Unit 1

Over the centuries, accounting has remained confined to the financial

record-keeping functions of the accountant. But, today’s rapidly changing
business environment has forced the
accountants to reassess their roles and functions both within the organisation and
the society. The role of an accountant has now shifted from that of a mere recorder
of transactions to that of the member providing relevant information to the
decision- making team. Broadly speaking, accounting today is much more than
just book-keeping and the preparation of financial reports. Accountants are now
capable of working in exciting new growth areas such as: forensic accounting
(solving crimes such as computer hacking and the theft of large amounts of money
on the internet); e-commerce (designing web-based payment system); financial
planning, environmental accounting, etc. This
realisation came due to the fact that accounting is capable of providing the kind of
information that managers and other interested persons need in order to make
better decisions. This aspect of accounting gradually assumed so much
importance that it has now been raised to the level of an information system.
As an information system, it collects data and communicates economic
information about the organisation to a wide variety of users whose decisions and
actions are related to its performance. This introductory chapter therefore, deals
with the nature, need and scope of accounting in this context.

1.1 Meaning of Accounting

In 1941, The American Institute of Certified Public Accountants (AICPA) had
defined accounting as the art of recording, classifying, and summarising in a
significant manner and in terms of money, transactions and events which
are, in part at least, of financial character, and interpreting the results
thereof’. With greater economic development resulting in changing role of
accounting, its scope, became broader. In 1966, the American Accounting
Association (AAA) defined accounting as ‘the process of identifying, measuring
and communicating economic information to permit informed judgments and
decisions by users of information’.
Fig. 1.1 : Showing the process of accounting
In 1970, the Accounting Principles Board of AICPA also emphasised that the
function of accounting is to provide quantitative information, primarily
financial in nature, about economic entities, that is intended to be useful in
making economic decisions.
Accounting can therefore be defined as the process of identifying,
measuring, recording and communicating the required information relating to
the economic events of an organisation to the interested users of such
information. In order to appreciate the exact nature of accounting, we must
understand the following relevant aspects of the definition:
• Economic Events
• Identification, Measurement, Recording and Communication
• Organisation
• Interested Users of Information

1.1.1 Economic Events

Business organisations involves economic events. An economic event is known
as a happening of consequence to a business organisation which consists
of transactions and which are measurable in monetary terms. For example,
purchase of machinery, installing and keeping it ready for manufacturing is
an event which comprises number of financial transactions such as buying
a machine, transportation of machine, site preparation for installation of
a machine, expenditure incurred on its installation and trial runs. Thus,
accounting identifies bunch of transactions relating to an economic event. If an
event involves transactions between an outsider and an organisation, these are
known as external events. The following are the examples of such transactions:
• Sale of merchandise to the customers.
• Rendering services to the customers by ABC Limited.
• Purchase of materials from suppliers.
• Payment of monthly rent to the landlord.
An internal event is an economic event that occurs entirely between the
internal wings of an enterprise, e.g., supply of raw material or components
by the stores department to the manufacturing department, payment of
wages to the employees, etc.
1.1.2 Identification, Measurement, Recording and Communication
Identification : It means determining what transactions to record, i.e., to identity
events which are to be recorded. It involves observing activities and selecting
those events that are of considered financial character and relate to the
organisation. The business transactions and other economic events therefore
are evaluated for deciding whether it has to be recorded in books of account.
For example, the value of human resources, changes in managerial policies or
appointment of personnel are important but none of these are recorded in
books of account. However, when a company makes a sale or purchase, whether
on cash or credit, or pays salary it is recorded in the books of account.
Measurement : It means quantification (including estimates) of business
transactions into financial terms by using monetary unit, viz. rupees and
paise as a measuring unit. If an event cannot be quantified in monetary
terms, it is not considered for recording in financial accounts. That is why
important items like the appointment of a new managing director, signing of
contracts or changes in personnel are not shown in the books of accounts.
Recording : Once the economic events are identified and measured in financial
terms, these are recorded in books of account in monetary terms and in a
chronological order. Recording is done in a manner that the necessary financial
information is summarised as per well-established practice and is made
available as and when required.
Communication : The economic events are identified, measured and recorded
in order that the pertinent information is generated and communicated in
a certain form to management and other internal and external users. The
information is regularly communicated through accounting reports. These
reports provide information that are useful to a variety of users who have an
interest in assessing the financial performance and the position of an enterprise,
planning and controlling business activities and making necessary decisions
from time to time. The accounting information system should be designed in
such a way that the right information is communicated to the right person at
the right time. Reports can be daily, weekly, monthly, or quarterly, depending
upon the needs of the users. An important element in the communication
process is the accountant’s ability and efficiency in presenting the relevant
information.
1.1.3 Organisation
Organisation refers to a business enterprise, whether for profit or not-for-profit
motive. Depending upon the size of activities and level of business operation,
it can be a sole-proprietory concern, partnership firm, cooperative society,
company, local authority, municipal corporation or any other association of
persons.

1.1.4 Interested Users of Information

Accounting is a means by which necessary financial information about business
enterprise is communicated and is also called the language of business. Many
users need financial information in order to make important decisions.
These users can be divided into two broad categories: internal users and
external users. Internal users include: Chief Executive, Financial Officer, Vice
President, Business Unit Managers, Plant Managers, Store Managers, Line
Supervisors, etc. External users include: present and potential Investors
(shareholders), Creditors (Banks and other Financial Institutions,
Debenture-holders and other Lenders), Tax Authorities, Regulatory Agencies
(Department of Company Affairs, Registrar of Companies, Securities Exchange
Board of India, Labour Unions, Trade Associations, Stock Exchange and
Customers, etc. Since the primary function of accounting is to provide useful
information for decision- making, it is a means to an end, with the end being
the decision that is helped by the availability of accounting information. You
will study about the types of accounting information and its users later in
this chapter.

Box 2
Why do the Users Want Accounting Information?

• The owners/shareholders use them to see if they are getting a satisfactory return
on their investment, and to assess the financial health of their company/business.

