, which is the maximum amount the insurer is liable to pay. If the loss exceeds this limit, the policyholder will not be compensated for the excess. In such cases, the claim amount will be restricted to the sum insured.

Deduction of Salvage Value:

Salvage value refers to the residual value of any goods, property, or assets that can still be used or sold after the fire. The insurer reduces the claim amount by the salvage value, as the policyholder can recover some amount by selling or reusing salvageable items. This is essential for fair compensation as the insured should not be paid for goods that still retain some value.

Formula:

Net Loss = Total Loss − Salvage Value

Application of the Average Clause (if applicable)

Average clause is a provision in fire insurance that applies if the insured sum is less than the actual value of the property. In such cases, the policyholder is considered to have underinsured the property, and the insurer reduces the claim payout proportionally.

Formula for Average Clause:

Claim Amount = (Sum Insured / Actual Value of Property) × Net Loss

For example, if a property worth ₹10,00,000 is insured for ₹6,00,000 and suffers a loss of ₹4,00,000, the claim is reduced as follows:

Claim Amount = (₹6,00,000 / ₹10,00,000) × ₹4,00,000 = ₹2,40,000

The policyholder will only receive ₹2,40,000, instead of the full ₹4,00,000, because of underinsurance.

Consideration of Deductibles

Fire insurance policies often include deductibles or excess clauses, which are amounts the policyholder must bear out of pocket before the insurance coverage kicks in. For example, if the deductible is ₹50,000, and the total loss is ₹3,00,000, the insurer will pay only ₹2,50,000. Deductibles encourage policyholders to avoid making small claims and to take preventive measures.

Calculation of Business Interruption Loss (if applicable)

In cases where the policy covers loss of profit due to business interruption, the insurer compensates for the reduction in gross profit caused by the fire. To calculate business interruption loss, the following factors are considered:

• Historical profit trends.
• Fixed operating expenses (e.g., rent, salaries).
• The duration of business disruption. The amount paid for business interruption is based on the financial data provided by the insured, and it helps maintain financial stability while the business recovers from the fire.

Claim Settlement by Insurer

After assessing all the factors value of the loss, salvage, deductibles, and the average clause the insurer arrives at the final claim amount. Once agreed upon, the insurer pays the policyholder the claim, restoring them to their pre-loss financial position as closely as possible.

Example: Calculation of Fire Insurance Claim

• Value of stock before the fire: ₹15,00,000
• Loss of stock due to fire: ₹5,00,000
• Salvage value of remaining stock: ₹50,000
• Sum insured: ₹12,00,000
• Deductible: ₹25,000
• Actual value of stock: ₹15,00,000

Steps:

1. Calculate the Net Loss:

Net Loss = ₹5,00,000 − ₹50,000 = ₹4,50,000

2. Apply the Average Clause:

Since the sum insured (₹12,00,000) is less than the actual value (₹15,00,000), the average clause applies:

Claim Amount = (₹12,00,000 / ₹15,00,000) × ₹4,50,000 = ₹3,60,000

3. Apply the Deductible:

The final claim amount after deducting the policy deductible (₹25,000):

Final Claim = ₹3,60,000 − ₹25,000 = ₹3,35,000

The final payout by the insurer would be ₹3,35,000.

Minimum Rent (also known as Dead Rent) is a guaranteed payment that the lessee (tenant) must make to the lessor (landlord) irrespective of the actual production or sales. If the actual royalty based on production or sales exceeds the minimum rent, the lessee will pay the higher amount. However, if the royalty is lower than the minimum rent, short workings occur, which may be recouped in future periods when the actual royalty exceeds the minimum rent.

In this explanation, we will cover the journal entries and ledger accounts in the books of the lessee that include minimum rent, royalty, short workings, and recoupment of short workings.

Key Terms:

1. Minimum Rent (Dead Rent):

The fixed payment that the lessee must pay regardless of production.

2. Actual Royalty:

Royalty payment based on the actual production or sales.

3. Short Workings:

The difference between the minimum rent and actual royalty when the actual royalty is less than the minimum rent.

4. Recoupment of Short Workings:

Recovering short workings in future periods when actual royalty exceeds minimum rent.

