Accounting for management

Unit – II

Financial Accounting System – Generally Accepted

Accounting Principles and Accounting Standards
Governing Financial Statements – Contents of Profit and
Loss Account –Balance Sheet (Theory only)

Contents:
1. Generally Accepted Accounting Principles
2. Objectives
3. Introduction
4. Need for GAAP
5. Accounting standards
6. Contents of Profit and Loss Account
7. Contents of Balance sheet
 Professional accountants follow a set of standards known as the
Generally Accepted Accounting Principles (GAAP) while preparing
financial statements.

Generally Accepted Accounting Principles: GAAP

Generally accepted accounting Principles, or GAAP as they are more
commonly known, are rules for the preparation of financial statements.
Accountants all over the world have developed certain rules, procedures
and conventions which are generally referred to Generally Accepted
Accounting Principles (GAAP).

Every public traded company must release their financial statements

each year. These statements are used by investors, banks and creditors to
determine the financial health of the company and its suitability for
investment or extension of credit.

Meaning of Accounting Principles:

The term “Principle “refers to fundamental belief or a general truth
which once established does not change.

Accounting Principles can be classified into 2 categories:

(i) Accounting Concepts

(ii) Accounting Conventions

Accounting Concepts:
These may be considered as postulates i.e. Basic assumptions or
conditions upon which the science of accounting is based.

Accounting Conventions:
The term “convention” denotes traditions which guide the accountants
while preparing the accounting statements.

Accounting Principles:
Accounting Concepts Conventions
a. Business Entity a. Consistency

b. Money Measurement b. Full Disclosure

c. Going concern c. Conservatism

d. Cost d. Materiality

e. Dual Aspect

f. Accounting Period

g. Matching

h. Realisation

i. Objective Evidence
j. Accrual

a. Business Entity Concept:

The business entity concept (also known as separate entity and
economic entity concept) states that the transactions related to a
business must be recorded separately from those of its owners.

In other words, while recording transactions in a business, we take into

account that a business unit is separate and distinct from the persons
who supply capital to it. That is business is kept separate from the
proprietor so that transactions of the business, may also be recorded with
him.

This concept is very important because if transactions of a business are

mixed up with that of its owners or other businesses, the accounting
information would lose its usability.

The business entity concept of accounting is applicable to all types of

business organizations (i.e., sole proprietorship, partnership and
corporation.)

Ex: Rent paid i.e., House rent is different from business rent.

b. Money measurement concept:

Money Measurement Concept in accounting, also known as
Measurability Concept, means that only transactions and events that are
capable of being measured in monetary terms are recognized in the
financial statements.

Ex → Furniture: If the business owned 2 chairs, 10 tables like that it

should record its monetary value only. That is its monetary value may be
Rs.15,000.
→ Land: The business unit may be possessing Land of 5 Acres. It
should record its monetary value only say Rs.50 lakh.

c. Going Concern Concept or Continue of Activity Concept:

The going concern concept of accounting implies that the business
entity will continue its operations in the future and will not liquidate or
be forced to discontinue operations due to any reason.

A company is a going concern if no evidence is available to believe that

it will or will have to cease its operations in foreseeable future.

An example of the application of going concern concept of accounting is

the computation of depreciation on the basis of expected economic life
of fixed assets rather than their current market value.

Companies assume that their business will continue for an indefinite

period of time and the assets will be used in the business until fully
depreciated.

Another example of the going concern assumption is the prepayment

and accrual of expenses. Companies prepay and accrue expenses
because they believe that they will continue operations in future.

d. Cost Concept:
The cost principle is an accounting principle that requires assets,
liabilities, and equity investments to be recorded on financial records at
their original cost.

The cost principle is also known as the historical cost principle and the
historical cost concept.
Ex: Machinery purchased for Rs. 1,00,000. The market value at the end
of the year may be Rs. 2,00,000. But it must be shown in accounts as Rs.
1lakh only. If any depreciation, it must be deducted.
Rs.1,00,000 minus 10,000 = Rs.90,000.

e. Dual aspect concept:

As per double entry accounting, it is known that any transaction of a
business is recorded in two separate accounts.
The dual aspect concept indicates that each transaction made by a
business impacts the business in two different aspects which are equal
and opposite in nature.

