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Accounting Unit - 1

We Make The Difference

 Objectives
After studying this unit, you will be able to:
• Explain accounting principles
• Describe accounting Concepts and Conventions
• State the basic accounting terms.

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 Meaning

• Accounting is the process of recording financial transactions pertaining to a business.

• The accounting process includes Recording, summarizing, analyzing and reporting these
transactions to oversight agencies, regulators and tax collection entities.
• The financial statements used in accounting are a concise summary of financial transactions
over an accounting period, summarizing a company's operations, financial position and cash
flow.
• In accounting, transactions which are non-financial in character can not be recorded.
• Transactions are recorded either individually or collectively according to their groups.

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 Accounting Principles
The transactions of the business enterprise are recorded in the business language, which routed through
accounting.
The entire accounting system is governed by the practice of accountancy.
The accountancy is being practiced through the universal principles which are wholly led by the concepts
and conventions.

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Accounting Concepts
• The term ‘concepts’ is used to connote accounting postulates, that is necessary assumptions and
conditions upon which accounting is based.

• These are the theories on how and why certain categories of transactions should be treated in a
particular manner.

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Accounting Concepts

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Accounting Concepts
1. Business Entity Concept: The business and its owner(s) are two separate entities. The
transactions of a business are to be kept separate from those of its owners. By doing so, there

is no intermingling of personal and business transactions in a company's financial statements.

Example: Mr. Z has brought a capital of 1 lakh for the commencement of retailing business of
refrigerators. The brought capital of 1 lakh is utilized for the purchase of refrigerators from the

Godrej Ltd. He finally bought 10 different sized refrigerators. Out of 10 refrigerators, one was
taken away by himself as the owner. It means that 90,000 out of 1 Lakh is the volume of real
capital and the 10,000 worth of the refrigerator considered to be as drawings; which illustrates
the capital owed by the firm is only 90,000 not 1 lakh.

2. Going Concern Concept: The concept deals with the quality of long lasting status of the
business enterprise irrespective of the owners’ status, whether he is alive or not. This concept
is known as concept of long term assets. The fixed assets are bought in the intention to earn
profits during the season of the business.
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 Accounting Concepts
3. Money Measurement Concept: In accounting, a record is made only of those transactions or
events
which can be measured and expressed in terms of money. The transactions which are not in the
expression of monetary terms cannot be registered in the book of accounts as transactions.

Examples: 1. 5 machines, 1 ton of raw material, 6 fork-lift trucks, 10 lorries and so on. The early mentioned

items are not expressed in terms of money instead they are illustrated only in numbers.

4. Accounting Period Concept: The life period of the business is of a long span which is classified into the
operating periods which are smaller in duration. The accounting period may be either calendar year of
Jan.-Dec. or fiscal year of April-Mar.

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 Accounting Concepts
5. Cost Concept: Under this concept, the transactions are recorded only in terms of cost rather than in
market value. Fixed assets are only entered in terms of the purchase price which is an original cost of
the asset at the moment of purchase. The depreciation is deducted from the original value which is the
initial purchase price of the asset will highlight the book value of the asset at the end of the accounting
period. The marketing value of the asset should not be taken into consideration, why? The main reason
is that the market value of the asset is subject to fluctuations due to demand and supply forces.

6. Dual - Aspect Concept: Every transaction should have a two- sided effect to the extent of same amount.
The law of entire business revolves around only on mutual agreement sharing policy among the players.
Example : Payment of Wages = Labourers’ service

7. Matching Concept: The matching principle states that the related revenues and expenses must be matched in
the same period. This is done in order to link the costs of an asset or revenue to its benefits.
Example : The expense must relate to the period in which they were incurred rather than on the period in
which they were paid. For example, if a business pays a 10% commission to sales representatives at the end
of each month. If the company has Rs. 50,000 in sales in the month of December, the company will pay the
commission of Rs. 5,000 next January.

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 Accounting Conventions

Accounting conventions are the common practices which are universally followed in
recording and presenting accounting information of business. It helps in comparing
accounting data of different business or of same units for different periods.

