ACCOUNTANCY

Chapter 2: Theory Base Of Accounting

 THEORY BASE OF ACCOUNTING
02

Theory Base of Accounting

Accounting Principles:
Accounting statements disclose the profitability and solvency of business to various parties. It
is necessary to prepare such a statement in a standard language following a standard set of
rules and regulations. These rules are known as “Generally Accepted Accounting Principles” or
GAAP.
Basic Concepts:
Theory Base of Accounting concepts are fundamentally the basic ideas holding the theory
base of accounting and therefore, can be regarded as general working practices for all
accounting activities. These concepts are mentioned below:

1. Business Entity Concept: This concept assumes that a business, has a distinct and
separate entity from its owners. Thus, for the purpose of accounting, a business and its
owners are to be treated as two separate entities.

2. Going concern concept: As per this concept it is assumed that the business will
continue to exist for a long period in future and the transactions are recorded in the
books of business on the assumption that it is a continuing enterprise.
3. Consistency concept: It states that accounting principles and methods should remain
consistent from one year to another. It helps them to compare the profit and loss of
different periods and draw meaningful conclusions.
4. Accrual concept: As per this concept revenue is recorded when sales are made, and it is
immaterial whether cash received or not and same applies to expenses also. It provides
more appropriate information about business enterprise as compared to cash basis.
5. Matching Concept: The concept of matching emphasizes 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 this revenue must belong to the
same accounting period.
6. Cost Concept: The cost concept requires that all assets are recorded in the book of
accounts at their cost price, which includes the cost of acquisition, transportation,
installation, and making the assets ready for use.
7. Objectivity concept: This principle of accounting specifies that the transactions should
be recorded in an objective manner and should be unbiased in nature.

Systems of Accounting:

There are two systems of recording business transactions which are following:

1. Double Entry System: This 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

(1)
 THEORY BASE OF ACCOUNTING
02

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. A double-entry system is a complete system as both the aspects
of a transaction are recorded in the books of accounts.

2. Single Entry System: This system is not a complete system of maintaining records of
financial transactions. It does not record the two-fold effect of each and every
transaction. Instead of maintaining all the accounts, only personal accounts and cash
books are maintained under this system. The accounts maintained under this system
are incomplete and unsystematic and, therefore, not reliable.

Basis of Accounting:

1) Cash basis:
Under this entries in the books of accounts are made when cash id 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 in
the 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.

Difference between accrual basis of accounting and cash basis of accounting:

No. Basis Accrual Basis of Accounting Cash Basis of Accounting

1. Recording Both cash and credit Only cash transactions

of transactions are are recorded.
transactions recorded
2. Profit or Profit or Loss is Correct profit/ loss is
Loss ascertained correctly not ascertained
due to complete record because it records only
of transactions. cash transactions.
3. Distinction This method makes a This method does not
between distinction between make a distinction
Capital and capital and revenue between capital and
Revenue items. revenue nature items.
4. Legal This basis is recognized This basis is not
position under the companies recognized under the

(2)
 THEORY BASE OF ACCOUNTING
02

Act companies Act.

Accounting Standards:
Accounting standards are those written statements, which are issued from time to time by
the accounting professionals’ body, specifying uniform rules or practices for the preparation
of the financial statements.

Need for Accounting Standards:

Accounting standards are needed to improve reliability and bring uniformity in accounting
practices and to ensure transparency, consistency, and comparability in financial
information.

Benefits of Accounting Standards:

• Accounting standards makes the financial statements more reliable.

• Accounting standards help in resolving conflict of financial interest among various
groups.
• Accounting standards ensure the consistency and comparability of financial
statements.
• Accounting standards significantly reduce the chances of manipulations and frauds.

Accounting-Standards (AS):

The ICAI has issued the following standards:

• AS 1 Disclosure of Accounting Policies.

• AS 2 Valuation of Inventories.
• AS 3 Cash Flow Statements.
• AS 4 Contingencies and Events Occurring after the Balance Sheet Date.
• AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting
Policies.
• AS 6 Depreciation Accounting.
• AS 7 Construction Contracts.
• AS 8 Accounting for Research and Development.
• AS 9 Revenue Recognition.
• AS 10 Accounting for Fixed Assets.

Goods and Service Tax (GST):

Goods and Services Tax is an indirect tax levied on supply of goods and services with
consideration in the course of furtherance of business. GST is built on the principle of One
Nation one Tax. It is a comprehensive, multistage, destination-based tax. GST extends to

(3)
 THEORY BASE OF ACCOUNTING
02

whole India including Jammu & Kashmir.

Features of GST:

• It is a consumption-based tax.
• Burden can be shifted in respect of GST.
• Taxpayers do not receive a direct pinch while paying indirect taxes.
• It is regressive in nature, and it promotes social welfare
• It is levied on commodities and services.

Advantages of GST:

• Ease of doing business.

• Reduce Tax Evasion.
• Tax system becomes more clear, systematic, and foreseeable.
• Decrease in the cost of goods since tax on tax is eliminated in the GST regime.

