ACCOUNTING FOR MANAGERS

INTRODUCTION

Prepared by

Dr M Maschendar Goud
 Introduction of Financial Accounting

History of Accounting

The history of accounting dates back to the earliest days of human agriculture and civilization
when the need to maintain accurate records of the quantities and relative values of agricultural
products first arose.

 Simple Accounting is mentioned in the Christian Bible in the book of Mathew in the
parable of the Talents
 The Quran also mentions simple accounting for trade and credit arrangements
In India, Chanakya written a manuscript similar to a financial management book, during the
period of the Mauryan Empire. His book "Arthashasthra" contains few detailed aspects of
maintaining books of accounts for a Sovereign State.
 Kautilya’s famous Arthashastra not only relates to Economics and Politics, but also
explains the art of account keeping or book keeping

Written in 4th century B.C. in Shlokas or Sanskrit verses, a chapter in the book provided the details
about account keeping, accountant’s office, methods of supervising and checking of accounts and
also about the distinction between capital and revenue, profits, expenses etc.

The development in trade and commerce has been responsible for the growing importance of a
methodical accounting work. It is in the important world trade centers of Geneva and Venice, the
Italian cities that a systematic method of accounting developed between 14th and 15th centuries.

Luca Pacioli also known as Friar Luca dal Borgo wrote a book, primarily on mathematics,
“Summa de Arithmetica, geormetrica, Proportioni et Proportionalita” (Review of
Arithmetics, Geometry and Proportions) in 1494. This book contains a brief section under the
chapter heading “Particularis de computis et scripturis” (Particulars of Reckoning and their
recording) on double entry system of Book-Keeping. Although Pacioli codified rather than
invented this system, he widely regarded as Father of Modern Accounting.
Benedetto Cortugli is economist, diplomat, merchant, scientist and humanist completed a book
and he was a first person to publish a book on double entry system in 1458 but it was not published
till 1573.
Luca Pacioli used the term ‘Debito’ (owed to) and ‘Credito’ (owed by); these came from the Latin
words ‘debitur’ and ‘creder’. The terms used today have their origin from debitur and creder.

The system he published included most of the accounting cycle as we know it today. Hedescribed
the use of journals and ledgers, and warned that a person should not leave until the debits equaled
to credits. He was in favor of closing accounts every year. He stressed to measurement of profit or
loss at regular interval. He also suggested the preparation of an‘inventory’ i.e. financial position
of a business which is called ‘Balance Sheet’ now. However, Pacioli’s book initiated an important
step in keeping of records under double-entry system.

In the succeeding years, many improvements took place in the accounting books and methods for
the convenience of different organizations. Industrial revolution of 18th century and globalised
trade necessitated further improvements in accounting, such as mechanized accounts,
computerized accounting statements, etc.

The modern profession of the chartered accountant originated in Scotland in the nineteenth
century. Accountants often belonged to the same associations as solicitors, who often offered
accounting services to their clients. Early modern accounting had similarities to today's forensic
accounting. Accounting began to transition into an organized profession in the nineteenth century,
with local professional bodies in England merging to form the Institute of Chartered Accountants
in England and Wales in 1880.

Introduction of Accounting

A business Concern has to keep a systematic record of its business transactions. Book keeping is
the art of recording business transactions in regular and systematic manner. According to Carter
“Book Keeping” is the science and art of correctly recording in books of account all those business
transactions that result in the transfer of money or money’s worth. The term ‘Accountancy’ is
used for accounting work of a higher order. According to Smith Ashburne
“Accounting is the science of recording and classifying business transactions and events, primarily
of financial character, and the art of making significant summaries, analysis and interpretations of
those transactions and events, and communicating the results to persons who must make decisions
or form judgments”. According to Committee on Terminology of American Institute of Certified
Public Accountants (AICPA), “Accounting is the art of recording, classifying and summarizing in
a significant manner and in terms of money, transactions and events which are, in part at least, o a
financial character and interpreting the results there of”. According to above definition,
Accounting involves the following characteristics.
1. It is an art of recording financial transactions
2. It involves making summaries and analysis of financial transactions
3. It is an art of interpreting the results of the financial transactions and communicating the results
to the persons who are interested in such results. Accounting is regarded as ‘Language of
businesses. It means that it communicates with parties concerned through accounting statements

Objectives of Accountancy

1. To keep a permanent, accurate and complete record of business transactions

2. To maintain records of incomes, expenses and losses in such a way that the net profit or loss
for any specified period may be ascertained
3. To keep records of assets and liabilities in such a way that the financial position of the
business at any point can be easily ascertained
4. To enable the businessman to review and revise his policies in the light of past experience
brought to light by analyzing and interpreting records and reports
5. To provide information for legal and tax purposes

Book keeping differs Accounting

Book Keeping means recording of daily business transactions in a systematic manner. Accounting
is a wider term and includes besides book keeping, preparation of financial statements and their
analysis and interpretations. Accounting is a broad subject. It involves greater understanding of
records and capability to analyse and interpret the information provided by book keeping records.
The process of accounting begins where book keeping process ends. The distinction between Book
Keeping and Accounting are as follows:
Book Keeping Accounting
Book keeping is the first stage It is the second stage
It is recording of phase of an accounting It is recording, classifying and summarising the
business transactions
Bookkeeping deals with identifying and Accounting refers to the process of
recording financial transactions only summarising, interpreting and communicating
the financial data of an organisation
It has the limited scope It has wider scope and includes book keeping
and analysing etc.,
It does not require special skills It requires special skills
It does not give complete picture It critically analyses and shows the complete
picture
it does not help legal complying Legal formalities can be complied
It does not provide any information for taking It provides information for taking decisions
decisions
It has no branches It has the deferent branches
Book keeping is the first stage of recording It is the second stage of recording day to day
daily transactions transactions
It is temporary book It is permanent book with maintaining accurate
information
The main objective of book Keeping is to The main objective accounting is to find out
maintain systematic record of books of profit and loss and financial position of the
account company
Book Keeping work is performed by Junior Accounting work is performed by Senior staff
staff which they may or may not require which they require higher knowledge
higher knowledge
The work of book keeper is routine. Need not An Accountant requires analytical skills due to
have analytical skills the nature of job
It covers four activities like identifying, It covers recording, classifying, summarising
measuring, recording and classifying the the business transactions and so on.
transactions
Data provided by bookkeeping is not Management can take important decisions
sufficient for decision making based on the data obtained from accounting
No analysis is required in the bookkeeping Accounting analyses the data and creates
insights for the business
The person concerned with bookkeeping is The person concerned with accounting is
known as a bookkeeper known as an accountant
Bookkeeping does not show the financial Accounting helps in showing a clear picture of
position of a business the financial position of a business

Users of Accounting

Accounting is the language used to communicate financial information of a concern to various

parties who are interested in such information. Users of Accounting Information may be
categorised into Internal Users and External Users. The parties that may be interested in accounting
information are as follows:

Internal Users

1. Owners: The owners provide funds for the operations of a business. They are interested in
knowing whether their funds are being properly utilized or not, and return they would get on their
capital. This information will be provided by the financial statement prepared by the business
concerns.
2. Management: The management makes extensive use of accounting information to arrive at
informed decisions such as determination of selling price, cost controls and reduction, investment
into new projects, etc. The Management requires financial information for planning, control and
decision making.
3. Employees and Workers: Employees and workers are entitled to bonus at the year end, which
is linked to the profit earned by an enterprise. Therefore, the employees and workers are interested
in financial statements. Besides, the financial statements also reflect whether theenterprise
has deposited its dues into the provident fund and employees state insurance accounts, etc., or not.

External Users

1. Banks and Financial Institutions: Banks and financial institutions are an essential part of any
business as they provide loans to the businesses. Naturally, they watch the performance of the
business to know, whether it is making progress as projected to ensure the safety and recovery of
the loan advanced. They assess it by analyzing the accounting information
2. Creditors: Creditors are those parties who suppliers of goods and services on credit and
bankers are interested in knowing the financial position of a concern before giving loan or
granting credit. The financial statements (P&L A/C and Balance Sheet) help them in judging such
position. The financial statements help them immensely in making such an assessment.
3. Prospective Investors: Investors use accounting information while determining the relating
merits of various investment opportunities. They will be interested in knowing the profitability
and safety of their investment which they can know by studying the financial statements carefully.
Investment involves risk and also the investors do not have direct control over the business affairs.
Therefore, they rely on the accounting information available to them and seek answers to the
questions such as - what is the earning capacity of the enterprise and how safe is their investment?
4. Government and its authorities: The government makes use of financial statements to
compile national income accounts and other information. The information so available to it enables
them to take policy decisions. Government is interested in financial statement for the purpose of
taxation.
Government levies varied taxes such as Excise Duty, VAT, Service Tax and Income Tax. These
government authorities assess the correct tax dues from an analysis of financial statements
5. General Public: Public in the society want to see the business running since it makes
substantial contribution to the economy in many ways, e.g., employment of people, patronage to
suppliers, etc. Thus, financial accounting provides useful financial information to various user
groups for decision-making.

