20

ACCOUNTANCY

CHAPTER 2

Theory Base of Accounting

LEARNING OBJECTIVES

After studying this chapter, you will be able to :

comprehend the meaning of Generally Accepted Accounting Principles (GAAP),

state and relate the basic operating guidelines used by accountants in the accounting process,

explain the basic assumptions;

explain the accounting principles;

explain the modifying principles.

21

THEORY BASE OF ACCOUNTING

We have discussed the meaning and

objectives of accounting in the
preceding chapter. It was discussed
that basic objective of accounting is to
provide information to the different
users. This information is embodied in
Profit & Loss Statement and Balance
Sheet which contain ter ms and
concepts, having their basis in the
theoretical foundation of accounting,
usually, referred to as Generally
Accepted Accounting Principles
(GAAP). The set of rules and practices
followed in recording transactions and
preparing financial statements are
usually called Generally Accepted
Accounting Principles. GAAP provides
a set of guidelines to be observed by
the accounting profession for
preparing and reporting the financial
information. The guidelines can be
categorized into basic assumptions,
principles and modifying principles
(figure 2.1).

The understanding of these

guidelines is important for both, the
accountants who prepare the financial
statements, and the users who need
to use these statements. Now, we will
discuss these assumptions and
principles.
2.1 Basic Assumptions
Assumptions are traditions and
customs, which have been developed
over a period of time and wellaccepted by the profession. Basic
accounting assumptions provide a
foundation for recording the transactions and preparing the financial
statements there from. There are four
basic assumptions that are
considered as cornerstones of the
foundation of accounting. These are:
accounting entity, money measurement, going concern and accounting
period which are discussed below:

Generally Accepted Accounting Principles

Principles

Modifying
Principles

Accounting Entity

Duality

Cost-benefit

Money Measurement
Going Concern
Accounting Period

Revenue Recognition
Historical Cost
Matching
Full Disclosure
Objectivity

Materiality
Prudence
Consistency
Timeliness
Substance over Legal
form
Industry practice

Fig. 2.1

Assumptions

Accounting
Standards

Issued by
Accounting
Standards Board
(Indian And
International)

22

ACCOUNTANCY

2.1.1 Accounting Entity Assumption

Accounting entity assumption states
that the activities of a business entity
be kept separate from its owners and
all other entities. In other words,
according to this assumption business
unit is considered a distinct entity from
its owners and all other entities having
transactions with it. For example, in
the case of proprietorship, the law does
not make any distinction between the
proprietorship firm and the proprietor
in the event of firms inability to pay
its debts. Hence, in this situation, to
meet the deficit, law requires the
proprietor to pay firms debts from his/
her personal assets. But, these two are
treated as separate entities while
recording business transactions and
preparing the financial statements.
This assumption enables the
accountant to distinguish between the
transactions of the business and those

of the owners. Consequently, the

capital brought into the business and
withdrawals from the business by the
owners will also be recorded in the
same manner as that of transaction
with other entities. For example, if the
owner brings in cash or any other
asset, it will result in increase in assets
of the business and capital of the firm.
This capital represents firms liability
to the owner. The expenses of the
owner paid by the firm assets are
recorded as withdrawals from the
business. This means the profit and
loss account will show the revenues
and expenses related to the business
entity only. Consequently, balance
sheet will show the assets and
liabilities of the business entity only.
This assumption is followed in all
organizations irrespective of their form,
i.e., sole proprietorship, partnership,
cooperative, or company.

A manufacturing company owns different assets such as 200 sq mts of land; building with
40,000 sq feet of built-up area; furniture and fittings comprising of 2 sofa sets, 2 central
tables, 10 chairs, 6 computer tables, 2 steel almirahs and electrical fittings (switches,
wires, tube lights, fans, etc. ); plant and machinery capable of processing 200 units of
output per day; 2 cars, 1 delivery van; 5000 Kgs of raw materials, etc. Since these assets
are expressed in different units of measurement, they cannot be subjected to any
arithmetical calculation. However, all these assets must have been acquired by paying
certain amount of money (i.e., rupees). Hence, using rupee as a unit of measurement,
these can be expressed as follows:
Land
:
Rs. 2,00,000
Building
:
Rs. 13,70,000
Furniture and Fittings
:
Rs.
25,000
Plant and Machinery
:
Rs. 3,85,000
Motor vehicles
:
Rs. 8,75,000
(2 cars + 1 van)
Raw Materials
:
Rs.
75,000
Now, we can say that the total assets owned by the firm amounts to Rs.29,30,000.
Box 2.1

