Accounting Concepts | ISC Class 11 Accounts Notes

This note covers Generally Accepted Accounting Principles (GAAP) and the basic accounting concepts that make up GAAP, the cash and accrual bases of accounting, the meaning and utility of Accounting Standards, and a brief introduction to IFRS (International Financial Reporting Standards).

Why does accounting need a theory base?

Accounting records, classifies and summarises financial transactions and reports the results to owners, managers, employees, investors, creditors, suppliers and tax authorities.

For this information to be useful it must be reliable and comparable, both between firms (inter-firm comparison) and between years for the same firm (inter-period comparison).

Comparability is possible only if the information is based on consistent accounting policies, principles and practices throughout the process of identifying, measuring, recording and reporting transactions.

This need for uniformity and consistency is what calls for a proper theory base of accounting: a body of principles, concepts, rules and guidelines built up over time.

In addition to these concepts, the Institute of Chartered Accountants of India (ICAI), the regulatory body for standardisation of accounting policies in the country, issues Accounting Standards that are expected to be uniformly followed so that accounting practice stays consistent across enterprises.

What is GAAP (Generally Accepted Accounting Principles)?

Definition: GAAP. Generally Accepted Accounting Principles refer 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.

The word "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." "Generally" means pertaining to many persons, cases or occasions.

These rules have been called by different names: principles, concepts, conventions, postulates, assumptions and modifying principles.

The term concept refers to the necessary assumptions and ideas fundamental to accounting practice, while convention connotes customs or traditions used as a guide in preparing accounting statements.

GAAP has evolved over a long period from past experience, usages or customs, statements by individuals and professional bodies, and regulations by government agencies, so it has general acceptability among most accounting professionals.

However, these principles are not static; they are constantly influenced by changes in the legal, social and economic environment and by the needs of users.

From a practicality viewpoint, principles, postulates, conventions, modifying principles and assumptions are used interchangeably and referred to together as the basic accounting concepts.

What does the business entity, money measurement, going concern and accounting period concept each require?

Business entity (accounting entity) concept

Definition: business entity concept. The concept assumes that business has a distinct and separate entity from its owners, so for accounting purposes the business and its owners are treated as two separate entities.

When an owner brings in money as capital, it is treated in the books as a liability of the business to the owner.

When the owner withdraws money for personal expenses (drawings), it is treated as a reduction of the owner's capital and consequently a reduction in the liabilities of the business.

Records are made from the point of view of the business unit, so the owner's personal assets, liabilities and personal transactions are not recorded in the business books, unless they involve an inflow or outflow of business funds.

Money measurement concept

Only those transactions and happenings that can be expressed in terms of money, such as sale of goods, payment of expenses or receipt of income, are recorded in the books of accounts.

Happenings that cannot be expressed in money, such as the appointment of a manager, the capabilities of human resources, the creativity of a research department or the image of the organisation among people, do not find a place in the accounting records. Records are also kept in monetary units, not physical units.

A limitation of the money measurement concept is that it is not free from the effect of changing prices: the value of money does not remain the same over time, so adding assets bought at different points of time clubs together heterogeneous values, and accounting data may fail to show the true and fair view of a firm's affairs.

Going concern concept

Definition: going concern concept. The concept assumes that a business firm would continue to carry out its operations indefinitely, for a fairly long period of time, and would not be liquidated in the foreseeable future.

This assumption provides the basis for showing the value of assets in the balance sheet.

When an asset is purchased, what is really being bought is the services the asset will give over its estimated life span, so the whole cost should not be charged against the revenue of the year of purchase.

Instead, the part of the asset consumed during a period is charged against that period's revenue, and the remainder carried forward.

Accounting period concept

The accounting period is the span of time at the end of which the financial statements are prepared, to know whether profit has been earned or loss incurred, and the position of assets and liabilities at that date.

