 Good morning class. Before I get into the other five accounting concepts that we still have to be covered, just a quick clarification in last class's exercise that we did. There was one entry in which I was talking about the partner's capital, how that gets recorded as the owner's equity and in which the partner could get some portion of the retained earnings or also can draw from the partner's contribution and we made an example entry. In that there was a specific reference to an earnings amount of 30,000. While I had mentioned as 30,000, it actually the example is 35,000 that makes the total 91,000 tally otherwise if it is 30,000 the total is 86,000. So that is the minor correction that you will have to ensure. Now the remaining portion of this class I will be covering the remaining five accounting principles. Now you would have understood that with those six accounting principles that we had already covered, you had a fair understanding of how a balance sheet is created and what a balance sheet is and how these accounting principles are more or less balance sheet centric. Which explains that the remaining five accounting principles are more or less income statement centric or you need to have an understanding of what an income statement is so that you appreciate these accounting principles. Now I had already explained to the class that the income statement is a flow statement. It indicates the financial performance of an entity throughout a given period of time. Now the five accounting principles that we saw before was relevant to a balance sheet which I had already mentioned that it is a status report. Now if income statement is a flow statement which means it is over a period of time then the sixth accounting principle to begin with has to do something with the period that we are interested in understanding. So the sixth accounting principle is the accounting or the sixth accounting concept on which accounting principles are being framed is the accounting period concept. Now what do you mean by accounting period concept? It means that every entity we need to measure the activity of an entity for a specific interval of time for a specific period of time. No doubt that every entity is assumed to be a going concern as per one of the concept that we have already discussed. We need to observe the financial performance for specific intervals of time. Now how small or how big should this interval of time be depends on the type of entity that we are handling. I will give you two examples. The first example let us say the entity the character of the entity is in such a way that it does business only for short periods of time. Let us say at IIT here we are having a summer camp in swimming and there is an entity that conducts swimming camps coaching classes during summer for one month period. And this is the entity which means the time interval that is of concern to us is just that one month period. So one month period students come join pay fees there is expenses you incur those expenses at the end of one month period the summer camp concludes and then the entity disappears. This is one example where the interval that we are concerned is just this one month period. But invariably business entities operate beyond this one month time interval business entities are assumed to exist for an infinite period of time. So typically the interval that we are interested in understanding is more than this one month period. So we have this terminology called the fiscal period and for business entities which operate for an indefinite period of time as per the going concern going entity concept the longer time period is what we are interested. Now as the entity is a going concern we need some reasonable time intervals at which point of time we need to understand what has been the financial performance. So the accounting period concept says that define this specific time interval and invariably this definition this duration of this specific time interval is an alignment with what an accounting period is generally it is a one year period and that is why you find annual reports on an every year basis for various business entities year ending 2008, 9, 10, 11 and so on. So the accounting period in general for a going concern whose existence is for an infinite period of time is assumed to be one year that is a standard unit of accounting period which means for a majority of statutory purposes we submit income statement and a balance sheet for a one year period of time sales revenue at the end of one year during the period of one year and then we record expenses during this one year period based on which we find the financial performance. So this one year is a unit accounting period but having said that as somebody internal to the organization let us say I am the management I would like to know at different time slots what has happened to the entity. Let me for example say that I took a decision today and that I would like to know the impact of this decision on the income statement two months later three months later and I have already told you that the accounting system records every activity in a concern almost on a day to day basis which means two months later if I need to know what the balance sheet is and what the income statement is yes I can know about it. So for the purpose of analyzing the impact of certain decisions let us say within the next three month period I can say I will put a halt a time halt and at the end of the third month I can prepare an income statement and a balance sheet and this you would see normally when companies release quarterly results on one hand that is also a statutory requirement especially for listed companies probably the SEBI guidelines say that you will have to find quarterly return that is why you see companies announcing their quarterly results quarter one quarter two quarter three quarter four results. Now these are also income statements and balance sheets at the end of every quarter and when you look at the income statement and balance sheet at the end of every year