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 Accounting Conventions
1. Convention of Consistency: The nature of recording the transactions should not be changed at
any cause or moment. It should be maintained throughout the life period of the firm. If a firm
follows the straight line method of charging the depreciation since its inception should be
followed without any change. The firm should not alter the method of charging the
depreciation from one method to another. The change cannot be entertained. If any change
has to be incorporated, the valid reason for change should be emphasized.
2. Convention of Conservatism: The conservatism won’t give any emphasis on the anticipation of
the firm, instead it gives paramount importance to all possible losses of the firm without
considering the future profits. This provision is created for bad and doubtful debts of the firm

in order to meet the losses expected out of the defaulters.

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 Accounting Conventions
3. Convention of Disclosure: Convention of disclosure requires that all material and relevant facts
concerning financial statements should be fully disclosed. Full disclosure means that there should be
full, fair and adequate disclosure of accounting information. Adequate means sufficient set of
information to be disclosed. Fair indicates an equitable treatment of users. Full refers to complete and

detailed presentation of information. Thus, the convention of disclosure suggests that every financial
statement should fully disclose all relevant information.
4. Convention of Materiality: The convention of materiality states that, to make financial statements
meaningful, only material fact i.e., important and relevant information should be supplied to the users

of accounting information.

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 Caselet: Rule V/s Principle

Students of accounting would be well aware of the long discussed differences between rule-based accounting and
principle-based accounting. Both have their protagonists. While the US GAAP is rule-based, the International
Accounting Standards (IAS), both as IAS and IFRS, are principle-based. The debate on which is better will be put to
rest when the US GAAP converges with IFRS eventually and becomes principle-based. Being principle-based means
that broad principles are laid out by the standard-fixing body and the interpretation is left to the users of these
standards. The problem (and also the benefit) with principle-based accounting is that most of the times, in a situation
which requires a finding, one would have to exercise a great deal of judgment based on substance as opposed to a
readymade solution being available for a particular issue prescribed in the rule-based accounting. While the US
accounting is considered to be rule-based, one can find echoes of principle based accounting also in it. In the widely
publicised 1969 case of Continental Vending where the auditors were questioned for lack of professional standards,
the court gave a direction to the jury to look at the facts and the substance of the case rather than rules of
accountancy and mere adherence to GAAP. The court held that in the audit report the statement “fairly presented …
in accordance with generally accepted accounting principles” is two statements rather than one, i.e., “fairly
presented” is principle-based and the other “in accordance with generally accepted accounting principles” is rule-
based.

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 Caselet: Rule V/s Principle

Problems for Auditors

The preparation of financial statements in accordance with the GAAP in a rule-based environment,
however, presents problems to the auditors. If an auditor were to confront the management over a certain
treatment of a transaction, the management is likely to ask the auditor “show me where it says I can’t do
that”. In other words, in a rule-based environment, the onus is on the auditor to demonstrate clearly that
the particular treatment is not permitted and hence closes the avenues for the auditor to develop further
arguments that would be available in a principle-based accounting environment (Principles-based
Accounting, by Ronald M. Mano, Matthew Mouritsen and Ryan Pace, published in the CPA Journal,
February 2006). Since accounting standards followed in India have their origin in the IAS, the Indian
accounting standards are principle-based. However, there are exceptions to the rule. One prime example is
the Income Recognition and Asset Classification (IRAC) norms prescribed by the Reserve Bank of India for
provisioning for non-performing assets applicable to banks. Thus, if any asset is non-performing, based on
certain prescribed criteria, a provision is created for the potential loan loss irrespective of the security
available with the bank.

