SAI KRIPA

ACCOUNTING THEORY
By:- CA Rakesh Kalra

INTRODUCTION OF ACCOUNTING AND ACCOUNTING PROCESS

1. ACCOUNTING: -
Accounting is Recording Financial Transactions, Summarising them and communicating the
financial information to users (i.e. Proprietors, Creditors, Investors, Government
agencies, researchers, Consumers, Public etc.). It is because of these characteristics that
accounting is necessary for each and every enterprise and now it becomes the Language
of Business.

“Accounting is the art of recording, classifying and summarising in a significant manner

and In terms of money; transactions and event which are, in part at least, of a financial
character, and interpreting the result thereof.”Issued by Terminology of the American
Institute of Certified Public Accountants

2. ACCOUNTING CONCEPTS
There are Ten Accounting concepts which everyone has to follow while maintaining books
of accounts of the Business. These Accounting Concepts are universally applicable, and
accepted by all accounting Institutes. These are back bone of Accountancy, they are as
follows: -

Business Entity Concept: - According to this concept business is considered separate

from its business man. All transactions are viewed and recorded in the books of accounts
from the Business point of view and not business man point of view. For Example- amount
invested by Mr X a business man in his Firm XYZ Limited will be viewed and recorded from
the XYZ Limited’s point of view and not from X’s point of view, so such amount will
become liability of the business and business has to show such liability in his Balance
Sheet.

Money Measurement Concept: - According to this Concept only those transaction are
recorded in the books of accounts which can be measures in terms on money only and
those transactions which are not measures in terms of money are not recorded in books of
accounts. This concept states that money is the common denominator in recording all
transaction. For Example- suppose business has 50,000 kg of raw material or it has 65,000
square feet of land that in books of accounts only their monetary value will be shown i.e.
they will be converted into money terms.
This concept has limitations also as it is not recorded those transactions which are not in
money terms however it effected routine work or profitability of business such as-
suppose there will be a fight between management and worker and due to this factory
remain close for 2 months, this will affect the profitability of business but it cannot be
recorded anywhere as management Fight cannot converted in term of money.

Going Concern Concept: - According to this concept it is assumed that business will
continue for an indefinite period and there is no intention to close the business or scale
down its operation significantly. For Example- Because of this concept Business will
consider for purchasing long term assets like Land, Machinery, Plant, etc. this concept
will assume that business man will run the business in future and will not have any
intention to make his production down.
Accounting Period Concept: - According to this concept the indefinite life of business is
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broken into smaller period generally one year to measure its performance i.e. to
calculate profit. This concept states that as per going concern concept the life of business
is indefinite, but the performance of the business will be measures in one year intervals.

Cost Concept: -This concept is for assets of the company, according to this concept all
assets are recorded it the books of the accounts at the value which are spend for its
purchase that is assets are recorded at purchase cost of it and same will be reduced for
the depreciation point of view, suppose a firm purchased Land for Rs 1500,000 and
Depreciation of land is Rs 100,000 so at the end of the year Land will be show in Balance
sheet at Rs 1400,000 (1500,000 – 100,000). This concept has one limitation also that it
will not consider market value of assets it recorded assets on historical cost only for
example- If in above example such land is purchased in year 1990 than in Balance Sheet it
will be recorded at Purchase cost reduced by depreciation however its market value on
present date is Rs 75,00,000.

Dual Aspect Concept: - According to dual aspect concept, every transaction entered into
enterprises must have two effects. These two effects must be of equal amount For
Example- Mr X invested Rs 500,000 in his business XYZ Limited, this transaction will also
recorded with effects such as Capital of the Business will increases and Assets (cash) will
also increase.

Revenue Recognition Concept: - According to these concept Revenue will be

Recognised/ considered when transaction is entered and obligation to receive payment is
arises, For Example- if goods are sold in the month of March but its payment received in
August than the Revenue is recognised in March i.e. when transaction of sale occurred
and legal obligation to receive amount is arises.

Matching Concept: -According to matching concept all the cost which is incurred to earn
the revenue should be recognised as expenses in the period when revenue is recognised.
For Example- Rs 25000 is spend to make the sale of goods whose income is recognised in
next year than such expenses will be considered to be the expense of next year and in
current year it will become prepaid expense and show in Balance sheet as Assets.