this quarterly financial statements will be unit of those annual returns they will be integrated and they will they will form a part of the annual returns that you will see it would not be different but for the purpose of knowing in advance as somebody inside the organization as a management person I do not have to wait for one year to know the impact of certain decisions on the income statement I can know immediately on a quarterly basis if I want to do it on a fortnightly basis yes I can do it if I do it on a if I need to do it on a monthly basis yes I can do it but for the purpose of convenience and practicality quarterly statements are also filed so in general an accounting period means a specific interval a time interval which will provide some room for entities to understand record communicate and create these financial statements. So this is the accounting period concept which means that specific time intervals and there should be some reason reason reasonability in fixing those time intervals as I said before it could be quarterly and invariably one year time duration is the general norm the accepted norm where every and every one year an entity has to file its balance sheet and income statement. So an accounting period provides this specific time interval by which entities have to record and communicate all the activities that happen in that particular corresponding time interval in this case the general case is one year. So that is the accounting period concept where you have one year as the general norm and of course there is room for all your quarterly financial statements this is a very generic accounting concept. Now the next accounting concept is called the conservatism concept now conservatism concept is very important when it comes to the issue of recognizing revenues of an entity. See before I explain this conservatism concept you must understand two things that the revenue of an entity increases the owner's equity this we saw in last class and the expenses of the same entity decreases the owner's equity and it is this revenue minus expenses is your net income and I will explain this further when I actually talk about the income statement. Now this I am telling you now so that you do not get confused between revenue cash receipts revenue is not cash but you should understand that an activity that brings in revenue to an entity increases the owner's equity an activity that consumes or creates an expense to the entity reduces the owner's equity and the more revenue less is the expense the more is your net income increase in income means the owner's equity or the owner is better off here again you should not confuse between income and cash because increase in income means the owner is better off can we say that increase in cash also means that the owner is better off no assume that an entity borrows money and it is from that borrow well the cash balance has increased so it does not mean that the owner is better off. So there is a difference between income and cash now have this as the background I will give you some specific examples for you to understand this in a better light but for the purpose of conservatism concept have this as the background now the conservatism concept is essential because it is all about reporting financial statement is about reporting activities in an entity and specifically when we are talking about income statement we are reporting the revenue of an organization the revenue of an entity the sales revenue and the expenses which means the natural tendency as human beings is to report higher revenue so that you present the income statement in a form where the net profit or the net income is high the profitability is high this is the natural tendency favorable reporting if I can call it so which means there is a chance that you will also end up reporting revenues which actually is not earned or cannot be earned by the entity as a result of which we need some accounting safeguards against such favorable reporting because reporting is done by human being so we need some accounting safeguards against such favorable reporting and this concept of conservatism is the that accounting safeguard so this accounting safeguard ensures that there is no room for favorable reporting now how does this ensure the concept is that to recognize revenue you need better evidence than to recognize expenses so that is the fundamental premise of this conservatism concept which clearly says that recognizing revenue requires better evidence than recognizing expense and this is the accounting safeguard very reasonable because if you say that you have the entity as earned revenue conservatism says please provide me enough evidence that supports this claim that there is revenue activity if you say that the entity has incurred an expense then in terms of the evidence requirement it is not as strong a requirement as the case of revenue is I will give you a very small example suppose you are running a dealer network you are you are running an automobile dealership you are selling cars somebody walks into your store let us say it is a Mercedes Benz so somebody says I want to buy a Mercedes Benz car as a salesperson you provide him all product literature provide all product features everything then he says well I like this car so I have decided that I will buy this car next month and then come this month end you are filing the quarterly results let us say now the question is based on the interaction that you had with a prospective customer would you at the end of this month record the conversation that just gave you little signal that somebody is going to buy a Mercedes Benz from you and because he told you that he is going to buy it next month will you record this as a sales revenue that is the question that you will have to answer now the principle of conservatism says no do not record this as a revenue for this month because the sales transaction has not happened at all it is just that the customer said I will come next month and buy the car so let the customer come and buy the car