Accounting Theory

Paper-8 Max. Marks.: 100

Time 3: Hrs

Note: There will be three sections of the question paper. In section A there will be 10 short answer
questions of 2

markseach.Allquestionsofthissectionarecompulsory.SectionBwillcompriseof10questionsof5markseach

out of which candidates are required to attempt any seven questions. Section C will be having 5
questions of

15 marks each out of which candidates are required to attempt any three questions. The examiner will
set the

questionsinallthethreesectionsbycoveringtheentiresyllabusoftheconcernedsubject.

Course Inputs

Unit-1 Fundamentals: Meaning, Need Nature, Classification, Evaluation, Role and Users of Accounting
and

Accounting Theory, History of Accounting Thoughts. Approaches to Accounting Theory. Accounting

Postulates, Concepts and Principles.

Unit-2 Income Measurement: Concepts of Income Revenues, Expenses, Gains, losses, Assets, Liabilities
and

Equity. Depreciation Method, Depreciation and Indian Companies Act, Inventory: Inventory Coating

methods. AS-2 on valuation of Inventories.

Unit-3 Corporate Reporting: Financial Reporting: Concept and development of Financial Reporting
(including

True blood Report, The Corporate Report, FASB Concept No. 1, Stamp Report). Specific Issues in

Corporate Reporting: Segment, Social and Interim Reporting. Harmonization of Financial Reporting

(including IASCs Guidelines.)

Unit-4 Contemporary Issues in Accounting: Accounting for Changing Prices, Human Resource
Accounting.

Financial Engineering (A Multi-disciplinary Approach to Risk Return Management)

Unit-5 Accounting Standards: Formation, Meaning, Benefits and Management of Accounting Standards,
Process

of Standards setting in India, U. K. and U.S.A. Elementary knowledge of Indian Accounting Standards.

Lease Accounting Social Accounting.

Chapter 1

Accounting-An Intoduction

Accounting is generally termed as the language of business throughout the world. The

language is the means of communication of ideas or feelings by the use of

conventionalised signs, gestures, marks and articulated vocal sound. In the same way,

the accounting language seaves as a means to communicate matters relating to various

aspects of business operations. As the individual business enterprises keep their

accounting records separately, the offer to communicate is essentially from a business

enterprise to various individuals, groups and institutions that are having interest in the

operations and results of that enterprise. Now, although accounting is generally

recognised with the business, trade and profession, the business enterprise is not the

only kind of organisation that makes use of accounting. Legal entities ranging from

individual to governments use and prepare accounting to obtain information on the

financial condition and performance of the entity in question. Just as the business

enterprises (like firms, companies, societies and institutions keep their accounts, so can

the nations and even the individual owners of the business and profession entities.

It is necessary to have a good knowledge of accounting-grammar (in the shape of

construction of accounts, conventions, concepts, postulates, principles, standards etc.)

to interpret accounting information for purposes of communication, reporting, decision

making or appraisal.

Definition of Accounting

The role of accounting then is that of communicating the results of the operations of a

business. How does accounting accomplish this ? This is best understood by commonly

accepted definition of accounting : “Accounting is 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.

(AICPA) ”

The art of recording involves putting into writing or in print the transactions of financial
character, reasonably soon after occurrence, in the records maintained by the company

e.g. cash book, day books, journals, memoranda books, etc. This part of accounting is

essentially concerned with not only ensuring that all business transactions of financial

character are in fact recorded but also that they are recorded in an orderly manner. For

example, when a business executive has to travel in connection with his work, he will

ask the cashier in the company’s accounts department to advance funds for meeting

his travel expenses. On receipt of the memo from the executive, the cashier will prepare

a voucher, hand over the cash to the executive against his signature acknowledging

receipt of the cash advance. This transaction will then be appropriately recorded in the

cash book and the “travel advances” account of the ledger. When the executive returns

from the business trip, he will prepare a statement of his travel expenses (usually called

Travel Allowance Bill or T.A. Bill), get it approved by his superior (if required by the

Accounting Theory6

regulations in this regard), and send it on to the accounts department. If he has spent

less than the amount originally advanced, he will return the balance amount in cash

along with the travel statement. The accounts department, after verification of the

statement to ensure that the expenditure is in conformity with prescribed regulations

will make appropriate entries in the cash book and other accounting records and suitably

adjust the “travel advances” account. If the amount spent is greater than the original

advance, the balance amount will be paid to the executive and the required entries will

be made in the accounting records.

The art of classifying is concerned with the systematic analysis of the recorded data

so that items of like nature are classified under appropriate heads. This accounting

classification is usually done by maintaining ledgers with individual account heads under

which all financial transactions of a similar nature are collected. For instance, continuing

with the earlier illustration, the original advance will be classified by entries in the cash

book (or cash account) leading to a reduction of cash held by the company and in the

“travel advances” account in the ledger, thereby increasing the amount of such advances

outstanding. On receipt of the travel expenses statement, the balance amount of cash,
received from or paid to the executive (as the case may be), will be entered in the cash

book the “travel advances” in the ledger will be reduced by adjustment of the accounts

rendered and the “travelling expenses” account in the ledger will be posted with the

amount by way of accounting of such expenses incurred in connection with the operations

of the enterprise. In the process, the events of the original cash advance and

the subsequent incurrence of travel expenses are classified under three relevant heads

– namely, cash account, travel advances account and travelling expenses account.

