Basic Theories Of Accounting

Welcome to Learn At Ur Desk! Today, we are going to Discuss “Basic Theories of Accounting.”

First, let’s see what we are going to learn in this lesson!

Overview:

In this lesson, we are going to focus on the following topics:

1.     What is GAAP?

2.     Basic Accounting Concepts

3.     Accounting Standards

4.     IFRS as Global Standards

5.     Basis of Accounting

6.     Accounting Systems

7.     What is GST?

So, what we are waiting for!

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Before digging into a new lesson let’s check out the recap of the previous lesson Introduction to Accounting

RECAP:

As discussed in the previous lesson, accounting is concerned with the recording, classifying and summarising of financial transactions and interpreting the results thereof. It aims at providing information about the financial performance of a firm to its various users such as owners, managers’ employees, investors, creditors, suppliers, tax authorities etc. and help them in taking important decisions. All these people look forward to accounting for appropriate, useful and reliable information.

For making the accounting information meaningful to its internal and external users, it is important that such information is reliable as well as comparable. The comparability of information is required both to make inter-firm comparisons, i.e. to see how a firm has performed as compared to the other firms, as well as to make the inter-period comparison, i.e. how the firm has performed as compared to the previous years. This becomes possible only if the information provided by the financial statements are based on consistent accounting policies, principles and practices.

Which we are going to learn now in this lesson Basic Theories of Accounting

Let’s start learning this lesson!

 

Have you ever heard about GAAP?

ACCOUNTING PRINCIPLES (GAAP)

GAAP (Generally Accepted Accounting Principles) refers to the rules or guidelines adopted for recording and reporting of business transactions, to bring uniformity in the preparation and the presentation of financial statements. Accounting principles are described by various terms such as assumptions, concepts, conventions, doctrines, postulates, etc.

These Principles are derived from experience and practice, and when they prove useful, they become accepted as Accounting Principles. The main purpose of GAAP is to ensure some basic level of consistency in the accounting statement of all different organizations. It enables external users of the financial statements to easily interpret and understand the accounts of a company. GAAP will also allow intra-firm and inter-firm comparisons, which help these users make investment decisions. Another purpose of imposing GAAP is to ensure that the representation of the financial statement is true and fair. If GAAP rules are followed religiously then there is a certain level of certainty in the fairness of the financial statements. These principles will ensure that the management is not manipulating accounts to suit their purposes.

However, GAAP is not universal. The details and specifications of GAAP will vary according to different geographic locations, industries, accounting body etc. For example, in USA GAAP rules have been modified by the Financial Accounting Standards Board (FASB). Similarly many countries and accounting bodies modify the GAAP rules to suit their industries and economies.

So now, let's check out these Accounting Principles

As I mentioned before, these Accounting Principles are also referred to as concepts and conventions. The term concept refers to the necessary assumptions and ideas, which are fundamental to accounting practice, and the term Conventions mean customs or traditions as a guide for the preparation and presentation of accounting statements. Practically, it is observed that these terms have been used interchangeably. Hence to avoid any confusion we are going to refer these principles as Basic Accounting Concepts.

 

BASIC ACCOUNTING CONCEPTS

Accounting is a business language. It speaks about business affairs. This business language must convey the same meaning everywhere. So, it has been developed around some commonly accepted ideas or assumptions. These fundamental ideas are called basic accounting concepts. These Concepts guide how transactions should be recorded and reported. These thirteen accounting concepts find wide acceptance across the world by accounting professionals. They are as follows:

1.     Business Entity Concept: The concept of Business Entity suggests that business is an entity in itself. Business is separate from its owner. So, the businessman should keep his expenses and income, separate from the business expenses or income, unless it is related to business funds. Meaning, whenever businessmen invest in the business firm, it is recorded in a separate account known as capital account and whenever businessmen withdraw from the business firm, it is recorded in a separate account known as Drawings. However, businessmen’s other household transactions which do not link to business is not considered.