• The directors/managers use them for making both internal and external
comparisons in their attempts to evaluate the performance. They may compare the
financial analysis of their company with the industry figures in order to
ascertain the company’s strengths and weaknesses. Management is also
concerned with ensuring that the money invested in the company/organisation
is generating an
 adequate return and that the company/organisation is able to pay its debts and
remain solvent.
• The creditors (lenders) want to know if they are likely to get paid and look
particularly at liquidity, which is the ability of the company/organisation to pay
its debts as they become due.
• The prospective investors use them to assess whether or not to invest their money
in the company/organisation.

• The government and regulatory agencies such as Registrar of companies, Custom

departments IRDA, RBI, etc. require information for the payment of various taxes
such as Value Added Tax (VAT), Income Tax (IT), Customs and Excise duties for
protecting the interests of investors, creditors(lenders), and also to satisfy the legal
obligations imposed by The Companies Act 2013 and SEBI from time-to-time.

1.2 Accounting as a Source of Information

As discussed earlier, accounting is a definite processes of interlinked activities,
(refer figure 1.1) that begins with the identification of transactions and ends
with the preparation of financial statements. Every step in the process of
accounting generates information. Generation of information is not an end
in itself. It is a means to facilitate the dissemination of information among
different user groups. Such information enables the interested parties to take
appropriate decisions. Therefore, dissemination of information is an essential
function of accounting. To be useful, the accounting information should
ensure to:
• provide information for making economic decisions;
• serve the users who rely on financial statements as their principal source
of information;
• provide information useful for predicting and evaluating the amount,
timing and uncertainty of potential cash-flows;
• provide information for judging management’s ability to utilise resources
effectively in meeting goals;
• provide factual and interpretative information by disclosing underlying
assumptions on matters subject to interpretation, evaluation, prediction,
or estimation; and
• provide information on activities affecting the society.
The role of an accountant in generating accounting information is to observe,
screen and recognise events and transactions to measure and process them,
and thereby compile reports comprising accounting information that are
communicated to the users. These are then interpreted, decoded and used
by management and other user groups. It must be ensured that the
information provided is relevant, adequate and reliable for decision-making.
The apparently divergent needs of internal and external users of accounting
information have resulted in the development of sub-disciplines within the
accounting discipline namely, financial accounting, cost accounting and
management accounting
Financial accounting assists keeping a systematic record of financial
transactions the preparation and presentation of financial reports in order
to arrive at a measure of organisational success and financial soundness. It
relates to the past period, serves the stewardship function and is monetary in
nature. It is primarily concerned with the provision of financial information
to all stakeholders.
Cost accounting assists in analysing the expenditure for ascertaining the
cost of various products manufactured or services rendered by the firm and
fixation of prices thereof. It also helps in controlling the costs and providing
necessary costing information to management for decision-making.
Management accounting deals with the provision of necessary
accounting information to people within the organisation to enable them in
decision-making, planning and controlling business operations. Management
accounting draws the relevant information mainly from financial accounting
and cost accounting which helps the management in budgeting, assessing
profitability, taking pricing decisions, capital expenditure decisions and so on.
Besides, it generates other information (quantitative and qualitative,
financial and non-financial) which relates to the future and is relevant for
decision-making in the organisation. Such information includes: sales
forecast, cash flows, purchase requirement, manpower needs, environmental
data about effects on air, water, land, natural resources, flora, fauna, human
health, social responsibilities, etc.
As a result, the scope of accounting has become so vast, that new areas
like human resource accounting, social accounting, responsibility accounting
have also gained prominance.

1.2.1 Qualitative Characteristics of Accounting Information

Qualitative characteristics are the attributes of accounting information which
tend to enhance its understandability and usefulness. In order to assess
whether accounting information is decision useful, it must possess the
characteristics of reliability, relevance, understandability and comparability.

Reliability
Reliability means the users must be able to depend on the information.
The reliability of accounting information is determined by the degree of
correspondence between what the information conveys about the transactions
or events that have occurred, measured and displayed. A reliable information
should be free from error and bias and faithfully represents what it is meant
to represent. To ensure reliability, the information disclosed must be credible,
verifiable by independent parties use the same method of measuring, and be
neutral and faithful (refer figure 1.3).

Box 3
Branches of Accounting

The economic development and technological advancements have resulted in an

increase in the scale of operations and the advent of the company form of business
organisation. This has made the management function more and more complex and
increased the importance of accounting information. This gave rise to special branches
of accounting. These are briefly explained below :
Financial accounting : The purpose of this branch of accounting is to keep a record
of all financial transactions so that:
(a) the profit earned or loss sustained by the business during an accounting period
can be worked out,
(b) the financial position of the business as at the end of the accounting period
can be ascertained, and
(c) the financial information required by the management and other interested
parties can be provided.
Cost Accounting : The purpose of cost accounting is to analyse the expenditure so
as to ascertain the cost of various products manufactured by the firm and fix the
prices. It also helps in controlling the costs and providing necessary costing
information to management for decision-making.
Management Accounting : The purpose of management accounting is to assist the
management in taking rational policy decisions and to evaluate the impact of its
decisons and actions.

Relevance
To be relevant, information must be available in time, must help in prediction
and feedback, and must influence the decisions of users by :
(a) helping them form prediction about the outcomes of past, present or
future events; and/or
(b) confirming or correcting their past evaluations.

Understandability
Understandability means decision-makers must interpret accounting
information in the same sense as it is prepared and conveyed to them. The
qualities that distinguish between good and bad communication in a
message are fundamental to the understandability of the message. A
message is said

Qualitative Characteristics of Accounting Information

Decision Makers
(Users of Accounting Information)
Understandability

Decision Usefulness

Relevance Reliability

Timeliness

Dedicative Feedback Verifiability Faithfulness

Value Value

Neutrality

Comparability

Fig. 1.3 : The qualitative characteristics of accounting information

to be effectively communicated when it is interpreted by the receiver of the

message in the same sense in which the sender has sent. Accountants should
present the comparable information in the most intenlligible manner
without sacrificing relevance and reliability.

