THE ACCOUNTING CONCEPTS1

Definition of Accounting

American Accounting Association Committee defines accounting as the

process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of the information.

Balance Sheet and related concepts

The balance sheet shows the financial position of an accounting entity as of a

specified moment of time. A balance sheet dated 'March 31' means, at the
close of business on March 31. It is therefore a status report, rather than a
flow report.

In India, the format and the contents of the Balance Sheet for companies are
specified in Schedule 3 of the Companies Act, 2013. Accordingly, assets are
shown at the top of the balance sheet while owners' equity and liabilities are
shown after listing all assets.

The Assets side includes major groupings like non-current Assets (property
plant, & equipment, capital-work-in-progress, intangible assets, financial
assets like investments) and Current Assets (inventories, financial assets like
receivables, cash & cash equivalents, bank balances). For each line item,
additional details are given in the form of “Notes” attached to the Balance
Sheet.

The Liabilities side includes major groupings like Equity (share capital and
other equity), non- current liabilities (borrowings), and current liabilities
(payables, short term borrowings). For each line item, additional details are
given in the form of “Notes” attached to the Balance Sheet.

The basic concepts in relation to the balance sheet are:

Entity concept, Going Concern concept, Monetary Unit concept, Cost concept,
Conservatism concept, and Accounting Equivalence Concept.

1. Entity Concept

The entity (i.e. organization) consists of many persons and bodies. They
include the owners – shareholders in case of a company or partners in case of
a partnership firm, or a proprietor in case of a proprietorship firm. Similarly,
the entity like a public charitable trust or a society includes trustees or the
members of the governing body and the donor or funding agencies. An Entity
exists primarily to produce and deliver goods and services. Hence, in the
ultimate analysis, the results of the operations must be related to the entity
itself and they are distinct from the owners, trustees, members of the board

1 Prepared by Prof. Shailesh Gandhi from various published sources. For restricted circulation only.
and the donor agencies. Accordingly, the accounting process must be related
to the operation of the entity distinct from the persons within that entity.

Example: The entity concept helps us to understand that share capital is a

liability for a business entity but an asset for an investor in that entity (an
entity separate from the business entity).

2. Going Concern Concept

In corporation laws of all countries, an organisation, is presumed to have

uninterrupted existence with continuing activity till such time as it is legally
liquidated. It is for this reason that for purposes of accounting, organisations
are presumed to carry on their operations indefinitely till such time as they
are in fact liquidated. A corollary to this concept is the assumption that an
organisation will not be liquidated within the foreseeable future since this
would make it impossible for it to carry out its present contractual
commitments or to use its resources according to a predetermined plan of
operation.

3. Monetary Unit Concept

In financial accounting, a record is made only of these facts that can be

expressed in monetary terms. This is so because money provides a common
denominator by means of which heterogeneous facts about the operations of
an organisation can be expressed as numbers that can be added and
subtracted. This concept imposes a severe limitation on the scope of an
accounting report. Accounting does not record the state of the director's
health; it does not report that a strike is beginning; and it does not reveal that
a competitor has placed a better product on the market. Accounting therefore
neither gives a complete account of the happenings in, nor an accurate picture
of the condition of the organization.

4. Cost Concept

For purposes of accounting/all transactions are recorded at their monetary

cost of acquisition i.e. the price paid for acquiring the asset or for receiving the
services provided. Since all end-users are interested in knowing the value of
the assets owned by the organisation, it would be logical to argue that a
balance sheet would fail to achieve the primary objective of communicating
the worth of the organisation, if the present value of its assets is not shown in
the balance sheet. ‘Why, then, is this concept which is inconsistent with the
relevance convention (since present values are relevant to most end-users)
still adopted? There are several reasons for this. The primary one is that most
people cannot agree on what is the present value of an asset. Accordingly, the
recording of assets on acquisition cost basis meets the convention of
objectivity. Moreover, the present value of assets constantly undergoes
changes that would require altering them practically every day. This would
introduce a degree of instability in the accounts which would considerably
reduce their effectiveness and acceptance.
Example: The cost concept allows to record a fixed asset (land, building,
machinery, etc.) by adding all costs incurred to put that item of an asset for its
intended use. Such costs for a building may include: architect’s fees,
construction costs, supervisor fees, any legal charges, etc.

