BA4104 ACCOUNTING FOR DECISION MAKING

UNIT I FINANCIAL ACCOUNTING

Introduction to Financial, Cost and Management Accounting - Generally accepted

accounting principles, Conventions and Concepts - Balance sheet and related concepts-
Profit and Loss account and related concepts

Introduction to Financial Accounting

Financial accounting is the process of recording, summarizing and reporting a company’s

business transactions through financial statements. These statements are: the income statement,
the balance sheet, the cash flow statement and the statement of retained earnings.

What Are the Four Basic Financial Statements

The four basic financial statements used in financial accounting are as follows:

The Income Statement

An Income Statement is a company’s net income for a certain period of time. It is a company’s
total revenue minus its total expenses

“Profit and Loss Statement”.

The Balance Sheet

A balance sheet shows what a company owns (its “assets”) and owes (its “liabilities”) as of a
particular date, along with its shareholders’ equity.

Assets can include:

 Cash
 Prepaid Expenses
 Accounts Receivable
  Notes Receivable (money owed to the company within 1 year)
 Inventory
 Investments (including real estate)
 Buildings
 Machinery and equipment
 Vehicles
 Intangible Assets (such as patents)

Liabilities can include:

 Accounts Payable
 Loans Payable
 Notes Payable (money the company owes within 1 year)
 Unearned Revenue (a product or service a client has paid for, but the company has not
yet provided)
 Deferred Tax
 Current Taxes
 Payroll (owed but not yet paid)
 Warranty Obligations
 Mortgages

Shareholders’ Equity can include:

 Stocks (preferred and common stocks)

 Retained Earnings (money to be invested back into the business)
 Comprehensive Income (profit or loss in a company’s investments during a specific time
period)

On a balance sheet, Assets = Liabilities + Shareholders’ Equity.

The Cash Flow Statement

The cash flow statement documents in detail all of a company’s income and debts over a specific
period of time. It is only concerned with cash, as such the statement does not include
depreciation and amortization costs (like an income statement would).

A cash flow statement reflects the short-term viability of a company by indicating whether the
operation has enough working capital on hand to pay its employees and debts.

Statement of Retained Earnings

This is the amount of income a company has left over after dividends are paid to stockholders.

Introduction to cost Accounting

Cost accounting is defined as"a systematic set of procedures for recording and reporting
measurements of the cost of manufacturing goods and performing services in the aggregate and
in detail. It includes methods for recognizing, classifying, allocating, aggregating and reporting
such costs and comparing them with standard costs."

Elements of Cost Accounting

Basic cost elements are:

1. Material
2. Labour
3. Expenses and other overheads

Material (Inventory)

The materials directly contributed to a product and those easily identifiable in the finished
product are called direct materials. For example, paper in books, wood in furniture, plastic in a
water tank, and leather in shoes are direct materials. Other, usually lower cost items or
supporting material used in the production of in a finished product are called indirect materials.
For example, the length of thread used in a garment.
Furthermore, these can be categorized into three different types of inventories that must be
accounted for in different ways; raw materials, work-in-progress, and finished goods.[5]

Labour

Any wages paid to workers or a group of workers which may directly co-relate to any specific
activity of production, maintenance, transportation of material, or product, and directly associate
in the conversion of raw material into finished goods are called direct labour . Wages paid to
trainee or apprentices does not come under the category of direct labour as they have no
significant value.

Overheads

Overheads include:

 Production or works overhead including factory staff

 Administration overhead including office staff
 Sales overhead including production and maintenance of catalogues, advertising
(development and purchases), exhibitions, sales staff, cost of money
 Distribution overhead
 Maintenance and repair including office equipment and factory machinery
 Supplies
 Utilities including gas, electric, water, sewer, and municipal assessments
 Other variable expenses
 Salaries/payroll including wages, pensions, and paycheck deductions (e.g., NI and
PAYEE in the UK, FICA in the US)
 Occupancy (rent, mortgage, property taxes)
 Depreciation (durable goods including machinery and office equipment)
 Other fixed expenses

These categories are flexible, sometimes overlapping as different cost accounting principles are
applied.