Example Scenario

• Minimum Rent: ₹100,000
• Actual Royalty for Year 1: ₹80,000 (Short Workings: ₹20,000)
• Actual Royalty for Year 2: ₹120,000 (Recoupment of Short Workings: ₹20,000)

Journal Entries in the Books of Lessee:

Year 1: Actual Royalty is Less than Minimum Rent (Short Workings)

Year 2: Actual Royalty Exceeds Minimum Rent (Recoupment of Short Workings)

Ledger Accounts in the Books of Lessee

1. Minimum Rent Account

2. Royalty Account

3. Short Workings Account

4. Lessor’s Account

5. Short Workings Recouped Account

6. Bank Account

Explanation of Journal Entries

1. Year 1 (Short Workings):
   • The Royalty Account is debited with the actual royalty amount (₹80,000), and the Lessor’s Account is credited.
   • The Minimum Rent Account is debited with the guaranteed minimum rent (₹100,000), and the lessor is credited again.
   • The shortfall of ₹20,000 (short workings) is recorded by debiting the Short Workings Account and crediting the Minimum Rent Account.
   • The total amount due to the lessor is paid by debiting the Lessor’s Account and crediting the Bank Account.
2. Year 2 (Recoupment of Short Workings):
   • The actual royalty exceeds the minimum rent, so ₹120,000 is debited to the Royalty Account and credited to the Lessor’s Account.
   • The Minimum Rent Account is debited with ₹100,000, reflecting the minimum amount payable.
   • The Short Workings Recouped Account is debited with ₹20,000 (the amount of short workings recouped), and the Short Workings Account is credited.
   • Finally, the total payment of ₹120,000 is made to the lessor.

In a royalty agreement, the lessee (tenant) pays the lessor (landlord) for the use of land, property, or other resources. The lessee records journal entries for royalty payments, minimum rent (also known as dead rent), short workings, and recoupment of short workings in their books of accounts. These transactions are reflected in both the Journal Entries and Ledger Accounts.

Key Components in Lessee’s Books:

1. Royalty Payments:

Payments made by the lessee based on the actual production or sales of goods or resources.

2. Minimum Rent (Dead Rent):

The minimum payment that must be made to the lessor, regardless of production levels.

3. Short Workings:

The difference when the royalty based on actual production is less than the minimum rent.

4. Recoupment of Short Workings:

The process by which the lessee recovers the short workings in future years when actual production exceeds the minimum rent.

Example Scenario

Consider a situation where:

• Minimum Rent (Dead Rent) = ₹100,000
• Actual Royalty (based on production) = ₹80,000 in Year 1, ₹120,000 in Year 2
• Short Workings in Year 1 = ₹20,000 (₹100,000 – ₹80,000)
• Recoupment of Short Workings in Year 2 = ₹20,000

Journal Entries in the Books of Lessee

Ledger Accounts in the Books of Lessee:

1. Royalty Account

2. Minimum Rent Account

3. Short Workings Account

4. Lessor’s Account

5. Short Workings Recouped Account

6. Bank Account

Explanation of Journal Entries

1. Year 1 Entries:
   • The first entry records the royalty amount based on actual production.
   • The second entry records the minimum rent payable to the lessor.
   • The short workings are recorded when the actual royalty is less than the minimum rent.
   • Finally, the payment to the lessor is recorded by crediting the bank account.
2. Year 2 Entries:
   • The actual royalty exceeds the minimum rent, so no short workings are created.
   • The short workings from Year 1 are recouped by reducing the royalty payment in Year 2.

Explanation of Ledger Accounts

• Royalty Account reflects the actual royalty amounts based on production.
• Minimum Rent Account shows the minimum rent payable each year.
• Short Workings Account records the shortfall between minimum rent and actual royalty.
• Lessor’s Account tracks payments made to the lessor and any amounts owed.
• Short Workings Recouped Account tracks the amount of short workings recovered in subsequent years.
• Bank Account reflects the cash payments made to the lessor.

Royalty Accounts refer to the accounting treatment for payments made by one party (the licensee or lessee) to another (the licensor or lessor) for the right to use assets like patents, copyrights, trademarks, natural resources, or land. The payments, known as royalties, are often based on a percentage of revenue or production. In accounting, royalty expenses are recorded by the lessee as an operating expense, while the lessor records it as income, reflecting the earnings from the agreement.