This concept form the basis of double-entry accounting and is used by

all accounting frameworks for generating accurate and reliable financial
statements.
The accounting equation used in this concept is:
Assets = Liabilities + Equity

The accounting equation is registered in the balance sheet, where the

amount of the total assets should be equal to liabilities and equity of the
firm.
Dual aspect concept is also described as the duality principle.
This concept explains that if something is given, someone will receive it.
This can be explained as whenever a transaction occurs, there is a two-
sided effect.

One is credit, and the other is debit for a similar amount.

It means one is benefit given and the other is benefit received.

Ex: Assets = Equities

Machinery = Rs.25,000
Furniture = Rs. 15,000
Cash = Rs. 10,000

Total assets = Rs. 50,000 = capital

Subsequently, if the business purchases stock worth Rs. 10,000 on

credit, the position will be as follows:

Machinery Rs. 25,000 + Furniture Rs.15,000 + Cash Rs.10,000

+ stock Rs.10,000 = Creditors Rs.10,000 + Capital Rs.50,000

Assets Rs.60,000 = Equities ( or liabilities + capital) Rs. 60,000

The accounting equation demonstrates the fact that for every debit
there is an equivalent credit.

f. Accounting period concept:

This concept helps in estimating the profit or loss and financial position
of a business for a particular period.
If there are different accounting periods then various problems can arise
like in the calculation of profits, comparability of various incomes &
expenses etc.
Thus to study the results of a business, the life of a business is divided
into short periods of equal length. Each such period is known
as accounting period.

Generally, an accounting period is one year.

Hence, an income statement shows the financial performance over
one year while
a balance sheet shows the financial position at the end of a year.
This year may not necessarily be a calendar year.
It may run from January to December, or from July of one year to
June of the next or 1st April to 31st March.

g. Matching Concept:
Matching principle is an important concept of accrual
accounting which states that the revenues and related expenses must be
matched in the same period to which they relate.
Additionally, the expenses must relate to the period in which they have
been incurred and not to the period in which the payment for them is
made.
For example, a company consumes electricity for the whole month of
January, but pays its electricity bill in February.
So if the company has been operating under “cash based accounting”,
they may have recorded the expense in the month of February, as it has
actually paid cash in February. But under “accruals accounting” the
entity is bound to record the electricity expense for the month of January
and not February, because the expense has originally been incurred in
January.
h. Realisation concept:
Realisation being one of the fundamental principle of accounting states that
revenue is recognized by the seller when it is earned irrespective of whether
the cash from the transaction has been received or not. It is also known as
revenue recognition concept.

Example:
Consider a case where an order was received in April, the goods were
transferred in May and the payment was received in June.
The revenue would be deemed to have been earned in May when the
transfer took place notwithstanding the fact that the order was received
in April and cash was received in June.

If Mr. A sold goods worth of Rs.1,000 to Mr. B, the later agrees on the
proposal that goods will be transferred after 15 days.

After receiving goods Mr. B makes payment after 10 days.

Here according to the Realization Principle of Accounting, sales are
considered when the goods are transferred from Mr. A to Mr. B.

i. Objective Evidence Concept:

It states that no accounting record should be made unless it is supported
by independently verifiable (i.e., objective) evidence.

Generally, such evidence is in writing or should be reduced to writing

before an accounting entry is made.
All transactions must be evidenced by a document, e.g., cash sales are
evidenced by cash memos, credit sales by invoices, payments through
bank etc.

Purchase of things of larger value like land, building, motor vehicles,

etc. is generally supported by elaborate legal documentation like title
deeds, sale deed etc.

j. Accrual Concept:
Accrual accounting is an accounting method where revenue or
expenses are recorded when a transaction occurs rather than when
payment is received or made.
The method follows the matching principle, which says that revenues
and expenses should be recognized in the same period.
Therefore, outstanding expenses and outstanding incomes are taken into
consideration while preparing final accounts.

ACCOUNTING CONVENTIONS:
i. Consistency

ii. Full Disclosure

iii. Conservatism or prudence

iv. Materiality
i. Consistency:

Convention of consistency means to use the same accounting methods

for making financial statement in different years.

When we use same accounting methods, it is easy for us to compare the

financial statements of different years.

For example: There are many inventory valuation methods like LIFO,
FIFO and average cost method.

If we use same method of inventory valuation of inventory, it will be

very good for comparing the financial statement of two or more years.

Closing stock affects both profit and loss account and balance sheet. If
there will be consistence in its valuation, we can analyze our financial
statement very with accuracy.

