Theory base of Accounting Chapter Notes | Accountancy Class 11 - Commerce PDF Download

Introduction

• Accounting involves recording, classifying, and summarizing financial transactions, then interpreting results to inform users like owners, managers, investors, and creditors. 
•  This information helps them make key decisions. 
•  For example, investors assess a firm’s profit or loss over time, while creditors evaluate its liquidity. 
•  To be useful, accounting information must be reliable and comparable—both across firms and over time. 
•  Achieving this requires consistent accounting policies, principles, and practices. 

• Consistency is important in every step of accounting—from identifying and measuring to summarizing and reporting transactions.
• A solid foundation of principles, concepts, and guidelines helps keep accounting clear and uniform.
• To support this, the Institute of Chartered Accountants of India (ICAI) has created Accounting Standards to ensure accounting practices are consistent across the country.

Generally Accepted Accounting Principles

• To ensure consistency and uniformity in accounting records, the accounting profession has established certain widely accepted rules or principles.
• These rules are known by various names such as principles, concepts, conventions, postulates, assumptions, and modifying principles.
• The American Institute of Certified Public Accountants (AICPA) defines a principle as a general rule or guideline for action.
• Generally Accepted Accounting Principles (GAAP) refer to the guidelines used for recording and reporting business transactions to ensure uniformity in financial statements.
• GAAP principles have evolved over time based on past experiences, customs, professional statements, and government regulations.
• These principles are not static; they are influenced by changes in the legal, social, and economic environment.
• The terms concepts and conventions are also used to describe these principles.
• Concepts refer to fundamental assumptions in accounting, while conventions refer to customary practices.
• Different authors may use terms like concepts, postulates, or conventions interchangeably, which can be confusing for learners.
• However, the focus should be on the practical application of these terms.
• For practical purposes, these various terms are often grouped together as Basic Accounting Concepts.

Basic Accounting Concepts

Basic Accounting Concepts refer to the essential ideas or fundamental assumptions that form the foundation of financial accounting. These concepts are broad working rules developed by the accounting profession to guide all accounting activities. Here are the important concepts:

• Business Entity: Accounts should be maintained for each business separately, independent of the owners or other businesses.
• Money Measurement: Only transactions that can be measured in monetary terms are recorded in the accounts.
• Going Concern: It is assumed that the business will continue to operate indefinitely unless there is evidence to the contrary.
• Accounting Period: Financial statements are prepared for specific periods, such as a month, quarter, or year.
• Cost: Assets are recorded at their cost price, which includes all expenses incurred to bring the asset to its current condition and location.
• Dual Aspect (or Duality): Every transaction has two aspects – debit and credit – ensuring that the accounting equation (Assets = Liabilities + Equity) remains balanced.
• Revenue Recognition (Realization): Revenue is recognized when it is earned, regardless of when the cash is received.
• Matching: Expenses should be matched with the revenues they help to generate in the same accounting period.
• Full Disclosure: All relevant information that could impact the understanding of financial statements should be disclosed.
• Consistency: Once an accounting method is chosen, it should be applied consistently from one period to the next.
• Conservatism (Prudence): Accountants should anticipate losses but not profits, ensuring that liabilities and expenses are not understated.
• Materiality: Only information that could influence the decisions of users should be included in the financial statements.
• Objectivity: Financial information should be based on objective evidence and not on personal opinions or biases.

Business Entity Concept

• The business entity concept is a fundamental principle in accounting that treats a business as a separate legal entity from its owners.
• According to this concept, when an owner contributes capital to the business, it is recorded as a liability of the business to the owner.
• Similarly, when the owner withdraws money for personal use (drawings), it reduces the owner's capital and the business's liabilities.
• The accounting records are maintained from the perspective of the business, excluding the personal assets, liabilities, and transactions of the owner.

Money Measurement Concept

• The money measurement concept states that only transactions and events that can be expressed in monetary terms are recorded in the accounting books.
• For example, sales, expenses, and income are recorded, while non-monetary aspects like employee capabilities or organizational image are not.
• Transactions are recorded in monetary units, not physical units. For instance, assets like land, buildings, and equipment are valued in rupees and paise.
• The concept has limitations due to changes in the value of money over time. For example, adding assets purchased at different times can be misleading because of inflation.
• Despite these limitations, the money measurement concept remains essential in providing a clear and standardized way to record and report financial information.