Types of Royalties:

1. Patent Royalties

Patent royalties are paid by a licensee to a patent owner for the right to use, manufacture, or sell products or services based on the patented technology. These payments are usually a percentage of revenue or a fixed amount per unit sold. Companies that want to avoid developing proprietary technologies often pay patent royalties to leverage existing innovations.

2. Copyright Royalties

Copyright royalties are paid for the use of creative works like books, music, films, and software. Writers, musicians, and content creators earn these royalties when their work is used by others, such as publishers, broadcasters, or digital platforms. The payments are often a percentage of revenue generated from sales, downloads, or streaming.

3. Trademark Royalties

Trademark royalties are payments for the use of a registered trademark or brand. Companies may license their brand names or logos to others in exchange for royalties, typically in industries like franchising or merchandising. This helps maintain brand identity while generating income for the trademark owner.

4. Natural Resource Royalties

These royalties are paid to the owners of land or mineral rights for extracting natural resources like oil, gas, minerals, or timber. The payments are usually based on the volume or value of resources extracted. This type of royalty is common in the energy, mining, and forestry sectors.

5. Franchise Royalties

Franchise royalties are recurring payments made by a franchisee to the franchisor for using the brand, operational systems, and business model. They are usually a percentage of the franchisee’s gross revenue.

Parties in Royalties Accounting:

1. Licensor (Lessor)

The licensor is the party that owns the asset or rights being licensed. This could be intellectual property like patents, copyrights, trademarks, or physical assets such as land, minerals, or oil resources. The licensor allows the licensee to use these rights or assets in exchange for a royalty payment. The licensor benefits by earning revenue without having to directly exploit the asset themselves.

Accounting Treatment for the Licensor:

The royalty payments received by the licensor are recorded as income in their books. This income is typically recognized based on the royalty agreement, which could involve a fixed percentage of sales, production, or output.

• The journal entry for royalty income for the licensor is:
  • Debit: Bank or Accounts Receivable (when the payment is due or received)
  • Credit: Royalty Income Account (for the amount earned)

If there are minimum guaranteed royalties (MGRs) in the agreement, the licensor records the minimum amount as income even if the actual royalties fall short of the agreed threshold. Adjustments can be made in future periods if royalties exceed the minimum.

2. Licensee (Lessee)

Licensee is the party that pays the royalties for the right to use the licensor’s asset or intellectual property. The licensee might use a patent to manufacture products, extract minerals from land, or distribute copyrighted content. The licensee benefits by gaining access to valuable assets or intellectual property without the need to develop or acquire them directly.

Accounting Treatment for the Licensee:

• The royalty payments made by the licensee are treated as an operating expense and are recorded in their books under a royalty expense account.
• The journal entry for royalty payments for the licensee is:
  • Debit: Royalty Expense Account (for the amount paid or due)
  • Credit: Bank or Accounts Payable (depending on when the payment is made)

Similar to the licensor, if there is a minimum royalty payment clause in the agreement, the licensee must record the payment of the minimum amount even if the actual usage or output does not generate sufficient royalties.

3. Other Potential Parties

In more complex royalty arrangements, there could be additional parties, such as sub-licensees (who acquire rights from the original licensee) or intermediaries involved in collecting and distributing royalties. However, the primary relationship is between the licensor and licensee.

Important Terms in Royalties Accounting:

1. Royalty

Royalty is a payment made by a licensee to a licensor for the right to use an asset, intellectual property (IP), or natural resource. Royalties are typically calculated as a percentage of revenue, sales, or production, or as a fixed payment per unit.

2. Licensor (Lessor)

Licensor is the owner of the asset or IP that is being licensed. The licensor receives royalty payments in exchange for allowing the licensee to use the asset.

3. Licensee (Lessee)

Licensee is the party that pays royalties to the licensor in exchange for the right to use the licensor’s asset or IP. The licensee records royalty payments as an operating expense.