THEORY BASE OF ACCOUNTING

2.1.2 Money Measurement

Assumption
This assumption requires use of
monetary unit as a basis of
measurement, i.e., the currency of the
country where the organization is to
report its operations. This implies that
those transactions which can not be
measured by monetary unit will not
be recorded in the books of accounts.
Monetary unit is supposed to provide
a common yardstick to measure the
assets, liabilities and equity of the
business. The dif ferent items,
expressed in varied basis of
measurement, like area, volume,
numbers, cannot be added together
because of heterogeneity of scales of
measurement. But, once all these are
converted into a homogeneous unit of
money, they can be added together or
subjected to any arithmetical
calculations. It also indicates that
certain infor mation, howsoever
important it may be to state the true
and fair picture of the entity, will not
be recorded in the financial accounting
books if it can not be expressed in
terms of money. For example, the
union-management relations, health of
the key manager, quality of its
manufacturing facilities, etc. can not
be expressed in monetary value, and
hence, are not recorded in books of
accounts.
It is clear from the above that
money measurement assumption
makes the accounting records clear,
simple, comparable and under standable. The acceptability of money
as a unit of measurement is not free

23

from problems when we compare the

financial statement over a period of
time or integrate the financial
statements of an entity having
operations in more than one nation.
This is to be noted that the assumption
implies stability of measuring unit over
a period of time. This may not be true
over a period of time because prices of
goods and services may change, hence,
the purchasing power (value) of money
may undergo changes. But these
changes are not usually recorded. This
af fects the comparability of the
financial statements prepared at
different time periods.
2.1.3 Going Concern Assumption
The financial statements are prepared
assuming that the business will have
an indefinite life unless there is
evidence to the contrary. The business
is called going concer n thereby
implying that it will remain in
operation in the foreseeable future
unless it is to be liquidated in the near
future. Since, this assumption believes
in continuity of the business over
indefinite period, it is also known as
continuity assumption. The going
concern assumption facilitates that
distinction made between: (i) fixed
assets and current assets, (ii) Short
term and long term liabilities, and (iii)
capital and revenue expenditure.
2.1.4 Accounting Period Assumption
We have stated in the previous
paragraph that accountants assume
business to be in activities in the
foreseeable future. Therefore, results

24

of business operations cannot be truly

ascertained before the closure of the
business operations. But this period
is too long and the users of the
accounting information cannot wait for
such a long period of time. Hence, the
accountants make the assumption of
accounting period (also known as
periodicity assumption). This
assumption permits the accountant to
divide the lifespan of the business
enterprise into different time periods
known as accounting period
(quarterly, half-yearly, annually) for
the purpose of preparing financial
statements. Hence, financial statements are prepared for an accounting
period and results thereof are reported
on periodic basis.
This assumption requires that the
distinction be made between the
expenditure incurred and consumed
in the period, and the expenditure,
which is to be carried forward to the
future period. The cut off period for
reporting the financial results is
usually considered to be twelve
months. Usually the same is true for
tax purpose. However, in some cases
accounting period may be more or less
than 12 months depending on the
needs of business enterprises. For
example, a company can prepare its
first financial statements for a period
of more than or less than one year.
Currently, the interim reports issued
by the company, though unaudited are
not less reliable. Such information is
considered to be more relevant for
decision-makers because of timeliness
and certainty of information.

ACCOUNTANCY

This assumption requires deferring

of costs that are not related to the
revenues of the current period. The
assumption of continuity allows
depreciation on fixed assets to be
charged in the profit & loss account
and show the assets in the balance
sheet at net book value (cost of
acquisition less depreciation). The
income measurement is done on the
basis of continuity assumption whereby
unexpired costs are carried to next
period as assets and not charged to
current years income. In those cases,
where, it is reasonably certain that the
business will be liquidated in the near
future, the resources may be reported
on the basis of current realizable values
(or liquidation value). Also, in such
a case, this fact needs to be clearly
reported in the financial statements.
2.2 Basic Accounting Principles
Basic accounting principles are the
general decision rules which govern
the development of accounting
techniques. These principles, do not
violate or conflict with the four basic
assumptions discussed above, but
refine the application thereof. The
following are the basic accounting
principles:

Duality (Dual Aspect Principle)

Revenue Recognition Principle
Historical Cost Principle
Matching Principle
Full Disclosure Principle
Objectivity

These are discussed hereunder:

THEORY BASE OF ACCOUNTING

2.2.1 Duality
This principle states that every
transaction has two aspects. It
therefore, implies that minimum two
accounts will be involved in recording
a transaction. When an investment is
made by the owner in the business, it
results in increase in an asset and
increase in owners equity. Thus, this
transaction is recorded considering
these two aspects, i.e. asset and
owners equity. Every transaction will
af fect the accounting equation,
whereby, there will be corresponding
increase or decrease on both sides of
the equation or increase and decrease
on one side of the equation. The
accounting equation is given below:
Assets = Liabilities + Owners
Equity
The enterprise can acquire an asset
by sacrificing another asset, incurring
the liability or receiving it from owner
(resulting in increase in owners
equity). The use of accounting equation
for processing of business transaction
is discussed in the next chapter.
2.2.2 Revenue Recognition Principle
Revenue recognition (Revenue realization) principle helps in ascertaining
the amount and time of recognizing the
revenues from the business activities.
Revenues are the amount a business
ear ns by selling its products or
providing services to the customers.
The revenue is deemed to have been
earned in the period in which the sale
has taken place or services have been
performed to the satisfaction of the

