4 Financial Accounting · 4.1 Accounting basics: concepts, conventions and the accounting process
4.1.1 Accounting: meaning, users, accounting concepts and conventions
Accounting records, classifies and summarises money transactions of a business and reports the results to its users; a common set of concepts (assumptions) and conventions (customs) makes those reports reliable and comparable.
- APPSC Paper I
- Advanced level
- 10 min read
- Free
Core facts
- Accounting: the art of recording, classifying and summarising transactions of a financial character, in money terms, and interpreting the results (American Institute of Accountants, now the AICPA, 1941). The AAA (1966) calls it identifying, measuring and communicating economic information to users.
- Book-keeping = recording and classifying (the clerical part). Accounting = book-keeping + summarising, analysing and interpreting. Accountancy = the whole body of knowledge.
- Father of double entry: Luca Pacioli, Italy, book Summa de Arithmetica (1494).
- Branches: financial accounting (past results for outsiders), cost accounting (cost per unit, cost control), management accounting (information for managers' decisions).
- Users:
- internal: owners, management, employees;
- external: creditors and suppliers, banks and lenders, investors, government and tax authorities, customers, researchers and the public.
- Accounting concepts (assumptions/principles): business entity, money measurement, going concern, accounting period, cost (historical cost), dual aspect, realisation (revenue recognition), accrual, matching.
- Accounting conventions (customs): consistency, full disclosure, materiality, conservatism (prudence).
- AS 1 (ICAI) fundamental accounting assumptions: going concern, consistency, accrual. Considerations in choosing policies: prudence, substance over form, materiality.
- Standard setters in India: Accounting Standards Board of the ICAI (set up 1977) issues AS; Ind AS (converged with IFRS) are notified by the Ministry of Corporate Affairs, phased in from 1 April 2016.
- GAAP: Generally Accepted Accounting Principles, the rules and customs that the profession follows.
Explained
The nine concepts, each with what it means in the books
| Concept | Meaning | Effect in the books |
|---|---|---|
| Business entity | Business is separate from its owner | Owner's capital is a liability of the business; personal use is drawings |
| Money measurement | Only events measurable in money are recorded | Staff skill, a strike or a quarrel among directors is not recorded |
| Going concern | Business will continue for the foreseeable future | Fixed assets at cost less depreciation, not at sale value |
| Accounting period | Life of the business is split into periods (usually a year) | Profit is found every year; in India 1 April to 31 March |
| Cost | Assets are recorded at the price paid | Land bought for ₹5,00,000 stays at ₹5,00,000 even if now worth more |
| Dual aspect | Every transaction has two equal aspects | Assets = Liabilities + Capital; double entry |
| Realisation | Revenue is earned when goods or services pass to the buyer | Not when an order is received, not only when cash comes |
| Accrual | Income and expenses are recorded when earned or incurred | Outstanding and prepaid items are adjusted |
| Matching | Expenses of a period are set against the revenue of that period | Cost of goods sold is matched with sales |
The four conventions
- Consistency: the same method year after year (for example straight-line depreciation), so results can be compared. A change is allowed only for a good reason and must be disclosed with its effect.
- Full disclosure: all material information is shown in the accounts or the notes (contingent liabilities, method of stock valuation).
- Materiality: items too small to affect a user's decision need not be shown separately or treated strictly (a stapler costing ₹150 is written off as an expense, not shown as an asset).
- Conservatism (prudence): "anticipate no profit but provide for all possible losses". Stock is valued at cost or net realisable value, whichever is lower; provision is made for doubtful debts.
Example 1 (conservatism). Closing stock cost ₹50,000; it can now be sold for only ₹46,000. At what value is it shown? Solution. Lower of cost (50,000) and realisable value (46,000). Answer: ₹46,000
Example 2 (accrual). A firm pays salary of ₹10,000 a month. By 31 March it has paid ₹1,10,000 for the year; March salary is unpaid. What is the salary expense for the year? Solution. Expense belongs to the year in which it is incurred: 12 × 10,000. Cash paid (₹1,10,000) is not the test. Answer: ₹1,20,000, with ₹10,000 shown as outstanding salary (a liability).
