THEORY BASE OF ACCOUNTING

The principles are generally accepted by the accountants as general guidelines for preparing
accounting records. These are classified as:
(i) Basic Assumptions/Concepts
(ii) Basic Principles
(iii) Modifying Principles/Conventions
BASIC ASSUMPTION/CONCEPTS
In order to make the accounting statements convey the same meaning to all people and to make
them more meaningful, accountants have agreed on a number of assumptions/concepts, which
are usually followed in preparing accounting records. These are following:
1. Going Concern Assumption: According to this assumption, it is assumed that business will
continue to exist for a long period in future. All transactions are recorded assuming that
enterprise will continue in future for a long time. That is why fixed assets are recorded at their
cost price and depreciated during its useful life, irrespective of its market value, because fixed
asset are not meant for resale in business. Also without this assumption, the classification of
fixed and current assets, current and long term liabilities is impossible.
2. Accrual Concept: Accrual concept holds the recognition of transactions as they occur,
whether receipt or payment for the same is made or not. The accrual concept recognizes
revenue when it earned rather than when it is collected and recognizes expense when they occur
rather than when these are paid.
3. Concept of Consistency: This principle states that accounting principles and methods
followed for preparing accounting statements should remain consistent year after year. If this
concept is not followed, different results can be drawn from the same accounting data. E.g. if
method of calculation of depreciation is changed, the profit figure will distort and no longer
comparable.
BASIC PRINCIPLES:
On the basis of accounting assumptions, certain principles have been developed that guide how
transactions should be recorded and reported. Following are some of basic principles:
1. Accounting Entity Concept: According to this concept, a business is treated as an entity
distinct from its owners. Business has its separate books of accounts and all business
transactions are recorded from firm’s point of view and not from owner’s point of view. It this
assumption is not followed, the operating results and financial position of the business entity
can’t be ascertained correctly.
2. Money Measurement Principle: According to this principle, only those transactions and
events are recorded in books of accounts, which can be measured and expressed in terms of
money. Also, accounting records are made simple, understandable and homogeneous by
expressing all the items in a common unit of measurement i.e. money.
3. Accounting Period Principle: According to this principle, the entire life of the business is
divided into small time intervals for calculation of profits and losses of the business and for
ascertaining its financial position. Each time interval, for which results are calculated, is known
as an Accounting Period. Twelve months is usually adopted for this purpose. This accounting
period can be of two types i.e. calendar year (from 1st Jan. - 31st Dec.) or financial year (from
1st Apr. – 31st Mar.). In India, financial year is adopted as accounting year.
4. Dual Aspect Principle: According to this principle, every transaction has two aspects i.e.
debit and credit, and both are recorded at the time of occurrence of a transaction. Each
transaction affects at least two accounts, one is debited and other is credited. This system is
based on dual aspect and is called Double Entry System of Book Keeping.
5. Historical Cost Principle: According to this principle, an asset is recorded in the books of
accounts at the price at which it is acquired. Market value of assets and price level changes
(inflation and deflation) are ignored and not recorded.
The cost of the asset relates to the past, it is referred to as Historical Cost. If nothing is paid to
acquire assets of company, it is not recorded as an asset like increasing goodwill. 19
6. Principle of Full Disclosure: According to this principle, all significant financial
information of an entity should be completely disclosed in financial statements. It means
disclosing sufficient information, which is material to the interests of users of financial
statements e.g. while reporting sales during the year, sales returns should be disclosed
separately as deduction from the amount of sales, rather than showing the net sales for the year.
As the huge amount of sales return can raise the inquiry and may lead to corrective action.
7. The Revenue Recognition Concept: This concept holds that revenue is considered to have
been realized when a transaction has been entered into and the obligation to receive the amount
has been established. In other words, revenue is considered as being earned when goods are
sold or services rendered and not when cash is received.
8. The Matching Concept: This principle holds that the cost incurred to earn the revenue
should be set out against the revenue in the period during which it is recognized as earned. For
matching expenses with revenue, first revenue is recognized and the costs associated with this
revenue are recognized.
9. Verifiable Objective Evidence/Objectivity Concept: All transactions, which are recorded
in books of accounts, must be supported by relevant vouchers e.g. invoices, bills, passbook etc.
Personal bias has no place in preparation and presentation of financial records.