25

customer and the revenue has been

received or becomes receivable.
However, there may be situations
where, within the accounting period,
sale may not have concluded or
services have not been fully rendered.
This poses the problem of revenue
recognition.
Normally, the revenue is recognized at the point of sale when title to
the goods passes from the seller to the
buyer. However, there are few exceptions to this rule of revenue recognition.
In a situation where the
gover nment has appointed an
authority to acquire entire production,
such as refine of gold, the revenue may
be recognized on the completion of the
refining irrespective of the fact of
physical transfer of goods.
In case of work to be completed on
contractual basis taking longer period
of time such as road construction,
bridge construction, the revenue may
be recognized on the basis of cash
received on partially completed and
certified works. In such contracts,
payment is made on the basis of the
terms of contract, which specify partial
payment in relation to the work
certified and completed. On the
completion of contract, the remaining
amount is treated as sales.
In some cases, revenue may be
realized at the time of receiving cash
and not at the time of providing
services. For example, a lawyer may
charge the fee from his client and treat
it as revenue earned for the current
period, whereas legal services may be
provided in future.

26

ACCOUNTANCY

A Ltd. purchased equipment from X Ltd. for Rs. 57,000 on 1 April 1999. The freight and
cartage of Rs. 1,200 is spent to bring the asset to the factory (intended condition of use)
and Rs. 3,000 is incurred on installing the equipment to make it possible for the use
(intended condition of use). In this case, the cost of acquisition which is the historical cost
is Rs. 61,200. This amount can objectively be ascertained from the invoice and hence
verifiable. After the purchase of equipment even if its price increases in the market, the
company will continue to show it at its historical cost, i.e. Rs. 61,200.
Box 2.2

The basic test, as discussed above,

is used to ascertain the revenue. The
revenue from permitting other entities
to use the enterprises asset is to be
recognized as the time passes or as the
asset is used. The rent from the
premises let out or interest on money
loaned will be recognized on the basis
of passage of time. The royalty may be
recognized on the basis of production/
sale of the products.
2.2.3 Historical Cost Principle
Historical cost principle requires that
all transactions should be recorded at
their acquisition cost. The cost of
acquisition refers to the cost of
purchasing the asset and expenses
incurred in bringing the asset to the
intended condition and location of use.
In other words acquisition cost is equal
to buying price plus all expenses
incurred to put the asset to use. The
cost is historical in nature and will not
change year after year. This implies
that no adjustment is made for any
change in the market value of such
assets.
The advantage of using historical
cost for recording the transactions is
that it is objective, verifiable and

reliable. Thus, it imparts reliability to

the financial statements.
2.2.4 Matching Principle
Matching principle requires that the
expenses should be matched with the
revenues generated in the relevant
period. The simple rule that followed
in this context is, let expenses follow
revenues.
The Matching Principle by relating
expenses to the associated revenues
helps in measuring income (profit) for
the given period. It is of great
significance since the performance of
an entity is usually measured in terms
of income earned by the entity.
We do not recognize the expense
when cash is paid or when a product
is produced. It is recognized when the
service or the product actually
contributes to the revenue. Therefore,
expenses are not related to the period
of cash outflow but to the period in
which the revenues are generated. The
matching principle requires that part
of the cost of fixed assets used in the
operations of the business, known as
depreciation, is treated as expense of
the period. Likewise, in case revenues
received in advance for which the

27

THEORY BASE OF ACCOUNTING

services have not been rendered will

be treated as unearned income, and
hence, it will be carried forward to the
following accounting period.
2.2.5 Full Disclosure Principle
Full disclosure principle requires that
all those facts that are necessary for
discharging the accountability and
proper understanding of the financial
statements must be revealed. All
material infor mation should be
disclosed fully and completely, which
is relevant for decisions to be taken by
users. The infor mation may be
disclosed in the main body of the
financial statements, schedules and
annexure, and the footnotes appended
thereto. Further, it requires that any
significant event, which takes place
after the balance sheet date and is
likely to affects the financial status of
the enterprise significantly, should
also be reported in notes to financial
statements. There might be some
claims pending against the firm, which
if not revealed in the financial
statements will mislead the users. The
regulatory bodies like SEBI mandates
disclosures to be made by the
companies to portray true and fair view
of business operations to ensure
discharge of accountability. Accountability is said to have been discharged
if complete information is delivered
with due diligence by the prepares
(management and accountants) of that
information, so that the economic
interest of the users of the information
is not adversely affected.

2.2.6 Objectivity Principle

The principle of objectivity implies that
the accounting data should be
verifiable and free from any bias. In
fact, to generate the reliable
accounting information, the basic
requirements are neutrality (free from
bias) and verifiability. The historical
cost recorded in the books is on the
basis of original documents, which
contain the information, which is not
af fected by the personal bias.
Therefore, the accounting entries are
recorded on the objective basis and is
verifiable from the source documents.
Historical cost accounting, therefore,
is preferred inspite of its shortcomings
due to objectivity.
2.3 Modifying Principles
The basic assumptions and accounting
principles discussed above provide a
set of operating guidelines for the
preparation of financial statements.
These guidelines are used while
preparing the financial statements
with the basic objective of making the
information useful for the users. The
information is considered to be useful
if it is reliable and relevant. The
information is said to be reliable when
it is free from error and bias and
faithfully represents what it seeks to
represent. The information must be
believed to be reliable by the users for
a given purpose. To ensure that
information is reliable it must be
verifiable, neutral and faithful in
representing the economic condition.
Information is said to be relevant if it