For items of inventories like raw materials, packing materials and

consumables, the cost of acquisition is the “end cost” or “landed cost” i.e. the
sum of all costs incurred to bring the material from a supplier to a buyer
(invoice value, handling charges, freight, insurance, customs duty, if
applicable, etc.).

5. Conservatism Concept

It means that when the accountant has a reasonable choice as to how a given
event should be recorded, he ordinarily chooses the alternative that results in
a lower, rather than higher, asset amount or owners' equity amount. This
concept is often stated as “Anticipate no profit, and provide for all possible
losses.”

Example: Provision for sales returns, provision for doubtful debts.

6. Accounting Equivalence Concept (Accounting Equation)

The resources owned by an organisation are called "assets". The claims of

various parties against these assets are called "equities". There are two types
of equities; (1) Liabilities; which are the claims of creditors, i.e. everyone other
than the owners of the business; and (2) owners' equity which is the claim of
the owners of the business. Since all of the assets of an organisation are
claimed by someone and since the total of these claims cannot exceed the
amount of assets, it follows that:

Assets = Equities

Because of the two different types of equities,

Assets = Liabilities + Owners’ Equity

The profit increases Owners’ Equity and the loss decreases it. Now, profit or
loss is the difference between Revenues (arising out of sale of goods/services)
and Expenses related to such revenues. Using this premise, the accounting
equation is as follows:

Assets = Liabilities + Owners’ Equity + (Revenues – Expenses) or

Assets + Expenses = Liabilities + Owners’ Equity + Revenues

Examples:
(1) Shailesh Gandhi commences business in the name of Gandhi & Co. and he
contributes Rs. 500,000 as capital which is deposited in the current account
of Gandhi & Co.

Assets Equities
Bank Rs.500,000 = Capital Rs.500,000

(2) Materials worth Rs. 400,000 are bought by issuing a cheque. Now, the bank
balance goes down and another asset – inventories go up.

Bank + Inventories
-400,000 400,000 =0

(3) The same inventories are sold for Rs. 425,000, the cheque is received from
a customer and deposited in the bank. We record this transaction as sales.

Bank = Revenues
425,000 425,000

At this stage, inventories got converted into cost of sales which is an expense.

Inventories + Cost of sales

-400,000 -400,000 =0

Thus, every transaction affects at least two items of the accounting equation
and therefore accounting is properly called a double-entry system.

Profit and Loss Statement (Income Statement) and related concepts

The end-users of accounting statements are interested not only in knowing

the financial position of an organisation at a particular point of time but also
in finding out financial performance i.e. whether it has earned profits or
incurred losses during a particular period. Thus, the profit & loss statement
is a statement of financial performance and it is expressed for a period
(month, quarter, half-yearly, annual).

Types of revenues

• Revenues from sale of goods

• Revenues from services rendered
• Other Income – not derived from the business operations such as
dividend received, interest received, profit on sale of fixed assets etc.

Types of Expenses

• Raw material consumed.

• Manufacturing expenses such as power & fuel, repairs & maintenance,
stores & spares consumed, factory wages, etc.
 • General and Administrative expenses such as salaries, conveyance,
travel, communication, printing & stationery, staff welfare, rent, legal,
auditing etc.
• Marketing & Selling expenses such as advertisement, commission,
discount, salesmen salaries & incentives, freight outward, warehouse
rent etc.
• Interest and Finance charges such as interest on loans, interest on
working capital, other interest, lease rentals, interest on hire purchase,
bank charges etc.

The basic concepts in relation to the profit and loss statement are:

Accounting period concept, realization concept, matching costs with revenues

concept, and accrual concept.

1. Accounting Period concept

Normally the profit & loss statement or income statement is prepared for a
period of one year. The accounting period varies from company to company
but by and large in India, the companies define their accounting period from
April to March.