4. Minimum Guaranteed Royalty (MGR)

MGR is a minimum amount that the licensee agrees to pay the licensor, regardless of the actual revenue or usage of the licensed asset. If royalties based on actual sales fall below the minimum amount, the licensee must still pay the MGR.

5. Advance Royalties

Advance royalties are payments made by the licensee in advance, often before any revenue or production occurs. These advances are typically recouped by deducting them from future royalty payments.

6. Recoupable Royalties

This refers to the arrangement where the licensee can recover advance royalty payments from future earnings generated by the asset or IP.

7. Royalty Rate

Royalty rate is the percentage or fixed amount used to calculate the royalty payments. It is often defined in the royalty agreement and can vary based on revenue, units sold, or resources extracted.

8. Dead Rent

Dead rent is a fixed minimum amount of royalty paid by a lessee (in case of natural resource extraction, like mining) even if the production is less than expected or zero.

9. Short-workings

Short-workings refer to the difference when the actual royalty calculated is lower than the minimum guaranteed royalty (MGR). The licensee may be able to carry forward this amount and adjust it against future royalty payments.

10. Normal and Abnormal Losses

In the context of royalties based on production, normal losses are expected losses during the extraction or production process, while abnormal losses are unexpected and beyond the usual course of business. These affect royalty payments, especially in industries like mining and oil extraction.

11. Royalty Expense

For the licensee, royalty expense represents the amount paid to the licensor as per the royalty agreement. This is recorded as an operating expense in the licensee’s financial statements.

12. Royalty Income

For the licensor, royalty income represents the earnings received from the licensee. This is recorded as revenue or income in the licensor’s financial statements.

13. Overriding Commission

An Overriding commission is an additional commission paid to a party, often an agent, for overseeing a royalty agreement or managing consignment or franchise sales. This is separate from the basic royalty or commission.

14. Sub-License

Sub-license occurs when the original licensee grants permission to a third party to use the licensed asset. The original licensor may receive additional royalties from such agreements.

15. Exploitation Rights

These are the rights granted by the licensor to the licensee to use, sell, or otherwise exploit the licensed property or asset.

There are two methods for entering hire purchase transactions in the books of the hire- purchaser. The first is to enter transactions like ordinary purchases with the difference that interest is to be provided. This method recognizes the fact that the intention of the parties is to complete the purchase and to pay all the instalments. Hence, on purchase of machinery, machinery is debited and the hire vendor is credited with the cash price. When payment is made, the hire vendor is debited. At the end of each financial year, interest is credited to the hire vendor and debited to Interest Account. Depreciation is charged in the ordinary manner.

illustration 1:

Delhi Tourist Service Ltd. purchased from Maruti Udyog Ltd. a motor van on 1st April, 2009 the cash price being Rs 1,64,000. The purchase was on hire purchase basis, Rs 50,000 being paid on the signing of the contract and, thereafter, Rs 50,000 being paid annually on 31st March, for three years, Interest was charged at 15% per annum. Depreciation was written off at the rate of 25 per cent per annum on the reducing instalment system. Delhi Tourist Service Ltd. closes its books every year on 31st March. Prepare the necessary ledger accounts in the books of Delhi Tourist Service Ltd.

The other method of passing entries in the books of the hire purchaser seeks to recognize the fact that no property passes to the hire-purchaser till the final payment is made. Hence, no entry is passed when the contract is signed.

Entries are made at the time of payment of each instalment. The interest included in the instalment is debited to the interest account; the remaining amount is debited to the asset. Thus, if a payment is made down, the entry is to debit the asset and credit Bank, there being no interest when payment is made on the signing of the contract.

When the next instalment is paid, the entries will be:

1. Debit Asset Account

• Debit Interest Account
• Credit Hire Vendor; and

2. Debit Hire Vendor Credit Bank.

Depreciation must be allowed on the basis of the full cash price. This is because the whole asset is being used and because ultimately the asset must be paid for wholly.

The journal entries for the illustration number 3 given above, under this method will be as under:

Entries in Interest Account, Depreciation Account and Profit & Loss Account will be the same as have been passed under the first method.