28

influences the decision. For financial

information to be useful, apart from
it being reliable and relevant should
be understandable and comparable.
The financial infor mation is
comparable when policies used are
consistent at inter -firm and interperiod levels.
Generally, the financial statements
are prepared keeping in view the basic
principles and assumptions of
accounting. However, difficulties are
encountered in relation to the
application of accounting principles in
certain situations which call for the
modified application of the principles
and assumptions of accounting. These
constraints are referred to as
modifying principles. These are cost
benefit, materiality, consistency,
prudence, timeliness substance over
legal form and industry-practices
which need to be considered for
making the information useful. In the
following paragraphs these modifying
principles are discussed.
2.3.1 Cost Benefit
This modifying principle states that
cost of generating the information
should not exceed the benefits to be
derived from it. Sometimes application
of a particular principle may be
desirable but will not be beneficial
because it does not generate materially
significant information but cost of
generating the information by using
the principle is higher. This modifying
principle, implies that the cost of
applying the principle should not
exceed its benefits. It thus, plays a role

ACCOUNTANCY

in weeding out the redundancy in

information. For example, companies
registered under The Companies Act,
1956 were earlier required to give
unabridged annual report to all its
shareholders. But, as the number of
shareholders increased manifold and
the cost of paper and printing rose
considerably, The Act was amended,
where by, companies are now required
to give abridged reports to the
shareholders. In many developed
countries, the companies were
required to give, on supplementary
basis, the effect of price level changes
on its financial results. Since evidences
from recent studies suggesting that the
additional benefits from such
disclosures were not more than the
cost of providing additional
infor mation, this practice has
therefore, been discontinued.
A few years before, companies were
required to disclose detailed
information about employees such as
qualification, experience, previous
employment and relationship with
directors if any for those drawing
salary above Rs. 36,000 per annum.
Though, the information was quite
crucial in its intent, but due to increase
in salaries due to inflation, even the
employees at low levels such as drivers,
peons would figure in the list. Had
the limit not been raised, this would
have marred the quality of information.
Therefore, government was persuaded
to increase the limit of the emoluments
draws by employees to improve the
quality of information and reduction
of cost of information.

29

THEORY BASE OF ACCOUNTING

2.3.2 Materiality Principle

The term materiality refers to the relative importance of an item. It requires
that while recording and presenting
the financial information, the focus
should be on material items. Immaterial items/events should be ignored.
An item or event is considered to be
material if it is likely to be relevant to
the user of financial statements. According to this modifying principle items
of insignificant effect or which are not
relevant to the user need not be disclosed.
The items of insignificant effect are
to be viewed in relation to the size of a
company. It is not possible to define
materiality precisely since it is a
relative term. An item of expense may
be insignificant for a big organization,
and need not be reported separately,
may not be true for a small
organization. The amounts reported in
balance sheet and income statement
may be reported by approximating it
to the nearest thousands, lacs,
millions, or crores of rupees depending
upon the amounts under individual
heads to be reported. For the sake of
better understanding while reporting
the items in financial statements
approximate numbers are preferred to
precise numbers. The purchase of
certain items of small amount may be
treated as expense whereas in real life
these may be carried over to next
year. For example, stationery items
like pens, stapler, scissors, etc. may
be treated as expense once issued
to employees for work and may
be clubbed under the head of
Office stationery expense. However,

mate-riality varies from industry to

industry as well as country to country.
2.3.3 Consistency Principle
The Consistency principle requires
that the accounting policies, which are
used from period to period, should not
change. Hence, their application is
assumed to be consistent. This implies
that users of the financial statement
have a right to assume that accounting
policies have been followed on
consistently followed from time to
time. In case there is a change in any
of the accounting policies in a
particular accounting period, the
revised statement of accounting policy,
as well as, its impact on the reported
income of the year should be disclosed
clearly. The same is true when different
firms operating in an industry follow
the same accounting policies and
reporting method. This helps in
comparing the financial results across
the firms and over a period of time.
The consistency helps in comparing
the accounting reports.
However, consistency principle
does not prohibit the change in the
accounting policy/method when it is
preferable to old one since the new
method will result in more meaningful
information. It also requires that the
nature and effect of change in the
accounting
method
and
the
justification for the change must be
disclosed in the financial statements
in the form of footnotes. It will enable
the users of accounting information to
be aware of such facts and consider
them while using these statements.