MODIFYING PRINCIPLES/CONVENTIONS:
These are certain accounting principles, which can be modified by different accountants
according to the situations and requirements of business. Some of these are following:
1. Principle of Conservatism/Prudence: This principle tells us that all anticipated losses
should be recorded in books of accounts, but all anticipated and unrealized gains should be
ignored. Provision is made for all known liabilities and losses even though the amount can’t be
determined with certainty. It is the policy of playing safe. E.g. closing stock is valued at cost
or market price whichever lower and making provision for doubtful debts etc.
2. Principle of Materiality: According to this principle, only those items are to be disclosed
separately in financial statements which are material for decision making for the users of
financial statements of the business. Insignificant items or items which are not relevant to the
users need not to be disclosed separately in books of accounts. These can be merged with other
items. Here materiality based on both information and amount.
An information is considered material if this could change the decisions of a person to whom
this information is communicated. This principle is an exception to the principle of full
disclosure.

ACCOUNTING STANDARDS
Accounting standards may be defined as written statements issued from time to time by
institutions of accounting professionals e.g ICAI, specifying uniform rules or practices for
preparing ad presenting financial statements. Some of accounting standards are as follows:
(i) AS-1: Disclosure of Accounting Policies
(ii) AS-2: Valuation of Inventories
(iii) AS-3: Cash Flow Statement
Need or Utility or Advantages of Accounting Standards:
(i) Accounting standards bring uniformity in preparation and presentation of financial
statements.
(ii) They ensure the consistency and comparability of different financial statements.
(iii) They significantly reduce the chances of manipulations and frauds.
(iv) To improve the reliability and credibility of financial statements.

Nature of accounting standards:

(i) These are based on applicable law, customs and business environment.
(ii) These are intended to apply only on material items.
(iv) Mostly accounting standards are mandatory in nature.
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.
Meaning of IFRS: IFRS is a principle-based accounting standard. IFRS are a single set of
high-quality accounting Standards developed by IASB, recommended to be used by the
enterprises globally to produce financial statements.
Benefits of IFRS:
(1) Global comparison of financial statements of any companies is possible
(2) Financial statements prepared by using IFRS shall be better understood with financial
statements prepared by the country specific accounting standards. So the investors can make
better decision about their investments.
(3) Industry can raise or invest their funds by better understanding if financial statements are
there with IFRS.
(4) Accountants and auditors are in a position to render their services in countries adopting
IFRS.
(5) By implementation of IFRS accountants and auditors can save the time and money.
(6) Firm using IFRS can have better planning and execution. It will help the management to
execute their plans globally.
Basis of Accounting:
(1) Cash basis
Under this entry in the books of accounts are made when cash received or paid and not when
the receipt or payment becomes due. For example, if salary Rs. 7,000 of January 2010 paid in
February 2010 it would be recorded in the books of accounts only in February, 2010.
(2) Accrual basis
Under this however, revenues and costs are recognized in the period in which they occur rather
when they are paid. It means it record the effect of transaction is taken into book when they are
earned rather than in the period in which cash is actually received or paid by the enterprise. It
is more appropriate basis for calculation of profits as expenses are matched against revenue
earned in the relation thereto. For example, raw materials consumed are matched against the
cost of goods sold for the accounting period.
 Goods and Services Tax
(One Country One Tax)
GST is a destination-based tax on consumption of goods and services. It is proposed to be
levied at all stages right from manufacture up to final consumption with credit of taxes paid at
previous stages available as setoff.
GST has a dual aspect with the Centre and States simultaneously levying on a common tax
base. There are three main components of GST which are CGST, SGST, IGST
CGST means Central Goods and Services Tax. Taxes collected under CGST will constitute the
revenues of the Central Government.
SGST means State Good and Services Tax. A collection of SGST is the revenue of the State
Government.
For example, Ramesh a dealer in Punjab sell goods to Seema in Punjab worth ` 10,000. If the
GST rate is 18%, i.e., 9% CGST and 9% SGST, ` 900 will go to Central Government and 900
will go to Punjab Government.
IGST means Integrated Goods and Services Tax. Revenue collected under IGST is divided
between Central and State Government as per the rates specified by the Government. IGST is
charged on transfer of goods and services from one state to another. Import of goods and
services are also covered under IGST.
Characteristics of Goods and Services Tax
1. GST is a common law and procedure throughout the country under single administration.
2. GST is a destination-based tax and levied at a single point at the time of consumption of
goods and services by the end consumer.
3. GST is a comprehensive levy and collection on both goods and services at the same rate with
benefit of input tax credit or subtraction of value.
4. Minimum number of rates of tax does not exceed two.
5. There is no scope for levy of cess, resale tax, additional tax, turnover tax etc.
6. There is no multiple levy of tax on goods and services, such as sales tax, entry tax, octroi,
entertainment tax or luxury tax etc.
Advantages
1. Introduction of GST has resulted in the abolition of multiple types of taxes in goods and
services.
2. GST widens the tax base and increased revenue to Centre and State thereby reducing
administrative cost for the Government.
3. GST has reduced compliance cost and increases voluntary compliance.
4. GST has affected rates of tax to the maximum of two floor rates.
5. GST has removed the cascading effect on taxation.
6. GST will result in enhancing manufacturing and distribution system affecting the cost of
production of goods and services and consequently the demand and production of goods and
services will increase.
7. It will eventually promote economic efficiency and sustainable long-term economic growth
as GST is neutral to business processes, business models, organisational structure and
geographical location.
8. GST would help to extend competitive edge in international market for goods and services
produced in the country leading to increased exports.
 Questions for Practice
1. Why is it necessary for accountants to assume that business entity will remain a
going concern?
2. When should revenue be recognised? Are there exceptions to the general rule?
3. What is the basic accounting equation?
4. The realisation concept determines when goods sent on credit to customers are to be
included in the sales figure for the purpose of computing the profit or loss for the accounting
period. Which of the following tends to be used in practice to determine when to include a
transaction in the sales figure for the period. When the goods have been:
a. dispatched b. invoiced c. delivered d. paid for