Comparability
It is not sufficient that the financial information is relevant and reliable at a
particular time, in a particular circumstance or for a particular reporting
entity. But it is equally important that the users of the general purpose financial
reports are able to compare various aspects of an entity over different time
period and
with other entities. To be comparable, accounting reports must belong to a
common period and use common unit of measurement and format of reporting.
Objectives of Accounting

As an information system, the basic objective of accounting is to provide

useful information to the interested group of users, both external and
internal. The necessary information, particularly in case of external users, is
provided in the form of financial statements, viz., profit and loss account and
balance sheet. Besides these, the management is provided with additional
information from time to time from the accounting records of business. Thus,
the primary objectives of accounting include the following:

1.2.2 Maintenance of Records of Business Transactions

Accounting is used for the maintenance of a systematic record of all financial
transactions in book of accounts. Even the most brilliant executive or
manager cannot accurately remember the numerous amount of varied
transactions such as purchases, sales, receipts, payments, etc. that takes
place in business everyday. Hence, a proper and complete records of all
business transactions are kept regularly. Moreover, the recorded information
enables verifiability and acts as an evidence.

1.2.3 Calculation of Profit and Loss

The owners of business are keen to have an idea about the net results of their
business operations periodically, i.e. whether the business has earned profits or
incurred losses. Thus, another objective of accounting is to ascertain the profit

earned or loss sustained by a business during an accounting period which can

be easily workout with help of record of incomes and expenses relating to the
business by preparing a profit or loss account for the period. Profit represents
excess of revenue (income), over expenses. If the total revenue of a given period
is ` 6,00,000 and total expenses are ` 5,40,000 the profit will be equal to
` 60,000(` 6,00,000 – ` 5,40,000). If however, the total expenses exceed the
total revenue, the difference reflects the loss.

1.2.4 Depiction of Financial Position

Accounting also aims at ascertaining the financial position of the business
concern in the form of its assets and liabilities at the end of every accounting
period. A proper record of resources owned by business organisation (Assets)
and claims against such resources (Liabilities) facilitates the preparation of a
statement known as balance sheet position statement.
1.2.5 Providing Accounting Information to its Users
The accounting information generated by the accounting process is
communicated in the form of reports, statements, graphs and charts to the
users who need it in different decision situations. As already stated, there are
two main user groups, viz. internal users, mainly management, who needs
timely information on cost of sales, profitability, etc. for planning, controlling
and decision-making and external users who have limited authority, ability
and resources to obtain the necessary information and have to rely on
financial statements (Balance Sheet, Profit and Loss account). Primarily, the
external users are interested in the following:
• Investors and potential investors-information on the risks and return on
investment;
• Unions and employee groups-information on the stability, profitability and
distribution of wealth within the business;
• Lenders and financial institutions-information on the creditworthiness of
the company and its ability to repay loans and pay interest;
• Suppliers and creditors-information on whether amounts owed will be
repaid when due, and on the continued existence of the business;
• Customers-information on the continued existence of the business and
thus the probability of a continued supply of products, parts and after
sales service;

• Government and other regulators- information on the allocation of

resources and the compliance to regulations;
• Social responsibility groups, such as environmental groups-information
on the impact on environment and its protection;
• Competitors-information on the relative strengths and weaknesses of their
competition and for comparative and benchmarking purposes. Whereas the
above categories of users share in the wealth of the company, competitors
require the information mainly for strategic purposes.
1.3 Role of Accounting
For centuries, the role of accounting has been changing with the changes
in economic development and increasing societal demands. It describes and
analyses a mass of data of an enterprise through measurement, classification
and summarisation, and reduces those date into reports and statements,
which show the financial condition and results of operations of that
enterprise. Hence, it is regarded as a language of business. It also performs
the service activity by providing quantitative financial information that helps
the users in various ways. Accounting as an information system collects and
communicates economic information about an enterprise to a wide variety of
interested parties. However, accounting information relates to the past
transactions and is quantitative and financial in nature, it does not provide
qualitative and non- financial information. These limitations of accounting
must be kept in view while making use of the accounting information.

1.4 Basic Terms in Accounting

1.4.1 Entity
Entity means a reality that has a definite individual existence. Business entity
means a specifically identifiable business enterprise like Super Bazaar, Hire
Jewellers, ITC Limited, etc. An accounting system is always devised for a specific
business entity (also called accounting entity).

1.4.2 Transaction
An event involving some value between two or more entities. It can be a
purchase of goods, receipt of money, payment to a creditor, incurring
expenses, etc. It can be a cash transaction or a credit transaction.

1.4.3 Assets
Assets are economic resources of an enterprise that can be usefully expressed
in monetary terms. Assets are items of value used by the business in its
operations. For example, Super Bazar owns a fleet of trucks, which is used
by it for delivering foodstuffs; the trucks, thus, provide economic benefit to
the enterprise. This item will be shown on the asset side of the balance sheet
of Super Bazaar. Assets can be broadly classified into two types: current and
Non-current (Figure 1.4).
Figure 1.4 : Classification of Assets
1.4.4 Liabilities

Liabilities are obligations or debts that an enterprise has to pay at some time in
the future. They represent creditors’ claims on the firm’s assets. Both small and big
businesses find it necessary to borrow money at one time or the other, and to
purchase goods on credit. Super Bazar, for example, purchases goods for
` 10,000 on credit for a month from Fast Food Products on March 25, 2005. If
the balance sheet of Super Bazaar is prepared as at March 31, 2005, Fast Food
Products will be shown as creditors on the liabilities side of the balance sheet. If Super
Bazaar takes a loan for a period of three years from Delhi State Co-operative Bank,
this will also be shown as a liability in the balance sheet of Super Bazaar. Liabilities
are classified as current and non-current (Figure 1.5).

Liabilities

Non-Current Current
Liabilities Liabilities

Deferred Tax Other Long Short Term Trade Short Term

Long Term Long Terms Other Current
Liabilities Term Borrowings Payables Provisions
Borrowings Provisions Liabilities
(Net) Liabilities

Figure 1.5 : Classification of LiabilitiesCapital

Amount invested by the owner in the firm is known as capital. It may be brought in
the form of cash or assets by the owner for the business entity capital is an
obligation and a claim on the assets of business. It is, therefore, shown as capital on
the liabilities side of the balance sheet.
1.4.5 Sales
Sales are total revenues from goods or services sold or provided to customers. Sales
may be cash sales or credit sales.