Books of Hire-Vendor

The hire-vendor treats the hire purchase sale like an ordinary sale. He debits the hire purchaser with the full cash price and credits the Sales Account. Interest is debited to the hire purchaser when instalments become due. Cash received is, of course, credited to the hire purchaser.

In the books of the hire-vendor, the accounts pertaining to the above illustration will be as follows:

Illustration 2:

On 1st April, 2008, Ashok acquired machinery on hire purchase system from Modmac Ltd., agreeing to pay four annual instalments of Rs 60,000 each payable at the end of each year. There is no down payment. Interest is charged @ 20% per annum and is included in the annual instalments.

Because of financial difficulties, Ashok, after having paid the first and second instalments, could not pay the third yearly instalment due on 31st March, 2011, whereupon the hire vendor repossessed the machinery. Ashok provides depreciation on the Machinery @ 10% per annum according to the written down value method. He closes his books of account every year on 31st March. Show Machinery Account and the account of Modmac Ltd. for all the years in the books of Ashok. All workings should form part of your answer. [B.Com. (Hons.) Delhi, 1995 Modified]

Accounting is basically the systematic process of handling all the financial transactions and business records. In other words, Accounting is a bookkeeping process that records transactions, keeps financial records, performs auditing, etc. It is a platform that helps through many processes, for example, identifying, recording, measuring and provides other financial information.

Accounting is the language of finance. It conveys the financial position of the firm or business to anyone who wants to know. It helps to translate the workings of a firm into tangible reports that can be compared.

Accounting is all about the process that helps to record, summarize, analyze, and report data that concerns financial transactions.

Accounting is all about the term ALOE. Do not confuse it with the plant! ALOE is a term that has an important role to play in the accounting world and the understanding of the meaning of accounting. Here is what the acronym, “A-L-O-E” means.

• A: Assets
• L: Liabilities
• E: Owner’s Equity

This is one of the basic concepts of accounting. The equation for the same goes like this:

Assets = Liabilities + Owner’s Equity

Here is the meaning of every term that ALOE stands for.

(i) Assets: Assets are the items that belong to you and you are the owner of it. These items correspond to a “value” and can serve you cash in exchange for it.  Examples of Assets are Car, House, etc.

(ii) Liabilities: Whatever you own is a liability. Even a loan that you take from a bank to buy any sort of asset is a liability.

(ii) Owner’s Equity: The total amount of cash someone (anyone) invests in an organization is Owner’s Equity. The investment done is not necessarily money always. It can be in the form of stocks too.

Scope of Accounting

Accounting has got a very wide scope and area of application. Its use is not confined to the business world alone, but spread over in all the spheres of the society and in all professions. Now-a-days, in any social institution or professional activity, whether that is profit earning or not, financial transactions must take place. So there arises the need for recording and summarizing these transactions when they occur and the necessity of finding out the net result of the same after the expiry of a certain fixed period. Besides, the is also the need for interpretation and communication of those information to the appropriate persons. Only accounting use can help overcome these problems.

In the modern world, accounting system is practiced no only in all the business institutions but also in many non-trading institutions like Schools, Colleges, Hospitals, Charitable Trust Clubs, Co-operative Society etc.and also Government and Local Self-Government in the form of Municipality, Panchayat.The professional persons like Medical practitioners, practicing Lawyers, Chartered Accountants etc.also adopt some suitable types of accounting methods. As a matter of fact, accounting methods are used by all who are involved in a series of financial transactions.

The scope of accounting as it was in earlier days has undergone lots of changes in recent times. As accounting is a dynamic subject, its scope and area of operation have been always increasing keeping pace with the changes in socio-economic changes. As a result of continuous research in this field the new areas of application of accounting principles and policies are emerged. National accounting, human resources accounting and social Accounting are examples of the new areas of application of accounting systems.

Journal in accounting is a detailed record of all financial transactions of a business, capturing the date, accounts involved, amounts, and a brief description of each transaction. It serves as the first point of entry for transactions before they are posted to the general ledger. Maintaining an accurate journal is crucial for ensuring the integrity of financial records and provides a clear audit trail.