30

2.3.4 Prudence (Conservatism)

The Prudence principle is applied
when more than one alternative is
available to record the transaction. The
principle of prudence implies that the
profit should not be over stated but all
anticipated losses should be recognized and related. The implication of
this is that all anticipated losses
should be recognized and recorded,
but no unrealized gain should be
recognized and recorded in the books
of account. If the market price of
investment is lower than the cost, then
the investments are recorded at
market price, whereas, if the market
price is above the cost, investments
will be reported at cost only. In a
consistently falling market price
situation, the inventories will be valued
at lower of cost or market price. Here,
inventory is not valued at market price
by sacrificing the historical cost
principle but because of prudence,
which dictates that future loss should
be accounted for immediately. Hence,
market price, which is lower than cost,
is a well-accepted principle for
valuation of inventories.
This modifying principle is applied
by choosing the alternative resulting
in reporting income/assets at lower
figure in case of great uncertainty and
doubt. This implies that errors
resulting in measuring income and
assets are preferred in the direction of
understatement rather than over statement. Prudence, thus, as
explained earlier, suggests that profits
are recognized only when realized
(need not necessarily be in cash) but

ACCOUNTANCY

all anticipated losses must be

immediately accounted for.
2.3.5 Timeliness
An information is useful for a decision
maker if it is relevant and reliable.
Information looses its relevance if it is
not available in time. Timeliness refers
to the fact that information must be
available to the users before it looses
its capacity to influence decisions. The
Companies Act, therefore, requires
that the annual reports must be
submitted to the Registrar and made
available to users within a specified
period of time after the close of financial year. It also requires companies
to publish unaudited quarterly reports
in the national newspapers.
2.3.6 Substance Over Legal Form
The transactions and events recorded
in the books of accounts and presented
in the financial statements, according
to this modifying principle, should be
governed by the substance of such
transactions and not the legality of
such transactions. In certain cases,
therefore, the transactions presented
may not represent the true legal
position. For example, in contrast to
outright purchase, under hire
purchase system assets are used for
business purpose but ownership does
not rest with the hire. Purchaser till
the last installment is paid. Yet, these
are recorded at cash price as assets of
the business. In this case, therefore,
we see that substance of the
transaction gets preference over legal
position.

THEORY BASE OF ACCOUNTING

2.3.7 Industry Practice

The GAAP are followed by the
enterprises but sometimes certain
practical considerations require that
the enterprises in an given industry
depart for m GAAP. The unique
characteristics of some industries may
require varied application of the
principles. For example, banks are
governed by the Banking Companies
(regulation) Act, therefore, the
reporting format for banks is strikingly
dif ferent from other companies
governed by the Companies Act, 1956.
Banks and insurance companies are
required to report certain investment
securities at cost rather than lower of
cost or market.
2.4 Accounting Standards
Accounting is considered as a language
of business. Even language has its own
grammar providing certain set of rules,
which are required to be followed.
Likewise, accounting has certain
norms to be observed by the accountants in recording of transactions and
preparation of financial statements.
These norms become accounting
standards when a professional body
codifies and makes them mandatory
for recording and reporting purposes.
These rules reduce the vagueness and
chances of misunderstanding by
harmonizing the varied applications
and practices. Similarly, accounting
also requires adherence to certain set
of rules, and guidelines, which reduces

31

the flexibility in preparation of financial

statements.
In 1977, the Institute of Chartered
Accountants of India set up the
Accounting Standards Board (ASB)
with the responsibility of developing
accounting standards and issuing
guidelines for implementation thereof.
For the purpose of income tax, Central
Board of Direct Taxes (CBDT) has also
set up its own standards setting body
to take care of the accounting practice
with regard to computation of income
and wealth for taxation purposes.
Currently, the members of the ASB are
drawn from the members of council of
ICAI, representatives from Industry,
Bank, Company Law Board, Central
Board of Direct Taxes, Comptroller and
Auditor General of India, Security
Exchange Board of India, etc.
ASB is assigned with the task of
formulating the standards by giving
due consideration to the International
Accounting Standards because India
is a member of International Accounting settings body. It tries to integrate
IAS to the extent possible considering
the practices prevailing in the country.
ASB has issued twenty-seven
accounting standards and one
exposure draft on interim reporting
as on as on 8 February 2002. The
standards issued in the recent years
have been based on IAS issued by
IASC. The list of Accounting
Standards and exposure draft issued
by ASB is given in the Appendix to
this chapter.

32

ACCOUNTANCY

Terms Introduced in the Chapter

Accounting Entity

Duality

Money Measurement

Accounting Period

Full Disclosure

Modifying Principles

Accounting Standards

Objectivity

Basic Assumption

Generally Accepted
Accounting Principles
[GAAP]

Basic Principles

Operating
Guidelines

Comparability

Prudence

Conservatism

Revenue Recognition

Consistency

Substance Over
form

Cost Benefit

Going Concern

Historical Cost

Industry Practice

Matching Principle

Materiality

SUMMARY WITH REFERENCE TO LEARNING OBJECTIVES

The transactions are recorded and financial statements prepared there from by
following certain rules and practices. These rules and guidelines are usually referred
to Generally Accepted Accounting Principles. The understanding of these guidelines
is important for both who prepare the financial statements, and the users who
need to use these statements.
1. Meaning of (GAAP)
Generally Accepted Accounting Principles are the set of rules and practices that are
followed while recording transactions and preparing the financial statements.
2. Basic Operating Guidelines
Basic operating guidelines refer to assumptions, accounting principles and modifying
principles. These guidelines are well-established and accepted in accounting.
3. Basic Assumptions
Assumptions have been developed over a period of time and considered as
cornerstones of the foundation of accounting. The four basic assump-tions are
accounting entity, money measurement, going concern and accounting period.

