Chapter -3

Theory Base of Accounting

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WHY ?�Theory base of accounting

For making the accounting information meaningful to its internal and external users, it is important that such information is reliable as well as comparable.

The comparability of information is required both to make inter-firm comparisons, i.e.to see how a firm has performed as compared to the other firms, as well as to make inter-period comparison, i.e. how it has performed as compared to the previous years.

This becomes possible only if the information provided by the financial statements is based on consistent accounting policies, principles and practices.

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Generally Accepted Accounting Principles�GAAP

GAAP refers to the rules or guidelines adopted for recording and

reporting of business transactions in order to bring uniformity in the preparation and the presentation of financial statements

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It refers to the necessary assumptions and ideas which are fundamental

to accounting practice

It refers to customs or traditions as a guide to the preparation of accounting statements.

From the practicability view point, it is observed that the various terms such as principles, postulates, conventions, modifying principles, assumptions, etc. have been used interchangeably and are referred to as Basic Accounting Concepts

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Basic Accounting Concepts

1. Business entity;
2. Money measurement;
3. Going concern;
4. Accounting period;
5. Cost
6. Dual aspect (or Duality);
7. Revenue recognition (Realisation);

8. Matching;
9. Full disclosure;
10. Consistency;
11. Conservatism (Prudence);
12. Materiality;
13. Objectivity.

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Business Entity Concept

• Business is treated as a separate entity or unit apart from its owner and others.
• All the transactions of the business are recorded in the books of business from the point of view of the business and not from point of view of businessman
• Even the owner is treated as a creditor to the extent of his/her capital.

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Examples�

• Insurance premiums for the owner’s house should be excluded from the expense of the business
• The owner’s property should not be included in the premises account of the business
• Any payments for the owner’s personal expenses by the business will be treated as drawings and reduced the owner’s capital contribution in the business

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Businessman

Business

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Money Measurement Concept

• In accounting, we record only those transactions which are expressed in terms of money.
• Qualitative feature of transactions are not recorded in accounting.
• Example : Good Management, Resignation of Director, loyal employees

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Money Measurement Concept

Records of the transactions are to be kept not in the physical units but in the monetary unit.

Factory 20 acers

Office building having 30 rooms

Bank balance

Rupees 50,000

1 Truck

Rupees

: 50 Lakh

Rupees

: 90 Lakh

Rupees

: 50,000

Rupees

: 5 Lakh

Total Assets :Rupees 145,50,000

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• The business will exists for a long time

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• There is no intention to close business or scale down its operations

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• Transactions are recorded from this point of view.

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Going concern concept

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I have no intention to close my business .My business will enjoy long life

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Businessman

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Examples

• Distinction is made between

Capital expenditure and Revenue expenditure

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• Fixed assets are recorded at their original cost and depreciated in a systematic manner

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Which give benefit for many years

Which give benefit for one year

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Accounting Period Principle

This life of a business is divided into a number of small periods which is known as accounting period

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Accounting Period Principle

It is done so that its performance is measured at regular intervals.

Profit and loss account is prepared for an accounting period to determine profit or loss

Balance sheet is drawn at to assess the financial position of the business

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Accounting Period Principle

The Companies Act 2013 and the Income Tax Act require that the income statements should be prepared annually.

Companies whose shares are listed on the stock exchange, are required to publish quarterly results to ascertain the profitability and financial position at the end of every three months period.

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Cost Concept

• All assets are recorded in the book of accounts at their purchase price, which includes cost of acquisition, transportation, installation and making the asset ready to use
• Example:
• A company purchases a Plant for Rs.50,00,000
• Rs.10,000 was spent on transporting the plant to the factory site.
• Rs.15,000 was spent on repairs for bringing the plant into running position and
• Rs.25,000 on its installation.

Plant will be recorded at Rs. 50,50,000

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At what price should I record Fixed assets of the business????

Market Price

Cost Price

All assets are recorded in the book of accounts

at their cost value

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Dual Aspect Concept

Each every transaction has a dual or two-fold effect and should therefore be recorded at two places

• At least two accounts will be involved in recording a transaction.
• The dual aspect can be expressed as under

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Dual Aspect Concept

Example 2

Goods purchased for cash Rs. 10,000

Cash Rs. 10,000

Stock Rs. 10,000

Two aspects are :

• Giving of cash
• Receiving of goods.

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Dual Aspect Concept

Example 1

Ram started business by investing in a sum of Rs. 50,00,000

Cash Rs. 50,00,000

Capital Rs. 50,00,000

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�Revenue Recognition Principle:-

This principle deals with the determination of the point of time when a revenue is to be recognized (recorded).

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It is important to know that it is not related to receipt of cash

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Example:

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• An organisation sells goods in January 2019,received cash in April 2020.Revenue of this sales is recognised in January 2019
• An organisation received advance in April 2019 for goods but if goods are sold or sent in July 2020, Revenue of this sales is recognised in July 2020

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Matching Principle :-�

• Matching concept implies that the expenses incurred to earn a revenue are to be matched with that revenue in order to ascertain the net profit or net loss made in a period.
• Revenues are recognized when they are earned, but not when cash is received and shown on Credit side of Profit and Loss Account
• Expenses are recognized as they are incurred, but not when cash is paid and shown on Debit side of Profit and Loss Account

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Expenses

Revenues

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NO , Salary

Finally got

Salary for March

31/3/2019

15/4/2019

EXAMPLE

In which month is salary taken as an expense ?