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 Caselet: Rule V/s Principle

Subjectivity Issue
Principle-based accounting has its own issues too. Ian Wright, Director of Corporate Reporting at the
Financial Reporting Council of UK, writing in accountancy magazine (October 2008), talks about the
subjectivity that is present in the IFRS. The IFRS is full of words and phrases that are open to interpretation.
The accompanying table has a selection of the probabilities in IFRS literature that a user is expected to
interpret in the context of understanding what an accounting standard requires. Ian Wright also identifies
other issues that are potentially problematic. The IFRS literature contains an increasing range of technical
terms which don’t translate well into languages other than English. Also, the standards were written in
different eras and sometimes by individual national standard-setters due to which the usage of the English
language differs resulting in them being structured in disparate ways. One can therefore see the potential
hazards in interpreting a principle-based accounting standard that contains highly subjective phraseology. In
this context, one can expect problems of interpretation in India also. For instance, the word “shall” (a key
word in accounting standards) is used in a manner that is completely different from its usage in countries
where English is the mother tongue. Any user of IFRS would therefore need to be alive to these issues when
interpreting IFRS.
Hint: The preparation of financial statements in accordance with the GAAP in a rule-based environment.

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 NATURE OF ACCOUNTING
i) Accounting as a service activity: Accounting is a service activity. Its function is to provide quantitative
information, primarily financial in nature, about economic entities that is intended to be useful in making
economic decisions, in making reasoned choices among alternative courses of action. It means that
accounting collects financial information for the various users for taking decisions and tackling business
issues.
(ii) Accounting as a profession: Accounting is very much a profession. A profession is a career that involve
the acquiring of a specialised formal education before rendering any service.

(iii) Accounting as a social force: In early days, accounting was only to serve the interest of the owners.
Under the changing business environment the discipline of accounting and the accountant both have to
watch and protect the interests of other people who are directly or indirectly linked with the operation of
modern business. The society is composed of people as customer, shareholders, creditors and investors.
The accounting information/data is to be used to solve the problems of the public at large such as
determination and controlling of prices. Therefore, safeguarding of public interest can better be facilitated
with the help of proper, adequate and reliable accounting information and as a result of it the society at
large is benefited.

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 NATURE OF ACCOUNTING
(iv) Accounting as a language: Accounting is rightly referred the "language of business". It is one means of
reporting and communicating information about a business. As one has to learn a new language to converse
and communicate, so also accounting is to be learned and practised to communicate business events. A
language and accounting have common features as regards rules and symbols. Both are based and
propounded on fundamental rules and symbols.
(v) Accounting as science or art: Science is a systematised body of knowledge. It establishes a relationship of
cause and effect in the various related phenomenon. It is also based on some fundamental principles.
Accounting has its own principles e.g. the double entry system, which explains that every transaction has two
fold aspect i.e. debit and credit. It also lays down rules of journalising. So we can say that accounting is a
science. Art requires a perfect knowledge, interest and experience to do a work efficiently. Art also teaches us
how to do a work in the best possible way by making the best use of the available resources. Accounting is an
art as it also requires knowledge, interest and experience to maintain the books of accounts in a systematic
manner.

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 NATURE OF ACCOUNTING

(vi) Accounting as an information system: Accounting discipline will be the most useful one in the
acquisition of all the business knowledge in the near future. You will realise that people will be constantly
exposed to accounting information in their everyday life. Accounting information serves both profit-seeking
business and non-profit organisations. The accounting system of a profit-seeking organisation is an
information system designed to provide relevant financial information on the resources of a business and
the effect of their use.

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OBJECTIVES OF ACCOUNTING

1. To keep systematic records : Accounting is done to keep a systematic record of financial transactions. In
the absence of accounting there would have been terrific burden on human memory which in most
cases would have been impossible to bear.
2. To protect business properties : Accounting provides protection to business properties from unjustified
and unwarranted use. This is possible on account of accounting supplying the following information to
the manager or the proprietor:
(i) The amount of the proprietor's funds invested in the business.
(ii) How much the business have to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b) cash in hand, (c) cash at bank, (d)
stock of raw materials, work-in-progress and finished goods? Information about the above matters
helps the proprietor in assuring that the funds of the business are not necessarily kept idle or
underutilised.