Example 3 (realisation). Order received 25 March, goods delivered 5 April, cash received 20 April; the year ends 31 March. In which year is the sale recorded? Solution. Revenue is realised when goods pass to the buyer. Answer: the year beginning 1 April (delivery on 5 April)
Qualitative characteristics that make accounting information useful: reliability, relevance, understandability, comparability.
Deeper
- Concept or convention? Concepts are the basic assumptions on which accounts are built; conventions are customs that grew with practice. Textbooks differ in the label (some call all of them "principles"), so answer by the list each idea belongs to in the standard B.Com syllabus: consistency, disclosure, materiality and conservatism are the conventions.
- Conflicts between principles.
- Conservatism vs consistency: switching to the lower of cost or market in one year breaks comparability; the change must be disclosed.
- Cost vs relevance: historical cost is verifiable but can be far from current value in inflation, which is why inflation accounting and fair value (under Ind AS) exist.
- Accrual vs cash: accrual shows true profit; the cash basis is simpler and used by some professionals and small non-trading bodies.
- Going concern fails when a business is to be closed: assets are then shown at realisable values, and prepaid expenses may have no value.
- Business entity and the law. For a sole trader the law does not separate owner and business, but accounting does. A company is a separate legal person as well.
- Systems of accounting: double entry (complete, used by companies) and single entry (incomplete records of small traders; see the single entry note). Bases: cash basis, accrual (mercantile) basis, and a hybrid. Companies must use accrual under the Companies Act, 2013 (section 128).
- Limitations of financial accounting: historical cost, money measurement only (ignores quality of staff), estimates (depreciation, provisions), window dressing is possible.
Example 4. Which principle is violated if a trader records his house rent paid from the shop's cash as a business expense? (a) Money measurement (b) Business entity (c) Going concern (d) Matching Solution. The owner's personal expense must be treated as drawings. Answer: (b) Business entity
Example 5. A machine bought for ₹2,00,000 has a resale value of ₹1,20,000 today. The firm will keep using it and shows it at cost less depreciation. Which concept justifies this? Solution. The firm is expected to continue, so resale value is not relevant. Answer: going concern (supported by the cost concept)
Common traps
- ✗ "Book-keeping and accounting are the same." ✓ Book-keeping is only the recording stage; accounting also summarises and interprets.
- ✗ "Conservatism means recording expected profits early." ✓ It means no anticipated profits, but provide for all possible losses.
- ✗ "Stock is valued at market price." ✓ At cost or net realisable value, whichever is lower.
- ✗ "Revenue is recognised when the order is received." ✓ When goods or services pass to the buyer (realisation).
- ✗ "AS 1's fundamental assumptions are entity, money measurement and cost." ✓ They are going concern, consistency and accrual.
- ✗ "Capital is not a liability because the owner owns the business." ✓ Under the business entity concept, capital is owed by the business to the owner.
- ✗ "Double entry was introduced by Adam Smith." ✓ Luca Pacioli, 1494.
Quick revision
- Accounting: record, classify, summarise, interpret (in money terms).
- Book-keeping = recording part only.
- Luca Pacioli, Summa, 1494: double entry.
- Concepts: entity, money measurement, going concern, period, cost, dual aspect, realisation, accrual, matching.
- Conventions: consistency, full disclosure, materiality, conservatism.
- AS 1 assumptions: going concern, consistency, accrual.
- Conservatism: stock at lower of cost or NRV; provide for losses.
- Accrual: expense when incurred, not when paid.
- Matching: costs set against revenue of the same period.
- Indian year: 1 April to 31 March; Ind AS from 1 April 2016.
Go deeper: Mains writing (beyond what APPSC Paper I usually asks)
Mains writing Mains writing
- Frame: accounting is the language of business; concepts and conventions are its grammar, which make the statements of different firms and years comparable.
- Points: separate entity and dual aspect give the equation; accrual and matching give true profit; conservatism protects creditors; consistency and disclosure protect investors.
- Indian context: ICAI accounting standards, Ind AS converged with IFRS for listed and large companies from 2016, and the accrual basis required for companies under the Companies Act, 2013.
- Critique: historical cost hides inflation; excess conservatism creates secret reserves; standards reduce, but cannot remove, judgment.
Practise this topic. Questions on Accounting concepts, conventions & process, with answers explained.
All Accounting basics: concepts, conventions and the accounting process notes · APPSC Paper I syllabus · APPSC Paper I Mock 1 with answers · Start free
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