Branches of Accounting

The various branches of accounting are as follows:

1. Financial Accounting: Financial Accounting also known as historical accounting deals with
recording, classifying and summarizing business events. The day to day transactions are
journalised and posted in the ledger and at the end of the year profit and loss account and balance
sheet are prepared. The object of financial account is to show the profit or loss made by a business
concern and its financial position as on a particular date.
2. Cost Accounting: The main object of cost accounting is to find out the cost of the goods
produced and services rendered by a business concern. It also helps the business in controlling the
costs by indicating avoidable losses and wastes. It helps at estimating costs in future. The emphasis
is on ascertainment of cost and future decision making.
3. Management Accounting: Management accounting is concerned with generating information
relating to funds, cost and profits etc. The Management accounting is concerned with internal
reporting of information to management for (a) planning and controlling operations (b) decision
making and (c) formulating long term plans.

Tax Accounting

This branch of accounting has grown in response to the difficult tax laws such as relating to income
tax, sales tax etc. An accountant is required to be fully aware of various tax legislations.

Social Accounting

This branch of accounting is also known as social reporting or social responsibility accounting. It
discloses the social benefits created and the costs incurred by the enterprise. Social benefits include
such facilities as medical, housing, education, canteen, provident fund and so on while the social
costs may include such matters as exploitation of employees, industrial interest, environment
pollution, unreasonable terminations, social evils resulting from setting up industries etc.

Functions of Accounting

The function of accounting is to provide quantitative information primarily financial in nature

about economic entities, which is intended to be useful in making economic decisions. Financial
accounting performs the following major functions:

Maintaining Systematic Records

Business transactions are properly recorded, classified under appropriate accounts and
summarized into financial statements.

Communicating the financial results

It is used to communicate financial information in respect of net profits (or loss), assets, liabilities
etc. to the interested parties.
Meeting Legal Requirements

The provisions of various Laws such as Companies Act, 1956 Income Tax and Sales / VAT Tax
Acts, require the submission of various statements i.e. Annual accounts, Income Tax returns,
Returns for VAT etc.

Decision making

It provides the users the relevant data to enable them make appropriate decisions in respect of
investment in the capital of the business enterprise or to supply goods on credit or lend money etc.

Basis of Accounting

The matching of revenues and expenses of a period can be done on the three following basis.

1. Cash Basis: In the cash system of accounting, entries are made only when cash is received or
paid. No entry is made when a payment or receipt is merely due. In other words, the revenues,
are not recognized and recorded unless they are received in cash. Similarly expenses are
recognized only when they are paid in cash. Professional persons like doctors, lawyers and non
trading concerns generally adopt this system of recording business transactions. This systemdoes
not make a complete record of financial statements transactions in an accounting period. Hence, it
does not disclose the correct profit or loss for a particular period and will not disclose true ad fair
position of the business on the specified date.

2. Mercantile or Accrual Basis: Under this system, incomes as well as expenses are considered
on the basis o their occurrences in an accounting period and not on the basis of their actual receipts
and payments. Hence, incomes and expenses are recognized if they belong to the particular period,
irrespective of the fact whether they are received or paid in that period. It takes into consideration
all transactions are relating to a particular period. Outstanding expenses and incomes are taken into
consideration. Hence, it discloses correct profit and loss for a particular period and shows true and
fair financial position of a business on a particular day. The Companies Act requires all companies
to maintain accounts on accrual basis of accounting.
Mixed Basis: It is a combination of both the basis of maintaining accounts. Incomes arerecorded
on cash basis, but expenses are recorded on mercantile basis. This is a conservative principle where
in all expenses relating to a period whether actually paid or not is considered whereas only that
income which is received in cash is taken into consideration.

Advantages of Accounting

1. Financial Information about Business: Financial performance during the accounting period,
i.e., profit or loss and also the financial position at the end of the accounting period is known
through accounting.
2. Assistance of Management: The management makes business plans, takes decision and
exercise control on affairs on the basis of accounting information.
3. Replace Memory: A systematic and timely recording of transactions obviates the necessity to
remember the transactions. The accounting record provides this necessary information.
4. Facilitates Comparative Study: A systematic record enables a businessman to compare one
year’s results with those of other years and locate significant factors leading to the change, if any.
5. Facilitates Settlement of Tax Liabilities: A systematic accounting record immensely helps
settlement of income tax, sales tax, VAT and excise duty liabilities since it is a good evidence of
the correctness of transactions.
6. Facilitates Loans: Loan is granted by the banks and financial institutions on the basis of growth
potential which is supported by the performance. Accounting makes available the information with
respect to performance.
7. Evidence in Court: Systematic record of transactions is often accepted by the Courts as good
evidence.
8. Facilitates Sale of Business: If someone desires to sell his business, the accounts maintained
by him will enable the ascertainment of the proper purchase price.
9. Assistance in the Event of Insolvency: Insolvency proceedings involve explaining many
transactions that have taken place in the past. Systematic accounting records assist a great deal in
such a situation.
10. Helpful in Partnership Accounts: At the time of admission of a partner, retirement or death
of a partner and dissolution of the firm, accounting records are of vital importance and use. It is so
because such records provide the basis to reach a settlement.

Limitations of Accounting

1. Accounting information is expressed in terms of Money: Non-monetary events or

transactions are completely omitted.
2. Fixed assets are recorded in the accounting records at the original cost: Actual amount
spent on the assets like building, machinery, plus all incidental charges is recorded. In this way the
effect of rise in prices is not taken into consideration. As a result the Balance Sheet does not
represent the true financial position of the business.
3. Accounting information based on estimates: Estimates are often inaccurate. For example, it
is not possible to predict the actual life of an asset for the purpose of depreciation.
4. Managerial performance on the basis of mere profits: Profit for a period of one year can
readily be manipulated by omitting certain expenses such as advertisement, research and
development, depreciation etc. i.e. window dressing is possible.
5. Accounting information is not neutral or unbiased: Accountants ascertain income as excess
of revenue over expenses. But they consider selected revenue and expenses for calculating profit
of the concern. They also do not include cost of such items as water, noise or air pollution i.e.
social cost, they may also use different methods of valuation of stock or depreciations.

Limitations of Financial Accounting

1. Financial Accounting is historical in nature: It supplies information in the form of Profit and
Loss Account and Balance Sheet normally for one year which is past. The information is historical
interest and is in the nature of postmortem of financial activities of the previous year. The
management need timely information at frequent to take corrective steps at the appropriate time.
2. Financial accounting does not provide detailed analysis: Financial accounts are concerned
with the ascertainment of profit and loss account of the business ‘as a whole’. They reveal the
overall Trading results for a period. They merely show the result of the collective activities of the
business. No detailed information is provided of the exact manner in which the net profit or loss
has been made. In a business the total turnover may be profitable, while ac others may be at a loss.
Separate information for each activity is not revealed hence profit or loss of each activity cannot
be known.

3. It ignores non – monetary information: Accounting deals only with those transactions which
can be measured in terms of money. Extent of competition faced by the business, efficiency and
loyalty of employees, effect of technical interventions etc., are the important matters in which the
managers of the business will be highly interested, but accounting information cannot provide such
information.
4. Financial accounting does not reveal the efficiency of a business concern: Profit is not the
e only measure of efficiency of a business concern. Inefficient concerns can make profits or
efficient firms lose money during different economic conditions. Financial accounting fails to
inform whether profits are due to efficiently in operation or due to external factors such as inflation,
trade depression etc., Material losses due to pilferage wastage etc., labour and machine hour lost
due to idle time cannot be found out with the help of financial accounting.
Basic Accounting Terms

In order to understand the subject matter clearly, one must grasp the following common
expressions always used in business accounting. The aim here is to enable the student tounderstand
with these often used concepts before we embark on accounting procedures and rules. You may
note that these terms can be applied to any business activity with the same connotation.

Transaction: It means an event or a business activity which involves exchange of money or

money’s worth between parties. The event can be measured in terms of money and changes the
financial position of a person e.g., purchase of goods would involve receiving material and making
payment or creating an obligation to pay to the supplier at a future date. Transaction could be a
cash transaction or credit transaction. When the parties settle the transaction immediately by
making payment in cash or by cheque, it is called a cash transaction. In credit transaction, the
payment is settled at a future date as per agreement between the parties.

Goods / Services: These are tangible article or commodity in which a business deals. These articles
or commodities are either bought and sold or produced and sold. At times, what may be classified
as ‘goods’ to one business firm may not be ‘goods’ to the other firm. e.g. for a machine
manufacturing company, the machines are ‘goods’ as they are frequently made and sold. But for
the buying firm, it is not ‘goods’ as the intention is to use it as a long term resource and not sell it.
Services are intangible in natures which are rendered with or without the object of earning profits.

Profit: The excess of Revenue Income over expense is called profit. It could be calculated for each
transaction or for business as a whole.