Financial statements are normally prepared after a period of one year so that timely information reaches users, although interim statements may be needed in certain situations, for example on the retirement of a partner, and companies whose shares are listed are required to publish quarterly results.

How does the cost concept and the dual aspect concept govern recording?

Cost (historical cost) concept

The cost concept requires that all assets are recorded in the books at their purchase price, which includes the cost of acquisition, transportation, installation and making the asset ready for use.

This cost is historical in nature, that is, it does not change year after year even though the market value of the asset may change.

Historical cost brings objectivity into recording because the cost of acquisition is verifiable from purchase documents, whereas market value is not reliable since it changes from time to time.

A 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 periods of rising prices.

Worked example 1. In June 2005, Shiva Enterprise, which manufactures detergent powder, bought an old plant for ₹50 lakh.

It spent ₹10,000 on transporting the plant to the factory site, ₹15,000 on repairs to bring it into running condition, and ₹25,000 on installation. At what amount will the plant be recorded in the books?

Answer: The cost concept includes the purchase price plus acquisition, transportation and installation costs. ₹50,00,000 (purchase) + ₹10,000 (transport) + ₹15,000 (repairs) + ₹25,000 (installation) = ₹50,50,000. The plant is recorded at ₹50,50,000.

Dual aspect (duality) concept

Definition: dual aspect concept. Every transaction has a dual or two-fold effect and should be recorded at two places, so at least two accounts are involved in recording any transaction.

This concept is the foundation of accounting and forms the core of the Double Entry System. It is commonly expressed through the fundamental accounting equation: Assets = Liabilities + Capital.

The assets of a business are always equal to the claims of the owners (capital, or owners' equity) and the claims of outsiders (liabilities, or creditors' equity).

Every transaction affects both sides of the equation in a way that keeps it balanced.

Worked example 2. Ram started business by investing ₹50,00,000 cash. The firm then purchased goods worth ₹10,00,000 on cash, and later purchased a machine worth ₹30,00,000 on credit from Reliable Industries. State the two-fold effect of each transaction.

Answer: (i) Investing ₹50,00,000 increases the asset cash by ₹50,00,000 and increases capital by ₹50,00,000. (ii) Buying goods for ₹10,00,000 cash increases the asset stock by ₹10,00,000 and reduces the asset cash by ₹10,00,000.

(iii) Buying machinery worth ₹30,00,000 on credit increases the asset machinery by ₹30,00,000 and increases the liability creditors (Reliable Industries) by ₹30,00,000. In each case the accounting equation, Assets = Liabilities + Capital, stays in balance.

Worked example 3. An organisation holds a factory on land costing ₹2 crore, an office building costing ₹1 crore, computers costing ₹15 lakh, office chairs and tables costing ₹2 lakh, raw material costing ₹33 lakh and finished goods costing ₹4 lakh.

What is the total value of these assets under the money measurement concept?

Answer: ₹2,00,00,000 + ₹1,00,00,000 + ₹15,00,000 + ₹2,00,000 + ₹33,00,000 + ₹4,00,000 = ₹3,59,00,000, that is, ₹3 crore and 59 lakh. These assets, though physically measured in different units (acres, rooms, numbers, tons, cartons), can only be added meaningfully once expressed in a common monetary unit.

When are revenue and expenses recognised?

Revenue recognition (realisation) concept

The concept requires that revenue for a business transaction be included in the accounting records only when it is realised.

Revenue is the gross inflow of cash arising from the sale of goods and services and from use by others of the enterprise's resources yielding interest, royalties and dividends.

Revenue is assumed to be realised when a legal right to receive it arises, that is, when goods have been sold or a service rendered.

Credit sales are treated as revenue on the day the sale is made, not when cash is received.

Income such as rent, commission or interest is recognised on a time basis, for the period to which it relates, regardless of when it is actually received or paid.

There are exceptions to this general rule: for long construction contracts, a proportionate amount of revenue based on the part of the contract completed is treated as realised, and for hire-purchase sales, the amount collected in instalments is treated as realised.