Nature of a Journal:

Journal is often referred to as the “book of original entry,” where transactions are initially recorded in chronological order. This means that transactions are recorded in the order they occur, providing a comprehensive timeline of the financial activities of the business. Journals help ensure that all transactions are accounted for and provide a basis for future financial reporting. Each entry in a journal is accompanied by relevant source documents, such as invoices, receipts, or contracts, which serve as evidence of the transaction.

Structure of a Journal

A typical journal entry consists of several key components:

1. Date: The date when the transaction occurred.
2. Account Titles: The names of the accounts affected by the transaction, with the debited account listed first and the credited account listed second.
3. Debit Amount: The amount being debited to the first account.
4. Credit Amount: The amount being credited to the second account.
5. Description: A brief explanation of the transaction.

The standard format for a journal entry looks like this:

Types of Journals:

1. General Journal:

This is the most common type of journal where all types of transactions are recorded that do not fit into specialized journals. It is used for recording adjusting entries, closing entries, and transactions that involve multiple accounts.

2. Special Journals:

These are used to record specific types of transactions to streamline the recording process. Common types of special journals:

• Sales Journal: Records all sales transactions made on credit.
• Purchases Journal: Records all purchases made on credit.
• Cash Receipts Journal: Records all cash received by the business.
• Cash Disbursements Journal: Records all cash payments made by the business.

Using special journals allows businesses to summarize similar transactions and reduces the time spent on posting to the general ledger.

Journalizing Process:

Journalizing is the process of recording transactions in the journal. Here’s how it typically works:

1. Identifying the Transaction: Determine the nature of the transaction and which accounts are affected.
2. Analyzing the Transaction: Assess whether each account is being debited or credited. This is guided by the double-entry accounting system, which states that every transaction must affect at least two accounts and that total debits must equal total credits.
3. Recording the Entry: Create a journal entry with the appropriate date, account titles, debit and credit amounts, and description.
4. Reviewing the Entry: Verify the accuracy of the journal entry to ensure that it reflects the transaction correctly.

Importance of Journals:

• Chronological Record:

Journals provide a chronological record of all transactions, making it easier to track and verify financial activities over time.

• Audit Trail:

A well-maintained journal serves as a valuable audit trail for both internal and external audits. Auditors can trace back transactions from the financial statements to the original journal entries.

• Error Detection:

By reviewing journal entries, accountants can identify errors or discrepancies early in the accounting process, facilitating timely corrections.

• Data Summary for Ledgers:

Journal entries serve as the source for postings to the general ledger, providing a summarized view of financial activity.

• Facilitating Financial Reporting:

Accurate journal entries are crucial for preparing reliable financial statements. They ensure that all transactions are accounted for, allowing for accurate revenue and expense recognition.

• Compliance and Accountability:

Maintaining a proper journal is essential for compliance with accounting standards and regulations. It helps businesses demonstrate transparency and accountability to stakeholders.

Accounting is basically the systematic process of handling all the financial transactions and business records. In other words, Accounting is a bookkeeping process that records transactions, keeps financial records, performs auditing, etc. It is a platform that helps through many processes, for example, identifying, recording, measuring and provides other financial information.

Accounting is the language of finance. It conveys the financial position of the firm or business to anyone who wants to know. It helps to translate the workings of a firm into tangible reports that can be compared.

Accounting is all about the process that helps to record, summarize, analyze, and report data that concerns financial transactions.

Accounting is all about the term ALOE. Do not confuse it with the plant! ALOE is a term that has an important role to play in the accounting world and the understanding of the meaning of accounting. Here is what the acronym, “A-L-O-E” means.

• A – Assets
• L – Liabilities
• E- Owner’s Equity

This is one of the basic concepts of accounting. The equation for the same goes like this:

Assets = Liabilities + Owner’s Equity

Here is the meaning of every term that ALOE stands for.

(i) Assets: Assets are the items that belong to you and you are the owner of it. These items correspond to a “value” and can serve you cash in exchange for it.  Examples of Assets are Car, House, etc.

(ii) Liabilities: Whatever you own is a liability. Even a loan that you take from a bank to buy any sort of asset is a liability.

(ii) Owner’s Equity: The total amount of cash someone (anyone) invests in an organization is Owner’s Equity. The investment done is not necessarily money always. It can be in the form of stocks too.