Accrual Concept: -As per this concept, a transaction is recorded at the time when it take
place and not when the settlement take place. For Example- Mr X Purchased a Car on May
2009 but its payment was made on December 2009 than in such case Car will be recorded
in balance sheet of X as Assets on May 2009 as Computer become assets of X on May 2009
with legal obligation.

Verifiable Objective Concept: - This Concept states that Accounting should be free from
all personal bias. All accounting transaction should be evidenced and supported by
business documents. For Example- Sale should be recorded only if there are Sales
invoices/ bills.

Convention of full disclosure: - According to this convention there should be complete

and understandable reporting on the financial statement of all the significant information
relating to the economic affairs of the business.

Convention of Consistency: - According to this convention, any accounting practise once

adapted and selected should be applied consistently year after year. This convention
helps in making financial statement capable of being comparable from previous year to
current year.
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Prudence Concept: - This Concept states that financial statement must present a realistic
picture of enterprises, it can easily understandable with English saying that “Do not
anticipate a profit, but provide for all possible losses” and “it takes into consideration
all prospective losses but not the prospective profits/gains.” It is also known as
Conservatism approach or conservatism state of mind.

Materiality Concept: - Material Concept states that item or event must be disclosed in
financial statement only if it is material. The term material means important nature of
such event, materiality define by American Accountant association that “an item is
regarded as material if there is a reason to believe that knowledge of it would influence
the decision of investors.” For Example- An event of spending an amount of Rs 500,000
paid for repair of Plant & Machinery where the Business has Sales of Rs 350,000 only
however same event will become immaterial for the business were Sales are Rs
50,00,00,000/-

3. BASIS OF ACCOUNTING
One of the basic functions of accountancy is to provide information related to profit
earned by a business enterprise during an accounting period. There are two methods for
preparing financial statements and calculating profit of the period such as: -

BASIS OF ACCOUNTING

Cash Basis Accounting Accrual Basis of Accounting

Accrual Basis Accounting: - Under Accrual basis of accounting all the Accounting
concepts like Revenue Recognition, Accrual concept and matching concept are applied.
Under this system of accounting Incomes and Expenses are recorded when they are due
actual receipt or payment of money is irrelevant in such system.

Cash Basis Accounting: - This is a system were the transactions are recorded only when
cash is paid or received by/to the business. Under this system there is no concept of
Accrual or Matching concepts, here transaction are recorded only when Cash paid or
received. For Example- an amount of Rs 25,000 is paid for rent of next year but it will
recorded as expenditure in a year in which it is paid not when the benefit realise from it.
Suppose a Sale of goods were made on 2009 but its amount were received in 2010 than it
will considerbeing the Income of the year 2010.

4. Financial Statements
The aim of accounting is to keep systematic records to ascertain financial performance and financial
position of an entity and to communicate the relevant financial information to the interested user groups.
The financial statements are basic means through which the management of an entity makes public
communication of the financial information along with selected quantitative details. All the entities will
prepare financial statements viz., balance sheet, profit and loss account, cash flow statement etc. by
following various accounting concepts, principles, and conventions which have been already discussed in
detail.

Qualitative Characteristics of Financial Statements

Understandability: An essential quality of the information provided in financial statements is that it must be
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readily understandable by users. For this purpose, it is assumed that users have a reasonable knowledge of
business,
economic activities and accounting and study the information with reasonable diligence. Information
about complex matters that should be included in the financial statements because of its relevance to
the economic decision-making needs of users should not be excluded merely on the ground that it may be
too difficult for certain users to understand.

Relevance: To be useful, information must be relevant to the decision-making needs of users. Information
has the quality of relevance when it influences the economic decisions of users by helping them evaluate
past, present or future events or confirming, or correcting, their past evaluations.

Reliability: To be useful, information must also be reliable, Information has the quality of reliability when
it is free from material error and bias and can be depended upon by users to represent faithfully that
which it either purports to represent or could reasonably be expected to represent.

Comparability: Users must be able to compare the financial statements of an enterprise through time in order
to identify trends in its financial position, performance and cash flows. Users must also be able to compare the
financial statements of different enterprises in order to evaluate their relative financial position,
performance and cash flows.

Materiality: The relevance of information is affected by its materiality. Information is material if its
misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users
Investors.

Completeness: To be reliable, the information in financial statements must be complete within the
bounds of materiality and cost. An omission can cause information to be false or misleading and thus
unreliable and deficient in terms of its relevance.