let there be some evidence that endorses your claim that the revenue transaction has happened now there again there will be two specific cases one the customer will say here is my return communication to that effect that I am going to buy the car and then I will do the payment later there is a different case also how to interpret this that I will come to that a little later but even without that return communication it is not advisable to record a revenue based on just an assurance somebody says that I will buy this car next month now come to another different example the same dealership store the Godowns manager comes and reports that one Mercedes Benz car is missing now as somebody who is running that entity I have every confidence that the moment that a larger complaint that I will get that Mercedes Benz car probably three months four months later but again end of this month I will have to file my financial statement the question is whether you will report this missing Mercedes as a bad expense or not conservatism concept says you report this missing Mercedes Benz as a bad expense despite the fact that you are very confident that you will get the car two months three months later I think you are able to understand the difference so conservatism concept says that I need strong evidence to support revenue claims and the slightest evidence possible is enough to record expenses so to put it in proper understanding perspective conservatism says recognize revenue only if you are reasonably certain about it so there should be an element of certainty when it comes to recognizing revenues but when it comes to recognizing expenses conservatism says you recognize expenses if it is reasonably possible when the slightest possibility that it could be an expense please record it as an expense please recognize it as an expense that is the principle of conservatism now why is this essential because if you look at revenue recognition some applications one is a direct sales revenue where you sell something you get cash so there is no doubt in that it is recorded as sales revenue there is also something called accounts receivable it means that you sell something on credit somebody promises to pay something the money after a brief period of time I already gave you this example before even in this case based on historical customer relationship entities record this as a sales revenue and when they receive the amount for that it just gets adjusted with cash and accounts receivable a different form of accounts receivable is also accrued revenues this is nothing but similar to accounts receivable let us say for a bank it has given money it is supposed to earn interest and at the end of the period it does not get the interest for the loan amount but it records that as a revenue because it will get the interest revenue after a period of time this is a form of accounts receivable but then you would also find some entities using this word accrued revenue so when it comes to revenue recognition you have a revenue activity that generates cash immediately after it happens or the revenues recognized but cash comes into the entity later so that is why initially I said you will have to appreciate the difference between revenue and cash receipts I will give you a small example for you to understand that because you need to really appreciate the distinction between revenue and cash receipts now for example let us say case 1 a cash sale made this year okay so we are talking about this year this is the amount let us say 200 rupees worth cash sales was made this year let us see how this affects cash receipts and sales revenue or just revenue cash receipts and revenue now if it is cash sale made this year which means I got cash this year itself and principle of conservatism says because you just got cash for the sale you do not require a better evidence because there is cash for the sale so you recognize that as a revenue credit sales made last year credit sales made last year cash received this year let us say the amount of credit sale that was made last year was 300 it is the entire amount that was received as cash this year so what would be the cash receipts this year 300 and assume that this customer was a credit worthy customer which means the principle of conservatism says though you did not receive cash at least there is strong evidence because of the credit worthiness of the customer you recognize that as a sales revenue and since this is a credit sale that was made last year this has already been recognized as a sales revenue in last year remember we are talking about this year so there is no sales revenue for this transaction this year next example is credit sales made this year cash received this year let us say the amount is 400 this try again I received cash this year itself for a credit sale which was made sometime earlier already recognized as a revenue and hence you also recognize this as a revenue for this year itself the fourth case is cash sorry credit sale made this year and cash received next year let us say the amount is 100 now what happens in your cash receipt it is a credit sale I have not received any cash and are you going to recognize this as a revenue yes because this customer is already a credit worthy customer so for this year sales I recognize this as a revenue but not as cash receipt because I have not received cash for this year so if you look at the total it is 900 here and 700 here this is the point that I want to make that your revenue is not equal to the cash receipts for this particular year because you have already recognized revenues for which you are collecting cash this year or you have recognized revenues this year and collected cash this year or the third case is you have recognized revenue this year for which you are going to collect cash next year so all these three combinations exist but that does not prevent you from recording sales revenue for a particular year because you are reasonably certain that for a credit worthy customer of this type I can recognize this as revenues