Matching concept (matching principle)

Definition: matching concept. Expenses incurred in an accounting period should be matched with the revenues of that period, so revenue and the expenses incurred to earn it must belong to the same accounting period.

An expense is recognised not when cash is paid but when an asset or service has been used to generate revenue, for example, salaries, rent and insurance are recognised on the basis of the period to which they relate, and depreciation is spread over the periods during which an asset is used.

Similarly, when ascertaining profit or loss for a year, only the cost of goods actually sold during that year is considered; the cost of unsold goods is deducted from the cost of goods produced or purchased.

The matching concept implies that all revenues earned during a year, whether received or not, and all costs incurred, whether paid or not, should be taken into account while ascertaining profit or loss for that year.

What do full disclosure, consistency, prudence and materiality require?

Full (complete) disclosure concept

Financial statements are the only, or basic, means of communicating financial information to interested parties, so they must make a full, fair and adequate disclosure of all information relevant for taking financial decisions.

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

The Companies Act, 2013 (Schedule III) provides a format for the preparation of the profit and loss account and balance sheet of a company that must be adhered to, and regulatory bodies such as SEBI mandate complete disclosures.

Consistency concept

Accounting information is useful for drawing conclusions about an enterprise only when it allows comparisons over time and with other enterprises, which is possible only when accounting policies and practices followed are uniform and consistent over time.

If, for instance, the method of depreciation used differs between two years, the profit figures of those years will not be comparable.

Consistency eliminates personal bias and helps achieve comparable results, but it does not prohibit a change in accounting policy, provided the change and its probable effect on financial results are fully disclosed.

Conservatism (prudence) concept

Definition: conservatism (prudence) concept. A conscious approach should be adopted in ascertaining income so that profits are not overstated; profits are not recorded until realised, but all losses, even those of remote possibility, are provided for in the books.

Examples include valuing closing stock at cost or market value, whichever is lower; creating a provision for doubtful debts and discount on debtors; and writing off intangible assets such as goodwill and patents.

If the market value of goods purchased has fallen, the stock is still shown at cost in the books, but if the market value has risen, the gain is not recorded until the stock is sold.

This approach may reflect a generally pessimistic attitude but protects creditors against an unwanted distribution of the firm's assets. A deliberate attempt to underestimate the value of assets should be discouraged, as it leads to hidden profits, called secret reserves.

Materiality concept

Accounting should focus on material facts; effort should not be wasted recording and presenting facts that are immaterial to the determination of income.

A fact is material if it is reasonably believed that its knowledge would influence the decision of an informed user of financial statements, for example, money spent creating additional capacity, or a change in the method of depreciation adopted.

Where amounts are very small, strict adherence to accounting principles is not required: stock of stationery such as erasers, pencils and scales is not shown as an asset; whatever is bought in a period is treated as an expense of that period, whether consumed or not.

What do objectivity, timeliness, industry practice and substance over form require?

Objectivity (verifiable objective) concept

Accounting transactions should be recorded in an objective manner, free from the bias of accountants and others, which is possible when each transaction is supported by verifiable documents or vouchers, such as a cash receipt, an invoice or a delivery challan.

One reason historical cost is adopted as the basis of recording is that it allows adherence to the principle of objectivity, since the actual cost paid can be verified from documents, whereas market value is difficult to ascertain until an asset is sold and may vary from person to person and place to place.

Timeliness, industry practice and substance over legal form

Alongside the concepts above, the timeliness principle holds that accounting information must reach users promptly enough to influence their decisions, since information that arrives too late loses much of its usefulness.

Industry practice recognises that accepted practice within a particular industry can guide the accounting treatment adopted by firms in that industry.

Substance over legal form requires that transactions be accounted for, and presented, in accordance with their economic substance and financial reality, and not merely their legal form, so that the accounts reflect what has actually happened rather than only the strict legal position.