Classification of Costs
1. By nature or traceability: Direct costs and indirect costs. Direct costs are directly
attributable/traceable to cost objects, while indirect costs (not being directly attributable)
are allocated or apportioned to cost objects.
2. By function: production, administration, selling and distribution, or research and
development.
3. By behavior: fixed, variable, or semi-variable. Fixed costs remain unchanged irrespective
of changes in the production volume over a given period of time. Variable costs change
according to the volume of production. Semi-variable costs are partly fixed and partly
variable.
4. By controllability: Controllable costs are those which can be controlled or influenced by
conscious management action. Uncontrollable costs cannot be controlled or influenced by
conscious management action.
5. By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-
day business operations. Abnormal costs arise because of any abnormal activity or event
not part of routine business operations, such as accidents or natural disasters.
6. By time: Historical costs and predetermined costs. Historical costs are costs incurred in
the past. Predetermined costs are computed in advance on basis of factors affecting cost
elements.
7. By decision-making costs: These costs are used for managerial decision making:
1. Marginal costs: The marginal cost is the change in the total cost caused by
increasing or decreasing output by one unit.
2. Differential costs: This cost is the difference in total cost resulting from selecting
one alternative over another.
3. Opportunity costs: The value of a benefit sacrificed in favour of an alternative
course of action.
4. Relevant cost: The relevant cost is a cost which is relevant in various decisions of
management.
5. Replacement cost: This cost is the cost at which existing items of material or fixed
assets can be replaced at present or at a future date.
6. Shutdown cost: Costs incurred if operations are shut down, and which would not
occur if operations are continued.
 7. Capacity cost: The cost incurred by a company for providing production,
administration and selling and distribution capabilities in order to perform various
functions. These costs are normally fixed costs.
8. Sunk cost: A cost already incurred, which cannot be recovered.
9. Other costs

Managerial Accounting

Managerial accounting is the practice of identifying, measuring, analyzing, interpreting, and

communicating financial information to managers for the pursuit of an organization's goals. It
varies from financial accounting because the intended purpose of managerial accounting is to
assist users internal to the company in making well-informed business decisions.

Accounting Concepts

1. Business entity concept: A business and its owner should be treated separately as far as
their financial transactions are concerned.
2. Money measurement concept: Only business transactions that can be expressed in
terms of money are recorded in accounting, though records of other types of transactions
may be kept separately.
3. Dual aspect concept: For every credit, a corresponding debit is made. The recording of a
transaction is complete only with this dual aspect.
4. Going concern concept: In accounting, a business is expected to continue for a fairly
long time and carry out its commitments and obligations. This assumes that the business
will not be forced to stop functioning and liquidate its assets at “fire-sale” prices.
5. Cost concept: The fixed assets of a business are recorded on the basis of their original
cost in the first year of accounting. Subsequently, these assets are recorded minus
depreciation. No rise or fall in market price is taken into account. The concept applies
only to fixed assets.
6. Accounting year concept: Each business chooses a specific time period to complete a
cycle of the accounting process—for example, monthly, quarterly, or annually—as per a
fiscal or a calendar year.
7. Matching concept: This principle dictates that for every entry of revenue recorded in a
given accounting period, an equal expense entry has to be recorded for correctly
calculating profit or loss in a given period.
8. Realisation concept: According to this concept, profit is recognised only when it is
earned. An advance or fee paid is not considered a profit until the goods or services have
been delivered to the buyer.