Loss: The excess of expense over income is called loss. It could be calculated for each transaction
or for business as a whole.
Asset: Asset is a resource owned by the business with the purpose of using it for generating future
profits. Assets can be Tangible and Intangible. Tangible Assets are the Capital assets which have
some physical existence. They can, therefore, be seen, touched and felt. The capital assets which
have no physical existence are known as lntangible Assets. e.g. Goodwill, Patents, Trade-marks,
Copyrights, Brand Equity, Designs, Intellectual Property, etc.
Assets can also be classified into Current Assets and Non-Current Assets.
Current Assets – An asset shall be classified as Current when it satisfies any of the following:
a. It is expected to be realised in, or is intended for sale or consumption in the Company’s normal
Operating Cycle,
(b) It is due to be realised within 12 months after the Reporting Date, or
(c) It is Cash or Cash Equivalent unless it is restricted from being exchanged or used to settle a
liability for at least 12 months after the reporting date.
Non-Current Assets – All other Assets shall be classified as Non-Current Assets. e.g.,
Machinery held for long term etc.

Liability: It is an obligation of financial nature to be settled at a future date. It represents amount

of money that the business owes to the other parties. E.g. when goods are bought on credit, the
firm will create an obligation to pay to the supplier the price of goods on an agreed future date or
when a loan is taken from bank, an obligation to pay interest and principal amount is created.
Depending upon the period of holding, these obligations could be further classified into Long Term
or non-current liabilities and Short Term or current liabilities.
Current Liabilities – A liability shall be classified as Current when it satisfies any of the
following:
a. It is expected to be settled in the Company’s normal Operating Cycle,
b. It is held primarily for the purpose of being traded,
c. It is due to be settled within 12 months after the reporting date, or
d. The Company does not have an unconditional right to defer settlement of the liability for at
least 12 months after the reporting date
Non-Current Liabilities – All other liabilities shall be classified as Non-Current Liabilities. e.g.,
Loan taken for 5 years, Debentures issued etc.
Internal Liability: These represent proprietor’s equity, i.e. all those amount which are entitled to
the proprietor, e.g., Capital, Reserves, Undistributed Profits, etc.

Working Capital: In order to maintain flows of revenue from operation, every firm needs certain
amount of current assets. For example, cash is required either to pay for expenses or to meet
obligation for service received or goods purchased, etc. by a firm. Cash, Bank, Debtors, Bills
Receivable, Closing Stock, and Prepayments etc. represent current assets of firm. From all of these
current assets from the working capital of a firm which is termed as Gross Working Capital.
Gross Working Capital = Total Current Assets
= Long term internal liabilities plus long term debts plus the current liabilities minus the amount
blocked in the fixed assets.
There is another concept of working capital. Working capital is the excess of current assets over
current liabilities. That is the amount of current assets that remain in a firm if all its current
liabilities are paid. This concept of working capital is known as Net Working Capital which is a
more realistic concept.
Working Capital (Net) = Current Assets – Currents Liabilities.

Contingent Liability: It represents a potential obligation that could be created depending on the
outcome of an event. E.g. if supplier of the business files a legal suit, it will not be treated as a
liability because no obligation is created immediately. If the verdict of the case is given in favour
of the supplier then only the obligation is created. Till that it is treated as a contingent liability.
Please note that contingent liability is not recorded in books of account, but disclosed by way of
a note to the financial statements.

Capital: It is amount invested in the business by its owners. It may be in the form of cash, goods,
or any other asset which the proprietor or partners of business invest in the business activity. From
business point of view, capital of owners is a liability which is to be settled only in the event of
closure or transfer of the business.

Drawings: It represents an amount of cash, goods or any other assets which the owner withdraws
from business for his or her personal use. e.g. if the life insurance premium of proprietor or a
partner of business is paid from the business cash, it is called drawings. Drawings will result in
reduction in the owners’ capital.

Net worth: It represents excess of total assets over total liabilities of the business. Technically,
this amount is available to be distributed to owners in the event of closure of the business after
payment of all liabilities. That is why it is also termed as Owner’s Equity.

Current Investments: Current investments are investments that are by their nature readily
realizable and are intended to be held for not more than one year from the date on which such
investment is made. e.g., 11 months Commercial Paper.

Non-current Investments: Non-current Investments are investments which are held beyond the
current period as to sale or disposal. e. g., Fixed Deposit for 5 years.

Debtor: The sum total or aggregate of the amounts which the customer owe to the business for
purchasing goods on credit or services rendered or in respect of other contractual obligations, is
known as Sundry Debtors or Trade Debtors, or Trade Receivable, or Book-Debts or Debtors. In
other words, Debtors are those persons from whom a business has to recover money on account of
goods sold or service rendered on credit. These debtors may again be classified as under:

a. Good debts : The debts which are sure to be realized are called good debts.
b. Doubtful Debts: The debts which may or may not be realized are called doubtful debts.
c. Bad debts: The debts which cannot be realized at all are called bad debts.

Creditor: A creditor is a person to whom the business owes money or money’s worth e.g., money
payable to supplier of goods or provider of service. Creditors are generally classified as Current
Liabilities.

Capital Expenditure: This represents expenditure incurred for the purpose of acquiring a fixed
asset which is intended to be used over long term for earning profits there from. e. g. amount paid
to buy a computer for office use is a capital expenditure. At times expenditure may be incurred for
enhancing the production capacity of the machine. This also will be a capital expenditure. Capital
expenditure forms part of the Balance Sheet.
Revenue expenditure: This represents expenditure incurred to earn revenue of the current period.
The benefits of revenue expenses get exhausted in the year of the incurrence. e.g. repairs, insurance,
salary & wages to employees, travel etc. The revenue expenditure results in reduction in profit or
surplus. It forms part of the Income Statement.

Balance Sheet: It is the statement of financial position of the business entity on a particular date.
It lists all assets, liabilities and capital. It is important to note that this statement exhibits the state
of affairs of the business as on a particular date only. It describes what the business owns and what
the business owes to outsiders (this denotes liabilities) and to the owners (this denotes capital). It
is prepared after incorporating the resulting profit/losses of Income Statement.

Profit and Loss Account or Income Statement: This account shows the revenue earned by the
business and the expenses incurred by the business to earn that revenue. This is prepared usually
for a particular accounting period, which could be a month, quarter, a half year or a year. The net
result of the Profit and Loss Account will show profit earned or loss suffered by the business entity.

Trade Discount: It is the discount usually allowed by the wholesaler to the retailer computed on
the list price or invoice price. e.g., the list price of a TV set could be Rs. 15000. The wholesaler
may allow 20 percent discount thereof to the retailer. This means the retailer will get it for Rs.
12000 and is expected to sale it to final customer at the list price.

Revenue: Revenue refers to the earnings of a business. It includes sale proceeds of goods receipts
for services rendered and earnings from interest, commission etc.,

Expenses: It is the amount spent in conducting business activities. It is the expenditure, in return
for some benefit. Ex: salary paid to staff, rent to landlords etc.,

Debit and Credit: To debit an account means to enter the transaction on the debit side of that
account. To credit an account means to enter the transaction on the credit side of that account.
Debit side means the left hand side of an account and credit means right hand side of an account.

Journal: It is an account book where business transactions are first recorded. It is a book of
 original entry.

Ledger: It is book in which various accounts are opened.

Posting: Posting is the process of entering in the ledger the information already recorded in journal
or subsidiary books.

Bought Down (b/d): This term is written in the ledger to show the opening balance in any account.
It suggests that the account has been brought down from the previous period.

Carried Down (c/d): This is written in the ledger account at the time of closing the account.

Accounting Concepts and Conventions

If accounting has to serve the purpose of communicating the results of a business to the outside
world, it should be based on certain uniform and scientifically laid down principles. Accounting
principles or standards are general rules adopted in accounting. These principles enable
standardization in recording and reporting of financial information. They are developed for
common usage to ensure uniformity and understandability. Accounting principles may be defined
as those rules of conduct or procedure which are adopted by the accountants universally while
recording. They are in the process of evaluation. i.e., they are fast developing. Accounting
Principles are divided into two types. They are Accounting Concepts and Accounting Conventions.
Theory Base of Accounting

Modifying
Basic Assumptions Basic Principles Principles

 Business Entity Concept  Revenue Realization Concept  Materiality Concept

 Going Concern Concept  Matching Concept  Consistency Concept
 Money Measurement  Full Disclosure Concept  Conservatism Concept
Concept  Dual Aspect Concept  Timeliness Concept
 Accounting Period Concept  Verifiable Objective Evidence  Industry Practice Concept
 Accrual Concept Concept
 Historical Cost Concept
 Balance Sheet Equation Concept
I. Basic Assumptions

1. Business Entity Concept: In accounting, business is treated as an entity different from the
proprietor. The business and the proprietors, i.e., owners are regarded as two separate entities. All
the transactions of the business are recorded in the books of the business from the view point of
business as an entity. In case this concept not followed, affairs of the business will be mixed with
the personal transactions of the proprietor and the true picture of the business will not be known.
Even the proprietor regarded as creditor to the extent of the capital contributed by him to the
business. Capital is regarded as liability of the business to the proprietor.