for this particular year because there is strong evidence to support that the last 10 years that I have been servicing this customer I have been able to collect all the cash for which I have made credit sales so this is the principle of conservatism which says you recognize revenues if you are reasonably certain and recognize expenses if there is a reasonable possibility you need strong evidence to support revenue claims and the slightest evidence for an expense you please recognize it as an expense so this is the principle of conservatism the next principle is realization concept the next concept that governs the eighth accounting principle is the concept of realization now the previous one the recognition of revenue the recognition concept or the conservatism concept is about timing when should I recognize revenues and expenses so a realization concept is about amount how much should be realized as revenues are expenses so realization is about amount for example you go to grocery store you buy something you pay cash the grocery store recognizes that as a revenue and also realizes the entire amount as against going to a grocery store and you say I will pay the entire amount one month later and on a recognition concept you find this customer doing this very often and that he has paid the entire amount the subsequent month so you recognize there is a revenue and if your experience has been that every time he pays he pays the entire amount then your realization concept says you record the entire amount as revenue during that time or if your experience has been that there were occasions and more often in the recent past that this customer has ended up paying only 90% of what he is supposed to pay but nevertheless I am going to recognize as a revenue in that case you realize that revenue to the extent of 90% and then the remaining 10% you can treat it as a bad expense so remember the principle of recognition is about timing whether I have to recognize that as a sales revenue this period itself vis-a-vis the realization concept having recognized that as a revenue how much is the amount that I should realize whether it is the entire 100% the 100% credit worthy or otherwise if it is otherwise to what extent is this revenue realizable to what amount can I realize this revenue is decided by the realization concept the next concept is the matching concept in matching concept already told you that revenue and expenses affect the retained earnings so a given event will affect revenues and expenses so the matching concept says the effect of an event that on both the revenues and expenses must be recorded within the same accounting period so both the effects for let us say sales generating item I mean a sales generating event the effect of that and the revenues and the corresponding expenses of this event has to be recorded within the same accounting period that is the matching concept you match revenues and related expenses to that particular revenue within the same accounting period so that you do not overestimate your net income and hence your retained earnings or do not end up underestimating your net income or your net retained earnings so it says if an event affects both revenue and expense the effect on both must be recognized or recorded in the same accounting period so this avoids any mismatch over estimation or under estimation of revenue or expenses whatever the case may be now the next concept is consistency concept now different activities happen in a business entity there will be some activities which have a particular character and that you have decided that for activities of this particular type I am using this method to record these transactions and when you have chosen to use a particular method for entries belonging to the same character as much as possible try to retain the same method unless you have compelling reasons to differ in the methodology I will give you a small example and I will explain about this in detail when we talk more about depreciation depreciation as I told you is the cost of using an asset now there are different methods of depreciation I can either use a simple straight forward linear straight line method or accelerated depreciation is also possible or sums of digits method is also possible so different ways of depreciating an asset but if I have decided for assets of a particular type I am going to follow straight line method then the principle of consistency says that you adopt the same method when it comes to depreciating assets of this particular type every accounting period do not keep changing the depreciation method rather it is like you say straight line for this year next year I am going to follow accelerated the next there is sums of digits and again back to straight line no do not do that as long as you continue to adopt the same methodology to record entries of similar character activities then you follow the principle of consistency now why is it essential it is essential because let us say we are comparing financial performance and to compare the performance of the entity we use an income statement and balance sheet and if you are comparing it over a five year period how the entity has performed in the last five years immediately I look at the income statement and balance sheet to make the comparison now only if I am able to follow the same method to record entries of identical types would then be possible for me to make a good comparison now if the way in which I have recorded these transactions have followed different methods in each of these five years then I would not be doing a fair comparison I would not be doing a fair performance analysis of the firm it is for that purpose it is always advised because of this principle of consistency to use the same method for recording entries of similar character why because comparison is easy does it mean that I should not change methodologies yes you can change methodology as long as you have enough reasons compelling reasons that usually you will find in an annual report or an income statement balance