Accounting Conventions

1. There are four main conventions in practice in accounting: conservatism;

consistency; full disclosure; and materiality.
2. Conservatism is the convention by which, when two values of a transaction are
available, the lower-value transaction is recorded. By this convention, profit
should never be overestimated, and there should always be a provision for losses.
3. Consistency prescribes the use of the same accounting principles from one period
of an accounting cycle to the next, so that the same standards are applied to
calculate profit and loss.
4. Materiality means that all material facts should be recorded in accounting.
Accountants should record important data and leave out insignificant information.
5. Full disclosure entails the revelation of all information, both favourable and
detrimental to a business enterprise, and which are of material value to creditors
and debtors.
 Basic Accounting Terms
 Here is a quick look at some important accounting terms.
 Accounting equation: The accounting equation, the basis for the double-entry system
(see below), is written as follows:
 Assets = Liabilities + Stakeholders’ equity
 This means that all the assets owned by a company have been financed from loans from
creditors and from equity from investors. “Assets” here stands for cash, account
receivables, inventory, etc., that a company possesses.
 Accounting methods: Companies choose between two methods—cash accounting or
accrual accounting. Under cash basis accounting, preferred by small businesses, all
 revenues and expenditures at the time when payments are actually received or sent are
recorded. Under accrual basis accounting, income is recorded when earned and expenses
are recorded when incurred.
 Account receivable: The sum of money owed by your customers after goods or services
have been delivered and/or used.
 Account payable: The amount of money you owe creditors, suppliers, etc., in return for
goods and/or services they have delivered.
 Accrual accounting: See “accounting methods.”
 Assets (fixed and current): Current assets are assets that will be used within one year.
 For example, cash, inventory, and accounts receivable (see above). Fixed assets (non-
current) may provide benefits to a company for more than one year—for example, land
and machinery.
 Balance sheet: A financial report that provides a gist of a company’s assets and liabilities
and owner’s equity at a given time.
 Capital: A financial asset and its value, such as cash and goods. Working capital is
current assets minus current liabilities.
 Cash accounting: See “accounting methods.”
 Cash flow statement: The cash flow statement of a business shows the balance between
the amount of cash earned and the cash expenditure incurred.
 Credit and debit: A credit is an accounting entry that either increases a liability or
equity account, or decreases an asset or expense account. It is entered on the right in an
accounting entry. A debit is an accounting entry that either increases an asset or expense
account, or decreases a liability or equity account. It is entered on the left in an
accounting entry.
 Double-entry bookkeeping: Under double-entry bookkeeping, every transaction is
recorded in at least two accounts—as a credit in one account and as a debit in another.
 For example, an automobile repair shop that collects Rs. 10,000 in cash from a customer
enters this amount in the revenue credit side and also in the cash debit side. If the
customer had been given credit, “account receivable” (see above) would have been used
instead of “cash.” (Also see “single-entry bookkeeping,” below.)
 Financial statement: A financial statement is a document that reveals the financial
transactions of a business or a person. The three most important financial statements for
 businesses are the balance sheet, cash flow statement, and profit and loss statement (all
three listed here alphabetically).
 General ledger: A complete record of financial transactions over the life of a company.
 Journal entry: An entry in the journal that records financial transactions in the
chronological order.
 Profit and loss statement (income statement): A financial statement that summarises a
company’s performance by reviewing revenues, costs and expenses during a specific
period.
 Single-entry bookkeeping: Under the single-entry bookkeeping, mainly used by small
or businesses, incomes and expenses are recorded through daily and monthly summaries
of cash receipts and disbursements. (Also see “double-entry bookkeeping,” above.)
 Types of accounting: Financial accounting reports information about a company’s
performance to investors and credits. Management accounting provides financial data to
managers for business development.

Accounting

Accounting is the art of recording, classifying and summarising the economic information 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.

➢ Functions of Accounting

1) Identifying:

The first step in accounting is to determine what to record, i.e., to identify the financial events
which are to be recorded in the books of accounts. It involves observing all business activities
and selecting those events or transactions which can be considered as financial transactions.

