Accounting is not a random collection of rules; it rests on a well-defined theoretical framework of concepts, conventions and principles that give it a logical and scientific base. This framework, known as the Generally Accepted Accounting Principles (GAAP), ensures that accounting information is reliable, comparable and useful. Without such a common set of rules, every business would prepare its accounts in its own way and no two sets of financial statements could be compared. The theory base of accounting therefore acts as the constitution of accountancy, guiding how transactions are recorded, measured and presented.
The theoretical foundation also includes the fundamental accounting equation, the two main bases of recording cash and accrual, and the accounting standards that harmonise financial reporting. This chapter explains the important concepts such as business entity, money measurement, going concern, accounting period, cost, dual aspect and matching, as well as the conventions of conservatism, consistency, materiality and full disclosure. Together, these principles ensure that the financial statements present a true and fair view of the state of affairs of the business.
The double entry system is based on the fundamental accounting equation, which states that every transaction must keep the following equality intact:
$$Assets = Liabilities + Capital$$
Since capital can also be seen as the residual claim of the owner, the equation can be written as:
$$Capital = Assets - Liabilities$$
Every business transaction affects at least two elements of this equation, but the equation always remains balanced. For example, when a business purchases furniture for cash, the asset cash decreases while the asset furniture increases, leaving the total unchanged. When goods are purchased on credit, an asset stock increases and a liability creditors also increases. When capital is introduced, cash increases and capital increases equally. This equation is the mathematical foundation of the double entry system.
The dual aspect principle is the very core of accounting. It states that every transaction has two aspects, the receiving aspect and the giving aspect, and both must be recorded. This is the basis of the rule that for every debit there is an equal and corresponding credit. The dual aspect principle is expressed through the accounting equation, because every transaction changes the assets, liabilities and capital in such a way that the equation remains balanced. Because of this principle, the trial balance of the business always agrees when the books are correctly maintained.
There are two main bases on which accounting transactions can be recorded:
Cash basis of accounting: Under this basis, income is recognised only when it is actually received in cash and expenses are recognised only when they are actually paid. It ignores outstanding and prepaid items. It is simple and is usually followed by professionals, small traders and the government. However, it does not give a true picture of the profit or loss of the period because credit transactions and accruals are not considered.
Accrual basis of accounting: Under this basis, income is recognised when it is earned, whether cash is received or not, and expenses are recognised when they are incurred, whether cash is paid or not. Outstanding expenses, prepaid expenses, accrued income and income received in advance are all adjusted. This basis follows the matching principle and gives a more accurate and complete picture of the profitability and financial position of the business. Most business organisations follow the accrual basis.
The difference between the two bases can be seen in the treatment of a credit sale. Under the cash basis, the sale is recorded only when cash is collected. Under the accrual basis, the sale is recorded as soon as the goods are delivered, regardless of the date of collection.
The main accounting concepts and principles are:
Business entity concept: The business is treated as a separate entity distinct from its owner. Personal transactions of the owner are recorded separately, and money taken by the owner is shown as drawings.
Money measurement concept: Only those transactions that can be expressed in terms of money are recorded in the books. Non-monetary factors such as the loyalty of workers are ignored.
Going concern concept: It is assumed that the business will continue to operate for a long period in the future. Because of this assumption, assets are recorded at cost and depreciation is charged over their useful life instead of valuing them at their break-up value.
Accounting period concept: The life of the business is divided into equal intervals known as accounting periods, usually one year, so that profit and financial position can be measured periodically.
Cost concept: Assets are recorded in the books at the price at which they are acquired, that is, historical cost. They remain at cost and are not shown at market value.
Dual aspect concept: Every transaction has two aspects, and both are recorded, giving rise to the accounting equation and the double entry system.
Revenue recognition concept: Revenue is recognised when it is earned and realised, not necessarily when cash is received.
Matching concept: All expenses incurred during a period are matched with the revenue earned during that same period to determine the net profit of the period. This concept supports the accrual basis of accounting and gives rise to adjustments for outstanding and prepaid items.
Full disclosure concept: Financial statements must disclose all material information fairly and completely to the users. This is the principle behind the accompanying notes to the financial statements.
Materiality concept: Only those items which are significant enough to influence the decisions of the users need to be disclosed separately, while insignificant items may be treated more freely.
Conservatism or prudence concept: The accountant must not anticipate income but must provide for all possible losses. The principle of "anticipate no profit, but provide for all possible losses" guides the valuation of stock at cost or market price, whichever is lower.
Consistency concept: Accounting policies and methods should be followed consistently from one period to another so that the results are comparable. A change can be made only when it is required by law or brings a better presentation, with proper disclosure.
Accounting standards are written policy documents issued by expert accounting bodies to standardise the treatment of various accounting items and to bring uniformity in financial reporting. In India, the Institute of Chartered Accountants of India (ICAI) issues Accounting Standards (AS) and Indian Accounting Standards (Ind AS) that are converged with International Financial Reporting Standards (IFRS). These standards make the financial statements of different companies comparable and reduce the scope of manipulation. Their benefits include reliability, comparability, better understanding and international harmonisation, but their implementation increases the cost and complexity of reporting.
Accounting functions as an information system because it collects raw data about economic events, processes it through recording, classifying and summarising, and produces reports such as the Profit and Loss Account, the Balance Sheet and cash flow statements for the users. The quality of accounting information depends on the attributes of reliability, relevance, understandability and comparability. If the information lacks any of these attributes, it cannot serve the purpose of decision-making.
| Concept | Meaning |
|---|---|
| Business entity | Business and owner are separate entities |
| Money measurement | Only monetary transactions are recorded |
| Going concern | Business continues for a long period |
| Accounting period | Life divided into yearly intervals |
| Cost | Assets recorded at acquisition cost |
| Dual aspect | Every transaction has two aspects |
| Matching | Expenses matched with revenues of the period |
| Feature | Cash Basis | Accrual Basis |
|---|---|---|
| Income recognition | When cash is received | When income is earned |
| Expense recognition | When cash is paid | When expense is incurred |
| Outstanding items | Ignored | Adjusted |
| Suitability | Small professionals | Business organisations |
| Accuracy of profit | Less accurate | More accurate |
| Convention | Principle |
|---|---|
| Conservatism | Provide for all possible losses, ignore anticipated profits |
| Consistency | Follow the same methods every year |
| Materiality | Disclose only significant items |
| Full disclosure | Disclose all material information fairly |
The theory base of accounting provides the logical foundation upon which the entire structure of accountancy is built. Concepts such as business entity, going concern, money measurement and matching, along with conventions like conservatism and consistency, ensure that financial statements present a true and fair view. The accounting equation expresses the dual aspect principle and is the mathematical heart of the double entry system. Together with accounting standards, this framework makes accounting information reliable, comparable and useful for all stakeholders.