Above is just example, when we do our accounting practice, we should

use so many accounting procedures and methods.

All should be consistent. If we do any change in our accounting

tradition, we have to disclose it in the footnote of our financial
statement.

For example, we have used fixed installment method of depreciation for

10 years, if we applied diminishing method of depreciation in this year,
we should disclose this fact in the footnote of our financial statement.

ii. Full Disclosure:

The purpose of the full disclosure principle is to share relevant and
material financial information with the outside world. Since outsiders
 don’t know the details of a company’s business deals, contracts, and
loans.

It’s difficult to form an opinion of the entity. Relevant information to

outsiders is anything that could change an external user’s decision about
the company.

This can include transactions that have already occurred as well as future
events contingent on third parties.

Any type of information that could sway the judgment of an outsider

should be included in the financial statements in an effort to be
transparent.

iii. Convention of Conservatism or prudence:

This is the policy of “Playing Safe”. According to this Conservatism or
prudence principle, current assets are valued at cost or market price
whichever is lesser.

This convention follows the rule, “anticipate no profit but provide for all
possible losses”. This Convention requires that proper care should be
kept while calculating the revenues.

iv. Convention of Materiality:

Whether something should be disclosed or not in the financial

statements will depend on whether it is material or not ?

Materiality depends on the amount involved in the transaction.

For example,
Minor expenditure of Rs.50 for the purchase of waste basket may be
treated as an expense rather than an asset.
Accounting Standards:
An accounting standard is a common set of principles, standards, and
procedures that define the basis of financial accounting policies and
practices.

These are authoritative standards for financial reporting and are the
primary source of Generally Accepted accounting principles (GAAP).

Accounting standards specify how transactions and other events are to

be recognized, measured, presented and disclosed in financial
statements.

Accounting standards translate general accounting principles to specific

accounting rules and are mandatory to be followed.

Accounting Standards in India

The Institute of Chartered Accountants of India (ICAI) is the
national professional accounting body of India. It was established on 1
July 1949 as a statutory body under the Chartered Accountants Act,
1949 enacted by the Parliament .

Accounting Standards Board (ASB) which was constituted as a body on

21st April, 1977. ASB is a committee under Institute of Chartered
Accountants of India (ICAI) which consists of representatives from
Government department, academicians, other professional bodies.

The Objectives of the ASB are as follows:

i. To suggest areas in which accounting standards need to be
developed.
ii. To examine how far the relevant international accounting standards
can be adapted while formulating the accounting standards, and
adapt the same.

iii. To provide from time to time, interpretation and guidance on

accounting standards.

International Accounting Standards Committee (IASC) was set up

in 1973, with headquarters in London.

The American Institute of Certified Public Accountants developed,

managed and enacted the first set of accounting standards.

These responsibilities were given to the newly created Financial

Accounting Standards Board.

KEY POINTS:
 An accounting standard is a common set of principles, standards, and
procedures that define the basis of financial accounting policies and
practices.

 Accounting standards apply to the full breadth of a entity’s financial

picture, including assets, liabilities, revenue, expenses and
shareholders' equity.

The” Accounting standards” issued by the ASB are to be complied by

the business entities.
The mandatory status of an accounting standard implies that while
discharging their audit functions, it will be the duty of the members of
the Institute of Chartered Accountants of India (ICAI) to examine
whether the accounting standard(s) is (are) complied with in the
presentation of financial statements covered by their audit.

In the event of any deviation from the accounting standards, it will be

their duty to make adequate disclosures in their audit reports so that the
users of the financial statements are aware of such deviation.

From 1st April, 2015

Accounting standard compliance is mandatory for

(a) Enterprises whose equity or debt securities are listed on a

recognized stock exchange in India or outside having net worth
of INR 500 cr. or more.
(b) Unlisted companies having networth of INR 500 crore or more.

From 1st April, 2017 (Phase II)

It is mandatory for unlisted companies having net worth of INR 250 cr.
or more but less than INR 500 cr.

Following is the list of some important Accounting Standards:

AS 1 - Disclosure of Accounting policies.

These were issued in the year 1979. It is related with disclosure
requirements of the accounting policies followed in preparing financial
statements. The areas in which different policies can be followed are
 - Accounting for depreciation
- Revaluation of inventories
- Valuation of fixed assets etc.,

AS 2 - Valuation of Inventories (Revised)

As per this standard, the cost of inventories should comprise costs of
purchase and costs incurred in bringing the inventories to their present
location.