Going Concern Concept

• The going concern concept in accounting assumes that a business will continue its operations for the foreseeable future, which is crucial for valuing assets on the balance sheet.
• When a business purchases an asset, like a computer for ₹50,000, it is essentially buying the services the computer will provide over its useful life, say 5 years.
• Instead of charging the entire ₹50,000 to the revenue of the purchase year, only the portion of the asset used to generate revenue in that period is charged.
• The going concern assumption allows for the allocation of asset costs over time, such as charging ₹10,000 annually for 5 years.
• Without this assumption, the full cost would need to be charged in the year of purchase.

Accounting Period Concept

• The accounting period concept involves preparing financial statements at regular intervals, usually annually, to assess whether a business has made a profit or loss during that time.
• These statements provide essential information about the company’s assets and liabilities, helping users make informed decisions.
• While the Companies Act 2013 and the Income Tax Act mandate annual income statements, there are instances, like partner retirements, where interim statements are necessary.
• Listed companies are also required to publish quarterly results to keep stakeholders updated on their financial performance.

Cost Concept

• The cost concept in accounting mandates that assets be recorded at their purchase price, including all costs necessary to make the asset operational, such as acquisition, transportation, and installation costs.
• For example, if a company buys an old plant for ₹50 lakh and incurs additional costs for transportation, repairs, and installation, these costs are added to the purchase price to determine the asset's recorded value.
• The recorded value remains constant over time, regardless of changes in market value, providing objectivity and verifiability in accounting records.
• While historical cost brings reliability, it may not reflect the true value of assets, especially during inflationary periods, leading to hidden profits.
• Despite its limitations, historical cost is preferred for its verifiability and consistency in recording asset values.

Dual Aspect Concept

• The dual aspect concept is a fundamental principle in accounting that states every business transaction has two-fold effects and must be recorded in at least two accounts. For example, when Ram invests ₹50,00,000 in his business, it increases both the cash (asset) and the owner's equity (capital) by the same amount.
• Similarly, if a firm purchases goods worth ₹10,00,000 in cash, it increases one asset (stock of goods) while decreasing another (cash). The duality principle is expressed in the accounting equation: 
  Assets = Liabilities + Capital
• This concept is the core of the Double Entry System of accounting, where every transaction affects at least two accounts to keep the accounting equation balanced.

Revenue Recognition (Realisation) Concept

• The revenue recognition concept dictates that revenue should only be recorded in accounting records when it is realized.
• Revenue refers to the gross inflow of cash from the sale of goods and services or the use of the enterprise's resources yielding interest, royalties, and dividends.
• Revenue is considered realized when there is a legal right to receive it, such as when goods are sold or services are rendered.
• For instance, credit sales are recorded as revenue at the time of sale, not when payment is received.
• Exceptions to this rule include long-term contracts, where revenue is recognized proportionately based on the work completed and hire purchase agreements, where instalment payments are treated as realized.

Matching Concept

• The matching concept is a principle in accounting that helps determine profit or loss by matching expenses with revenues in the same period. 
• It emphasizes that expenses should be recorded in the same period as the revenues they help generate, regardless of when cash is exchanged. 
• For example, expenses like salaries and rent are recognized when they are incurred, not when they are paid. 
• Similarly, the cost of goods sold is matched with sales revenue by considering only the cost of goods sold during the period, not the total cost of goods produced or purchased. 

Full Disclosure Concept

• The full disclosure concept in accounting ensures that financial statements provide complete and relevant information for decision-making by various stakeholders.
• Financial statements must disclose all material facts about an enterprise's financial performance to enable users to assess profitability and financial soundness accurately.
• The Indian Companies Act 1956 and regulatory bodies like SEBI mandate specific formats and complete disclosures in profit and loss accounts and balance sheets to ensure transparency and fairness.

Consistency Concept

• The usefulness of accounting information from financial statements relies on the ability to make comparisons over time and with other enterprises.
• Consistency in accounting policies and practices is essential for meaningful inter-firm and inter-period comparisons.
• For example, if an investor wants to compare this year's net profit with last year's, differing accounting policies (such as depreciation methods) would make the figures incomparable.
• Consistency ensures that financial statements are prepared in a way that allows for comparable results across different accounting periods.
• It helps eliminate personal bias and facilitates meaningful comparisons between enterprises.
• While consistency is important, it does not prevent changes in accounting policies.
• If changes are necessary, they should be fully disclosed in the financial statements, along with their potential impact on financial results.