1.4.6 Revenues
These are the amounts of the business earned by selling its products or providing
services to customers, called sales revenue. Other items of revenue common to many
businesses are: commission, interest, dividends, royalities, rent received, etc.
Revenue is also called income.

1.4.7 Expenses
Costs incurred by a business in the process of earning revenue are known as
expenses. Generally, expenses are measured by the cost of assets consumed or
services used during an accounting period. The usual items of expenses are:
depreciation, rent, wages, salaries, interest, cost of heater, light and water, telephone,
etc.
1.4.8 Expenditure
26
Spending money or incurring a liability for some benefit, service or property received
is called expenditure. Purchase of goods, purchase of machinery, purchase of
furniture, etc. are examples of expenditure. If the benefit of expenditure is exhausted
within a year, it is treated as an expense (also called revenue expenditure). On the
other hand, the benefit of an expenditure lasts for more than a year, it is treated as
an asset (also called capital expenditure) such as purchase of machinery, furniture,
etc.

1.4.9 Profit
The excess of revenues of a period over its related expenses during an accounting
year is profit. Profit increases the investment of the owners.

1.4.10 Gain
A profit that arises from events or transactions which are incidental to business such
as sale of fixed assets, winning a court case, appreciation in the value of an asset.

1.4.11 Loss
The excess of expenses of a period over its related revenues its termed as loss. It
decreases in owner’s equity. It also refers to money or money’s worth lost
(or cost incurred) without receiving any benefit in return, e.g., cash or goods lost by
theft or a fire accident, etc. It also includes loss on sale of fixed assets.

1.4.12 Discount
Discount is the deduction in the price of the goods sold. It is offered in two ways.
Offering deduction of agreed percentage of list price at the time selling goods is
one way of giving discount. Such discount is called ‘trade discount’. It is generally
offered by manufactures to wholesellers and by wholesellers to retailers. After
selling the goods on credit basis the debtors may be given certain deduction in
amount due in case if they pay the amount within the stipulated period or earlier.
This deduction is given at the time of payment on the amount payable. Hence, it is
called as cash discount. Cash discount acts as an incentive that encourages prompt
payment by the debtors.

1.4.13 Voucher
The documentary evidence in support of a transaction is known as voucher. For
example, if we buy goods for cash, we get cash memo, if we buy on credit, we get an
invoice; when we make a payment we get a receipt and so on.

1.4.14 Goods
It refers to the products in which the business unit is dealing, i.e. in terms of which it
is buying and selling or producting and selling. The items that are purchased for use in
the business are not called goods. For example, for a furniture dealer purchase of
 chairs and tables is termed as goods, while for other it is furniture and is treated as an
asset. Similarly, for a stationery merchant, stationery is goods, whereas for others it is
an item of expense (not purchases)

1.4.15 Drawings
Withdrawal of money and/or goods by the owner from the business for personal
use is known as drawings. Drawings reduces the investment of the owners.

1.4.16 Purchases
Purchases are total amount of goods procured by a business on credit and on
cash, for use or sale. In a trading concern, purchases are made of merchandise for
resale with or without processing. In a manufacturing concern, raw materials are
purchased, processed further into finished goods and then sold. Purchases may be
cash purchases or credit purchases.
1.4.17 Stock
Stock (inventory) is a measure of something on hand-goods, spares and other
items in a business. It is called Stock in hand. In a trading concern, the stock on
hand is the amount of goods which are lying unsold as at the end of an accounting
period is called closing stock (ending inventory). In a manufacturing company, closing
stock comprises raw materials, semi-finished goods and finished goods on hand on
the closing date. Similarly, opening stock (beginning inventory) is the amount of
stock at the beginning of the accounting period.

1.4.18 Debtors
Debtors are persons and/or other entities who owe to an enterprise an amount for
buying goods and services on credit. The total amount standing against such persons
and/or entities on the closing date, is shown in the balance sheet as sundry debtors on
the asset side.

1.4.19 Creditors
Creditors are persons and/or other entities who have to be paid by an enterprise an
amount for providing the enterprise goods and services on credit. The total amount
standing to the favour of such persons and/or entities on the closing date, is shown in
the Balance Sheet as sundry creditors on the liabilities side.

As discussed in the previous chapter, accounting is concerned with the recording,

classifying and summarising of financial transactions and events and
interpreting the results thereof. It aims at providing information about the
financial performance of a firm to its various users such as owners, managers
employees, investors, creditors, suppliers of goods and services and tax authorities
and help them in taking important decisions. The investors, for example, may be
interested in knowing the extent of profit or loss earned by the firm during a given
period and compare it with the performance of other similar enterprises. The
suppliers of credit, say a banker, may, in addition, be interested in liquidity 28
position of the enterprise. All these people look forward to accounting for
appropriate, usefuland reliable information.
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. Such consistency is required throughout the process of identifying the
 26

events and transactions to be accounted for, measuring them,

communicating them in the book of accounts, summarising the results
thereof and reporting them to the interested parties. This calls for
developing a proper theory base of accounting.
The importance of accounting theory need not be over-emphasised as no
discipline can develop without a sound theoretical base. The theory base of
accounting consists of principles, concepts, rules and guidelines developed over
a period of time to bring uniformity and consistency to the process of
accounting and enhance its utility to different users of accounting information.
Apart from these, the Institute of Chartered Accountants of India, (ICAI),
which is the regulatory body for standardisation of accounting policies in the
country has issued Accounting Standards which are expected to be uniformly
adhered to, in order to bring consistency in the accounting practices. These
are discussed in the sections to follow.