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MARCH

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OR

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APRIL

It is also taken as a liability in month of March,2019(Salary O/S)

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EXAMPLE

Rent of March ,2019 is received in July 2019?

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It is also taken as a Asset in month of March,2019(Accrued Rent)

In which month ,will business record this revenue

MARCH

OR

APRIL

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Principle Of Full Disclosure�

• All material and relevant facts concerning financial statements should be fully disclosed.
• This is to enable the users to make correct assessment about the profitability and financial soundness of the enterprise and help them to take informed decisions.
• Only material information (any fact or figure which has the capacity of altering the decisions of users associated with business)should be fully disclosed.

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The Indian Companies Act has provided a format for the preparation of Profit and Loss account and Balance sheet of a company, which needs to be compulsorily adhered to, for the preparation of these statements. The regulatory bodies like SEBI, also mandates complete disclosures to be made by the companies

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For example,�

• In a Balance Sheet the basis of valuation of assets, such as investments, inventories, land and building etc. should be clearly stated.
• Any change in the method of depreciation or in making provision for bad debts or creating any reserve must also be shown clearly in the Balance Sheet.
• Market value of investments should be given by way of a footnote
• Claim of a very big sum pending in a court of law against the enterprise should be brought to the notice of the users of the financial statements

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Concept of consistency�

• Same accounting practises should be used for year after year.
• If different accounting practices are used , then the result will not be comparable.
• Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company

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Example�

In case of charging depreciation on fixed assets accountant can decide to adopt

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diminishing value method

straight line method

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Different method of stock valuation that can be used by accountants are

LIFO

Or

FIFO

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�Principle of Prudence Or Conservatism

• It is based on the policy of playing safe.
• “Anticipate no profit, but provide for all possible losses”.

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• Benefit:This ensures the presentation of a realistic picture of business and not paints a better picture than what actually is.

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But make preparation for anticipated loss

Ignore anticipated profits

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Example�

• Stock valuation sticks to rule of the lower of cost and net realizable value(Market Value)
• The provision for doubtful debts or discount on debtors should be made
• Writing of intangible assets like goodwill, patents etc. as early as possible

CLOSING STOCK

MRP

Rs.50,000

Cost Price

Rs.40,000

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Principle Of Materiality�

• Only material information should be supplied to the users of accounting information.
• It is done so that accounting focus on material facts and efforts are not wasted in presenting the facts which are unimportant or immaterial.
• Material fact means the information of which will influence the decision of its user.
• The materiality of a fact depends on its nature and the amount involved.
• An item material for one organisation may not be material for another organisation

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For example:�

• Purchase of machinery is recorded as asset where as purchase of pen stand is not treated as asset and shown under stationery expenses.

• For business, Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses

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Verifiable Objective Principle�

• The accounting information should be free from bias and capable of independent verification.
• The information should be based upon verifiable evidences and should be supported by business documents like cash memo, bills, pay slips etc.

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This concept assumes that business has distinct and separate entity from its owners��

1. Going Concern

2. Accounting Period

3. Dual aspect

4. Separate Entity

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�All assets are recorded in the book of accounts at their cost price, which includes cost of acquisition, transportation, installation and making the asset ready for the use���

1. Going Concern

2. Separate entity

3. Cost concept

4. Dual Aspect

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Only those transactions and happenings in an organisation, which can be expressed in terms of money are to be recorded in the book of accounts.. ��

1. Full disclosure

2. Objectivity

3. Matching

4. Money measurement

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It assumes that a business firm would continue to carry out its operations indefinitely (for a fairly long period of time) and would not be liquidated in the near future.��

1. Matching Concept

2. Going concern

3. Prudence

4. Full disclosure

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��Accounting transactions should be recorded in the manner so that it is free from the bias of accountants and others.�

1. Going Concern

2. Accounting Period

3. Dual aspect

4. Objectivity

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Accounting should focus on material facts. If the item is likely to influence the decision of a reasonably prudent investor or creditor, it should be regarded as material, and shown in the financial statements. ��

1. Full disclosure

2. Objectivity

3. Matching

4. Materiality

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�Every transaction has a dual or two- fold effect on various accounts and should therefore be recorded at two places.���

1. Going Concern

2. Separate entity

3. Dual Aspect

4. Matching concept

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��The revenue for a business transaction should be considered realised when a legal right to receive it arises. .�

1. Matching concept

2. Accounting Period

3. Dual aspect

4. Revenue Recognition

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All material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes.��

1. Matching Concept

2. Full disclosure

3. Prudence

4. Going concern

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Identify the Accounting concept

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Identify the Accounting concept

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Accounting Concepts – Some Examples

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Accounting Concepts – Some Examples

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Identify the Accounting concept

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Accounting Concepts – Some Examples

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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Identify the Accounting concept

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