Conservatism Concept

• The conservatism concept, also known as prudence, guides the recording of transactions in accounting by emphasizing a cautious approach to determining income. 
• It aims to avoid overstating profits, as inflated profits could lead to unfair distributions of dividends from capital, thereby reducing the enterprise's capital. 
• According to this concept, profits should only be recognized when realized, while all potential losses, even those with a remote possibility, should be accounted for. 
• Examples of conservatism in practice include: 
  1. Valuing closing stock at the lower of cost or market value.
  2. Creating provisions for doubtful debts.
  3. Writing off intangible assets like goodwill and patents.
• For instance, if the market value of purchased goods has decreased, the stock will be recorded at cost price, but if the market value has increased, the gain is not recognized until the stock is sold. 
• This approach of recognizing losses but not gains, until realized, reflects a cautious attitude adopted by accountants to deal with uncertainty and protect creditors' interests. 
• However, deliberately underestimating asset values to create hidden profits, known as secret reserves, should be discouraged. 

Materiality Concept

• The concept of materiality in accounting emphasizes the importance of focusing on material facts while recording and presenting information. Efforts should not be wasted on facts that are immaterial to income determination.
• Material Fact Definition: A material fact is one that is likely to influence the decision of an informed user of financial statements. Its significance depends on its nature and the amount involved.
• For instance, spending money on increasing the capacity of a theatre is material because it impacts the future earning potential of the business.
• Information about changes in depreciation methods or upcoming liabilities is also considered significant and should be disclosed in financial statements.
• In cases of very small amounts, strict adherence to accounting principles may not be necessary. For example, items like erasers, pencils, and scales are not shown as assets, and their costs are treated as expenses in the period incurred.

Objectivity Concept

• The objectivity concept in accounting emphasizes the need for recording transactions in an unbiased manner, supported by verifiable documents or vouchers.
• Transactions should be backed by evidence such as cash receipts, invoices, or delivery challans.
• For example, the purchase of materials should be documented with receipts or invoices to ensure objectivity.
• The principle of objectivity is reinforced by using historical cost as the basis for recording transactions, as the actual cost paid for an asset can be verified from documents.
• In contrast, determining the market value of an asset can be subjective and vary from person to person.

Systems of Accounting

• Types of Accounting Systems: There are two main types of accounting systems: the Double Entry System and the Single Entry System.
  

Double Entry System:

• Based on the principle of "Dual Aspect," where every transaction has two effects: receiving a benefit and giving a benefit.
• Every transaction involves two or more accounts, with one account debited and another credited.
• Ensures completeness by recording both aspects of a transaction.
• Minimizes fraud and errors, and inaccuracies can be checked through a trial balance.
• Suitable for both large and small organizations.

Single Entry System:

• Not a complete system as it does not record the two-fold effect of every transaction.
• Typically maintains only personal accounts and a cash book.
• Lacks uniformity and reliability, making it less systematic.
• Commonly used by small businesses due to its simplicity and flexibility.

Basis of Accounting

• Cash Basis: Records transactions when cash is received or paid, regardless of when the transaction occurs. For example, if office rent for December 2014 is paid in January 2015, it is recorded in January 2015.
• Accrual Basis: Recognizes revenues and costs when they occur, regardless of cash movements. This approach matches expenses with the revenue earned in the same period. For instance, raw materials consumed are matched against the cost of goods sold.

Accounting Standards

Accounting standards are official guidelines that dictate how financial transactions should be recognized, measured, treated, presented, and disclosed in financial statements. These standards aim to ensure consistency and comparability in accounting practices across different entities.

Accounting standards are authoritative guidelines issued by the Institute of Chartered Accountants of India (ICAI), the professional body responsible for regulating accounting practices in the country.