5. Capital Expenditure V/S Revenue Expenditure

Revenue expenditures are transferred to profit and loss account in the year of spending while capital
expenditures are transferred to profit and loss account of the year in which their benefits are utilised.
Therefore we can conclude that it is the time factor, which is the main determinant for transferring the
expenditure to profit and loss account. Also expenses are recognized in profit and loss account through
matching concept which tells us when and howmuch of the expenses to be charged against revenue.
However, distinction between capital and revenue creates a considerable difficulty. In many cases borderline
between the two is very thin.
The basic considerations in distinction between capital and revenue expenditures are:

Nature of business: For a trader dealing in furniture, purchase of furniture is revenue expenditure but
for any other trade, the purchase of furniture should be treated as capital expenditure and shown in the
balance sheet as asset. Therefore, the nature of business is a very important criteria in separating an
expenditure between capital and revenue.

Recurring nature of expenditure: If the frequency of an expense is quite often in an accounting year
then it is said to be an expenditure of revenue nature while non-recurring expenditure is infrequent in
nature and do not occur often in an accounting year. Monthly salary or rent is the example of revenue
expenditure as they are incurred every month while purchase of assets is not the transaction done regularly
therefore, classified as capital expenditure unless materiality criteria defines it as revenue expenditure.

Purpose of expenses: Expenses for repairs of machine may be incurred in course of normal maintenance of
the asset. Such expenses are revenue in nature. On the other hand, expenditure incurred for major repair
of the asset so as to increase its productive capacity is capital in nature. However, determination of the
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cost of maintenance and ordinary repairs which should be expensed, as opposed to a cost which ought to be
capitalised, is not always simple.

Effect on revenue generating capacity of business: The expenses which help to generate income/
revenue in the current period are revenue in nature and should be matched against the revenue earned in
the current period. On the other hand, if expenditure helps to generate revenue over more than one
accounting period, it is generally called capital expenditure.
When expenditure on improvements and repair of a fixed asset is done, it has to be charged to Profit and
Loss Account if the expected future benefits from fixed assets do not change, and it will be included in book
value of fixed asset, where the expected future benefits from assets increase.

Materiality of the amount involved: Relative proportion of the amount involved is another important
consideration in distinction between revenue and capital.

Example 1
State with reasons whether the following statements are ‘True’ or ‘False’.
i. Overhaul expenses of second-hand machinery purchased are Revenue Expenditure.
ii. Money spent to reduce working expenses is Revenue Expenditure.
iii. Legal fees to acquire property is Capital Expenditure.
iv. Amount spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the
v. plaintiff’s land is Capital Expenditure.
vi. Amount spent for replacement of worn out part of machine is Capital Expenditure.
vii. Expense incurred on the repairs and white washing for the first time on purchase of an old
building are Revenue Expenses.
viii. Expenses in connection with obtaining a license for running the cinema is Capital Expenditure.
ix. Amount spent for the construction of temporary huts, which were necessary for construction
of the Cinema House and were demolished when the cinema house was ready, is Capital
Expenditure.

Example 2
State with reasons whether the following are Capital or Revenue Expenditure:
i. Expenses incurred in connection with obtaining a license for starting the factory for ` 10,000.
ii. ` 1,000 paid for removal of Inventory to a new site.
iii. Rings and Pistons of an engine were changed at a cost of ` 5,000 to get fuel efficiency.
iv. Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) ` 8,000 for installing telephone in the
office.
v. A factory shed was constructed at a cost of ` 1,00,000. A sum of ` 5,000 had been incurred in
the construction of temporary huts for storing building material

Example 3
State with reasons, how you would classify the following items of expenditure:
i. Overhauling expenses of ` 25,000 for the engine of a motor car to get better fuel efficiency.
ii. Inauguration expenses of ` 25 lacs incurred on the opening of a new manufacturing unit in an
existing business.
iii. Compensation of ` 2.5 crores paid to workers, who opted for voluntary retirement.

Example 4
Classify the following expenditures and receipts as capital or revenue:
i. ` 10,000 spent as travelling expenses of the directors on trips abroad for purchase of capital
assets.
ii. Amount received from Trade receivables during the year.
iii. Amount spent on demolition of building to construct a bigger building on the same site.
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 iv. Insurance claim received on account of a machinery damaged by fire.