Scope of Accounting

Accounting has got a very wide scope and area of application. Its use is not confined to the business world alone, but spread over in all the spheres of the society and in all professions. Now-a-days, in any social institution or professional activity, whether that is profit earning or not, financial transactions must take place. So there arises the need for recording and summarizing these transactions when they occur and the necessity of finding out the net result of the same after the expiry of a certain fixed period. Besides, the is also the need for interpretation and communication of those information to the appropriate persons. Only accounting use can help overcome these problems.

In the modern world, accounting system is practiced no only in all the business institutions but also in many non-trading institutions like Schools, Colleges, Hospitals, Charitable Trust Clubs, Co-operative Society etc.and also Government and Local Self-Government in the form of Municipality, Panchayat.The professional persons like Medical practitioners, practicing Lawyers, Chartered Accountants etc.also adopt some suitable types of accounting methods. As a matter of fact, accounting methods are used by all who are involved in a series of financial transactions.

The scope of accounting as it was in earlier days has undergone lots of changes in recent times. As accounting is a dynamic subject, its scope and area of operation have been always increasing keeping pace with the changes in socio-economic changes. As a result of continuous research in this field the new areas of application of accounting principles and policies are emerged. National accounting, human resources accounting and social Accounting are examples of the new areas of application of accounting systems.

The following is a list of the ten main accounting principles and guidelines together with a highly condensed explanation of each.

• Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner’s personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.

2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar’s purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2018 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2018, or the 5 weeks ended May 1, 2018. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2017, the amount is known; but for the income statement for the three months ended March 31, 2018, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders’ equity, and statement of cash flows. Labeling one of these financial statements with “December 31” is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2018 the month ended December 31, 2018 the three months ended December 31, 2018 or the year ended December 31, 2018.

4. Cost Principle

From an accountant’s point of view, the term “cost” refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today’s market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company’s long-term assets, you will not get this information from a company’s financial statements–you need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of “footnotes” are often attached to financial statements.

As an example, let’s say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company’s financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2018 revenues as a bonus on January 15, 2019, the company should report the bonus as an expense in 2018 and the amount unpaid at December 31, 2018 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run.

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to “break a tie.” It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For example, potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported. Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

Accounting is the process of systematically recording, classifying, summarizing, and reporting financial transactions of a business. It helps measure a company’s financial performance, track assets and liabilities, and provide information for decision-making. Key concepts include the double-entry system, accrual accounting, and the preparation of financial statements like the balance sheet, income statement, and cash flow statement.

Accounting Concepts:

1. Business Entity Concept

This concept states that a business is a separate legal entity from its owners or shareholders. The financial transactions of the business are recorded separately from the personal transactions of the owners. This distinction ensures clarity and accuracy in the financial statements, as the business’s financial position and performance are reflected independently.

2. Money Measurement Concept

Only transactions that can be measured in monetary terms are recorded in the financial statements. Non-financial factors such as employee morale or brand reputation are not included, as they cannot be objectively measured in terms of money. This concept ensures that financial statements are quantifiable, making them easier to analyze and compare.

3. Going Concern Concept

The going concern concept assumes that a business will continue its operations indefinitely, unless there is evidence to suggest otherwise (such as bankruptcy or liquidation). This assumption affects how assets and liabilities are valued. For example, assets are recorded at their original cost rather than liquidation value, as they are expected to be used over time.

4. Cost Concept

According to the cost concept, assets are recorded in the books at their purchase cost, not their current market value. This means that the historical cost of an asset remains unchanged over time, even if its market value fluctuates. This concept ensures objectivity in financial statements, as the value of assets is based on verifiable transactions.

5. Dual Aspect Concept

The dual aspect concept is the basis of the double-entry system of accounting, which states that every transaction affects at least two accounts. For example, when a business purchases equipment, it results in an increase in assets (equipment) and a decrease in cash or an increase in liabilities (loan). This ensures that the accounting equation—Assets = Liabilities + Equity—remains balanced.

6. Accounting Period Concept

Financial reporting is done for specific periods, such as monthly, quarterly, or annually. The accounting period concept ensures that businesses prepare financial statements at regular intervals to provide timely information for decision-making. This allows stakeholders to assess the financial performance and position of the business over time.