Accounting time cycle problems: - Unfortunately, the time cycle of revenues

does not necessarily synchronize with that of the accounting period. For
example, a company’s accounting year is April to March. Suppose in
February 2021 it receives advance money of Rs. 100,000 from the customers
for products to be sold during February 2021 to April 2021. In such cases, one
has to determine the portion of money received relating to the period 1st
February 2021 to 31st March 2021 so that it could be accounted as revenue for
the accounting period for which the income statement has to be prepared. The
remaining money in respect of April 2021 for the next year will be shown in
the balance sheet as a liability (deferred or unearned revenues). In the same
example, if a company has sold goods worth Rs. 80,000 during February and
March 2021, then sales revenue for F.Y. 2020-21 would be Rs. 80,000 and the
balance amount of Rs. 20,000 would be shown as the liability in the balance
sheet as on 31st March 2021.

In other situations, goods or services might have been supplied by a company

during the accounting period but money related to such goods/services may
not have been received from the customers during the same period. In such a
case, the income statement would show the value of such goods/services
supplied as “revenues” for the accounting period, but offset as “accounts
receivables / debtors” in the balance sheet. Since the time cycle of revenues
received are substantially different in many cases, one has to be particularly
careful in ensuring that only revenues related to the current accounting
period, representing goods/ services sold or transferred during the year, are
taken into account in the income statement.
Expenditure and Expenses: - expenditure takes place when the cash or other
assets of the company are exchanged for acquisition of new assets, goods or
services or by incurring liabilities. The important point to note is that the
expenditure is never related to the accounting period, but to the process of
exchange of assets or acquisition of new assets or services.

Suppose an insurance policy for fixed assets for 1 year is purchased for Rs.12,
000 on 1st July 2020 by a company, which has its accounting period from April
to March. It is a fact that during the current accounting period an expenditure
of Rs. 12,000 took place in July. However, expenses are entirely different and
represent the sacrifice made or the goods or benefits received, or assets
consumed during an accounting period. In the above case, the expense for
the accounting period July 2020 to March 2021 would, however, be Rs. 9000.
Thus expenditures represent outflow of resources or assets while expenses
represent cost of services rendered or goods or assets consumed during an
accounting period. There are four situations where expenditure will have to
be distinguished from expense:

i) Expenditures during the accounting period which are also expenses of that
period. This is the easiest category to handle, as there is no 'spillover'
problem. For example, inventories purchased in the year are consumed in
the same year.

ii) Expenditure during the accounting period which will become expenses
only in future periods. In such cases cash or assets will be reduced and the
new assets or services acquired will be shown in the balance sheet either
as addition to assets or as prepaid expenses. For example, inventories
purchased on 31st March will be consumed only in the subsequent
accounting period, or insurance premium paid on 31st March for the next
financial year will be asset on 31st March and will become expense in the
subsequent financial year.

iii) Expenditure during the previous accounting period which will become
expenses during the current accounting period. In this case the assets or
prepaid expenses representing the expenditure in the balance sheet will be
reduced, as they are consumed during the current accounting period and
the amount so consumed will be shown as the expense for the current
accounting period. Example: Inventories of the previous year getting
consumed in the current year.

iv) Expenses of current accounting period that have not yet been paid i.e. for
which no expenditure has been incurred. For example, salaries /wages
payable to the employees in respect of the last month of accounting period
(say March), where the date of payment falls beyond the accounting
period (say 2nd April). The amount corresponding to the current period
will be shown as expenses in the income statement for the period and the
amount relating to future period will be shown as liability in the balance
sheet as payables.
 Salary expense = Salary Payable
100,000 100,000

2. Realization Concept

The realization concept revolves around the determination of the point of

time when revenues are earned. The concept followed is that revenue is
realised when goods and services produced by a business enterprise are
transferred to a customer either for cash or some other asset or, for a promise
to pay cash or other assets in future. The important thing is that revenue is
earned only when the goods are transferred or when services are rendered,
following the legal principle relating to transfer of property. There must also
be a reasonable expectation that the revenue will be realised either presently
or in future. The thing to note is that revenue is not earned merely when an
order is received. Nor does recognition of the revenue have to wait till actual
cash is paid. Consider a case where an order was received in April, the goods
were transferred in May and the payment was received in June. The revenue
would be deemed to have been earned in May when the transfer took place
notwithstanding the fact that the order was received in April and cash was
received in June.