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OBJECTIVES OF ACCOUNTING

3. To ascertain the operational profit or loss : Accounting helps in ascertaining the net profit earned or loss
suffered on account of carrying the business. This is done by keeping a proper record of revenues and
expense of a particular period. The Profit and Loss Account is prepared at the end of a period and if the
amount of revenue for the period is more than the expenditure incurred in earning that revenue, there is
said to be a profit. In case the expenditure exceeds the revenue, there is said to be a loss. Profit and Loss
Account will help the management, investors, creditors, etc. in knowing whether the business has proved
to be remunerative or not. In case it has not proved to be remunerative or profitable, the cause of such a
state of affairs will be investigated and necessary remedial steps will be taken.
4. To ascertain the financial position of the business : The Profit and Loss Account gives the amount of
profit or loss made by the business during a particular period. However, it is not enough. The businessman
must know about his financial position i.e. where he stands ?, what he owes and what he owns? This
objective is served by the Balance Sheet or Position Statement. The Balance Sheet is a statement of assets
and liabilities of the business on a particular date. It serves as barometer for ascertaining the financial
health of the business.

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OBJECTIVES OF ACCOUNTING

5. To facilitate rational decision making : Accounting these days has taken upon itself the task of
collection, analysis and reporting of information at the required points of time to the required levels of
authority in order to facilitate rational decision-making.
6. Information System : Accounting functions as an information system for collecting and
communicating economic information about the business enterprise. This information helps the
management in taking appropriate decisions. This function, as stated, is gaining tremendous importance
these days.

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 ACCOUNTING RECORDS

Any economic transaction or event of a business which can be expressed in monetary

terms should be recorded.
Traditionally, accounting is a method of collecting, recording, classifying, summarizing,
presenting and interpreting financial data of an economic activity.
The series of business transactions occurs during the accounting period and its
recording is referred to an accounting process/ mechanism.

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Process of Accounting

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MEANING AND FORMAT OF A JOURNAL

Journal is a historical record of business transactions or events. The word journal comes from the French
word "Jour" meaning "day". It is a book of original or prime entry written up from the various source
documents. Journal is a primary book for recording the day to day transactions in a chronological order i.e.
in the order in which they occur. The journal is a form of diary for business transactions. This is also called
the book of first entry since every transaction is recorded firstly in the journal. The format of a journal is
shown as follows :

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Illustration
From the following transactions of Nikhil, find out the nature of
accounts and also state which account should be debited and which should be credited :
i) Rent paid
ii) Interest received
iii) Purchased furniture for cash
iv) Machinery sold in cash
v) Outstanding salaries
vi) Paid to Surinder

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 Illustration
Journalise the following transactions :
2020 Rs.
Jan. 1 Mohan started business with cash 80,000
Jan. 6 Purchased goods from Ram on credit 30,000
Jan. 8 Sold goods on cash 6,000
Jan. 15 Bought Furniture from Yash for cash 8,000
Jan. 18 Paid Salary to manager 6,500
Jan. 20 Paid Rent to land lord in cash 1,000

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Compound Journal Entries
When more than two accounts are involved in a transaction and the transaction is
recorded by means of a single journal entry instead of passing several journal entries,
such single journal entry is termed as 'Compound Journal Entry’.

Illustration : Journalise the following :

Nov. 1 Paid to Arun Rs. 5,250 discount allowed by him Rs.50

6 Received from Somesh Rs. 1,900 and from Komesh Rs. 400
8 Goods purchased for cash Rs. 4,000
Furniture purchased for cash Rs. 3,000
Paid cash to Raman Rs. 2,090
Paid Salary in cash Rs. 7,600
Paid Rent in cash Rs. 1,400

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 LEDGER

Journal is a daily record of all business transactions. In the journal all transactions relating to persons,
expenses, assets, liabilities and incomes are recorded. Journal does not give a complete picture of the
fundamental elements
of book keeping i.e. properties, liabilities, proprietorship accounts and expenses and incomes at a
glance and at one place. The entries are therefore scattered over in the Journal. In fact, the whole
Journal will have to be gone through to find out the combined effect of various transactions on a
particular account. In case, at any time, a businessman wants to now :
i) How much he has to pay to the suppliers/creditors of goods ?
ii) How much he has to receive from the customers ?
iii) What is the total amount of purchases and sales made during a particular period?
iv) How much cash has been spent/incurred on various items of expenses such as salaries, rent,
carriage, stationery v) What is the amount of profit or loss made during a particular period ?
vi) What is the financial position of the unit on a particular date ?

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Format of a Ledger Account

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