Example 5
Are the following expenditures capital in nature?
i. M/s ABC & Co. run a restaurant. They renovate some of the old cabins. Because of this renovation
some space was made free and number of cabins was increased from 10 to 13. The total
expenditure was 20,000.
ii. M/s New Delhi Financing Co. sold certain goods on installment payment basis. Five customers did
notpay installments. To recover such outstanding installments, the firm spent ` 10,000 on account of
legal expenses.
iii. M/s Ballav & Co. of Delhi purchased a machinery from M/s Shah & Co. of Ahmedabad. M/s Ballav
& Co. spent ` 40,000 for transportation of such machinery. The year ending is 31st Dec, 2019.

Example 6
Classify the following expenditures as capital or revenue receipt or capital orrevenue
expenditure:
i. Traveling expenses of the chief executive officer for trips abroad for purchase of
capital assets.
ii. Amount spent on making a few more exists in a Cinema Hall to comply with
Government orders.
iii. Insurance claim received on account of inventory damaged by fire.
iv. Amount paid for removal of stock to a new site.
v. Cost of repairs on second-hand car purchased to bring it into working condition.

Example 7
Classify the following expenditures as capital or revenue expenditure:
i. Insurance claim received on account of inventory damaged by fire.
ii. Amount spent as lawyer’s fee to defend a suit claiming that the firm’s factory site
belonged to the plaintiff’s land.
iii. Travelling expenses of the chief financial officer on trips abroad for purchase of
special machinery.
iv. Dividend received from XYZ limited during the year.

Example 8
Classify the following expenditures as capital or revenue expenditure:
i. Expenses incurred to keep the machine in working condition.
ii. Registration fees paid at the time of purchase of a building.
iii. Expenses incurred for advertisement in newspaper.
iv. Amount spent on renewal fee of patent rights.
v. Cost of repairs on second-hand car purchased to bring it into working condition.

Example 9
Classify the following expenditures as capital or revenue expenditure:
i. An extension of railway tracks in the factory area.
ii. Amount spent on painting the factory
iii. Payment of wages for building a new office extension.
iv. Amount paid for removal of stock to a new site.
v. Rings and Pistons of an engine were changed to get full efficiency

6. Contingent Assets

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A contingent asset may be defined as a possible asset that arises from past events and whose existence
will be confirmed only after occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the enterprise
As per the concept of prudence as well as the present accounting standards, an enterprise should not
recognise a contingent asset.

7. Contingent Liability
a possible obligation that arises from past events and the existence of which will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the enterprise.
An enterprise should not recognise a contingent liability in balance sheet, however it is
required to be disclosed in the notes to accounts, unless possibility of outflow of a
resource embodying economic benefits is remote

8. Provisions
Provision means “any amount written off or retained by way of providing for depreciation, renewal or
diminution in the value of assets or retained by way of providing for any known liability of which the
amount cannot be determined with substantial accuracy”.

9. Accounting Policy
Accounting Policies refer to specific accounting principles and methods of applying these
principles adopted by the enterprise in the preparation and presentation of financial
statements. Policies are based on various accounting concepts, principles and conventions.
There is no single list of accounting policies, which are applicable to all enterprises in all
circumstances. Enterprises operate in diverse and complex environmental situations and so
they have to adopt various policies.

Selection of Accounting Policy

It is believed that no unified and exhaustive list of accounting policies can be suggested which has
universal application. Three major characteristics which should be considered for the purpose of selection
and application of accounting policies.
❖ Prudence
❖ Substance over form
❖ Materiality.
The financial statements should be prepared on the basis of such accounting policies, which exhibit true
and fair view of state of affairs of Balance Sheet and the Profit & Loss Account.

Change In Accounting Policy

A change in accounting policies should be made in the following conditions:
❖ It is required by some statute
❖ For compliance with an Accounting Standard.
❖ Change would result in more appropriate presentation of financial statement.

10. Prime objectives for providing depreciation are:

Correct income measurement: Depreciation should be charged for proper estimation
of periodic profit or loss. In case an enterprise does not account for depreciation on
Property, Plant & Equipment, it will not be considering loss in value of property, plant
& equipment due to their use in production or operations of the enterprise and will
not result in true profit or loss for the period.