2.1 Generally Accepted Accounting Principles

In order to maintain uniformity and consistency in accounting records, certain
rules or principles have been developed which are generally accepted by the
accounting profession. These rules are called by different names such as
principles, concepts, conventions, postulates, assumptions and modifying
principles.
The term ‘principle’ has been defined by AICPA as ‘A general law or rule
adopted or professed as a guide to action, a settled ground or basis of conduct
or practice’. The word ‘generally’ means ‘in a general manner’, i.e., pertaining
to many persons or cases or occasions. Thus, Generally Accepted Accounting
Principles (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. For example, one of
the important rule is to record all transactions on the basis of historical cost,
which is verifiable from the documents such as cash receipt for the money paid.
This brings in objectivity in the process of recording and makes the accounting
statements more acceptable to various users.
The Generally Accepted Accounting Principles have evolved over a long
period of time on the basis of past experiences, usages or customs, statements
by individuals and professional bodies and regulations by government agencies
and have general acceptability among most accounting professionals. However,
the principles of accounting are not static in nature. These are constantly
influenced by changes in the legal, social and economic environment as well
as the needs of the users.
These principles are also referred as concepts and conventions. The term
concept refers to the necessary assumptions and ideas which are fundamental
to accounting practice, and the term convention connotes customs or traditions
as a guide to the preparation of accounting statements. In practice, the same
rules or guidelines have been described by one author as a concept, by another
as a postulate and still by another as convention. This at times becomes
confusing to the learners. Instead of going into the semantics of these terms,
it is important to concentrate on the practicability of their usage. From the
practicability view point, it is observed that the various terms such as principles,
postulates, conventions, modifying principles, assumptions, etc. have been
used inter-changeably and are referred to as Basic Accounting Concepts in the
present chapter.

2.2 Basic Accounting Concepts

The basic accounting concepts are referred to as the fundamental ideas or
basic assumptions underlying the theory and practice of financial accounting
and are broad working rules for all accounting activities and developed by
the accounting profession. The important concepts have been listed as
below:

• Business entity;
• Money measurement; • Matching;
• Going concern; • Full disclosure;
• Accounting period; • Consistency;
• Cost • Conservatism (Prudence);
• Dual aspect (or Duality); • Materiality;
• Revenue recognition (Realisation); • Objectivity.

2.2.1 Business Entity Concept

The concept of business entity assumes that business has a distinct and
separate entity from its owners. It means that for the purposes of accounting,
the business and its owners are to be treated as two separate entities. Keeping
this in view, when a person brings in some money as capital into his business,
in accounting records, it is treated as liability of the business to the owner. Here,
one separate entity (owner) is assumed to be giving money to another distinct
entity (business unit). Similarly, when the owner withdraws any money from
the business for his personal expenses(drawings), it is treated as reduction of
the owner’s capital and consequently a reduction in the liabilities of the
business.
The accounting records are made in the book of accounts from the point of view
of the business unit and not that of the owner. The personal assets and liabilities
of the owner are, therefore, not considered while recording and reporting the
assets and liabilities of the business. Similarly, personal transactions of the
owner are not recorded in the books of the business, unless it involves inflow
or outflow of business funds.
 28

2.2.2 Money Measurement Concept

The concept of money measurement states that only those transactions and
happenings in an organisation which can be expressed in terms of money
such as sale of goods or payment of expenses or receipt of income, etc., are
to be recorded in the book of accounts. All such transactions or happenings
which can not be expressed in monetary terms, for example, the appointment
of a manager, capabilities of its human resources or creativity of its research
department or image of the organisation among people in general do not find
a place in the accounting records of a firm.
Another important aspect of the concept of money measurement is that the
records of the transactions are to be kept not in the physical units but in the
monetary unit. For example, an organisation may, on a particular day, have
a factory on a piece of land measuring 2 acres, office building containing 10
rooms, 30 personal computers, 30 office chairs and tables, a bank balance of
`5 lakh, raw material weighing 20-tons, and 100 cartons of finished goods.
These assets are expressed in different units, so can not be added to give any
meaningful information about the total worth of business. For accounting
purposes, therefore, these are shown in money terms and recorded in rupees
and paise. In this case, the cost of factory land may be say ` 2 crore; office
building ` 1 crore; computers `15 lakh; office chairs and tables ` 2 lakh; raw
material ` 33 lakh and finished goods ` 4 lakh. Thus, the total assets of the
enterprise are valued at ` 3 crore and 59 lakh. Similarly, all transactions are
recorded in rupees and paise as and when they take place.
The money measurement assumption is not free from limitations. Due to the
changes in prices, the value of money does not remain the same over a period
of time. The value of rupee today on account of rise in prices is much less than
what it was, say ten years back. Therefore, in the balance sheet, when we add
different assets bought at different points of time, say building purchased in
1995 for ` 2 crore, and plant purchased in 2005 for ` 1 crore, we are in fact
adding heterogeneous values, which can not be clubbed together. As the change
in the value of money is not reflected in the book of accounts, the accounting
data does not reflect the true and fair view of the affairs of an enterprise.

2.2.3 Going Concern Concept

The concept of going concern assumes that a business firm would continue to
carry out its operations indefinitely, i.e. for a fairly long period of time and
would not be liquidated in the foreseeable future. This is an important
assumption of accounting as it provides the very basis for showing the value
of assets in the balance sheet.
 An asset may be defined as a bundle of services. When we purchase an
asset, for example, a personal computer, for a sum of ` 50,000, what we are
buying really is the services of the computer that we shall be getting over its
estimated life span, say 5 years. It will not be fair to charge the whole amount
of ` 50,000, from the revenue of the year in which the asset is purchased.
Instead, that part of the asset which has been consumed or used during a
period should be charged from the revenue of that period. The assumption
regarding continuity of business allows us to charge from the revenues of a
period only that part of the asset which has been consumed or used to earn
that revenue in that period and carry forward the remaining amount to the
next years, over the estimated life of the asset. Thus, we may charge ` 10,000
every year for 5 years from the profit and loss account. In case the continuity
assumption is not there, the whole cost (` 50,000 in the present example)
will need to be charged from the revenue of the year in which the asset was
purchased.
2.2.4 Accounting Period Concept
Accounting period refers to the span of time at the end of which the financial
statements of an enterprise are prepared, to know whether it has earned
profits or incurred losses during that period and what exactly is the position of
its assets and liabilities at the end of that period. Such information is required
by different users at regular interval for various purposes, as no firm can wait
for long to know its financial results as various decisions are to be taken at
regular intervals on the basis of such information. The financial statements
are, therefore, prepared at regular interval, normally after a period of one year,
so that timely information is made available to the users. This interval of time
is called accounting period.
The Companies Act 2013 and the Income Tax Act require that the income
statements should be prepared annually. However, in case of certain situations,
preparation of interim financial statements become necessary. For example, at
the time of retirement of a partner, the accounting period can be different from
twelve months period. Apart from these 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.
 30