(4)
 THEORY BASE OF ACCOUNTING
02

(5)
 THEORY BASE OF ACCOUNTING
02

Important Questions
Multiple Choice Questions-
Question 1. Generally the duration of an Accounting period is of-
(a) 6 months
(b) 3 months
(c) 12 months
(d) 1 month.
Question 2.The sum of Liabilities and Capital is-
(a) Expense
(b) Income
(c) Drawings
(d) Assets.
Question 3.In India, the accounting standard board was set up in the year-
(a) 1972
(b) 1977
(c) 1956
(d) 1932.
Question 4.The basic accounting postulates are denoted by –
(a) Concepts
(b) Book – keeping
(c) Accounting standards
(d) None of these.
Question 5.The amount drawn by businessmen for his personal use is-
(a) Capital
(b) Drawing
(c) Expenditure
(d) Loss.
Question 6.Meaning of credibility of going concern is:
(a) Closing of business
(b) Opening of business
(c) Continuing of business
(d) None of these.

(6)
 THEORY BASE OF ACCOUNTING
02

Question 7 . Which of the following categories of information is NOT provided by Financial

Accounting?
a) Overheads
b) Cash Flow
c) Financial Position
d) Profit or Surplus
Question 8. The Trading and Profit and Loss Account is prepared under which attribute of
accounting:
a) Summarising
b) Recording
c) Classifying
d) Analysis and Interpretation
Question 9. Identified and measured economic events should be recorded in _________
order.
a) Chronological
b) Financial
c) Proper
d) Monetary
Question 10. Which of the following statements is correct:
a) Book Keeping is a part of Accounting.
b) Accounting is a part of book-keeping.
c) The term book-keeping and accounting can be used interchangeably.
d) Book keeping is not a part of accounting.
Answer : Book Keeping is a part of Accounting.
Very Short-
1. How is the total amount of Capital calculated?
2. How is the total amount of Liabilities calculated?
3. Give 2 examples of Capital receipts.
4. Mention different types of liabilities.?
5. What are the drawings?
6. Give 2 examples of Tangible assets.
7. The amount which the proprietor has invested in a business is known as,
8. A Ltd. imported from London one machinery for sale in India and other machinery for
production purpose. Will you treat them as goods or fixed assets?
(7)
 THEORY BASE OF ACCOUNTING
02

9. What is income?
10. What are the different bases of accounting?
Short Questions-
1. When should revenue be recognised? Are there exceptions to the general rule?
2. What is the basic accounting equation?
Long Questions-
1. Why is it necessary for accountants to assume that business entity will remain a going
concern?
2. ‘Only financial transactions are recorded in accounting’. Explain the statement.
3. What is matching concept? Why should a business concern follow this concept?
Discuss.
4. Briefly explain your understanding of IFRS and also give the underlying assumptions in
IFRS.
Case Study Based Question-
1. Read the following hypothetical text and answer the given questions: -
Olly and Robin are two friends graduated from a top college of the country. After the
college, they decide to build a start up in their hometown, Bengaluru. They decided to
start a subscription service of fruits in the nearby cities. For obtaining high-quality
fruits, they made 5-year contracts with farmers in and around Karnataka. They also
decided to purchase machinery for cleansing and quality check of the fruits. The
business of the company started booming. Two years down the line, they had built a
strong brand and reputation. To leverage the same, the company decided to venture
into other states as well with the similar service line. They first expanded to Tamil
Nadu and got great emand. While accounting, company usually booked a normal loss
to account forspoiled fruits that they might get. Moreover, they charged depreciation
on the machinery to ensure that expenses are distributed over the years. With all
these good practices, after four more years of operations, the company attained a
unicorn status.
Questions:
1. “They first expanded to Tamil Nadu and got great demand.” Which type of GST is
applicable on this supply to Tamil Nadu?
(a) Centre GST
(b) State GST
(c) Integrated GST
(d) Both (a) and (b)
2. Which AS will be applicable to evaluate the reputation and brand value of firm?

(8)
 THEORY BASE OF ACCOUNTING
02

(a) AS-20
(b) AS-26
(c) AS-30
(d) AS-2
3. The principle highlighted in the line, “Moreover, they charged depreciation on the
machinery to ensure that expenses are distributed over the years” is matching
principle.
(a) True
(b) False
(c) Partially false
(d) Can’t say
4. Which concept is highlighted in the fact that company made long-term contracts
with the farmers?
(a) Going concern concept
(b) Accrual concept
(c) Consistency concept
(d) Both (a) and (b)
5. Which principle is highlighted in the line, “While accounting, company usually
booked a normal loss to account for spoiled fruits that they might get”?
(a) Business entity principle
(b) Prudence principle
(c) Materiality principle
(d) Full disclosure principle
2. Read the following hypothetical text and answer the given questions: -
Golu Plastic Ltd (GPL) is a leading plastic articles manufacturing company. It was listed
on Indian stock market in 1999. The founders and promoters of the company hold the
highest number of shares of the company, approximately around 55%. All these
founders belong to a single family. Unfortunately, all of them died in a car accident
recently. However, the company continued to exist and grow. In the year 2004, the
company imported multiple machines for producing low – cost plastic sheets. The
machines were recorded at the price prevailing in 2004 and have been subjected to
depreciation year on year based on written down value method. The depreciation is
treated as a non-cash expense while preparing the cash flow statement. When GST
was implemented in 2017, it benefitted the company by streaming the processes. A
single rate of GST was charged on the supply of the goods and the process of filing was
very simple.
Question:
(9)
 THEORY BASE OF ACCOUNTING
02