True position statement: Value of the Property, Plant & Equipment should be adjusted
for depreciation charged in order to depict the actual financial position. In case
depreciation is not accounted for appropriately, the property, plant and equipment would
be disclosed in financial statements at a value higher than their true value. We should

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always present the same at its unexpired cost which is after charging the expired cost
as depreciation.

Funds for replacement: Generation of adequate funds in the hands of the business for
replacement of the asset at the end of its useful life. Depreciation is a good indication
of the amount an enterprise should set aside to replace a fixed asset after its economic
useful life is over. However, the replacement cost of a fixed asset may additionally be
impacted by inflation or other technological changes.

Ascertainment of true cost of production: For ascertaining the cost of the production,
it is necessary to charge depreciation as an item of cost of production.

11. Promissory Notes

A promissory note is an instrument in writing, not being a bank note or currency note
containing an unconditional undertaking signed by the maker to pay a certain sum of
money only to or to the order of a certain person. Under Section 31(2) of the Reserve
Bank of India Act a promissory note cannot be made payable to bearer.
A promissory note has the following characteristics:
• It must be in writing.
• It must contain a clear promise to pay. Mere acknowledgement of a debt is
not a promissory note.
• The promise to pay must be unconditional.“I promise to pay `50,000 as
soon as I can” is not an unconditional promise.
• The promiser or maker must sign the promissory note.
• The maker must be a certain person.
• The payee (the person to whom the payment is promised) must also be
certain.
• The sum payable must be certain. “I promise to pay `50,000 plus all fine”
is not certain.
• Payment must be in legal currency of the country.
• It should not be made payable to the bearer.
• It should be properly stamped.

OBJECTIVES OF ACCOUNTING STANDARDS

i. eliminate the non-comparability of financial statements and thereby improving the
reliability of financial statements; and
ii. provide a set of standard accounting policies, valuation norms and disclosure
requirements.

BENEFITS OF ACCOUNTING STANDARDS

(i) Standards reduce to a reasonable extent or eliminate altogether confusing
variations in the accounting treatments used to prepare financial statements.
(ii) There are certain areas where important information are not statutorily required
to be disclosed. Standards may call for disclosure beyond that required by law.
(iii) The application of accounting standards would, to a limited extent, facilitate
comparison of financial statements of companies situated in different parts of
the world and also of different companies situated in the same country. However,
it should be noted in this respect that differences in the institutions, traditions
and legal systems from one country to another give rise to differences in
accounting standards adopted in different countries.

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LIMITATION OF ACCOUNTING STANDARDS
However, there are some limitations of accounting standards:
i. Difficulties in making choice between different treatments: Alternative
solutions to certain accounting problems may each have arguments to
recommend them. Therefore, the choice between different alternative accounting
treatments may become difficult.
ii. Restricted scope: Accounting standards cannot override the statute. The standards
are required to be framed within the ambit of prevailing statutes.

LIST OF ACCOUNTING STANDARDS IN INDIA

Sl. Number of the Title of the Accounting Standard
No. Accounting
Standard (AS)

1. AS 1 Disclosure of Accounting Policies

2. AS 2 (Revised) Valuation of Inventories
3. AS 3 (Revised) Cash Flow Statements
4. AS 4 (Revised) Contingencies and Events Occurring after the Balance Sheet
Date

5. AS 5 (Revised) Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies

6. AS 7 (Revised) Accounting for Construction Contracts

7. AS 9 Revenue Recognition
8. AS 10 Property, Plant and Equipment
9. AS 11 (Revised) The Effects of Changes in Foreign Exchange Rates
10. AS 12 Accounting for Government Grants
11. AS 13 Accounting for Investments
12. AS 14 Accounting for Amalgamations
13. AS 15 (Revised) Employee Benefits
14. AS 16 Borrowing Costs
15. AS 17 Segment Reporting
16. AS 18 Related Party Disclosures
17. AS 19 Leases
18. AS 20 Earnings Per Share
19. AS 21 Consolidated Financial Statements
20. AS 22 Accounting for Taxes on Income
21. AS 23 Accounting for Investments in Associates in Consolidated
Financial Statements
22. AS 24 Discontinuing Operations

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23. AS 25 Interim Financial Reporting
24. AS 26 Intangible Assets
25. AS 27 Financial Reporting of Interests in Joint Ventures
26. AS 28 Impairment of Assets
27. AS 29 Provisions, Contingent Liabilities & Contingent Assets

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