What is the difference between cash basis and accrual basis of accounting?

There are two broad approaches to recognising revenue and costs: the cash basis and the accrual basis (also called the accrual concept).

Under the cash basis, entries are made in the books only when cash is actually received or paid, not when the receipt or payment becomes due.

Office rent for December, paid in January, would be recorded in January, and credit sales made in January would not be recorded until the payment is received, perhaps in April.

This basis is incompatible with the matching principle, since the revenue of a period is not matched with the cost of the same period; although simple, it is inappropriate for most organisations because profit is calculated merely as the difference between receipts and disbursements rather than on the happening of transactions.

Under the accrual basis, revenues and costs are recognised in the period in which they occur rather than when cash is paid or received.

A distinction is made between the receipt of cash and the right to receive cash, and between payment of cash and the legal obligation to pay it.

This is a more appropriate basis for calculating profit, since expenses are matched against the revenue earned in relation to them, for example, raw material consumed is matched against the cost of goods sold.

What are Accounting Standards: meaning and advantages and limitations?

Definition: Accounting Standards. Accounting Standards are written policy documents covering the recognition, measurement, treatment, presentation and disclosure of accounting transactions in financial statements, issued as authoritative statements by the Institute of Chartered Accountants of India (ICAI).

Their objective is to bring uniformity in different accounting policies so as to eliminate the non-comparability of financial statements and enhance their reliability.

They also provide a set of standard accounting policies, valuation norms and disclosure requirements, improving the credibility of accounting data and enhancing comparability both within a firm (intra) and between firms (inter), which is widely used by users to assess firms' performance.

Advantages of Accounting Standards

1. Accounting standards help eliminate variations in accounting treatment used to prepare financial statements.
2. They may call for disclosures of information not otherwise required by law, which may be useful to the general public, investors and creditors.
3. They facilitate comparability between the financial statements of different companies (inter-company) and within the same company over time (intra-company).

Limitations of Accounting Standards

1. Accounting standards make the choice between different alternative accounting treatments more difficult to apply.
2. They are rigidly followed and fail to extend flexibility in their application.
3. Accounting standards cannot override the statute; they must be framed within the ambit of prevailing laws.

What is IFRS (International Financial Reporting Standards)?

Definition: IFRS. International Financial Reporting Standards are a single set of global accounting standards, issued by the International Accounting Standards Board (IASB), intended to bring uniformity, comparability and transparency to the financial statements of companies across different countries.

Because companies in different countries have traditionally followed their own national accounting rules, investors and lenders comparing a company in one country with a company in another faced difficulty, since the two sets of financial statements might not be prepared on the same basis.

IFRS seeks to overcome this by providing a common accounting language that many countries have adopted or aligned their own national standards with, so that financial statements prepared in one country can be understood and compared more reliably by users elsewhere.

In this way, IFRS performs, at an international level, much the same role that national Accounting Standards (such as those issued by ICAI) perform within a single country: bringing uniformity and reliability to financial reporting.

Glossary

• GAAP — rules or guidelines adopted for recording and reporting business transactions to bring uniformity in financial statements.
• Business entity concept — the assumption that a business has a distinct existence separate from its owners.
• Money measurement concept — only transactions expressible in money are recorded, in monetary units.
• Going concern concept — the assumption that a business will continue operating indefinitely rather than being liquidated soon.
• Accounting period — the span of time, usually one year, at the end of which financial statements are prepared.
• Cost concept — assets are recorded at purchase price plus costs of acquisition, transport and installation.
• Dual aspect concept — every transaction has a two-fold effect recorded in at least two accounts.
• Accounting equation — the relationship Assets = Liabilities + Capital that must always balance.
• Revenue recognition concept — revenue is recorded only when a legal right to receive it arises.
• Matching concept — expenses of a period are matched against the revenue of the same period.
• Full disclosure concept — all material facts relevant to financial decisions must be fully disclosed.
• Consistency concept — the same accounting policies are followed from one period to the next.
• Conservatism (prudence) concept — anticipate no profits but provide for all possible losses.
• Materiality concept — only facts significant enough to influence a user's decision need strict recording.
• Objectivity concept — transactions are recorded on the basis of verifiable documents, free from bias.
• Accrual basis — revenues and costs are recognised in the period in which they occur, not when cash moves.
• IFRS — a global set of accounting standards issued by the International Accounting Standards Board.