2) Recording: A transaction will be recorded in the books of accounts only it is considered as an

economic event and can be measured in terms of money. Once the economic events are
identified and measured in economic terms they will be recorded in the books of accounts in
monetary terms and in chronological order.
3) Classifying: Once the financial transactions are recorded in journal or subsidiary books, all
the financial transactions are classified by grouping the transactions of one nature at one place in
a separate room.

4) Summarising: It is concerned with presentation of data and it begins with balance of ledger
accounts and the preparation of trial balance with the help of such balances. 5)
Communication: The main purpose of accounting is to communicate the financial information
the users who analyse them as per their individual requirements. Providing financial information
to its users is a regular process.

➢ Objectives of Accounting

1) To keep systematic and complete records of financial transactions in the books of accounts
according to specified principles and rules to avoid the possibility of omission and fraud.

2) To ascertain the profit earned or loss incurred during a particular accounting period which
further help in knowing the financial performance of a business.

3) To ascertain the financial position of the business by the means of financial statement i.e.
balance sheet which shows assets on one side and Capital & Liabilities on the other side.

4) To provide useful accounting information to users like owners, investors, creditors, banks,
employees and government authorities etc who analyze them as per their requirements.

5) To provide financial information to the management which help in decision making,

budgeting and forecasting.

6) To prevent frauds by maintaining regular and systematic accounting records.

➢ Advantages of Accounting

1) It provides information which is useful to management for making economic decisions.

2) It helps owners to compare one year’s results with those of other years to locate the factors
which leads to changes.
3) It provides information about the financial position of the business by means of balance sheet
which shows assets on one side and Capital & Liabilities on the other side.

4) It helps in keeping systematic and complete records of business transactions in the books
of accounts according to specified principles and rules, which is accepted by the Courts as
evidence.

5) It helps a firm in the assessment of its correct tax Liabilities such as income tax, sales
tax, VAT, excise duty etc.

6) Properly maintained accounts help a business entity in determining its proper purchase
Price.

➢ Limitations of Accounting

1) It is historical in nature; it does not reflect the current worth of a business. Moreover, the
figures given in financial statements ignore the effects of changes in price level.

2) It contains only those information’s which can be expressed in terms of money. It ignores
qualitative elements such as efficiency of management, quality of staff, customer’s
satisfactions etc. 3) It may be affected by window dressing i.e. manipulation in accounts to
present a more favorable position of a business firm than its actual position.

4) It is not free from personal bias and personal judgment of the people dealing with it. For
example, different people have different opinions regarding life of asset for calculating
depreciation, provision for doubtful debts etc.

5) It is based on various concepts and conventions which may hamper the disclosure of
realistic financial position of a business firm. For example, assets in balance sheet are shown
at their cost and not at their market value which could be realised on their sale.

➢ Book Keeping - The Basis of Accounting

Book keeping is the record-making phase of accounting which is concerned with the recording
of financial transactions and events relating to business in a significant and orderly manner.
Book Keeping should not be confused with accounting. Book keeping is the recording phase
while accounting is concerned with the summarizing phase of an accounting system. The
distinction between the two are as under. Accounting Book Keeping

1) It is the summarizing phase of an accounting system.

1) It is the recording phase of an accounting system.

2) It is a Secondary Stage which begins where the Book keeping process ends.

2) It is a primary stage and basis for accounting.

3) It is analytical in nature and required special skill or knowledge.

3) It is routine in nature and does not require any special skill or knowledge

4) It is done by senior staff called accountants.

4) It is done by junior staff called bookkeepers

5) It gives the complete picture of the financial conditions of the business unit.

5) It does not give the complete picture of the financial conditions of the business unit.

➢ Types of accounting information

Accounting information can be categorized into following:

1) Information relating to profit or loss i.e. income statement, shows the net profit of business
operations of a firm during a particular accounting period.