2. Going Concern Concept: Accounting is done on the assumption that the business shall have
a long life and it will continue to exist until it is dissolved. It is for this reason that fixed assets are
recorded at original cost and are depreciated on the basis of their expected life rather than on the
basis of market value. It is not proper to show fixed assets in the balance sheet at the market value,
as they are not intended to be sold immediately.

3. Money Measurement Concept: The money measurement concept signifies that in accounting
a record is made only of those transactions or events which can be expressed in terms of money.
Any happening or events which cannot be expressed in terms of money cannot be recorded in
accounting books. Non – Monitory events such as retirement of manager, sales policy of
management, working conditions of workers, etc., cannot be recorded in accounting books. The
money measurement concept has one great advantage. It helps a concern to express heterogeneous
items such as bank balance, stock in trade, furniture, machinery, buildings etc., in terms of a
common denominator viz money.
4. The Accounting Period Concept: Even though it is assumed that business will continue to
exist for a long period, it is necessary to keep accounts in such a way that the results are known at
frequent intervals Accountants generally adopt a twelve month or one year period for measuring
the income of a concern. This time interval is called ‘Accounting Period’.

5. The Accrual Concept: The accrual concept is based on recognition of both cash and credit
transactions. In case of a cash transaction, owner’s equity is instantly affected as cash either is
received or paid. In a credit transaction, however, a mere obligation towards or by the business is
created. When credit transactions exist (which is generally the case), revenues are not the same
as cash receipts and expenses are not same as cash paid during the period. Today’s accounting
systems based on accrual concept are called as Accrual System or Mercantile System of
Accounting.

Basic Principles

1. The Revenue Realisation Concept: The concept of realisation talks about what revenue
should be recognized. It says amount should be recognized only to the tune of which it is certainly
realizable.
Consider that a store sales goods for Rs. 25 lacs during a month on credit. The experience and past
data shows that generally 2% of the amount is not realized. The revenue to be recognized will be
Rs. 24.50 lacs. Although conceptually the revenue to be recognized at this value, in practice the
doubtful amount of ` 50 thousand (2% of Rs. 25 lacs) is often considered as expense.

2. The Matching Concept: As we have seen the sale of goods has two effects: (i) a revenue effect,
which results in increase in owner’s equity by the sales value of the transaction and (ii) an expense
effect, which reduces owner’s equity by the cost of goods sold, as the goods go out ofthe
business. The net effect of these two effects will reflect either profit or loss. In order to correctly
arrive at the net result, both these aspects must be recognized during the same accounting period.
One cannot recognize only the revenue effect thereby inflating the profit or only the expense effect
which will deflate the profit. Both the effects must be recognized in the same accounting period.
This is the principle of matching concept.
To generalize, when a given event has two effects – one on revenue and the other on expense, both
must be recognized in the same accounting period.

3. Full Disclosure Concept: As per this concept, all significant information must be disclosed.
Accounting data should properly be clarified, summarized, aggregated and explained for the
purpose of presenting the financial statements which are useful for the users of accounting
information. Practically, this principle emphasizes on the materiality, objectivity and consistency
of accounting data which should disclose the true and fair view of the state of affairs of a firm.
This principle is going to be popular day by day as per Companies Act, 1956 major provisions for
disclosure of essential information about accounting data and as such, concealment of
material information, at present, is not very easy. Thus, full disclosure must be made for such
material information which are useful to the users of accounting information.

4. Dual Aspect Concept: The assets represent economic resources of the business, whereas the
claims of various parties on business are called obligations. The obligations could be towards
owners (called as owner’s equity) and towards parties other than the owners (called as liabilities).
When a business transaction happens, it will involve use of one or the other resource of the
business to create or settle one or more obligations. e.g. consider Mr. Suresh starts a

Assets = Liabilities + Capital

business with the investment of Rs. 25 lakhs. Here, the business has got a resource of cash worth Rs.
25 lacs (which is its asset), but at the same time it has created an obligation of business towards
Mr. Suresh that in the event of business closure, the money will be paid back to him. This could
be shown as:
In other words, Cash brought in by Mr. Suresh (Rs. 25 lakhs) = Liability of business towards
Mr. Suresh (Rs. 25 lakhs).

Assets = Liabilities + Owner’s equity

Cash Rs. 25,00,000 = Liabilities Rs. nil + Mr. Suresh’s equity Rs. 25,00,000

This is the fundamental accounting equation shown as formal expression of the dual aspect concept.
This powerful concept recognizes that every business transaction has dual impact on the financial
position. Accounting systems are set up to simultaneously record both these aspects of every
transaction; that is why it is called as Double-Entry System of accounting. In its present form the
double entry system of accounting owes its existence to an Italian expert Mr. Luca Pacioli in the
year 1495.
Continuing with our example of Mr. Suresh, now let us consider he borrows Rs. 15 lakhs from
bank. The dual aspect of this transaction on one hand the business cash will increase by Rs. 15 lakhs

Assets = Liabilities + Owner’s equity

Cash Rs. 40,00,000 = Liabilities Rs. 15,00,000 + Mr. Suresh’s equity Rs. 25,00,000
and a liability towards the bank will be created for Rs. 15 lakhs.
5. Verifiable Objective Evidence Concept: Under this principle, accounting data must be
verified. In other words, documentary evidence of transactions must be made which are capable
of verification by an independent respect. In the absence of such verification, the data which will
be available will neither be reliable nor be dependable, i.e., these should be biased data.
Verifiability and objectivity express dependability, reliability and trustworthiness that are very
useful for the purpose of displaying the accounting data and information to the users.

6. Historical Cost Concept: Business transactions are always recorded at the actual cost at which
they are actually undertaken. The limitation of this concept is that the Balance Sheet does not show
the market value of the assets owned by the business and accordingly the owner’s equity will not
reflect the real value. However, on an ongoing basis, the assets are shown at their historical costs
as reduced by depreciation.

7. Balance Sheet Equation Concept: Under this principle, all which has been received by us
must be equal to that has been given by us and needless to say that receipts are clarified as debits
and giving is clarified as credits. The basic equation, appears as :-

Debit = Credit
Naturally every debit must have a corresponding credit and vice-e-versa. So, we can write the
above in the following form –
Expenses + Losses + Assets = Revenues + Gains + Liabilities
And if expenses and losses, and incomes and gains are set off, the equation takes the following
form – Asset = Liabilities
or, Asset = Equity + External Liabilities
i.e., the Accounting Equation.

Modifying Principles / Accounting Conventions

Accounting Conventions refers to customs, traditions, usages or practices followed by accountants

as a guide in preparation of financial statements. They are followed to make the financial
statements clear and meaningful.
1. Convention of Consistency: The convention of consistency signifies that the accounting
practices and methods should remain consistent (unchanged) from one accounting period to
another. In other words, accounting practices should remain the same from one period to another.
Comparison of results from one period to another is possible only when same accounting rules are
followed. For example: if a concern adopts reducing installment method of depreciation in one
year, then it will be difficult to make comparison between the results of the two periods.
Sometimes, wrong conclusions may be drawn. If change becomes necessary the change and its
effect should be stated clearly.

2. Convention of Disclosure: The convention of disclosure means that all the material facts must
be disclosed in the financial statements. For example: in case of sundry debtors not only the total
amount of sundry debtors should be disclosed, but also the same amount of good and secured
debtors, the amount of good, but unsecured debtors and amount of doubtful debts should be stated.
Full disclosure does not mean disclosure of each and every item of information. It only means
disclosure of such information which is of significance to owners, investors and creditors.

3. Convention of Materiality: According to this convention, a detailed record is made only of

those business transactions which are material (i.e., significant). Accounts must not ne over
burdened with unnecessary minute details. Only material facts should be disclosed. ‘An item
should be regarded as material if there is reason to believe that knowledge of it would influence
the decision of informed investors’. Hence, unimportant matters should be either left out or merged
with other items.

4. Convention of Conservatism: This convention is based on the policy of ‘Playing Safe’.

According to this convention all possible or expected losses should be provided for but unearned
or unrealized profit should be left out. Example of application of this convention are valuation of
stock at cost price or market price, whichever is less, making provision for doubtful debts etc., The
idea behind the convention of conservatism is that the financial position of a firm should not be
shown better than what it is.
In a business Concern, an account may be related to a person or a thing – tangible or intangible.
While doing business transactions (that may be large in number and complex in nature), one may
come across numerous accounts that are affected. How does one decide about accounting
treatment for each of them? If common rules are to be applied to similar type of accounts, there
must be a way to classify the account on the basis of their common characteristics.

Types of Accounts

We have seen that an account may be related to a person or a thing – tangible or intangible. While
doing business transactions (that may be large in number and complex in nature), one maycome
across numerous accounts that are affected. How does one decide about accounting treatment for
each of them? If common rules are to be applied to similar type of accounts, there must be a way
to classify the account on the basis of their common characteristics. Please take look at the
following chart.