Common errors and misconceptions

• Misconception: The owner's personal car or personal bank balance can be shown as a business asset. Correct: under the business entity concept, only the assets and liabilities of the business, not the owner's personal ones, are recorded in the business books.
• Misconception: An asset should be shown at its current market value in the balance sheet. Correct: the cost concept requires assets to be recorded at historical purchase cost, which does not change with market value.
• Misconception: Revenue is recognised only when cash is actually received. Correct: under the revenue recognition concept, revenue is recognised when a legal right to receive it arises, as with a credit sale, not when cash is received.
• Misconception: Conservatism means deliberately understating assets to create hidden reserves. Correct: conservatism means not anticipating profits and providing for all probable losses, but deliberate understatement leading to secret reserves is discouraged.
• Misconception: Consistency means an enterprise can never change its accounting policy. Correct: a policy change is permitted provided it is disclosed along with its probable effect on the financial results.
• Misconception: Cash basis and accrual basis give the same profit figure. Correct: cash basis records only actual receipts and payments, while accrual basis matches revenue and cost to the period they relate to, so profit figures usually differ.
• Misconception: Accounting Standards can be used to override a provision of law. Correct: Accounting Standards cannot override the statute and must be framed within the ambit of prevailing law.

Exam-style questions with model answers

Q1. State which basic accounting concept assumes that a business will not be liquidated in the near future. [1 mark]

1. The going concern concept, which assumes the business will continue operating for a fairly long period of time.

Q2. Distinguish between the cash basis and the accrual basis of accounting with one example each. [2 marks]

1. Under the cash basis, a transaction is recorded only when cash is actually received or paid, for example, rent for December paid in January is recorded in January.
2. Under the accrual basis, a transaction is recorded in the period to which it relates regardless of when cash moves, for example, raw material consumed is matched against the cost of goods sold in the same period.

Q3. Explain the matching concept and the conservatism concept, each with a brief example. [4 marks]

1. The matching concept requires that expenses incurred in a period be matched against the revenues of that same period, so that profit or loss reflects only the costs that produced those revenues.
2. For example, depreciation on machinery used during the year is charged against the revenue earned that year, even though the machine was paid for in an earlier year.
3. The conservatism (prudence) concept requires that profits should not be recorded until realised, while all probable losses, even of remote possibility, are provided for.
4. For example, closing stock is valued at cost or market value, whichever is lower, so an unrealised fall in value is recognised but an unrealised rise is not.

Q4. A firm purchased machinery for ₹40,000 and spent ₹2,000 on transport and ₹3,000 on installation. State the accounting concept applicable and calculate the amount at which the machine will be recorded. [3 marks]

1. The applicable concept is the cost (historical cost) concept, which requires assets to be recorded at their purchase price plus the cost of acquisition, transport and installation.
2. Calculation: ₹40,000 (purchase price) + ₹2,000 (transport) + ₹3,000 (installation) = ₹45,000.
3. The machine will be recorded in the books at ₹45,000, and this figure will not be changed later even if the market value of the machine changes.

Q5. Explain the dual aspect concept and the fundamental accounting equation, and show how the equation stays balanced when a firm buys goods worth ₹10,000 on credit. [5 marks]

1. The dual aspect concept states that every transaction has a two-fold effect and must be recorded in at least two accounts, forming the basis of the double entry system.
2. This is commonly expressed through the fundamental accounting equation: Assets = Liabilities + Capital.
3. The equation states that the assets of a business are always equal to the combined claims of the owners (capital) and outsiders (liabilities).
4. When goods worth ₹10,000 are purchased on credit, the asset stock of goods increases by ₹10,000.
5. At the same time, the liability creditors increases by ₹10,000, so the equation Assets = Liabilities + Capital continues to balance.