Objectives of Accounting Standards:

• Uniformity: Accounting standards promote uniformity in accounting policies, reducing the non-comparability of financial statements.
• Credibility: By providing standard accounting policies and disclosure requirements, these standards enhance the credibility of accounting data.
• Comparability: Accounting standards improve the comparability of financial statements both within the same enterprise over time and between different enterprises.
• Performance Assessment: Standardized accounting practices help users effectively assess and compare firms' performance.

Need for Accounting Standards:

• Accounting provides crucial information to various users, and this information must be uniform and fully disclosed to serve their interests effectively. 
•  Without accounting standards, different entities might use alternative accounting treatments and valuation norms, leading to inconsistencies. 
• Accounting standards guide entities toward accounting treatments that fulfill the basic qualitative characteristics of true and fair financial statements, ensuring reliability and comparability. 
•  By establishing a framework for accounting practices, standards help maintain the integrity and usefulness of financial information for all stakeholders. 

Benefits of Accounting Standards:

• Accounting standards help eliminate variations in accounting treatment for preparing financial statements.
• Accounting standards may require disclosures of certain information that, while not mandated by law, could be beneficial for the general public, investors, and creditors.
• Accounting standards facilitate comparability between financial statements of different companies and within the same company over time.

Limitations of Accounting Standards:

• Accounting standards can make the choice between different accounting treatments difficult to apply.
• They are rigidly followed and lack flexibility in their application.
• Accounting standards cannot override statutory requirements and must be framed within the boundaries of prevailing laws.

Goods and Services Tax (GST) 

One Country, One Tax

• GST is a consumption-based tax on goods and services, applied at all stages from production to final consumption.
• It allows for tax credits on taxes paid at previous stages, ensuring that only value addition is taxed and the final consumer bears the tax burden.
• GST is a destination-based tax, meaning it accrues to the authority where the goods or services are consumed, also known as the place of supply.
• GST is levied by both the Centre and the States on a common tax base.

Components of GST:

• CGST (Central Goods and Services Tax): Revenue goes to the Central Government. It subsumes various central taxes like central excise duty, additional excise duty, special excise duty, and central sales tax.
• SGST (State Goods and Services Tax): Revenue goes to the State Government. It merges state taxes like VAT, entertainment tax, luxury tax, and entry tax.
• IGST (Integrated Goods and Services Tax): Charged on inter-state transfer of goods and services, as well as imports. Revenue is shared between the Central and State Governments based on specified rates.

Examples of GST Transactions:

• CGST and SGST Example: If Ramesh, a dealer in Punjab, sells goods worth ₹10,000 to Seema in Punjab with an 18% GST rate (9% CGST and 9% SGST), ₹900 goes to the Central Government and ₹900 goes to the Punjab Government.
• IGST Example: If goods are transferred from Madhya Pradesh to Rajasthan, IGST is applicable. For instance, if Ramesh in Madhya Pradesh sells goods worth ₹1,000,000 to Anand in Rajasthan with 18% GST (9% CGST and 9% SGST), IGST of ₹18,000 is charged and goes to the Central Government.

Characteristics of Goods and Services Tax (GST):

1. GST is governed by a unified legal framework and procedures applicable across the entire country under a single administration.
2. It is a destination-based tax, levied at a single point during the consumption of goods and services by the end consumer.
3. GST is a comprehensive levy applied to both goods and services at the same rate, allowing for input tax credit or value subtraction.
4. The system maintains a minimum number of tax rates, not exceeding two.
5. There is no provision for additional levies such as cess, resale tax, or turnover tax.
6. GST eliminates the multiple taxation of goods and services, such as sales tax, entry tax, octroi, entertainment tax, or luxury tax.

Advantages of Goods and Services Tax (GST):

1. The implementation of GST has led to the elimination of various types of taxes on goods and services.
2. GST expands the tax base and increases revenue for both the Centre and State, thereby reducing administrative costs for the government.
3. It lowers compliance costs and encourages voluntary compliance.
4. GST impacts tax rates, limiting them to a maximum of two-floor rates.
5. It eliminates the cascading effect of taxation.
6. GST is expected to enhance manufacturing and distribution systems, affecting the cost of production for goods and services, and subsequently increasing demand and production.
7. It promotes economic efficiency and sustainable long-term economic growth, being neutral to business processes, models, organizational structures, and geographical locations.
8. GST helps improve the competitive edge of goods and services produced in the country in the international market, leading to increased exports.