sheet there is something called an auditor's note where the auditor would have explained that till last year I was following the firm was following the straight line method for depreciation and it is from this year that it is switching over to an accelerated mode and you will have reasons explained for that so it is possible for you to change the methodology but as long as you are not changing the methodology it is easy to make a comparison and hence that consistency is required to ensure that you follow the common identical methodologies when it comes to recording entries of identical character now the last concept is materiality concept now what is this materiality concept now the materiality concept is very simple there is a doctrine in law which says minimis noncura which means this law this doctrine in law says that the court will not consider trivial matters this is what this means the court is least bothered about trivial issues now extending this doctrine to the materiality concept accounting is not concerned with trivial events there should be an exact line that separates material events and immaterial events see you will understand that the principle of conservatism or the realization concept there is always a room for subjectivity because you think somebody is credit worthy there will always be another person who will think the same person is not credit worthy you think you can realize 100% of the sales revenue recognized there is somebody who will always think that I can realize only 75% there is always room for subjectivity as a result of which there will be judgmental errors and as long as it falls within an accepted framework which has some reasonability we accept the financial statements that are prepared in similar lines the materiality concept there will be some events which I think it is immaterial for me to record that I will give you one example let us say the business entity the the office administrative office purchases stationary pens pencils erasers markers and all that no doubt that the pen pencil marker that you purchase is an asset to the administrative office no but does that mean that you are going to record every pens that you purchase and suppose you are going to use that pen for three years will you be depreciating the pen at the end of every year pencils will you be depreciating every month no then what is the alternative I would say I record it as an expense for that particular year which means I just say I I purchased pen pencils erasers for 10,000 rupees and it got consumed during that particular year whether it is consumed or not that is a different issue it is a different issue or probably it is not even material enough for me to see whether check whether this has been consumed in that year or not and if it is not consumed then the extent to which it is consumed is only treated as an expense and whatever remaining half pencil or the pen that you have has to be recorded as an asset no that entire 10,000 rupees is treated as an expense for that particular year so in essence the materiality concept says you ignore such immaterial events what you should be looking at is those significant material events and it is only those events that you should be exercising enough caution proper judgment in measuring the worth of that event and communicating it properly there is not a big error in your financial statement because you failed to record some of those immaterial events properly now that you have failed to record it but record it properly it is okay because it is immaterial but the same will not protect you when it comes to recording events of great material value so these 11 concepts the 5 that we saw before and the 6 that we saw now quick recap as to what they are first we started off with money measurement then going concern cost concept the principle of duality then was the entity concept that says the individual is different from the concern and the other 6 concepts the accounting period concept the conservatism concept the realization concept the matching concept consistency concept and materiality concept these 11 concepts from the fundamentals for the accounting principles now why these are important as I told you before is because it removes to a certain extent some levels of subjectivity I am not saying that all of those who will be following these concepts will have the same level of objectivity but at least it would remove some reasonable levels of subjectivity when it comes to recording these transactions now we know these 11 concepts what are we going to do with these 11 concepts just as the 5 concepts were enough for us to understand this balance sheet in the 6 concepts that we saw today importantly the principle of conservatism and the realization concept these 2 will have an impact on an income statement because an income statement records your revenue and you will record your revenue when only when you think you have recognized it and to what extent you record as a revenue depends on to what extent you have realized that revenue so it is very important from an income statement point of view the matching concept says the moment you have recognized revenues make sure that those expenses related to that particular revenue gets recorded within the same accounting period so you are also interested in knowing what these expenses are so you have revenue you have expenses and revenue minus expenses is your income and with revenues expenses and income you will be able to estimate the financial performance of an entity of this statement that captures the revenue expense and the income is your income statement so when we sit for next class I will give you a very brief overview of what an income statement is what constitutes an income statement and then we will start the basics on double entry bookkeeping the income statements I told you before is essential because it provides some inputs to understand the financial performance of an entity so when we meet next class we will talk about income statement and also double entry bookkeeping thank you.