Natural Persons

Personal Accounts Artificial Persons

Accounts Representative
Persons

Real Accounts
Impersonal (Tangible and Intangible)
Accounts
Nominal Accounts

1. Personal Account: As the name suggests these are accounts related to persons.
(a) These persons could be natural persons like Suresh’s A/c, Anil’s A/c, Rani’s A/c etc.
(b) The persons could also be artificial persons like companies, bodies corporate or association
of persons or partnerships etc. Accordingly, we could have Videocon Industries A/c,
Infosys Technologies A/c, Charitable Trust A/c, Ali and Sons trading A/c, ABC Bank
A/c, etc.
(c) There could be representative personal accounts as well. e.g. when salary is payable to
employees, we know how much is payable to each of them, but collectively the account
is called as ‘Salary Payable A/c’. Similar examples are rent payable, Insurance prepaid,
commission pre-received etc. You people the students should be careful to have clarity
on this type and the chances of error are more here.
2. Real Accounts: These are accounts related to assets or properties or possessions. Depending
on their physical existence or otherwise, they are further classified as follows:-
(a) Tangible Real Account – Assets that have physical existence and can be seen, and touched.
e.g. Machinery A/c, Stock A/c, Cash A/c, Vehicle A/c, and the like.
(b) Intangible Real Account – These represent possession of properties that have no physical
existence but can be measured in terms of money and have value attached to them. e.g.
Goodwill A/c, Trade mark A/c, Patents & Copy Rights A/c, Intellectual Property Rights
A/c and the like.
3. Nominal Account: These accounts are related to expenses or losses and incomes or gains e.g.
Salary and Wages A/c, Rent of Rates A/c, Travelling Expenses A/c, Commission received A/c,
Loss by fire A/c etc.

The Accounting Process

There are two approaches for deciding when to write on the debit side of an account and when to
write on the credit side of an account:

i. American Approach / Modern Approach

ii. British Approach / Traditional Approach / Double Entry System

American approach: In order to understand the rules of debit and credit according to this
approach transactions are divided into five categories:

(i) Transactions relating to owner, e.g., Capital – These are personal accounts
(ii) Transactions relating to other liabilities, e.g., suppliers of goods – These are mostly personal
accounts
(iii) Transactions relating to assets, e.g., land, building, cash, bank, stock-in-trade, bills
receivable – These are basically all real accounts
(iv) Transactions relating to expenses, e.g., rent, salary, commission, wages, cartage – These are
nominal accounts
(v) Transactions relating to revenues, e.g., interest received, dividend received, sale of goods –
These are nominal accounts
The rules of debit and credit in relation to these accounts are stated as under:
(i) In case of Capital Account:
Debit means decrease in the Capital Dr
Credit means increase in the Capital Cr
(ii) In case of any Liability Account:
Debit means decrease in the Liability Dr
Credit means increase in the Liability Cr
(iii) In case of any Asset Account:
Debit means increase in the Asset Dr
Credit means decrease in the Asset Cr
(iv) In case of any Expenses / Losses Account:
Debit means increase in an Expenses / Losses Dr
Credit means decrease in an Expenses / Losses Cr
(v) In case of any Revenue (Incomes / Gain) Account:
Debit means decrease in the Revenue (Income / Gain) Dr
Credit means increase in the Revenue (Income / Gain) Cr

A careful perusal of the above rules will reveal that meaning of debit is the same for the first three
types of accounts on the one side and last two types of accounts on the other. It also reveals that in
the first three cases ‘debit’ stands for decrease, and for increase in the last two cases. Similarly,
‘credit’ stands for increase in the first three cases and for decrease in the last two cases.

British Approach or Double Entry System:

The Golden Rules will guide us whether the account is to be debited or credited. There is one
rule for each basic type of account i.e. personal, real and nominal. These rules are shown in the
following chart.
 Debit the receiver or who owes to
Personal Accounts
Credit the giver or to whom business

Debit what comes into business

Real accounts
Credit what goes out of business

Debit all expenses or losses

Nominal Accounts
Credit all income or gains

Difference between Single entry and double entry system

Features of Single Entry System:

Single Entry System has the following features.
(a) Maintenance of books by a sole trader or partnership firm: The books which are
maintained according to this system can be kept only by a sole trader or by a partnership firm.
(b) Maintenance of cash book: In this system it is very often to keep one cash book which mixes
up business as well as private transactions.
(c) Only personal accounts are kept: In this system, it is very common to keep only personal
accounts and to avoid real and nominal accounts. Therefore, sometimes, this is precisely
defined as a system where only personal accounts are kept.
(d) Collection of information from original documents: For information one has to depend on
original vouchers, example, in the case of credit sales, the proprietor may keep the invoice
without recording it anywhere and at the end of the year the total of the invoices gives an idea
of total credit sales of the business.
(e) Lack of uniformity: It lacks uniformity as it is a mere adjustment of double entry system
according to the convenience of the person.
(f) Difficulty in preparation of final accounts: It is much difficult to prepare trading, profit and
loss account and balance sheet due to the absence of nominal and real accounts in the ledger.

Basis Single Entry System Double Entry System

Overview In the Single Entry system of book In Double Entry system of book
 keeping, only one effect of the keeping, only both or all effects of
transaction is recorded which is related the transaction is recorded in the
to our business. books of accounts.
Objective To know or remember the cash, To know every financial term of the
debtors and creditor balance only. business entity
Type of Recording It is an incomplete system of recording It is the complete system of recording
the transactions. the transactions.
Fraud In this system, here is very easy to In this system, here is difficult to
record fraud entry of transactions record fraud entry of transactions
Because you are not showing the second Because you are showing the second
affected account by the same affected account by the same
transaction transaction.
Error It is very hard to identify the error in It is easy to identify the error in the
the books books.
Accounts Included Only account related to persons and All accounts are considered in this
cash are included. method. Like the person, real and
nominal.
Acceptance by It is not accepted by the taxation It is accepted.
Taxation department department.
Profit / loss for the It requires a lot of labour and time to It is easy to find out the Profit and
year calculate the Profit/loss for the year. Loss for the Year.
Suitable This system is suitable for only a very It is suitable for all type of business
small business.
Cost of This system does not require any cost This system does require any cost of
Implementation of implementation implementation.
Users Only Owner of the Business can use All related Parties can use this system
this system because it is not maintained because all books are maintained on
on the particular standard. the standard formats.
Reconciliation of Reconciliations of accounts are not Reconciliations of accounts are
accounts possible. possible.
Double Entry System, Books of Prime Entry, Subsidiary Books

Journal (Books of Prime Entry)

A journal is often referred to as Book of Prime Entry or the book of original entry. In this book
transactions are recorded in their chronological order. The process of recording transaction in a
journal is called as ‘Journalisation’. The entry made in this book is called a ‘journal entry’.

Functions of Journal

i. Analytical Function: Each transaction is analysed into the debit aspect and the credit aspect.
This helps to find out how each transaction will financially affect the business.
ii. Recording Function: Accountancy is a business language which helps to record the
transactions based on the principles. Each such recording entry is supported by a narration, which
explain, the transaction in simple language. Narration means to narrate – i.e. to explain. It starts
with the word – Being …
iii. Historical Function: It contains a chronological record of the transactions for future
references.

Advantages of Journal

i. Chronological Record: It records transactions as and when it happens. So it is possible to get

a detailed day-to-day information.
ii. Minimising the possibility of errors: The nature of transaction and its effect on the financial
position of the business is determined by recording and analyzing into debit and credit aspect.
iii. Narration: It means explanation of the recorded transactions.
iv. Helps to finalise the accounts: Journal is the basis of ledger posting and the ultimate Trial
Balance. The Trial balance helps to prepare the final accounts.
 The specimen of a journal book is shown below:

Format of Journal
Date Particulars Voucher Ledger folio Debit amount Credit amount
number (Rs.) (Rs.)
dd-mm-yyyy Name of A/c to be debited Reference of
page number
Name of A/c to be credited ----------- of the A/c in ----------- -----------
ledger
(Narration describing the
transaction)

Explanation of Journal

i. Date Column: This column contains the date of the transaction.

ii. Particulars: This column contains which account is to be debited and which account is to be
credited. It is also supported by an explanation called narration.
iii. Voucher Number: This Column contains the number written on the voucher of the respective
transaction. iv. Ledger Folio (L.F.): This column contains the folio (i.e. page no.) of the ledger,
where the transaction is posted. v. Dr. Amount and Cr. Amount: This column shows the
financial value of each transaction. The amount is recorded in both the columns, since for every
debit there is a corresponding and equal credit.
All the columns are filled in at the time of entering the transaction except for the column of ledger
folio. This is filled at the time of posting of the transaction to ‘ledger’.

Sub – division of Journals

Journal is divided into two types -(i) General Journal and (ii) Special Journal.

Journal

General Special

Cash Book Purchase Sales Returns Returns Bills Bills

Day Day Inward Outward Receivable Payable
Book Book Book Book Book Book
(i) General Journal

This is a book of chronological record of transactions. This book records those transactions which
occur so infrequently that they do not warrant the setting up of special journals.
Ex: (i) opening entries (ii) closing entries (iii) rectification of errors

(ii) Special Journal

It is subdivided into Cash Book, Purchase Day Book, Sales Day Book, Returns Inward Book,
Returns Outward Book, Bills Receivable Book and Bills Payable Book. These books are called
subsidiary books.