Q6. State the meaning of Accounting Standards and name the body that issues them in India. [2 marks]

1. Accounting Standards are written policy documents covering the recognition, measurement, treatment, presentation and disclosure of transactions in financial statements.
2. In India, they are issued by the Institute of Chartered Accountants of India (ICAI).

Q7. Explain any two advantages and any two limitations of Accounting Standards. [4 marks]

1. Advantage: Accounting standards help eliminate variations in the accounting treatment used to prepare financial statements, bringing uniformity across firms.
2. Advantage: they may call for disclosures of information not otherwise required by law but useful to investors, creditors and the public.
3. Limitation: standards make the choice between different alternative accounting treatments more difficult to apply, since flexibility is reduced.
4. Limitation: accounting standards cannot override the statute and must be framed within the ambit of the prevailing law.

Q8. What is IFRS, and why is it considered useful for comparing companies across different countries? [3 marks]

1. IFRS stands for International Financial Reporting Standards, a single set of global accounting standards issued by the International Accounting Standards Board (IASB).
2. Before such standards, companies in different countries followed different national accounting rules, making their financial statements difficult to compare directly.
3. IFRS provides a common accounting language, so that financial statements prepared under it in one country can be more reliably understood and compared by users in another country.

Key takeaways

• GAAP refers to the rules and guidelines adopted for recording and reporting business transactions so that financial statements are prepared and presented uniformly.
• The basic accounting concepts include business entity, money measurement, going concern, accounting period, cost, dual aspect, revenue recognition, matching, full disclosure, consistency, conservatism, materiality and objectivity.
• The dual aspect concept underlies the fundamental accounting equation: Assets = Liabilities + Capital.
• The cash basis records transactions only when cash moves, while the accrual basis recognises revenue and costs in the period to which they relate.
• Historical cost is preferred for recording assets because it is objective and verifiable from documents, though it does not reflect current market value.
• Conservatism means not anticipating profits but providing for all probable losses, without deliberately understating assets to create secret reserves.
• Accounting Standards, issued by the ICAI, bring uniformity and comparability to financial statements but cannot override the statute.
• IFRS is a global set of accounting standards, issued by the IASB, intended to make financial statements of companies in different countries comparable.

Test yourself

Which concept assumes that the business and its owner are two separate accounting entities?

The business entity concept, under which the owner's personal assets, liabilities and transactions are kept separate from those of the business.

Why is the fall in the value of money a limitation of the money measurement concept?

Because prices change over time, adding assets bought in different years clubs together heterogeneous values, so accounting data may not reflect the true and fair view of the business.

State the fundamental accounting equation.

Assets = Liabilities + Capital, meaning the assets of a business always equal the combined claims of owners and outsiders.

Why does the matching concept require that revenue and related expenses belong to the same accounting period?

Because profit or loss can be correctly ascertained only when the expenses incurred to earn a period's revenue are deducted from that same period's revenue.

Give one example of the application of the conservatism (prudence) concept.

Valuing closing stock at cost or market value, whichever is lower, so an unrealised fall is recognised but an unrealised rise is ignored until the stock is sold.

How does the accrual basis differ from the cash basis in recording a credit sale?

Under the accrual basis, the sale is recorded when made, regardless of when payment is received; under the cash basis, it is recorded only when cash is actually received.

Name two limitations of Accounting Standards.

They make the choice between alternative accounting treatments more difficult to apply, and they cannot override the statute, being framed within the ambit of prevailing law.

What does IFRS stand for, and which body issues it?

International Financial Reporting Standards, issued by the International Accounting Standards Board (IASB), to bring uniformity to financial statements across countries.