2.2.5 Cost Concept

The cost concept requires that 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. To illustrate, on June 2005,
an old plant was purchased for ` 50 lakh by Shiva Enterprise, which
is into the business of manufacturing detergent powder. An amount of
` 10,000 was spent on transporting the plant to the factory site. In addition,
` 15,000 was spent on repairs for bringing the plant into running position
and ` 25,000 on its installation. The total amount at which the plant will
be recorded in the books of account would be the sum of all these, i.e.
` 50,50,000.
The concept of cost is historical in nature as it is something, which has
been paid on the date of acquisition and does not change year after year.
For example, if a building has been purchased by a firm for ` 2.5 crore, the
purchase price will remain the same for all years to come, though its market
value may change. Adoption of historical cost brings in objectivity in
recording as the cost of acquisition is easily verifiable from the purchase
documents. The market value basis, on the other hand, is not reliable as the
value of an asset may change from time to time, making the comparisons
between one period to another rather difficult.
However, an important limitation of the historical cost basis is that it does
not show the true worth of the business and may lead to hidden profits. During
the period of rising prices, the market value or the cost at (which the assets can
be replaced are higher than the value at which these are shown in the book of
accounts) leading to hidden profits.

2.2.6 Dual Aspect Concept

Dual aspect is the foundation or basic principle of accounting. It provides the
very basis for recording business transactions into the book of accounts. This
concept states that every transaction has a dual or two-fold effect and should
therefore be recorded at two places. In other words, at least two accounts
will be involved in recording a transaction. This can be explained with the
help of an example. Ram started business by investing in a sum of `
50,00,000. The amount of money brought in by Ram will result in an increase
in the assets (cash) of business by ` 50,00,000. At the same time, the owner’s
equity or capital will also increase by an equal amount. It may be seen that
the two items that got affected by this transaction are cash and capital
account.
Let us take another example to understand this point further. Suppose
the firm purchase goods worth ` 10,00,000 on cash. This will increase an
asset (stock of goods) on the one hand and reduce another asset (cash) on
the other. Similarly, if the firm purchases a machine worth ` 30,00,000 on
credit from Reliable Industries. This will increase an asset (machinery) on
the one hand and a liability (creditor) on the other. This type of dual effect takes
place in case of all business transactions and is also known as duality
principle.
The duality principle is commonly expressed in terms of fundamental
Accounting Equation, which is as follows :

Assets = Liabilities + Capital

In other words, the equation states that the assets of a business are
always equal to the claims of owners and the outsiders. The claims also called
equity of owners is termed as Capital(owners’ equity) and that of outsiders, as
Liabilities(creditors equity). The two-fold effect of each transaction affects in
such a manner that the equality of both sides of equation is maintained.
The two-fold effect in respect of all transactions must be duly recorded
in the book of accounts of the business. In fact, this concept forms the core
of Double Entry System of accounting, which has been dealt in detail, in
chapter 3.
2.2.7 Revenue Recognition (Realisation) Concept
The concept of revenue recognition requires that the revenue for a business
transaction should be included in the accounting records only when it is
realised. Here arises two questions in mind. First, is termed as revenue and
the other, when the revenue is realised. Let us take the first one first.
Revenue is the gross inflow of cash arising from (i) the sale of goods and
services by an
 32

enterprise; and (ii) use by others of the enterprise’s resources yielding interest,
royalties and dividends. Secondly, revenue is assumed to be realised when a
legal right to receive it arises, i.e. the point of time when goods have been sold
or service has been rendered. Thus, credit sales are treated as revenue on the
day sales are made and not when money is received from the buyer. As for
the income such as rent, commission, interest, etc. these are recongnised on
a time basis. For example, rent for the month of March 2017, even if received
in April 2017, will be taken into the profit and loss account of the financial
year ending March 31, 2017 and not into financial year beginning with April
2017. Similarly, if interest for April 2017 is received in advance in March
2017, it will be taken to the profit and loss account of the financial year ending
March 2018.
There are some exceptions to this general rule of revenue recognition. In
case of contracts like construction work, which take long time, say 2-3 years
to complete, proportionate amount of revenue, based on the part of contract
completed by the end of the period is treated as realised. Similarly, when goods
are sold on hire purchase, the amount collected in installments is treated as
realised.

2.2.8 Matching Concept

The process of ascertaining the amount of profit earned or the loss incurred
during a particular period involves deduction of related expenses from the
revenue earned during that period. The matching concept emphasises
exactly on this aspect. It states that expenses incurred in an accounting
period should be matched with revenues during that period. It follows from
this that the revenue and expenses incurred to earn these revenues must
belong to the same accounting period.
As already stated, revenue is recognised when a sale is complete or service
is rendered rather when cash is received. Similarly, an expense is recognised
not when cash is paid but when an asset or service has been used to generate
revenue. For example, expenses such as salaries, rent, insurance are recognised
on the basis of period to which they relate and not when these are paid.
Similarly, costs like depreciation of fixed asset is divided over the periods during
which the asset is used.
Let us also understand how cost of goods are matched with their sales
revenue. While ascertaining the profit or loss of an accounting year, we
should not take the cost of all the goods produced or purchased during that
period but consider only the cost of goods that have been sold during that
year. For this purpose, the cost of unsold goods should be deducted from the
cost of the
goods produced or purchased. You will learn about this aspect in detail in the
chapter on financial statement.
The matching concept, thus, implies that all revenues earned during
an accounting year, whether received during that year, or not and all costs
incurred, whether paid during the year, or not should be taken into account
while ascertaining profit or loss for that year.
2.2.9 Full Disclosure Concept
Information provided by financial statements are used by different groups
of people such as investors, lenders, suppliers and others in taking various
financial decisions. In the corporate form of organisation, there is a
distinction between those managing the affairs of the enterprise and those
owning it. Financial statements, however, are the only or basic means of
communicating financial information to all interested parties. It becomes all the
more important, therefore, that the financial statements makes a full, fair and
adequate disclosure of all information which is relevant for taking financial
decisions.
The principle of full disclosure requires that 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. 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. To ensure proper disclosure of material accounting
information, the Indian Companies Act 1956 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, to
give a true and fair view of profitability and the state of affairs.