1. Which principle is highlighted in the line, ‘‘The machines were recorded at the price
prevailing in 2004”?
(a) Full disclosure principle
(b) Conservatism principle
(c) Duality principle
(d) Historical cost principle
2. “A single rate of GST was charged on the supply of the goods …”. Who levy GST on
this common base?
(a) Centre government
(b) State government
(c) Union territory government
(d) Both (a) and (b)
3. Which principle/concept is highlighted in the line,” … and have been subjected to
depreciation year on year based on written down value method.”?
(a) Full disclosure principle
(b) Business entity principle
(c) Consistency concept
(d) Accrual concept
4. Which principle is highlighted in the fact that the company continued even after
death of the founders?
(a) Business entity principle
(b) Money measurement principle
(c) Duality principle
(d) Historical cost principle
5. Which AS is required to be followed to prepare cash flow statements?
(a) AS-1
(b) AS-2
(c) AS-3
(d) AS-4
MCQ Answers-
1. Answer: (c) 12 months
2. Answer: (d) Assets.
3. Answer: (b) 1977
4. Answer: (a) Concepts
(10)
 THEORY BASE OF ACCOUNTING
02

5. Answer: (b) Drawing

6. Answer: (c) Continuing of business
7. Answer: Overheads
8. Answer: Summarising
9. Answer: Chronological
10.Answer: Book Keeping is a part of Accounting.
Very Short Answers-
1. Ans. Capital = Assets – Liabilities
2. Ans. Liabilities = Assets – Capital
3. Ans.
• The amount received by way of loans
• The amount received from the sale of fixed assets or investments
4. Ans.
• Current liabilities
• Non-current liabilities
• Contingent Liabilities
5. Ans. Drawings refer to any value of commodities or cash withdrawn by the owner for
personal use.
6. Ans.
• Stock
• Land and Building
7. Ans. Capital
8. Ans. First machinery will be treated as goods and the second machinery will be treated
as Fixed Asset.
9. Ans. Excess of revenue over expenses is called as Income.
10.Ans. Different bases of accounting are,
• Cash basis
• Accrual basis
Short Answers-
1. Ans. Revenue should be recognised when sales take place either in cash or credit
and/or right to receive income from any source is established. Similarly, rent for the
month of March even if received in April month will be treated as revenue of the financial
year ending 31st March.

(11)
 THEORY BASE OF ACCOUNTING
02

There are two exceptions of this rule:

a. In case of sales on installment basis, only the amount collected in installments is
treated as revenue.
b. In case of long term construction contracts, proportionate amount of revenue,
based on part of the contract completed by the end of the financial year is treated
as realised.
2. Ans. The basic accounting equation is given below
Assets = Liabilities + Capital
or
Assets = Claim of Outsiders + Owner’s Equity or Capital.
Long Answers-
1. Ans. Going Concern Concept assumes that the business entity will continue its
operation for an indefinite period of time. It is necessary to assume so, as it helps to
bifurcate revenue expenditure (i.e. expenditure related to current year), and capital
expenditure (i.e. expenditure whose benefits accrue over a period of time). For example,
a machinery that costs Rs 1,00,000, having an expected life of 10 years, will be treated as
a capital expenditure, as its benefit can be availed for more than one year; whereas, the
per year depreciation of the machinery, say Rs 10,000, will be regarded as a revenue
expenditure.
2. Ans. According to this principle, only those transactions and events are recorded in
accounting which are capable of being expressed in terms of money are recorded in the
books of accounts, such as the sale of goods or payment of expenses or receipt of income,
etc.
An event may be important for the business (such as dispute among the owners or
managers, the appointment of a manager, etc.), but it will not be recorded in the books of
accounts simply because it can not be converted or recorded in terms of money. For
instance, strike by workers may adversely affect the business but it cannot be recorded in
the books of accounts unless its effect can be measured in terms of money with a fair
degree of accuracy.
Another aspect of this principle is that the transactions that can be expressed in terms of
money have to be converted in terms of money before being recorded.It should be
remembered that money is the only measurement which enables various things of diverse
nature to be added up together and dealt with. The money measurement assumption is
not free from limitations. Due to the changes in price, the value of money does not
remain the same over a period of time. The value of rupee today on account of rising in
price is much less than what it was, say ten years back. 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. As, such, to make accounting records
relevant, simple, understandable and homogeneous, they are expressed in a common unit
of measurement,i.e., money.

(12)