AS 3 – Cash Flow Statements (Revised)

It deals with the provision of information about the historical changes
in cash of an enterprise by means of cash flow statement. That is
operating, investing and financing activities.

AS 4 - Events after Balance Sheet Date

It deals with those events that take place after the Balance Sheet date but
before approval of the same by the Board of Directors.
(making of Provision for all known liabilities and losses). For instance,
if a debtor becomes insolvent after the BS date, adjustment should be
made for loss on receivables in the B/S.

AS 7 - Construction Contracts (Revised)

This standard prescribes the accounting treatment of revenue and costs
associated with construction contracts by laying down certain guidelines.
As per this standard, the gross amount due from and to customers for
contract works are shown as asset and liability respectively.

AS 10 – Accounting for Fixed Assets:

This standard deals with the disclosure of the status of the fixed assets in
terms of value. An entity should disclose the gross and net book values
of fixed assets at beginning and end of an accounting period showing
additions, disposals and acquisitions etc.,

AS 11 – Effects of changes in Foreign Exchange Rates:

An enterprise may carry on activities involving foreign exchange in 2
ways.
a. by transacting in foreign currencies
b. by indulging in foreign operations
The standard requires the enterprises to disclose the amount of exchange
differences adjusted in the carrying amount of fixed assets.

AS 12 – Accounting for Government Grants

It prescribes the accounting treatment of Govt. grants and the manner in
which the necessary disclosures should be made.

AS 13 – Accounting for Investments:

The enterprises are required to disclose the current investments and long
term investments.
AS 14 – Accounting for Amalgamations:
It prescribes the accounting treatment for amalgamations.
 Amalgamation in the nature of merger
 Amalgamation in the nature of purchase

AS 15 - Employee Benefits:
This standard requires enterprises to recognize the employee benefits
and to be paid in future. These are wages, salaries etc., and post-
employment benefits like gratuity, pension etc.,

AS 19 – Lease:
It prescribes the accounting and disclosure requirements regarding
leases. These must be shown clearly in the financial statement of
Balance Sheet.

AS 27 – Financial reporting of Interests in Joint ventures:

It prescribes the principles and procedures for accounting for interests in
joint ventures regarding assets, liabilities, income and expenditure in the
financial statements.

AS 29 – Provisions, contingent liabilities and contingent

Assets:
It applies in accounting for provisions to be made for contingent
liabilities and contingent assets (insurance companies).
AS 30 AS 31 and AS 32 are withdrawn by ICAI.
Final Accounts

Non- manufacturing entities are the trading entities which are engaged
in the purchase and sale of goods at a profit without changing the form
of the goods. At the end of the year, it prepares final accounts

1. Trading account
2. Profit and loss account and
3. Balance sheet

Manufacturing entities generally prepare a separate Manufacturing

account as a part of Final accounts in addition to Trading account, profit
and loss account and Balance Sheet.

The objective of preparing Manufacturing account is to determine

manufacturing costs of finished goods.

Manufacturing costs of finished goods are then transferred from

manufacturing account to Trading account.
 Design of a Manufacturing account

Dr. Cr.

Particulars Amt Particulars Amt

To Raw-material consumed:

Opening stock By Cost of

goods
+ Purchases xxx
Manufactured
- Closing stock xxx
(Transferred to
To Direct wages xxx trading
account)
To Direct exp. xxx

Prime cost xxx

To Factory overheads

To Indirect exp.

Repairs &maintenance xxx

Depreciation xxx
Salary of foreman xxx

Factory cost xxx

To Opening work-in-process xxx

- Closing work-in-progress
- Sale of scrap

xxx

xxx

Trading Account
This account is the first account prepared as a final account, it is
prepared to ascertain gross profit or gross loss incurred during an
accounting period. On the debit side i.e. the LHS of the trading account
items such as opening stock, purchases, and all direct expenses are
shown.

Gross Profit – If the total of credit side is greater than debit side i.e.
RHS > LHS the excess is called Gross Profit. It is transferred to the
credit side of Profit and Loss account.
Gross Loss – If the total of the debit side is greater than the credit side
i.e. LHS > RHS the excess is called Gross Loss. It is transferred to the
debit side of Profit and Loss account.

Profit and Loss Account

After preparation of trading account a profit and loss account also
known as an income statement is prepared to ascertain the Net Profit or
Net Loss incurred by a business. It begins with Gross Profit or Gross
Loss being transferred from the trading account.