2) Information relating to Financial position i.e. Balance Sheet. It shows assets on one side and
Capital & Liabilities on the other side. Schedules and notes forming part of balance sheet and
income statement to give details of various items shown in both of them.
1) Financial Accounting:
It is that subfield/Branch of accounting which is concerned with recording of business
transactions of financial nature in a systematic manner, to ascertain the profit or loss of the
accounting period and to present the financial position of the Business.
2) Cost Accounting: It is that Subfield/Branch of accounting which is concerned with
ascertainment of total cost and per unit cost of goods or services produced/ provided by a
business firm.

3) Management Accounting: It is that subfield/Branch of accounting which is concerned with

presenting the accounting information in such a manner that help the management in planning
and controlling the operations of a business and in better decision making.

➢ Qualitative Characteristics of Accounting Information

1) Reliability: Means the information must be based on facts and be verified through
source documents by anyone. It must be free from bias and errors.

2) Relevance: To be relevant, information must be available in time and must influence

the decisions of users by helping them to form prediction about the outcomes.

3) Understandability: The information should be presented in such a manner that users

can understand it well.

4) Comparability: The information should be disclosed in such a manner that it can be

compared with previous year’s figures of business itself and other firm’s data. Accounting
information is useful for interested users only if it poses the following characteristics:

ACCOUNTING TERMS

➢ Assets

Assets are valuable and economic resources of an enterprise useful in its operations.
Assets can be broadly classified as:

1) Current Assets: Current Assets are those assets which are held for short period and can

be converted into cash within one year. For example: Debtors, stock etc.

2) Non-Current Assets: Non-Current Assets are those assets which are hold for long period and
used for normal business operation. For example: Land, Building, Machinery etc.

They are further classified into:

a) Tangible Assets: Tangible Assets are those assets which have physical existence

and can be seen and touched. For Example: Furniture, Machinery etc.

b) Intangible Assets: Intangible Assets are those assets which have no physical existence and
can be felt by operation. For example: Goodwill, Patent, Trade mark etc.

➢ Liabilities

Liabilities are obligations or debts that an enterprise has to pay after some time in the future.
Liabilities can be classified as:

1) Current Liabilities: Current Liabilities are obligations or debts that are payable within a

period of one year. For Example: Creditors, Bill Payable etc.

2) Non-Current Liabilities: Non-Current Liabilities are those obligations or debts that are
payable after a period of one year. Example: Bank Loan, Debentures etc.

➢ Receipts

A written acknowledgment of having received, or taken into one's possession, a specified

amount of money, goods, etc. receipts, the amount or quantity received. the act of receiving or
the state of being received. Receipts can be classified as:
1) Revenue Receipts: Revenue Receipts are those receipts which are occurred by normal

operation of business like money received by sale of business products.

2) Capital Receipts: Capital Receipts are those receipts which are occurred by other than
business operations like money received by sale of fixed assets.

➢ Expenses

Costs incurred by a business for earning revenue are known as expenses. For example:

Rent, Wages, Salaries, Interest etc.

➢ Expenditure

Spending money or incurring a liability for acquiring assets, goods or services is

called expenditure. The expenditure is classified as:

1) Revenue Expenditure: It is the amount spent to purchase goods and services that are used
during an accounting period is called revenue expenditure. For Example: Rent, interest, etc.

2) Capital Expenditure: If benefit of expenditure is received for more than one year, it
is called capital expenditure. Example: Purchase of Machinery.

3) Deferred Revenue Expenditure: There are certain expenditures which are revenue in nature
but benefit of which is derived over number of years. For Example: Huge Advertisement
Expenditure.

➢ Business Transaction

An Economic activity that affects financial position of the business and can be measured in
terms of money e.g., expenses etc.

➢ Account
Account refers to a summarized record of relevant transactions of particular head at one place.
All accounts are divided into two sides. The left side of an account is called debit side and the
right side of an account is called credit side.

➢ Capital

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.

➢ Drawings

The money or goods or both withdrawn by owner from business for personal use, is known as
drawings. Example: Purchase of car for wife by withdrawing money from Business.

➢ Profit

The excess of revenues over its related expenses during an accounting year is profit. Profit =
Revenue – Expenses.