2.2.10 Consistency Concept

The accounting information provided by the financial statements would be
useful in drawing conclusions regarding the working of an enterprise only when
it allows comparisons over a period of time as well as with the working of other
enterprises. Thus, both inter-firm and inter-period comparisons are required
to be made. This can be possible only when accounting policies and practices
followed by enterprises are uniform and are consistent over the period of time.
To illustrate, an investor wants to know the financial performance of an
enterprise in the current year as compared to that in the previous year. He may
compare this year’s net profit with that in the last year. But, if the accounting
policies adopted, say with respect to depreciation in the two years are different,
the profit figures will not be comparable. Because the method adopted for the
 34

valuation of stock in the past two years is inconsistent. It is, therefore, important
that the concept of consistency is followed in preparation of financial
statements so that the results of two accounting periods are comparable.
Consistency eliminates personal bias and helps in achieving results that are
comparable.
Also the comparison between the financial results of two enterprises would
be meaningful only if same kind of accounting methods and policies are adopted
in the preparation of financial statements.
However, consistency does not prohibit change in accounting policies.
Necessary required changes are fully disclosed by presenting them in the
financial statements indicating their probable effects on the financial results
of business.

2.2.11 Conservatism Concept

The concept of conservatism (also called ‘prudence’) provides guidance for
recording transactions in the book of accounts and is based on the policy of
playing safe. The concept states that a conscious approach should be adopted
in ascertaining income so that profits of the enterprise are not overstated. If
the profits ascertained are more than the actual, it may lead to distribution of
dividend out of capital, which is not fair as it will lead to reduction in the capital
of the enterprise.
The concept of conservatism requires that profits should not to be recorded
until realised but all losses, even those which may have a remote possibility, are
to be provided for in the books of account. To illustrate, valuing closing stock
at cost or market value whichever is lower; creating provision for doubtful
debts, discount on debtors; writing of intangible assets like goodwill, patents,
etc. from the book of accounts are some of the examples of the application of the
principle of conservatism. Thus, if market value of the goods purchased has
fallen down, the stock will be shown at cost price in the books but if the
market value has gone up, the gain is not to be recorded until the stock is
sold. This approach of providing for the losses but not recognising the gains
until realised is called conservatism approach. This may be reflecting a
generally pessimist attitude adopted by the accountants but is an important
way of dealing with uncertainty and protecting the interests of creditors
against an unwanted distribution of firm’s assets. However, deliberate attempt
to underestimate the value of assets should be discouraged as it will lead to
hidden profits, called secret reserves.

2.2.12 Materiality Concept

The concept of materiality requires that accounting should focus on material
facts. Efforts should not be wasted in recording and presenting facts, which
are immaterial in the determination of income. The question that arises here is
what is a material fact. The materiality of a fact depends on its nature and the
amount involved. Any fact would be considered as material if it is reasonably
believed that its knowledge would influence the decision of informed user
of financial statements. For example, money spent on creation of additional
capacity of a theatre would be a material fact as it is going to increase the
future earning capacity of the enterprise. Similarly, information about any
change in the method of depreciation adopted or any liability which is likely
to arise in the near future would be significant information. All such
information about material facts should be disclosed through the financial
statements and the accompanying notes so that users can take informed
decisions. In certain cases, when the amount involved is very small, strict
adherence to accounting principles is not required. For example, stock of
erasers, pencils, scales, etc. are not shown as assets, whatever amount of
stationery is bought in an accounting period is treated as the expense of that
period, whether consumed or not. The amount spent is treated as revenue
expenditure and taken to the profit and loss account of the year in which the
expenditure is incurred.

2.2.13 Objectivity Concept

The concept of objectivity requires that accounting transaction should be
recorded in an objective manner, free from the bias of accountants and others.
This can be possible when each of the transaction is supported by verifiable
documents or vouchers. For example, the transaction for the purchase of
materials may be supported by the cash receipt for the money paid, if the
same is purchased on cash or copy of invoice and delivery challan, if the same
is purchased on credit. Similarly, receipt for the amount paid for purchase of
a machine becomes the documentary evidence for the cost of machine and
provides an objective basis for verifying this transaction. One of the reasons
for the adoption of ‘Historical Cost’ as the basis of recording accounting
transaction is that adherence to the principle of objectivity is made possible
by it. As stated above, the cost actually paid for an asset can be verified from
the documents but it is very difficult to ascertain the market value of an asset
until it is actually sold. Not only that, the market value may vary from person
to person and from place to place, and so ‘objectivity’ cannot be maintained if
such value is adopted for accounting purposes. Systems of Accounting
The systems of recording transactions in the book of accounts are generally
classified into two types, viz. Double entry system and Single entry system.
Double entry system is based on the principle of “Dual Aspect” which states
that every transaction has two effects, viz. receiving of a benefit and giving of
a benefit. Each transaction, therefore, involves two or more accounts and is
recorded at different places in the ledger. The basic principle followed is that
every debit must have a corresponding credit. Thus, one account is debited
and the other is credited.
Double entry system is a complete system as both the aspects of a
transaction are recorded in the book of accounts. The system is accurate and
more reliable as the possibilities of frauds and mis-appropriations are
 36
minimised. The arithmetic inaccuracies in records can mostly be checked by
preparing the trial balance. The system of double entry can be implemented
by big as well as small organisations.
Single entry system is not a complete system of maintaining records of
financial transactions. It does not record two-fold effect of each and every
transaction. Instead of maintaining all the accounts, only personal accounts
and cash book are maintained under this system. In fact, this is not a system
but a lack of system as no uniformity is maintained in the recording of
transactions. For some transactions, only one aspect is recorded, for others,
both the aspects are recorded. The accounts maintained under this system
are incomplete and unsystematic and therefore, not reliable. The system is,
however, followed by small business firms as it is very simple and flexible
(you will study about them in detail later in this book).