On the debit side of a Profit and Loss account, all indirect

expenses such as salary, rent, office and admin, marketing, stationery
etc. and loss incurred by the sale of assets or fire/theft etc. are
mentioned.

On the credit side of a Profit and Loss account, all indirect

incomes such as interest earned, dividends received on shares, bad debts
recovered, profit on the sale of assets etc. are mentioned.

Below is a sample format of profit and loss account or income

statement
 Profit and loss Appropriation Account
Dr. Cr.

Amount in Rs Lak.

Particulars Amt. Particulars Amt.

To Statutory reserve 28.0
By Net profit after
To Gen. Reserve 35.0
taxes
280
To Machine replacement
reserve 30.0

To Dividend proposed 84.0

Balance Sheet or Position Statement
Both trading account and income statement help to determine the
profitability of a business whereas a balance sheet is constructed to find
out the financial position of the business as on a particular date. The
balance sheet consists of capital, assets, and liabilities of a business.

It provides information about the financial standing or position of a

firm at a particular point of time, say as on March 31, 2017. It is valid
for only one day --- the reference day. The position of the firm on the
preceding or following day is most likely to be different.

It is a statement and not an account, it has no debit or credit side there

“To” & “By” are not used inside a balance sheet. On the LHS of a
balance sheet are all liabilities including capital and

RHS will be all assets, for a balance sheet liability will always be equal
to assets.

Balance sheet
Liabilities Rs. Assets Rs.

Sundry Creditors xxxxx Cash in hand Xxxx

Bills Payable Xxxxx Cash at Bank Xxxx
Outstanding amounts Bills receivable Xxxx
Bank Loans Xxxx Prepaid expenses Xxxx
Long term borrowings xxxx Furniture and
Other loans Fixtures Xxxx
Short-term borrowings Xxxx Motor car Xxxx
xxxx Goodwill Xxxx
Capital Patents Xxxx
(+) Net Profit xxxx Copy rights Xxxx
(-) Net Loss Computer software
Licences and Xxxx
franchises
Fixed deposits Xxxx
Plant & Machinery Xxxx
Land & Buildings Xxxx
Investments Xxxx
Sundry Debtors Xxxxx
Closing stock Xxxx
Xxxx
xxxxx
Xxxxxxx Xxxx
----------- -----------

The Balance Sheet should be prepared (in vertical form) in accordance

with companies (Indian Accounting Standards (IND AS ) Rules 2015. It
is mandatory for all Companies having net worth greater than or equal to
Rs.250 Crores. For companies having net worth of less than Rs.250 cr.
the adoption of the format is voluntary.
The new format classifies assets only in 2 categories.
1. Current assets and
2. Non-current assets (which are long term assets)

Like that liabilities have also been segregated in 2 groups.

1. Equity (representing shareholders’ funds including preferential
share capital) and
2. Liabilities indicating external liabilities payable.
 Form of Balance sheet

Name of the company -------

Balance sheet as at -------
In Rs.----
Particulars Figures at Figures at the
the end of end of
current previous
period period
 1. ASSETS

Non-current assets
b. Property, plant & equipment
c. Goodwill
d. Intangible assets
e. Intangible under development
f. Financial assets
(i) Investments
(ii) Loans
g. Other non-current assets

2. Current assets

a. Inventories
b.Financial assets

(i) Investments
(ii) Trade receivables
(iii) Cash and cash equivalents
(iv) Loans
(v) Other financial assets
(vi) Other current assets

TOTAL
______________________
EQUITY AND LIABILITIES

1.Equity
(a) Equity share capital
(b) Other equity ( capital reserves and capital
redemption reserve)
2. Liabilities
Non-current liabilities
 (a) Financial liabilities
(i) Borrowings
(ii) Other financial liabilities
(b) Deferred payment liabilities
(c) Provisions
(d) Deferred tax liabilities(net)

Current liabilities

(a) Financial liabilities

i. Borrowings
ii. Trade payables
iii. Other financial liabilities
(b) Other current liabilities
(c) Provisions
Total liabilities
Problem: 1

The following balances were extracted from the books of Thomas as on

31st March, 2018

Additional information:
i. Closing stock Rs. 9,000
ii. Provide depreciation @ 10% on machinery
iii. Interest accrued on investment Rs. 2,000

Prepare trading account, profit and loss account and balance sheet.
Solution:

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