Accounting Entity: Accounting entity assumption, states that the activities

of a business entity be kept separate from its owners and all other entities.
Money Measurement: Money measurement assumption requires use of money
as a unit of measurement that is the currency of the country where the
organization is to report its operations.

THEORY BASE OF ACCOUNTING

Going Concern: This assumption states that the business will have an
indefinite life unless there is evidence to the contrary.
Accounting Period Assumption: This assumption permits the accountant to
divide the lifespan of the business enterprise into different time period known
as accounting period for the purpose of preparing financial statements

4. Basic Accounting Principles

The accounting principles are the general decisions rules, which govern the
development of the accounting techniques.

Duality: This principle states that every transaction must be viewed from
two aspects. It therefore, necessitates that minimum two accounts will be
involved in recording a transaction.
Revenue Recognition Principle: The revenue is deemed to have occurred in
the period in which the sale has taken place or services have been performed.
There are some exceptions to the sale basis of revenue recognition.
Historical Cost Principle: Historical principle requires that all the transactions
should be recorded at their monetary cost.
Matching Principle: Matching Principle requires that the expenses should be
matched with the revenues generated in the relevant period.
Full Disclosure Principle: Full disclosure principle requires that all those
facts that are necessary for proper understanding of the financial statements
must be revealed.
Objectivity Principle: The principle of objectivity requires that the accounting data
should be verifiable and free from any bias.

5. Modifying Principles
There may be certain difficulties encountered while applying the accounting
principles in a given situation. Modifying principles guide in such a situation how
to encounter such difficulties and provide more reliability and understandability to
the accounting information.

Cost Benefit: This modifying principle states that cost of generating the
information should not exceed the benefits to be derived from it.
Materiality Principle: The term materiality refers to the relative importance
of an item. It requires that while recording and presenting the financial
information, the focus should be on material items.
Consistency Principle: The consistency principle requires that the accounting
policies which are used from period to period should not change.
Prudence: The prudence principle requires that when more than one
alternative is permissible to record a transaction, the one which results in
least favourable in immediate effect on profit or owners equity usually should
be adopted.
Timeliness: Timeliness refers to the fact that information must be available
to the users before it looses its capacity to influence decisions.
Substance over legal form: The transactions and events recor-ded in the
books of account and presented in the financial statements, according to
this modifying principle, should be governed by the substance of such
transactions and not the legality of such transactions.

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ACCOUNTANCY

Industry Practice: The unique characteristics of some indus-tries may require

a different approach and procedure to make the financial statements more
useful.

EXERCISES
1. State the accounting assumption/basic principle/modifying principle involved
in each of the following situation:
(i)

During the life time of an entity, accountants prepare

financial statements at arbitrary points in time
(ii) The tendency of accountants to resolve uncertainty
and doubt in favour of overstating liabilities and
expenses and understanding assets and revenues
(iii) Revenue is generally recorded at the point sale
(iv) The accountants assume that the business will not
be liquidated in the near foreseeable future
(v) The assets are recorded in books at the cost incurred
in acquisition of such assets
(vi) Expenses need to be recorded in the period in which the
associated revenues are recognized
(vii) The cash withdrawn by the owner to meet personal
expenses is recorded in the books of the business
as drawings
(viii) The benefits to be derived from accounting information
should exceed its cost
(ix) The inventory are to be recorded at lower of cost or
market value.
(x) The insignificant items or events, having an
insignificant economic effect need not be disclosed

_______________

_______________
_______________
_______________
_______________
_______________

_______________
_______________
_______________
_______________

2. State True or False

(i)

The accountants prudence states that preference should be given for errors
in measuring assets and recognizing revenues in the direction of
understatement rather than overstatement.
(ii) The benefits to be derived from information should not exceed its cost.
(iii) The expenses of the owners of the business need to be recorded as expenses
of business.
(iv) All transactions that affect the business must be recorded.
(v) The accounting data should be verifiable and free from any bias.
3.

Fill in the blanks below with the accounting principle, assumption or related
item that best completes each sentence:
(i)

Companies must prepare financial statements at least yearly due to

the _____________ assumption.
(ii) The _____________ principle requires that the same accounting method
should be used from one accounting period to the next.

35

THEORY BASE OF ACCOUNTING

(iii) Recognition of expenses in the same period as associated revenues is

known as the __________ principle.
(iv) Transactions between owner and business are recorded due to
_______________ assumption.
Short Answer Questions
4.