Subsidiary Books

The entries are easy to write, but if in case the transactions are too many, it may become difficult
to manage them and retrieve. For example, there are 25 purchase transactions in a day. Because
the journal will record all transaction chronologically, it may be possible that the purchase
transactions could be scattered i.e., they may not all come together one after the other. Now, at the
end of the day if the company wants to know the total purchases made during the day, the
accountant will spend time first to retrieve all purchase transactions from journal and then take
total.
This being the greatest limitation of journal, it is generally sub-divided into more than one journal.
It is done on the basis of similar transactions which are clubbed in a single book e.g. purchase
transactions, sales transaction etc.
Accounting Cycle: Steps / Phases of Accounting Cycle:

Recording of
Transactions

Financial Journal
Statement

Closing Ledger
Entries

Adjusted Trial Trial

Balance Balance

Adjustment
Entries

Accounting Cycle

The steps or phases of accounting cycle can be developed as under:

Recording of Transaction: - As soon as a transaction happens it is at first recorded in
subsidiary book.

Journal: - The transactions are recorded in Journal chronologically.

Ledger: - All journals are posted into ledger chronologically and in a classified manner.

Trial Balance: - After taking all the ledger account’s closing balances, a Trial Balance is
prepared at the end of the period for the preparations of financial statements.

Adjustment Entries: - All the adjustments entries are to be recorded properly and adjusted
accordingly before preparing financial statements.

Adjusted Trial Balance: - An adjusted Trail Balance may also be prepared.

Closing Entries: - All the nominal accounts are to be closed by the transferring to Trading
Account and Profit and Loss Account.

Financial Statements: - Financial statement can now be easily prepared which will
exhibit the true financial position and operating results.
Step: 1 – Collection of data and analysis of transactions

At this juncture, the accounting cycle begins. In this first step of accounting cycle, the accountant
of the company collects the data and analyzes the transactions. For a smoothly running business,
there would be many, many transactions. The accountant needs to look at each transaction, find
out why it occurred, put it under the right accounts, and then analyze it. This step is the most critical
of all because this kick-starts the process of accounting. As soon as a transaction happens it is at
first recorded in subsidiary book.

Step: 2 – Journalizing

After collecting and analyzing the transactions, it’s time to record the entries into the first books
of accounts. In this step of the accounting cycle, each transaction is transferred to the general
journal and under each entry, a narration is written to mention the reason behind debiting or
crediting one account. Recording the entries in the journal is important since if there is any error
at this stage of recording, it will linger on in the next books of accounts as well. The transactions
are recorded in Journal chronologically.

Step: 3 – Recording the journals into the ledger accounts

Accounting is a series of steps taken one by one. After journalizing all the transactions, it’s time
for the accountant to record the entries into the secondary books of accounts. That means if there
are cash and capital, there will be two ‘t-tables’ in the general ledger and then the balances of
respective accounts will be transferred. General ledgers allow the accountant to get the closing
balance for preparing the trial balance in the next step of the accounting cycle. All journals are
posted into ledger chronologically and in a classified manner.

Step: 4 – Creating an unadjusted trial balance

As you know that trial balance is the source of all the financial statements. That’s why special
attention should be given to the trial balance. From the closing balances of the general ledger
accounts, an unadjusted trial balance is prepared. In this trial balance, the debit balances will be
recorded on the debit side and the credit balances will be recorded on the credit side. Then the
debit side is totaled and the credit side is also totaled. And then the accountant will see whether
both the side has similar balances or not.
Step: 5 – Performing adjusting entries

At this juncture, the unadjusted trial balance is already prepared. In this step of the accounting
cycle, the adjusting entries are prepared. The adjusting entries are typically related to accrual
adjustments, periodical depreciation adjustments or amortization adjustments. Without performing
these adjusting entries, no adjusted trial balance would be prepared. All the adjustments entries are
to be recorded properly and adjusted accordingly before preparing financial statements.

Step: 6 – Creating adjusted trial balance

After passing the adjusting entries, it’s time to create a fresh trial balance. This trial balance is
called adjusted trial balance since it is prepared after the adjustment entries are passed and as a
result, this trial balance can be used to prepare the most important financial statements. An adjusted
Trail Balance may also be prepared.

Step: 7 – Creating financial statements from the trial balance

This step of accounting cycle is the most critical part of the accounting cycle. As an investor, you
must know how all the financial statements are coming from. From the adjusted trial balance, all
the financial statements are born. There are four most important financial statements that are
prepared using the adjusted trial balance.
 Income statement: The first financial statement that every investor should look at is the
income statement. In the income statement, the first item is sales and the cost of sales and
other operating expenses are deducted from the sales to ascertain the operating profit. From
the operating profit, other expenses are deducted to compute the net profit of the year.
 Balance Sheet: The next financial statement on the list is the balance sheet. In the balance
sheet, we record the assets and the liabilities. And we see whether the balance of assets is
in harmony with the balance of liabilities.
 Shareholders’ Equity Statement: This is the next financial statement that would be
prepared. Here along with share capital, the retained earnings would be taken into account.
Retained earnings are the percentage of profit that has been reinvested into the company.
  Cash flow Statement: Finally, the cash flow statement would be prepared. In cash flow
statement, the accountant needs to find out cash flow from three kinds of activities –
operating activities, financial activities, and investing activities. The cash flow operating
activities can be prepared in two ways – the direct and indirect cash flow from operations.

Step: 8 – Closing the books

This step is the penultimate step in the accounting cycle. Closing the books means that all financial
statements are prepared and all transactions have been recorded, analyzed, summarised, and
recorded. After closing the books, a new accounting period would start and the accountant would
need to start repeating the above steps of the accounting cycle once again. However, before that,
there are other steps of the accounting cycle. All the nominal accounts are to be closed by the
transferring to Trading Account and Profit and Loss Account.

Step: 9 – Creating a post-closing trial balance

 To ensure that the accounting transactions are properly recorded, analyzed, and
summarized, a post-closing trial balance is prepared. Here all the accounts are taken into
account and then the closing balances are recorded as per their respective position. Then
the credit side and the debit side are being matched to see whether everything is in the right
order or not.
If an investor can understand these 9 steps of the accounting cycle, it would be clear to them how
they should approach the company and its progress or decline. The knowledge of the accounting
cycle will help them to decide whether they should invest in the company or not. And at the same
time, they would get a concrete idea about the financial accounting of the company.

Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) refer to a common set of accepted accounting
principles, standards, and procedures that companies and their accountants must follow when they
compile their financial statements. GAAP is a combination of authoritative standards (set bypolicy
boards) and the commonly accepted ways of recording and reporting accounting information.
GAAP improves the clarity of the communication of financial information.
GAAP may be contrasted with pro forma accounting and with the IFRS standards, which are both
considered to be non-GAAP.

Understanding GAAP

GAAP is meant to ensure a minimum level of consistency in a company's financial statements,

which makes it easier for investors to analyze and extract useful information. GAAP also facilitates
the cross-comparison of financial information across different companies.
These 10 general principles can help you remember the main mission and direction of the GAAP
system.

1. Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.
2. Principle of Consistency
Professionals commit to applying the same standards throughout the reporting process to prevent
errors or discrepancies. Accountants are expected to fully disclose and explain the reasons behind
any changed or updated standards.
3. Principle of Sincerity
The accountant strives to provide an accurate depiction of a company’s financial situation.
4. Principle of Permanence of Methods
The procedures used in financial reporting should be consistent.
5. Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the
expectation of debt compensation.
6. Principle of Prudence
Emphasizing fact-based financial data representation that is not clouded by speculation.
7. Principle of Continuity
While valuing assets, it should be assumed the business will continue to operate.
8. Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For example, revenue should
be divided by its relevant periods.
9. Principle of Materiality / Good Faith
Accountants must strive for full disclosure in financial reports.
10. Principle of Utmost Good Faith
This principle is derived from the Latin phrase “uberrimae fidei” used within the insurance
industry. It presupposes that parties remain honest in transactions.
Accounting Standards

Accounting Standard is a combination of two terms which is accounting and standard.

“Accounting is the art of recording, classifying, and summarizing in a significant manner and
in terms ofmoney, transactions and events which are, in part at least, of a financial character,
and interpreting the results thereof”.
Standard is a yardstick against which something is being compared. It means a generally
accepted modelor an ideal. It serves as a guidepost for truth and fair dealings.
According to Kohler, “Accounting standard is defined as a mode of conduct imposed on
accountants bycustom, law or professional body”.
Basically it deals with the following:

Recognition of events and transactions in financial

1. statement.

Transacting and measuring the events.

2.
Presenting the same in F.S. manner that provide a
3. meaningful information to users.

Disclosure requirement of events and transactions.

4.

Meaning

Accounting standards are the written statements consisting of rules and guidelines, issued by the
accounting institutions, for the preparation of uniform and consistent financial statements and also
for other disclosures affecting the different users of accounting information.