➢ Gain

A non-recurring profit from events or transactions incidental to business such as sale of fixed
assets, appreciation in the value of an asset etc.

➢ Loss

The excess of expenses of a period over its related revenues is termed as loss. Loss = Expenses –
Revenue.

➢ Goods

The products in which the business deal in. The items that are purchased for the purpose of
resale and not for use in the business are called goods.
➢ Purchases

The term purchased is used only for the goods procured by a business for resale. In case of
trading concerns it is purchase of final goods and in manufacturing concern it is purchase of raw
materials. Purchases may be cash purchases or credit purchases.

➢ Purchase Return

When purchased goods are returned to the suppliers, these are known as purchase return.

➢ Sales

Sales are total revenues from goods sold or services provided to customers. Sales may be cash
sales or credit sales.

➢ Sales Return

When sold goods are returned from customer due to any reason is known as sales return.

➢ Debtors

Debtors are persons and/or other entities to whom business has sold goods and services on credit
and amount has not received yet. These are assets of the business.

➢ Creditors

If the business buys goods/services on credit and amount is still to be paid to the persons and/or
other entities, these are called creditors. These are liabilities for the business.

➢ Bill Receivable

Bill Receivable is an accounting term of Bill of Exchange. A Bill of Exchange is Bill Receivable
for seller at time of credit sale.
➢ Bill Payable

Bill Payable is also an accounting term of Bill of Exchange. A Bill of Exchange is Bill Payable
for purchaser at time of credit purchase.

➢ Discount

Discount is the rebate given by the seller to the buyer. It can be classified as:

1) Trade Discount: The purpose of this discount is to persuade the buyer to buy more goods. It
is offered at an agreed percentage of list price at the time of selling goods. This discount is not
recorded in the accounting books as it is deducted in the invoice/cash memo. 2) Cash
Discount: The objective of providing cash discount is to encourage the debtors to pay the dues
promptly. This discount is recorded in the accounting books.

➢ Income

Income is a wider term, which includes profit also. Income means increase in the wealth of the
enterprise over a period of time.

➢ Stock

The goods available with the business for sale on a particular date is known as stock.

➢ Cost

Cost refers to expenditures incurred in acquiring manufacturing and processing goods to make it
saleable.

➢ 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 goods on credit, we get an invoice, when we
make a payment we get a receipt.
➢ Double Entry System of Book-keeping

Double Entry System of Book-keeping refers to a system of accounting under which both the
aspects (i.e. debit or credit) of every transaction are recorded in the accounts involved. The
individual record of person or thing or an item of income or an expense is called an account.
Every debit has equal amount of credit. So the total of all debits must be equal to the total of all
credits.

ACCOUNTING PRINCIPLES

➢ Introduction To maintain uniformity in recording transactions and preparing financial

statements, accountants should follow Generally Accepted Accounting Principles.

➢ Accounting Principles Accounting principles are the rules of action or conduct adopted by
accountants universally while recording accounting transactions. GAAP refers to the rules or
guidelines adopted for recording and reporting of business transactions, in order to bring
uniformity in the preparation and presentation of financial statements. These principles

are classified into two categories:

1) Accounting Concepts:

They are the basic assumptions within which accounting operates.

2) Accounting Conventions:

These are the outcome of the accounting practices or principles being followed over a long
period of time.

• Features of accounting principles

(1) Accounting principles are manmade.

(2) Accounting principles are flexible in nature.

(3) Accounting principles are generally accepted.

• Necessity of accounting principles

Accounting information is meaningful and useful for users if the accounting records and
financial statements are prepared following generally accepted accounting information in
standard forms which are understood.

• Types of Accounting concepts

1) Accounting Entity or Business Entity Principle:

An entity has a separate existence from its owner. According to this principle, business is treated
as an entity, which is separate and distinct from its owner. Therefore, transactions are recorded
and analyzed, and the financial statements are prepared from the point of view of business and
not the owner. The owner is treated as a creditor (Internal liability) for his investment in the
business, i.e. to the extent of capital invested by him. Interest on capital is treated as an expense
like any other business expense. His private expenses are treated as drawings leading to
reductions in capital.