3. Matching Expenses with Revenue

Since all transfer of goods is sales for the period during which such transfers
take place, we have to carefully trace the expenses for producing the goods
actually sold, if we are to determine the profit earned out of such sales. In
other words, the earnings or revenues and the expenses shown in an income
statement must both refer to the same goods transferred, or services rendered
to customers during the accounting period. Sometimes expenditures are
incurred either in advance or after the accounting period even though they
relate to expenses for goods or services sold during the current accounting
period. In such cases careful determination of such expenses must be made
and appropriate adjustments will require to be made in order to determine
the proper profits (or loss) for the current accounting period. The matching
principle, then, requires that expenses should be matched to the revenues of
the appropriate accounting period and not the other way around.
Consequently, the first step must be to determine what are the revenues
earned during a particular accounting period and then to determine the
expenses incurred to generate or earn the revenues during that accounting
period.

The usual accounting practice is that those expenses, which cannot be traced
to goods or services generating revenues, are charged as expenses in the
income statement of the accounting period in which they are incurred.
Obviously, the CEO’s salary and that of other administrative staff cannot be
related to a specific product and accordingly, have to be charged as expenses
in the income statement of the accounting period in which such salaries are
paid. Such expenses are called period expenses, as distinct from those
expenses known as product expenses which can be related to products.
4. Accrual Concept

Since all accounting transactions are monetary transactions, the organisations

have two options regarding timing of recording transactions viz. to record the
transaction when it takes place (accrual basis), or to record at the time of
receiving or paying money for that transaction (cash basis). For example, a
purchase transaction can be recorded when the goods are received and
accepted or when the payment is made to the supplier after the credit period
allowed by him, say 30 days credit.

Under the accrual concept, the transactions are recorded as soon as they take
place irrespective of the timings of receipt or payment of money thereto. This
concept is necessary to ensure that the financial statements of any period
reflect effect of all relevant transactions that took place in that period.

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A NOTE ON DEPRECIATION

Introduction

The organization produces goods and services by using various types of

resources. In doing so, it incurs operating expenses for use of such resources
like materials consumed (material resource), salaries and wages (manpower
resource), interest paid on loan (money resource) etc. These expenses are
recurring and are forming a part of the profit and loss statement.

On the other hand, the entire expenditure for a fixed asset is incurred on a
“one-time” basis at the time of acquisition and this fixed asset is used in
producing goods or services during its useful economic life which normally
exceeds one year. Except land, all other fixed assets have a limited period of
useful life. Hence, the fact that the asset is used during its useful economic life
though its cost was paid only once at the time of acquisition must also be
reflected in the profit and loss statement. In addition, when one determines
the cost of a product produced or a service rendered, this cost of use of the
fixed asset must be included otherwise the pricing of the product or service
would be incorrect.

Definition

The process of gradually converting fixed assets into current operating

expense over its useful economic life is called ‘DEPRECIATION”. The
depreciable value of an asset is the cost of the asset less its salvage value.
Thus, the depreciation amount per year would be equal to depreciable value
divided by useful economic life. The depreciation is computed in accordance
with the data on economic life of different categories of assets prescribed in
Schedule 2 of the Companies Act, 2013. Some regulatory authorities (CERC)
also prescribe the depreciation rates for those regulated industries.
Depreciation is tax-deductible expense. In India, for income tax purposes,
only Written Down Value method of computing depreciation is allowed.
Further, the WDV depreciation rates for income tax purposes are prescribed
in the Act.

Example: An asset has value of 10,000 and the life is 8 years as per Schedule 2
of the Companies Act, 2013 and the WDV rate as per IT Act is 20%.

First year depreciation as per Companies Act for reporting purpose =

10,000/8 = 1250 and it would remain the same for all 8 years.

First year depreciation for tax purpose = 20* of 10,000 = 2000.

Second year depreciation for tax purpose = 20* of (10000-2000) = 1600, and so
on.

Depreciation is a non-cash expense.

Amortization: We use the term “amortization” for intangible assets, but the
process is the same – reducing the value of asset and transferring the amount
as an expense to the income statement. Amortization period is decided by the
management (it is management estimate).

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