Comprehensive theory, key formulas, diagrams, and memory aids for Chapter 2: Theory Base of Accounting.
Accounting principles are the rules of action or conduct adopted by accountants universally while recording accounting transactions. They bring uniformity and consistency to financial statements. These are known as Generally Accepted Accounting Principles (GAAP).
Accounting concepts are the fundamental assumptions or basic rules upon which accounting is based.
According to this concept, the business and its owner(s) are treated as two separate and distinct entities. Therefore, personal transactions of the owner are kept separate from business transactions. (e.g., Capital is treated as a liability of the business towards the owner).
Only those transactions and events are recorded in accounting which can be expressed in terms of money. Non-monetary events like employee morale, management efficiency, etc., are not recorded.
It is assumed that the business will continue to exist for an indefinitely long period in the future. Because of this concept, fixed assets are recorded at their original cost and depreciated over their useful life, rather than showing them at their market value.
The indefinite life of the business is divided into smaller, equal time intervals (usually one year) for the purpose of preparing financial statements and assessing performance. In India, the financial year usually runs from April 1st to March 31st.
According to this concept, an asset is recorded in the books of accounts at the price paid to acquire it, including the cost of installation. This cost becomes the basis for all future accounting of the asset.
Every business transaction has a dual effect—it yields a benefit and involves giving a benefit. Therefore, it affects at least two accounts. This concept is the foundation of the Double Entry System and is expressed as: Assets = Liabilities + Capital.
Revenue is considered to be realized when a transaction has been entered into and the obligation to receive the amount is established (i.e., when goods are sold or services are rendered, not necessarily when cash is received).
According to this concept, to calculate the correct profit or loss for an accounting period, all revenues earned during that period must be matched against the expenses incurred to earn those revenues, regardless of whether cash was paid/received.
Financial statements must fully, completely, and honestly disclose all significant information relating to the economic affairs of the enterprise. Footnotes are often used to disclose contingent liabilities or changes in accounting policies.
Accounting policies and practices should remain consistent from one year to another so that financial statements of different periods are comparable. (e.g., sticking to one method of depreciation).
"Do not anticipate a profit, but provide for all possible losses." Under this concept, potential liabilities are recognized immediately, but potential revenues are recognized only when certain. This is why Closing Stock is valued at Cost or Net Realizable Value, whichever is lower.
An exception to full disclosure. Only items that are material (significant) and capable of influencing the decisions of users need to be disclosed separately. Trivial matters can be grouped together.
There are two main bases of accounting: 1. Cash Basis: Entries in the books are made only when cash is actually received or paid. Outstanding expenses and accrued incomes are ignored. 2. Accrual Basis: Income is recorded when earned (not when received) and expenses are recorded when incurred (not when paid). This provides a truer picture of profit/loss and is recognized by the Companies Act.
Accounting Standards are written policy documents issued by an expert accounting body (like ICAI in India) covering the aspects of recognition, measurement, treatment, presentation, and disclosure of accounting transactions in financial statements.
A comprehensive, multi-stage, destination-based tax that is levied on every value addition. It replaced many indirect taxes in India.