7. Accrual Concept

The accrual concept states that transactions should be recorded when they occur, not when the cash is actually received or paid. Revenues are recognized when earned, and expenses are recognized when incurred, regardless of cash flow. This concept ensures that financial statements provide an accurate picture of a company’s financial performance during a specific period.

8. Matching Concept

Closely related to the accrual concept, the matching concept states that revenues and expenses should be matched to the same accounting period. In other words, expenses should be recognized in the period in which the related revenues are earned. This helps in determining the true profitability of a business for a specific period.

9. Materiality Concept

The materiality concept implies that only information that would affect the decisions of users should be included in the financial statements. Insignificant or immaterial information can be omitted. This concept ensures that financial statements are not cluttered with irrelevant details, making them easier to interpret.

10. Consistency Concept

Once a business adopts a specific accounting method or principle, it should continue to use it consistently in subsequent accounting periods. The consistency concept ensures that financial statements are comparable over time. However, if a change in accounting method is necessary, it must be disclosed and justified in the financial statements.

11. Prudence (Conservatism) Concept

The prudence concept advises accountants to exercise caution when recording financial transactions. This means recognizing expenses and liabilities as soon as they are known, but only recognizing revenues and assets when they are assured. The goal is to avoid overstating profits or assets, ensuring that financial statements present a conservative and reliable view of the business.

12. Full Disclosure Concept

The full disclosure concept requires that all relevant financial information is disclosed in the financial statements. This ensures that stakeholders have access to all the necessary data to make informed decisions. Important information that may not be included in the financial statements themselves should be disclosed in the notes to the accounts.

Accounting Conventions:

Accounting Conventions are widely accepted practices that guide the preparation of financial statements. While they are not legally binding, they provide a framework for consistent, accurate, and transparent accounting practices. These conventions help standardize how financial data is recorded, interpreted, and presented, making it easier for businesses to compare financial statements across time periods and industries. The four primary accounting conventions are consistency, full disclosure, conservatism, and materiality.

1. Consistency Convention

The consistency convention requires businesses to use the same accounting methods and practices from one accounting period to another. For example, if a company adopts the straight-line method for depreciation, it should continue using this method unless there is a justified reason for change. Consistency helps in comparing financial statements over multiple periods, allowing stakeholders to track trends and evaluate performance reliably. However, if a business changes its accounting practices, the change must be disclosed in the financial statements, along with an explanation of how it affects the financial results. This convention promotes transparency and comparability, making it easier for investors, auditors, and regulators to assess the company’s financial data over time.

2. Full Disclosure Convention

The full disclosure convention requires that all relevant and material financial information be fully disclosed in the financial statements. This includes not just the figures presented on the balance sheet, income statement, and cash flow statement, but also any information that may affect the users’ understanding of the financial condition of the business. For example, if a company is involved in a lawsuit that could significantly impact its financial position, this information must be disclosed in the notes to the accounts. Full disclosure ensures that stakeholders, such as investors, creditors, and regulators, have all the necessary information to make informed decisions. This practice fosters transparency and accountability in financial reporting.

3. Conservatism (Prudence) Convention

The conservatism convention, also known as the prudence convention, advises accountants to adopt a cautious approach when recording financial transactions. Under this convention, potential expenses and liabilities should be recorded as soon as they are known, while revenues and assets should only be recognized when they are reasonably certain. This conservative approach ensures that businesses do not overstate their financial performance or position. For example, if there is uncertainty about whether a debtor will repay a loan, the business should create a provision for doubtful debts. The goal of this convention is to present a realistic view of the financial condition, avoiding overly optimistic assessments that could mislead stakeholders.

4. Materiality Convention

The materiality convention dictates that only information that is significant enough to influence the decisions of stakeholders should be included in the financial statements. Immaterial or trivial information that would not affect users’ decisions can be omitted. For example, small office supplies purchased may not be itemized as individual assets but expensed immediately. This convention ensures that financial statements are not cluttered with insignificant details, making them easier to understand and analyze. Materiality is subjective and depends on the size and nature of the business, but it is guided by the principle that financial reporting should focus on information that is useful for decision-making.