2) Money Measurement Principle:

According to this principle, only those transactions that are measured in money or can be
expressed in terms of money are recorded in the books of accounts of the enterprise. Non-
monetary events like death of any employee/Manager, strikes, disputes etc., are not recorded at
all, even though these also affect the business operations significantly.

3) Accounting Period Principle:

According to this principle, the life of an enterprise is divided into smaller periods so that
its performance can be measured at regular intervals. These smaller periods are called accounting
periods. Accounting period is defined as the interval of time, at the end of which the profit and
loss account and the balance sheet are prepared, so that the performance is measured at regular
intervals and decisions can be taken at the appropriate time. Accounting period is usually a
period of one year, which may be a financial year or a calendar year.
4) Full Disclosure Principle:

According to this principle, apart from legal requirements, all significant and material
information related to the economic affairs of the entity should be completely disclosed in its
financial statements and the accompanying notes to accounts. The financial statements should act
as a means of conveying and not concealing the information. Disclosure of information will
result in better understanding and the parties may be able to take sound decisions on the basis of
the information provided.

5) Materiality Principle:

According to this principle, only those items or information should be disclosed that have a
material effect and are relevant to the users. Disclosure of all material facts is compulsory but it
does not imply that even those figures which are irrelevant are to be included in the financial
statements. Whether an item is material or not depends on its nature. So, an item having an
insignificant effect or being irrelevant to user need not be disclosed separately, it may be merged
with other item. If the knowledge about any information is likely to affect the user’s decision, it
is termed as material Information.

6) Prudence or Conservatism Principle:

According to this principle, prospective profit should not be recorded but all prospective losses
should immediately be recorded. The objective of this principle is not to overstate the profit of
the enterprise in any case and this concept ensures that a realistic picture of the company is
portrayed. When different equally acceptable alternative methods are available, the method
having the least favorable immediate effect on profit should be adopted.

7) Cost Principle or Historical cost concept:

According to this Principle, an asset is recorded in the books of accounts at its original cost
comprising of the cost of acquisition and all the expenditure incurred for making the assets ready
to use. This cost becomes the basis of all subsequent accounting transactions for the asset. Since
the acquisition cost relates to the past, it is referred to as the Historical cost.
8) Matching Principle:

According to this principle, all expenses incurred by an enterprise during an accounting period
are matched with the revenues recognized during the same period. The matching principle
facilitates the ascertainment of the amount of profit earned or loss incurred in a particular period
by deducting the related expenses from the revenue recognized in that period. It is not relevant
when the payment was made or received. This concept should be followed to have a true and fair
view of the financial position of the company.

9) Dual Aspect Principle:

According to this principle, every business transaction has two aspects - a debit and a credit of
equal amount. In other words, for every debit there is a credit of equal amount in one or more
accounts and vice-versa. The system of recording transactions on the basis of this principle is
known as “Double Entry System”. Due to this principle, the two sides of the Balance Sheet are
always equal and the following accounting equation will always hold good at any point of time.
Assets = Liabilities + Capital Example: Ram started business with cash Rs. 1,00,000. It
increases cash in assets side and capital in liabilities- side by Rs. 1,00,000. Assets Rs. 1,00,000
= Liabilities + Capital Rs. 1,00,000.

10) Revenue Recognition Concept:

This principle is concerned with the revenue being recognised in the Income Statement of
an enterprise. Revenue is the grass inflow of cash, receivables or other considerations arising in
the course of ordinary activities of an enterprise from the sale of goods, rendering of services and
use of enterprise resources by others yielding interests, royalties and dividends. It excludes the
amount collected on behalf of third parties such as certain taxes. Revenue is recognised in the
period in which it is earned irrespective of the fact whether it is received or not during that
period.
11) Verifiable Objective concept:

This concept holds that accounting should be free from personal bias. This means that all
business transactions should be supported by business documents like cash memo, invoices, sales
bills etc.