2.3 Basis of Accounting

From the point of view the timing of recognition of revenue and costs, there
can be two broad approaches to accounting. These are:
(i) Cash basis; and
(ii) Accrual basis.
Under the cash basis, entries in the book of accounts are made when cash is
received or paid and not when the receipt or payment becomes due. Let us say,
for example, if office rent for the month of December 2014, is paid in January
2015, it would be recorded in the book of account only in January 2015.
Similarly sale of goods on credit in the month of January 2015 would not
be recorded in January but say in April, when the payment for the same is
received. Thus this system is incompatible with the matching principle,
which states that the revenue of a period is matched with the cost of the
same period. Though simple, this method is inappropriate for most
organisations as profit is calculated as a difference between the receipts and
disbursement of money for the given period rather than on happening of the
transactions.
Under the accrual basis, however, revenues and costs are recognised in the
period in which they occur rather when they are paid. A distinction is made
between the receipt of cash and the right to receive cash and payment of cash
and legal obligation to pay cash. Thus, under this system, the monitory effect
of a transaction is taken into account in the period in which they are earned
rather than in the period in which cash is actually received or paid by the
enterprise. This is a more appropriate basis for the calculation of profits as
expenses are matched against revenue earned in relation thereto. For example,
raw material consumed are matched against the cost of goods sold.

2.4 Accounting Standards

Accounting standards are written policy documents covering the aspects of
recognition, measurement, treatment, presentation and disclosure of accounting
transactions in financial statements. Accounting standard is an authoritative
statement issued by ICAI, a professional body of accounting in our country.
The objective of accounting standard is to bring uniformity in different
accounting policies in order to eliminate non comparability of financial
statements for enhancing reliability of financial statements. Secondly, the
accounting standard provides a set of standard accounting policies, valuation
norms and disclosure requirements. In addition to improving credibility of
accounting data, accounting standard enhances comparability of financial
statements, both intra and inter enterprises. Such comparisons are very
effective and widely used for assessment of firms’ performance by the users of
accounting.

Need for Accounting Standards

Accounting extends information to various users of information. Accounting
information can serve the interest of different users only if it possesses
uniformity and full disclosure of relevant information. There can be alternate
accounting treatment and valuation norms which may be used by any
business entity. Accounting standard facilitate the scope of those alternatives
which fulfil the basic qualitative characteristics of true and fair financial
statement.
 38

Benefits of Accounting Standards

1. Accounting standard helps in eliminating variations in
accounting treatment to prepare financial statements.
2. Accounting standard may call for disclosures of certain information
which may not be required by law, but such information might be
useful for general public, investors and creditors.
3. Accounting standard facilitate comparability between financial
statements of inter and intra companies.

Limitations of Accounting Standards

1. Accounting standard makes choice between different
alternate accounting treatments difficult to apply.
2. It is rigidly followed and fails to extend flexibility in applying
accounting
standards.
3. Accounting standard cannot override the statue. The
standards are required to be farmed within the ambit of
prevailing status.
Great question! Here’s a clear breakdown:

Accounting Concepts

 Definition: Fundamental principles or assumptions that underlie the

preparation and presentation of financial statements.
 Purpose: Provide a theoretical framework and ensure consistency, reliability,
and comparability in accounting.
 Examples:
 40
o Going Concern: Assumes the business will continue operating
indefinitely.
o Accrual Concept: Revenues and expenses are recorded when they are
earned or incurred, not when cash is received or paid.
o Consistency: Accounting methods should be applied consistently
across periods.
o Matching Concept: Expenses should be matched with the revenues
they help generate.

Accounting Conventions

 Definition: Accepted practices or customs that have evolved over time to deal
with practical problems in accounting.
 Purpose: Guide accountants on how to apply concepts in real-world situations
where exact precision is not possible or practical.
 Nature: More flexible and based on professional judgment.
 Examples:
o Conservatism (Prudence): Anticipate no profits but anticipate all
losses.
o Materiality: Only significant items that would influence decisions
should be recorded or disclosed.
o Full Disclosure: All important information should be disclosed to
users of financial statements.

Key Differences

Aspect Accounting Concepts Accounting Conventions

Practical customs or accepted
Nature Theoretical principles
practices
Provide a framework for preparing Guide practical application of
Purpose
accounts concepts
Generally fixed and universally
Flexibility Flexible and based on judgment
accepted
Example Assumptions about business and Guidelines on recognition and
Focus transactions disclosure

In short:
Concepts are the rules and assumptions behind accounting, while conventions are
the practical guidelines used when applying those rules in real life.
Definition of Accounting Convention

Accounting Convention refers to the generally accepted customs, practices, or

principles followed by accountants when preparing financial statements. These
conventions have evolved over time to address practical issues and uncertainties in
accounting where strict rules or concepts may not provide clear guidance. They help
ensure consistency, reliability, and comparability in financial reporting but are
flexible and based on professional judgment rather than rigid rules.

Types of Accounting Conventions

1. Conservatism (Prudence) Convention

This convention advises accountants to anticipate no profits, but provide

for all possible losses. In other words, if there is uncertainty, it's safer to
underestimate income and overestimate expenses to avoid overstating the
financial position.

2. Consistency Convention

This convention requires that accounting policies and methods be

applied consistently from one accounting period to another. This
ensures comparability of financial statements over time.

3. Materiality Convention

According to this, only information that is significant enough to

influence the decisions of users should be recorded and disclosed.
Insignificant details may be ignored to avoid cluttering the financial
statements.

4. Full Disclosure Convention

This convention states that all important information affecting the

understanding of financial statements should be disclosed. It
ensures transparency so that users can make informed decisions.
42