The art of summarizing in a significant manner consists of presenting the classified

data in a manner which is useful to the internal and external end-users of accounting

statements. At the end of stipulated periods (usually a month for internal purposes and

a year, for external reporting purposes as required by corporation law), the accounts in

the ledger will be balanced as at the end of that period. The accountant will check (or

“try”) the accuracy of the accounts by preparing a trial balance of all ledger accounts

as at the end of that period. This process leads to the preparation of financial statements

like the Balance Sheet, Income Statement (or Profit and Loss Account as it is often

called), Source and Application of funds statement, cost statements, internal reports to

management, etc.

The final function of accounting is the interpretation of the summarized data in such a

manner that the and-user can make meaningful judgements about the financial condition

or the profitability of the business operations or can use the data in preparing future

plans and laying down policies to execute such plans. After the monthly accounting

statements for internal purposes have been prepared, the chief accountant or controller

will prepare analytical notes appraising the performance of the enterprise and its various

units or departments (as reflected in the accounting statements prepared) in relation to

the expected performance and highlight areas of shortfall in performance so that

management can take appropriate remedial action for overcoming such shortfalls.

Similarly, in respect of the annual statutory accounts, the accountant will prepare a note

analyzing the results of operations for the year for the consideration of the Board of

Directors. Thereafter, the directors will include their comments analysing the results
reported in their report annexed to the final-accounts of the year.

7Accounting-An Intoduction

There is no single or unanimously accepted definition of accounting. Why ?

Generally, definition either formally or informally specifies the meaning of a

phenomenon or object in question. A definition sets boundaries to a phenomenon or

subject indicating not only what it is, but also what it is not. A definition answers questions

like, “What are its features ? What is its history or what does it do and how is it related

to other phenomenon ?” Very often definition depends on our purpose or intention with

the given matter. Accordingly, definition of accounting is bound to “come closer to our

own interpretation of the scope of accounting, and the manner in which we would like

to treat its subject matter”. In a rapidly changing socio-economic conditions the subject

matter of accounting is also changing. Accounting which initially began as the art or

science of record-keeping, is moving towards adoption of a dynamic role which also

emphasises its social goal. This is clearly evident from some of the definitions presented

below :

(i) Accounting as a recordkeeping device : The definition of the American Institute

of Certified Public Accountants highlight record-keeping as an essential attribute

of accounting. Accordingly “Accounting is 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 a financial character, and interpreting the

results thereof.”

(ii) Accounting as an information system : The definition of the American

Accounting Association highlights communication aspect of accounting for

decision-making by a wide variety of users. This user-oriented definition of

accounting “refers to the process of identifying, measuring and communicating

economic information to permit informed judgements and decisions by users of

the information”.

To Robert Sterling, accounting stands for a measurement communication process.

According to him, “Accountants ought to measure something and then

this interpretation, the outputs of the accounting system are the inputs to decision

theories”.

(iii) Accounting as a service activity : A later definition of the Accounting Principles

Board of the AICPA endorses the views of American Accounting Association

about the elements of decision making embedded in accounting : “Accounting is a

service activity. Its function is to provide quantitative information, primarily financial

in nature, about economic entities that is intended to be useful in making reasoned

choices about the alternative course of action.”

W.A. Paton, however, attempts to elicit a definition of accounting from the

structural viewpoint “Accounting is a synthesis of concepts, rules and techniques

designed to facilitate understanding and control of economic activity.”

(iv) Accounting as a dynamic social science : According to Glautier and Underdown,

accounting is a social science. They observe that “The history of accounting

reflects the evolutionary pattern of social developments and in this respect, illustrates

how much accounting is a product of its environment and at the same time a force

for changing it. There is, therefore, an evolutionary pattern which reflects changing

socio-economic conditions and changing purpose to which accounting is applied”.

Accounting Theory8

The Nature of Accounting

According in its essence is a function that aims to accumulate the communicate

information essential to the understanding of the activities of an entity. It is an obstraction

of the real world economic events. The distinctive nature that makes accounting a

unique system is as follows :

(i) Accounting as a process : Accounting is a process which involves gathering,

compacting, interpreting and disseminating economic information in a systematic

way.

(ii) Stewardship function : Accounting is a stewardship function. Its basic goal is to

report on the resources and obligation of the entity to the owners. Through the
medium of financial statements it communicates to the interested parties of the

contributions and relative rights of the economy segments– the shareholders/owners,

creditors and others.

(iii) Concepts and conventions : Since accounting is a process that aims at

communicating economic information, it must rely on a set of previously agreed

concepts, conventions and rules. These rules and conventions are not discovered

but they are contrived and mutually agreed upon.

(iv) Accounting as a means to an end : Although accounting system is characterised

by a host of rules, procedures and conventions, they are not the