Accounting standards lay down the terms and conditions of accounting policies and practices by
way of codes, guidelines and adjustments for making the interpretation of the items appearing in
the financial statements easy and even their treatment in the books of account.
Definitions:

According to some authorities like Yorston, Smyth and Brown, ‘a standard is a performance target
or goal or an agreed criterion of what is proper practice in a particular situation.’ There are some
other authorities who prefer to use the term “Accounting Principles” in place of “Accounting
Standards”.
According to Michael Bromwich – The Economics of Accounting Standards Setting “Accounting
Standards are uniform rules for financial reporting applicable to either all or to a certain class of
entity”
The accounting institutions / bodies are currently found in many countries of the world, e.g.,
Accounting Standards Board, (INDIA). Financial Accounting Standards Board (USA),
Accounting Standards Board (UK), Accounting Standards Committee (CANADA), etc. At the
international level, International Accounting Standards Board (IASB) has been created “to
formulate and publish, in the public interest, basic standards to be observed in the presentation
of audited accounts and financial statements and to promote their world wide acceptance and
observance”.

Objectives of Accounting Standards:

Accounting is often considered the language of business, as it communicates to others the financial
position of the company. These rules in the case of accounting are the Accounting Standards (AS).
They are the framework of rules and regulations for accounting and reporting in a country. Let us
see the main objectives of forming these standards.

1. For bringing uniformity in accounting methods: Accounting standards are required to bring
uniformity in accounting methods by proposing standard treatments to the accounting issue. For
example, AS-6 (Revised) states the methods for depreciation accounting.

2. For improving the reliability of the financial statements: Accounting is a language of

business. There are many users of the information provided by accountants who take various
decisions relating to their field just on the basis of information contained in financial statements.
In this connection, it is necessary that the financial statements should show true and fair view of
the business concern. Accounting standards when used give a sense of faith and reliability to
various users.
3. Simplify the accounting information: Accounting standards prevent the users from reaching
any misleading conclusions and make the financial data simpler for everyone. For example, AS-
3 (Revised) clearly classifies the flows of cash in terms of ‘operating activities’, ‘investing
activities’ and ‘financing activities’.

4. Prevents frauds and manipulations: Accounting standards prevent manipulation of data by

the management and others. By codifying the accounting methods, frauds and manipulations can
be minimized.

5. Helps auditors: Accounting standards lay down the terms and conditions for accounting
policies and practices by way of codes, guidelines and adjustments for making and interpreting the
items appearing in the financial statements. Thus, these terms, policies and guidelines, etc. become
the basis for auditing the books of accounts.

Significance of Accounting Standards (AS)

Accounting Standards (AS) are basic policy documents. Their main aim is to ensure transparency,
reliability, consistency, and comparability of the financial statements. They do so by standardizing
accounting policies and principles of a nation/economy. So the transactions of all companies will
be recorded in a similar manner if they follow these accounting standards. This Accounting
Standards (AS) is issued by an accounting body or a regulatory board or sometimes by the
government directly. In India, the Indian Accounting Standards are issued by the Institute of
Chartered Accountants of India (ICAI).

Benefits of Accounting Standards

Accounting Standards are the ruling authority in the world of accounting. It makes sure that the
information provided to potential investors is not misleading in any way. Let us take a look at the
benefits of AS.
1. Attains Uniformity in Accounting

Accounting Standards provides rules for standard treatment and recording of transactions. They
even have a standard format for financial statements. These are steps in achieving uniformity in
accounting methods.

2. Improves Reliability of Financial Statements

There are many stakeholders of a company and they rely on the financial statements for their
information. Many of these stakeholders base their decisions on the data provided by these
financial statements. Then there are also potential investors who make their investment decisions
based on such financial statements. So it is essential these statements present a true and fair picture
of the financial situation of the company. The Accounting Standards (AS) ensures this. They make
sure the statements are reliable and trustworthy.

3. Prevents Frauds and Accounting

Manipulations Accounting Standards (AS) lay down the accounting principles and methodologies
that all entities must follow. One outcome of this is that the management of an entity cannot
manipulate with financial data. Following these standards is not optional, it is compulsory. So
these standards make it difficult for the management to misrepresent any financial information. It
even makes it harder for them to commit any frauds.

4. Assists Auditors

Now the accounting standards lay down all the accounting policies, rules, regulations, etc in a
written format. These policies have to be followed. So if an auditor checks that the policies have
been correctly followed he can be assured that the financial statements are true and fair.

5. Comparability

This is another major objective of accounting standards. Since all entities of the country follow the
same set of standards their financial accounts become comparable to some extent. The users of the
financial statements can analyze and compare the financial performances of various companies
before taking any decisions. Also, two statements of the same company from different years can
be compared. This will show the growth curve of the company to the users.
6. Determining Managerial

Accountability The accounting standards help measure the performance of the management of an
entity. It can help measure the management’s ability to increase profitability, maintain the
solvency of the firm, and other such important financial duties of the management. Management
also must wisely choose their accounting policies. Constant changes in the accounting policies
lead to confusion for the user of these financial statements. Also, the principle of consistency and
comparability are lost.

Formulation of Accounting Standard Board (ASB)

In India, the Institute of Chartered Accountants of India (ICAI), being a premier accounting body
in the country, constituted the Accounting Standard Boards (ASB) on 21st April 1977 to formulate
Accounting Standards to be established in India by the council of the ICAI. The council of the
ICAI, so far, has issued 32 (Thirty-two) Accounting Standards (AS). However, AS
– 8 on “Accounting for Research & Development” has been withdrawn consequent to the issuance
of AS – 26 on “Intangible Assets” thus effectively, there are 31 Accounting Standardsat present.

These Standards issued by the ASB establish Standards which have to be complied by the business
entities so that the financial statements are prepared in accordance with Generally Accepted
Accounting Principles (GAAP).

These Standards set out overall requirements for the presentation of financial statements,
guidelines for their structure and minimum requirements for their content.

Scope and Functions of Accounting Standards Board

1. The main function of ASB is to formulate accounting standards so that such standards may
be established by the Council of the Institute in India. While formulating the accounting standards,
ASB will take into consideration the applicable laws, customs, usages and business environment.
2. The Institute is one of the Members of the International Accounting Standards Committee
(IASC) and has agreed to support the objectives of IASC. While formulating the Accounting
Standards, ASB will give due consideration to International Accounting Standards, issued by
IASC and try to integrate them, to the extent possible, in the light of the conditions and practices
prevailing in India.

3. The Accounting Standards will be issued under the authority of the Council. ASB has also been
entrusted with the responsibility of propagating the Accounting Standards and of persuading the
concerned parties to adopt them in the preparation and presentation of financial statements.

4. ASB will issue guidance notes on the Accounting Standards and give clarifications on issues
arising there from. ASB will also review the Accounting Standard at periodical intervals

Procedure for Issuing / Setting / Formulating of Accounting Standards in India

1. First, the ASB will identify areas where the formulation of accounting standards may be needed
2. Then the ASB will constitute study groups and panels to discuss and study the topic at hand.
Such panels will prepare a draft of the standards. The draft normally includes the definition of
important terms, the objective of the standard, its scope, recognition and measurement principles
and the representation of said data in the financial statements.
3. The ASB then carries out deliberations of the said draft of the standard. If necessary changes
and revisions are made.
4. Then this preliminary draft is circulated to all concerned authorities. This will generally include
the members of the ICAI, and any other concerned authority like the Department of Company
Affairs (DCA), the SEBI, the Central Board of Direct taxes (CBDT), Standing Conference of
Public Enterprises (SCPE), Comptroller and Auditor General of India etc. These members and
departments are invited to give their comments.
5. Then the ASB arranges meetings with these representatives to discuss their views and concerns
about the draft and its provisions
6. The exposure draft is then finalized and presented to the public for their review and comments
7. The comments by the public on the exposure draft will be reviewed. Then a final draft will be
prepared for the review and consideration of the ICAI
8. The Council of the ICAI will then review and consider the final draft of the standard. If
necessary they may suggest a few modifications in consultation with ASB
9. Finally, the Accounting Standard on the relevant subject is then issued under the authority of
the council.

Convergence with IFRS (Global Standards)

Ind AS are set of accounting standards notified by Ministry of Corporate Affairs (MCA),
converged with International Financial Reporting Standards (IFRS). These accounting standards
are formulated by Accounting Standards Board (ASB) of Institute of Chartered Accountants of
India (ICAI). Convergence means alignment of the standards of different standard setters with a
certain rate of compromise, by adopting the requirements of the standards either fully or partially.
Indian Accounting Standards are almost similar to IFRS but with few carve-outs so asto make
them suitable for Indian environment.

Objectives and Need of IFRS

IFRS are set of rules for reporting the accounting transactions in same manner worldwide. Their
principal objectives are:

1. To bring harmony: The basic objective of IFRS is to bring synchronization in accounting

transactions throughout the world so that financial statements may become understandable,
transparent and comparable. International reporting standards will assist in trading and increasing
economic development as well as the user of financial statements will be capable to analyze the
financial statements of a company which are prepared using same set of accounting standards.