Why do accounting principles emphasize the use of historical cost as a

basis for measuring assets?
5. Why it is necessary for accountants to make going concern assumption?
6. When should revenue be recognized?
7. What are the exceptions to the general rule of revenue recognition.
8. Describe the following modifying principles:
(a) Cost Benefit (b) Materiality
9. What is accounting entity assumption?
10. What is the monetary unit assumption? Does it hold good when the prices
are not stable?
11. Why is periodicity assumption necessary for preparing the financial
statements?
12. What is the matching principle?
Essay Type Questions
13. Name the basic assumptions that underlie the financial accounting
structure?
14. Explain the effect of going concern and periodicity assumptions on financial
statements.
15. What is substance over form? Explain the implications by giving suitable
examples.
16. Explain the effect of revenue recognition principle and matching principle
on financial statements.
17. What are modifying principles? What role they play in preparation of financial
statements.
18. Explain the constraints that require the accounting principles to be modified?

Check-list of Key Letters/Words

Q 1.
i. Periodicity
ii. Prudence
iii. Revenue Recognition
iv. Going Concern
v. Historical Cost
vi. Matching
vii. Accounting Entity
viii. Cost Benefit
ix. Prudence
x. Materiality

Q 2.

i.
ii.
iii.
iv.
v.

True
True
False
False
True

Q 3.

i.
ii.
iii.
iv.

Periodicity
Consistency
Matching
Accounting Entity

36

ACCOUNTANCY

Appendix
Accounting Standards (AS)
The ICAI has issued the following standards as on 8.2.2002:
(Date of issue)
AS1

Disclosure of Accounting Policies (Jan 1979)

This Standard deals with the disclosure of significant accounting
policies followed in preparing and presenting financial statements.
Such policies should form part of the financial statements and be
disclosed in one place.

AS2

Valuation of Inventories (June 1981)

This Standard deals with the principles of valuing inventories for
financial statements. For this purpose inventories include tangible
property held for sale in ordinary course of business, or in the
process of production for such sale, or for consumption in the
production of goods or services for sale, including maintenance
supplies and consumables other than machinery spares.

AS3

Cash Flow Statements (June 1981, Revised in March 1992)

This Standard deals with the financial statement which
summarises for a given period the sources and applications of
funds of an enterprise. This Standard supersedes Accounting
Standard (AS) 3, Changes in Financial Position, issued in June
1981. The cash flows are to be classified into three categories, viz.
operating activities, investing activities and financing activities.

AS4

Contingencies and Events Occurring after the Balance Sheet

Date (November 1982, Revised in April 1995)
This Standard deals with the treatment if financial statements of
contingencies and events occurring after the balance sheet date.
The Standard, however, does not cover contingency situations
relating to the liabilities of life insurance and general insurance
enterprises arising from policies issued; obligations under
retirement benefit plan; and commitments arising from long-term
lease contracts.

AS5

Net Profit or Loss for the Period, Prior Period Items and Changes
in Accounting Policies (November 1992, Revised in February 1997)
This Standard deals with the treatment in the financial statements
of prior period and extraordinary items and changes in accounting
policies. The Standard does not deal with the tax implications of
prior period items, extraordinary items and changes in accounting

THEORY BASE OF ACCOUNTING

policies and estimates for which appropriate adjustments will have

to be made depending on the circumstances. It also does not deal
with adjustments arising out of revaluation of assets.
AS6

Depreciation Accounting (November 1982)

This Standard applies to all depreciable assets. The Standard does
not apply to assets in the category of forests, plantations and similar
natural resources; wasting assets including expenditure on the
exploration for natural non-regenerative resources; expenditure on
research and development; goodwill and live stock. This also does
not apply to land unless it has a limited useful life for the enterprise.

AS7

Accounting for Construction Contracts (December 1983, Revised

in April 2003)
This Standard deals with accounting for construction contracts
in the financial statements of contractors. The contracts may fall
into the category of fixed price contracts or cost plus contracts.
The accounting for such contracts may be follow either of the
percentage of completion method or completed contract method.

AS8 -

Accounting for Research and Development (January 1985)

This Standard deals with the treatment of costs of research and
development in financial statements. This Standard, however, does
not deal with the accounting implications of the following
specialized activities: (i) research and development activities
conducted for others under a contract; (ii) exploration for oil, gas
and mineral deposits; and (iii) research and development activities
of enterprises at the construction stage.

AS9

Revenue Recognition (November 1985)

This Standard deals with this bases for recognition of revenue in
the statement of profit and loss of an enterprise. The Standard is
concerned with the recognition of revenue arising in the course of
the ordinary activities of the enterprise from the sale of goods, the
rendering of services, and the use by others of enterprise resources
yielding interest, royalties and dividends.

AS10

Accounting for Fixed Assets (November 1985)

This Standard deals with fixed assets grouped into various
categories, such as land, buildings, plant and machinery, vehicles,
furniture and fittings, goodwill, patents, trademarks and designs.
This Standard does not deal with the specialized aspects of
accounting for fixed assets that arise under a comprehensive
system reflecting the effects of changing prices but applies to

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ACCOUNTANCY

financial statements prepared on historical cost basis. This also

does not deal with accounting for following assets: (i) forests,
plantations and similar regenerative natural resources; (ii) wasting
assets including mineral rights, expenditure on the exploration
for and extraction of minerals, oil, natural gas and similar nonregenerative resources; (iii) expenditure on real estate
development; and (iv) livestock.
AS11

Accounting for the Effects of Changes in Foreign Exchange Rates

(August 1991)
This Standard deals with the issues relating to accounting for
effect of changes in foreign exchange rates. This applies to
accounting for transactions in foreign currencies and translating
the financial statements of foreign branches for inclusion in the
financial statements of the enterprise.