Give reasons for your answer.

5. Complete the following worksheet:
(i) If a firm believes that some of its debtors may ‘default’, it should act on this by making
sure that all possible losses are recorded in the books. This is an example of the ___________
concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified
by the ___________ concept.
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by
the ___________ concept.
(iv) The ___________ concept states that if straight line method of depreciation is used in
one year, then it should also be used in the next year.
(v) A firm may hold stock which is heavily in demand. Consequently, the market value of
this stock may be increased. Normal accounting procedure is to ignore this because of the
___________.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to
the ___________.
(vii) The management of a firm is remarkably incompetent, but the firms accountants can not
take this into account while preparing book of accounts because of
___________ concept.
6. Explain Cost concept.
7. What is mean by accounting standard? What is the main objective of accounting standard?
8. Explain the following concepts.
a. Business entity concept
b. Going concern concept
c. Revenue recognition concept
9. Explain the utility of Accounting Standards.
10.Which principle assumes that a business enterprise will not be liquidated in near future?
Ans. Going concern concept.
11. “Closing stock is valued lower than the market price” which concept of accounting is
applied here?
Ans. Conservatism (Prudence) concept.
12.An asset may define as a bundle of services‟ – explain with an example.
13.Under which accounting principle, quality of manpower is not recommended in the books
of accounts?
Ans. Money measurement concept.
 ACCOUNTING EQUATION

LEARNING OBJECTIVES

 Meaning of Accounting Equation

 Analysis of effect of transactions on assets, liabilities, capital, revenues & expenses
 Preparation of Accounting Equation

MEANING OF ACCOUNTING EQUATION

Accounting equation signifies that the assets of a business are always equal to the total of its
liabilities and capital. The equation reads as follows:

Where,
A = Assets
L = Liabilities
C = Capital
The above equation can also be presented in the following forms as its derivatives to enable
the determination of missing figures of Capital(C) or Liabilities (L).
(i) A – L = C
(ii) A – C = L
Since, the accounting equation depicts the fundamental relationship among the components
of the balance sheet, it is also called the Balance Sheet Equation. As the name suggests, the
balance sheet is a statement of assets, liabilities and capital.
Example 1.
Find the capital of the business if total assets are ₹1,70,000 and its liabilities are ₹70,000.
Solution:
Assets = Liabilities + Capital
So, Capital = Assets – Liabilities
Capital = 1,70,000 – 70,000 = ₹1,00,000
Example 2.
X commenced business on 1st April, 2016 with a capital of ₹50,000. On 31st March, 2017, his
assets were worth ₹95,000 and liabilities of ₹30,000. Find the capital at the end of the year
and profit earned during the year.
Solution:
Assets = Liabilities + Capital
So, Capital = Assets – Liabilities
Capital = 95,000 – 30,000 = ₹65,000
Profit = Closing Capital – Opening Capital
Profit = 65,000 – 50,000 = ₹15,000
Example 3.
Show effect of following transaction on the accounting equation:
(a) Manoj started business with Cash ₹2,30,000, Goods ₹1,00,000, Building ₹2,00,000
(b) He purchased goods for cash ₹50,000
(c) He sold goods (costing ₹20,000) ₹35,000
(d) He purchased goods from Rahul ₹55,000
(e) He sold goods to Varun (Costing ₹52,000) ₹60,000
(f) He paid cash to Rahul in full settlement ₹53,000
(g) Salary paid by him ₹20,000
(h) Received cash from Varun in full settlement ₹59,000
(i) Rent outstanding ₹3,000
(j) Prepaid Insurance ₹2,000
(k) Commission received by him ₹13, 000
(l) Amount withdrawn by him for personal use ₹20,000
(m) Depreciation charge on building ₹10,000
(n) Fresh capital invested ₹50,000
(o) Purchased goods from Rakhi ₹10,000
Solution:
S. TRANSACTION ASSETS = LIABILITIES + CAPITAL
N. CASH STOCK BUILDING DEBTORS PREPAID CREDITORS O/S CAPITAL
INSURANCE RENT
a Started business 2,30,000 1,00,000 2,00,000 5,30,000
2,30,000 1,00,000 2,00,000 5,30,000
b Purchased goods (50,000) 50,000
for cash
1,80,000 1,50,000 2,00,000 5,30,000
c Sold goods for 35,000 (20,000) 15,000
cash
2,15,000 1,30,000 2,00,000 5,45,000
d Purchased goods 55,000 55,000
from Rahul
2,15,000 1,85,000 2,00,000 55,000 5,45,000
 e Sold goods to (52,000) 60,000 8,000
Varun
2,15,000 1,33,000 2,00,000 60,000 55,000 5,53,000
f Paid cash to (53,000) (55,000) 2,000
Rahul
1,62,000 1,33,000 2,00,000 60,000 5,55,000
g Paid salary (20,000) (20,000)
142,000 1,33,000 2,00,000 60,000 5,35,000
h Received cash 59,000 (60,000) (1,000)
from Varun
2,01,000 1,33,000 2,00,000 5,34,000
i O/S Rent 3,000 (3,000)
2,01,000 1,33,000 2,00,000 3,000 5,31,000
j Prepaid Insurance (2,000) 2,000
1,99,000 1,33,000 2,00,000 2,000 3,000 5,31,000
k Commission 13,000 13,000
received
2,12,000 1,33,000 2,00,000 2,000 3,000 5,44,000
l Drawings (20,000) (20,000)
1,92,000 1,33,000 2,00,000 2,000 3,000 5,24,000
m Depreciation on (10,000) (10,000)
building
1,92,000 1,33,000 1,90,000 2,000 3,000 5,14,000
n Fresh capital 50,000 50,000
2,42,000 1,33,000 1,90,000 2,000 3,000 5,64,000
o Purchased goods 10,000 10,000
from Rakhi
2,42,000 1,43,000 1,90,000 2,000 10,000 3,000 5,64,000
5,77,000 5,77,000

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SELF ASSESSMENT

1. Prepare accounting equation for the following transactions:

(i) Introduced ₹8,00,000 as cash and ₹50,000 by stock.
(ii) Purchased plant for ₹3,00,000 by paying ₹15,000 in cash and balance at a later date.
(iii) Deposited ₹6,00,000 into the bank.
(iv) Purchased office furniture for ₹1,00,000 & paid by cheque.
(v) Purchased goods worth ₹80,000 for cash and for ₹35,000 in credit.
(vi) Goods amounting to ₹45,000 was sold for ₹60,000 on cash basis.
(vii) Goods costing ₹80,000 were sold for ₹1,25,000 on credit.
(viii) Cheque issued to the supplier of goods worth ₹35,000.
(ix) Cheque received from customer amounting to ₹75,000.
(x) Withdrawn by owner for personal use ₹25,000.

2. Prepare accounting equation for the following transactions:

(i) Started business with cash ₹2,00,000 & stock ₹1,50,000.
(ii) Purchased goods for cash ₹15,000 & on credit ₹20,000.
(iii) Sold goods for cash ₹20,000 & on credit ₹10,000.
(iv) Purchased goods of the value of ₹12,000 for ₹15,000.
(v) Sold goods for ₹20,000 (cost price ₹17,500).

3. Find the total assets of the firm if the capital is ₹60,000 & liabilities ₹39,000.

4. A started business on 1st April, 2017 with a capital of ₹1,10,000 & took loan from bank
₹40,000. At the end of the year on 31st March, 2018, his assets were for ₹2,50,000, creditors
for ₹70,000. Bank loan has not been paid so far, however, interest on loan has been paid. Find
the closing capital and profit earned during the year.

5. Find the opening capital of the firm from the following information given at the end of the
year:
Total assets: ₹1,30,000 External liabilities: ₹40,000
Additional capital: ₹20,000 Drawings: ₹15,000
Profit: ₹25,000
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