2. High quality standards: The aim of IFRS is to develop a same set of precise, comprehensible,
enforceable and internationally accepted accounting and reporting standards based on evidently
expressed principles.
3. To make economic decisions: These standards help investors to formulate investment choice
and other members of the capital markets globally and also help in taking economic decisions
using IFRS as they are based on same set of accounting and reporting principles.
4. Precise interpretation: With the help of IFRS, the objective of accounting the analogous
transactions and events in same way can be achieved and rigorous interpretation must be insisting.
Otherwise, it’s not feasible to attain the objective of comparability and transparency of the
statements.

For example, in mathematics, 1+1= 2 always; but in accounts a figure i.e. Profit or loss have
different meanings, depends upon the subje tive judgment of the accountant. It is important to
prepare financial reports on the basis of IFRS so that explanations are given to make correct
decisions.

5. Relevance: It makes financial statements more relevant for the users because they can easily
understand the accounting treatments of various transactions.

6. Realistic representation: With the help of IFRS it is easier to make financial statements
complete and unbiased.

7. Comparability: Anyone can easily compare the financial statements for more than one period
of same company or timely.

8. Verifiability: Different users of financial statements could make the similar assessment based
on the accounting information, but mmm

9. Timeliness: Historical information quickly become out of date. But with the use of IFRS
information is timely available to users.

10. Understandability: Clear and concise presentation of information is the key objective of
using IFRS so that it may be understandable to users.

./
Advantages and Importance of IFRS

The expansion of International Financial Reporting Standards (IFRS) helps by providing

guidelines for reporting financial transactions. These standards are based on one accounting
language company-wide which benefit to stakeholders, improve the corporate governance and
together with increased free flow of capital throughout the world. Many countries have moved
towards the IFRS, while other countries are in the process of adoption and convergence of these
standards. The worldwide acceptability of these standards have addressed many accounting issues,
but also created many problems. There are some advantages of adopting IFRS:

1. Greater and Global Comparability

Generally multinational companies use generally accepted accounting principal (GAAP) of that
particular country in which they are located. Therefore, comparison of financial statements of two
or more differently located companies becomes difficult. But, with the adoption of same set of
accounting standard, comparison of accounting and financial statement becomes easy and more
accurate. This comparability helps investors to better determine where to invest or not.

2. High Quality and transparency

IFRS are based on sound principles rather than set of laws as they always advance the worth and
lucidity of the financial statement. Whereas rule based standards may be benefitted to some
companies in one period and worse in another period. IFRS ensures the complete, relevant,
accurate picture of financial transactions and bring transparency by increase the quality of financial
information. It reduces the scope of manipulation.

3. Increase in international transactions and investment

Adoption of IFRS develops the faith between the investors and investees, buyer and sellers, etc
and enhance the reliance of global stakeholders. The foreign investor can simply belief on the
financial statement of other company and invest because the financial transactions and results are
based on the single global language. IFRS assist the process of mergers and acquisition at
international financial markets as these are based on a unified set of principles.
4. Understandability

All users and investors have the understanding the accounting data whether it is related to one
country or another. Using the same guidelines under IFRS, investors better understand the
investment opportunities at globally.

5. Easy Listing on international stock exchange

The organizations which are using national accounting standard have to face problems in listing
their stocks at foreign stock exchange. With the adoption of IFRS, the organizations having same
accounting procedures make the task of listing stocks on cross border stock exchange easier.

6. Flexibility

IFRS are based on principles which mean each standard has to arrive at a rational valuation and
different ways to complete assignments. This gives freedom to the organizations to adopt IFRS to
their precise situation; so that, the financial statements might be read more easily.

7. Beneficial to investors

The IFRS are helpful for new and small investors by making greater financial and operational
transparency and, as a result, make better fact-based investment decisions. IFRS promise to reduce
risk for the investors from professionals as they will not be able to take advantage because the
harmonization and simple to understand nature of financial statements.

8. Reduced cost and Risk: The use of a single trusted accounting language and high quality
standards lower international reporting costs. Adoption of IFRS also reduces the firms cost of
equity capital as the firm is capable to hoist capital from international markets at lesser cost because
it creates trust in the mind of investors.
IFRS provide economic efficiency by reducing the threat for investors from trading and owning
the shares and also help investors to identify opportunity by providing higher quality information.
IFRS also provide needed information to irrational investors and protect them to incorrect selection
of investment due to lack of knowledge and understanding. It also reduced the information gap
between the investors and regulators and makes financial market efficient around the world.

9. Determine need of the users

IFRS refer to a unified set of accounting and reporting standards issued by IASB used in different
countries. These standards provide a common global accounting language to make financial
statement transparent, understandable, and globally enforceable according to the need of its users.
The IASB identifies the needs of different user and integrate their needs in to the standards with
the help of investors, auditors and regulators enhance confidence of global stakeholders.

10. Consistent Financial Statement Format

IFRS provide a consistent format of financial statements which make financial statement easily
comparable among various countries. The gross and net profit, operating income expenses are
treated in same manner in the statements. Internationally, the balance sheet, the cash flows
statement and the statement of retained earnings follow same formats. This helps the end user to
evaluate the financial statements.

11. Improve business performance

With the adoption of IFRS, businesses will gain better knowledge into the operations and measure
them more precisely. The companies will be able to improve tax planning processes, make faster
decision about day-to-day operations, standardize and rationalize accounting systems lessen the
risk and loss of penalties and conformity problems by getting quicker access to vast accounting
and financial information.
 Details of Indian Accounting Standards
Accounting Title of the Indian Accounting Date of Applicability Enterprise Category to which
Sl. No Standard(AS) No. Standard (AS) (Accounting period AS is applicable
commencing on or after)
1 AS – 1 Disclosure of AccountingPolicies 1st April 1991 For all enterprises:
Level – I, II, & III
2 AS – 2 (Revised) Valuation of Inventories 1st April999 For all enterprises
3 AS – 3 (Revised) Cash Flow Statements 1st April 2001
AS – 4 (Revised) Contingencies and Events occurring after the For all enterprises:
4 Balance Sheet date 1st April995 Level – I, II, & III
AS – 5 (Revised) Net Profit or Loss for the period, Prior- 1st April996 For all enterprises:
5 period Items & Changes in Accounting Level – I, II, & III
Policies
6 AS – 6 (Revised) Depreciation Accounting 1st April995 For all enterprises:
Level – I, II, & III
7 AS – 7 (Revised) Accounting for Construction Contracts st
1 April995 For all enterprises:
Level – I, II, & III
8 AS – 8 (withdrawnin Accounting for Research & Development As in the case of AS – 1 above For all enterprises:
pursuantto AS – 26 Level – I, II, & III
becoming mandatory)
9 AS – 9 Revenue Recognition As in the case of AS – 1 above For all enterprises:
Level – I, II, & III
10 AS – 10 Accounting for Fixed Assets As in the case of AS – 1 above For all enterprises:
Level – I, II, & III
11 AS – 11 (Revised) The Effects of Changes in 1st April995 For all enterprises:
Foreign Exchange Rates Level – I, II, & III
12 AS – 12 Accounting for Government 1st April994 For all enterprises:
Grants Level – I, II, & III
13 AS – 13 Accounting for Investments 1st April995 For all enterprises:
Level – I, II, & III
14 AS – 14 Accounting for Amalgamation 1st April995 For all enterprises:
Level – I, II, & III
15 AS – 15 (Revised) Employee Benefits 1st April995 For all enterprises:
Level – I, II, & III
16 AS – 16 Borrowing Costs 1st April 2000 For all enterprises:
Level – I, II, & III
17 AS – 17 Segment Reporting 1st April 2001 Level – II
18 AS – 18 Related Party Disclosures st
1 April 2001 Level – II
Leases In respect of all assets leased For all enterprises
19 AS – 19 during accounting periods Level – I, II, & III
commencing on or before
1st April 2001
20 AS – 20 Earnings per Share 1st April 2001 Level – I
21 AS – 21 Consolidated Financial Statements st
1 April 2001
Accounting for Taxes on Income 1st April 2001, 1st April 2002 & For listed companies and other
22 AS – 22 1st April 2003 enterprises
st st
Accounting for Investments in associates in 1 April 2002, 1 April 2004 & Mandatory
23 AS – 23 Consolidated Financial Statements 1st April 2005
24 AS – 24 Discontinuing Operations 1st April 2004 Level – I
25 AS – 25 Interim Financial Reporting 1st April 2002 Level – I
26 AS – 26 Intangible Assets st
1 April 2003 Level – I, II, & III
27 AS – 27 Financial Reporting of 1st April 2002
Interests in Joint Ventures
28 AS – 28 Impairment of Assets 1st April 2004, 1st April 2006 & Level – I, II & III
1st April 2008
29 AS – 29 Provisions, Contingent Liabilities and 1st April 2004 Level – I, II, & III
Contingent Assets
30 AS – 30 Financial Instruments: Recognition & 1st April 2009 & 1st April 2011 Level – I
Measurement
31 AS – 31 Financial Instruments: Presentations 1st April 2009 & 1st April 2011 Level – I
32 AS – 32 Financial Instruments: Disclosure 1st April 2009 & 1st April 2011 Level – I