➢ Accounting Convention

1) Convention of consistency

The convention of consistency provides that the business shall follow the same accounting
principles and methods for upcoming accounting periods.

Consistency helps the users of accounting to make conclusions and draw comparisons between
financial statements of different accounting periods.

The financial statements between two or more accounting periods can be only compared when
the accounting convention of consistency is followed.

If the business makes unnecessary changes in accounting policies each year, it would render the
comparison useless and futile.

Convention of consistency does not imply that the company shall be rigid, rather it should only
adapt to accounting principles only when necessary.

1) Going Concern Assumption:

This concept assumes that an enterprise has an indefinite life or existence. It is assumed that
the business does not have an intention to liquidate or to scale down its operations significantly.
This concept is instrumental for the company in:

1. making a distinction between capital expenditure and revenue expenditure.

2. Classification of assets and liabilities into current and non-current.

3. providing depreciation charged on fixed assets and appearance in the Balance Sheet at book
value, without having reference to their market value.
4. It may be noted that if there are good reasons to believe that the business, or some part of it,
is going to be liquidated or that it will cease to operate (say within a year or two), then the
resources could be reported at their current values (or liquidation values).

2) Consistency Assumption:

According to this assumption, accounting practices once selected and adopted, should be
applied consistently year after year. This will ensure a meaningful study of the performance of
the business for a number of years. Consistency assumption does not mean that particular
practices, once adopted, cannot be changed. The only requirement is that when a change is
desirable, it should be fully disclosed in the financial statements along with its effect on income
statement and Balance Sheet. Any accounting practice may be changed if the law or Accounting
standard requires so, to make the financial information more meaningful and transparent.

3) Accrual Assumption:

As per Accrual assumption, all revenues and costs are recognized when they are earned or
incurred. This concept applies equally to revenues and expenses. It is immaterial, whether the
cash is received or paid at the time of transaction or on a later date.

➢ Bases of Accounting

There are two bases of ascertaining profit or loss, namely:

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 Basis
Accrual Basis of Accounting Cash Basis of accounting

1) Recording of Transactions Both cash and credit transactions are recorded. Only cash
transactions are recorded.

2) Profit or Loss . Profit or Loss is ascertained correctly due to complete Correct profit/loss is
not ascertained because it records

3) Distinction between Capital and Revenue items .This method makes a distinction between
capital and revenue items. This method does not make a distinction between capital and
revenue items.

4) Legal position

This basis is recognized under the companies Act.This basis is not recognized under

the companies Act or any other act.

➢ Accounting Standards (AS)

“A mode of conduct imposed on an accountant by custom, law and a professional body.” – By

Kohler • Concept of Accounting Standards Accounting standards are written statements,
issued from time-to-time by institutions of accounting professionals, specifying uniform rules
and practices for drawing the financial Statements.

• Nature of accounting standards

1) Accounting standards are guidelines which provide the framework credible financial
statement can be produced.
2) According to change in business environment accounting standards are being changed or
revised from time to time.

3) To bring uniformity in accounting practices and to ensure consistency and comparability is

the main objective of accounting standards.

4) Where the alternative accounting practice is available, an enterprise is free to adopt. So

accounting standards are flexible.

5) Accounting standards are amendatory in nature.

Objectives of Accounting Standards

1) Accounting standards are required to bring uniformity in accounting practices and policies by
proposing standard treatment in preparation of financial statements.

2) To improve reliability of the financial statements: Statements prepared by using accounting

standards are reliable for various users, because these standards create a sense of confidence
among the users.

3) To prevent frauds and manipulation by codifying the accounting methods and practices.

4) To help Auditors: Accounting standards provide uniformity in accounting practices, so it helps

auditors to audit the books of accounts.