AS12

Accounting for Government Grants (August 1991)

This Standard deals with accounting for government grants.
Government grants are sometimes called by other names such
as subsidies, cash incentives, duty drawbacks, etc. This Standard
does not deal with: (i) the special problems arising in accounting
for government grants in financial statements reflecting the effects
of changing prices or in supplementary information of a similar
nature; (ii) government assistance other than in the form of
government grants; and (iii) government participation in the
ownership of the enterprise.

AS13

Accounting for Investments (September 1993)

This Standard deals with accounting for investments in the
financial statements of the enterprise and related disclosure
requirements. The issues relating to recognition of interest,
dividends and rentals earned on investments, operating or finance
lease and investment of retirement benefits plans and life
insurance enterprise are not within the purview of this standard.

AS14

Accounting for Amalgamations (October 1994)

This Standard deals with the accounting treatment of any
resultant goodwill or reserves in amalgamation of companies. This
does not apply to the cases of acquisitions where one company
purchase the shares in whole or in part of other company in
consideration of cash or by issue of shares or other securities (In
such a case the entity of acquired company continues).

THEORY BASE OF ACCOUNTING

AS15

Accounting for Retirement Benefits in the Financial Statements of

Employers (January 1995)
This Standard deals with accounting for retirement benefits in
the financial statements of employers. For this purpose, the
retirement benefits considered may be in the form of provident
fund, superannuation/pension, gratuity, leave encashment
benefits on retirement, post-retirement health and welfare scheme
and any other retirement benefits.

AS16

Borrowing Costs (May 2000)

This Standard deals with the issues involved relating to
capitalization of interest on borrowing for purchase of fixed assets.
This standard deals with issues related to identify the assets which
qualify for capitalization of interest, the period for which the interest
is to be capitalized and the amount of interest that can be
capitalized.

AS17

Segment Reporting (October 2000)

This Standard applies to companies which have an annual turnover
of Rs. 50 crores or more. This standard requires that the accounting
information should be reported on segment basis. The segments
may be based on products, services, geographical area, etc.

AS18

Related Party Disclosure (October 2000)

This Standard requires certain disclosure which must be made
for transactions between the enterprise and related parties. The
standard recognised related party as an enterprise which has a
common control with reporting enterprise, associate or joint
venture of reporting enterprise, individual having direct/indirect
interest in the voting power of reporting enterprise, key
management personnel, and enterprise over which any person
having direct/indirect interest in voting power or key management
personnel is able to exercise significance influence.

AS19

Leases (January 2001)

This Standard deals with the accounting treatment of transactions
related to lease agreements. For this purpose the standard divides
the agreements into operating and financing lease.

AS20

Earnings Per Share (January 2001)

This standard deals with the presentation and computation of
Earning Per Share (EPS). This Standard requires that the EPS need
to be calculated on consolidated basis as well as for the parent

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ACCOUNTANCY

(holding) company while presenting the financial statements of

the parent company. The standard requires to compute and present
basic as well as diluted EPS.
AS21

Consolidated Financial Statements (1.4.2001)

This Standard deals with the to preparation of consolidated
financial statements with an intention provide information about
the activities of a group (parent company and companies under
its control referred to as subsidiary companies).

AS22

Accounting for Taxes on Income (1.4.2001)

This Standard deals with determination of the amount of tax
expenses for the related revenues. The tax expense will comprise
of current tax and deferred tax for the purpose of determing the
net profit (loss) for the period.

AS23

Accounting for Investments in Associates in Consolidated Financial

Statements (July 2001)
This Standard deals with the principles and procedures to be
followed for recognizing, in the consolidated financial statements,
the effect of the investments in associates on the financial position
and operating results of a group.

AS24

Discontinued Operations (February 2002)

This Standard lays down the principles for reporting information
about discontinued operations, with an objective to enhance the
ability of users of financial statements to make projection of
enterprises cash flows, earnings generating capacity, and
financial position by segregating information about discontinued
operations from information about continuing operations.

AS25

Interim Financial Reporting (February 2002)

This Standard deals with the minimum content of interim financial
report and prescribes the principles for recognition and
measurement in complete or condensed financial statements for
an interim period. This Standard does not say anything about the
frequency of such reporting.

AS26

Intangible Assets (February 2002)

This Standard prescribes the accounting treatment for intangible
assets which are not covered by any other specific accounting
standard.

THEORY BASE OF ACCOUNTING

AS27

Financial Reporting of Interests in Joint Ventures (February 2002)

This Standard sets out principles and procedures for accounting
for interests in joint ventures and reporting of joint ventures assets,
liabilities, income and expenses in the financial statements of
venturers and investors.

All the above standar ds issued by Accounting Standar ds Board ar e

recommended for use by companies listed on a recognized stock exchange and
other large commercial, industrial and business enterprises in the public and
private sectors.

41