2.     Money Measurement Concept: The concept of Money Measurement suggests that Accounting records only those transactions or events, which can be measured in terms of money. The transactions or events which are not measurable in terms of money cannot be recorded. Therefore, monetary transactions such as the sale of goods, payment for the expense, etc. are recorded in books of accounts but non-monetary transactions such as the appointment of managers, capabilities of workers, the image of an organisation etc. are not be recorded in books of accounts.

3.     Cost Concept: The concept of Cost suggests that all Assets should be recorded at the Actual Cost, which includes, cost of purchase, transportation charges, and installation. Assets and transactions should never be overvalued or undervalued. This is necessary to make accounting reliable and accurate. For example, Old Machine is purchased for 5,00,000, transportation charges for the machine are 5,000, besides 10,000 is spent on repair and 5,000 on its installation. Hence, the amount recorded in the books of accounts for this machinery is 5, 20,000.

4.     Going Concern Concept: The concept of Going Concern suggests that we should assume, that the business will continue forever or it is a going concern. Therefore, we should create reserves for expected losses, such as depreciation and doubtful debt. For example, let’s assume we purchase machine costing 50,000 and its service lifespan is 5 years, we can’t charge the whole amount of Rs 50,000 from the revenue of the year in which the asset was purchased. Instead, we charge evenly in its lifespan. Hence 10,000 is charged for the period and the remaining amount is forwarded to the next year.

5.     Dual Aspect Concept: The concept of Dual Aspect suggests that every transaction has a dual or two-fold effect and therefore recorded at two places.

For example: Mr. B started a business with cash Rs. 50,000. Here, the A business firm is receiving the benefit in form of cash and Businessmen is the giving this benefit, hence the first effect is an increase in Asset (Cash) and the second effect is an increase in Owner’s Capital. Hmmm, confused!

Let’s take another example

Suppose firms purchase goods worth of 10,000 for cash. This will again affect two accounts that are increasing in the asset (Stock) as goods are coming into business and decrease in another asset (Cash) as we are paying money for the same.

This dual aspect concept also expressed in terms of the Fundamental Accounting Equation, which is as follows: ASSET = CAPITAL + LIABILITIES

6.     Accounting Period Concept: The Concept of Accounting Period suggests that Accounting Statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during the accounting period and what exactly is the position of its assets and liabilities at the end of that period. Different users require such information at regular interval.  Hence, the financial statements are prepared at regular intervals, normally after one year,  so that timely information is available to the users.

7.     Realisation Concept: The concept of Revenue Recognition/ Realisation suggests that Revenue should be recorded only when it is realised or achieved. It should not anticipate incomes. Incomes/Revenue should be taken in accounts, only when it is realised or some party has accepted its liability to pay in future. In short, revenue is recognised when a sale is complete or service is rendered rather when cash is received.  For example, suppose rent for March 2019, even if it is received in April 2019, it will be taken into the profit and loss account of the financial year ending March 31, 2019, and not into financial year beginning with April 2019.

8.     Matching Concept: The concept of Matching suggests that while ascertaining profit or loss of a year, expenses incurred in an accounting period should be matched with the revenues during that accounting period. For example, expenses such as salaries, rent, insurance are recognised based on the period to which they relate/matched and not when these are paid. Similarly, costs like depreciation of a fixed asset are divided over the periods during which the asset is used.

9.     Full Disclosure concept: According to this guiding principle, all material and relevant facts concerning the financial performance of an enterprise must be fully and completely disclosed in the financial statements along with their accompanying footnotes. This is to enable the users to make a correct assessment about the profitability and financial soundness of the enterprise and help them to make informed decisions.

10.  Consistency Concept: According to this guiding principle, the business concern should follow uniform accounts for all years. Consistency of record helps in making the comparison, between past and present business results. It also eliminates personal bias and helps in achieving comparable results.

11.  Conservatism or Prudence Concept: According to this guiding principle, an accountant has to record the actual financial position, while recording the accounts. Profits should not be recorded until it is realised and all losses even those, which may have a remote possibility, are to be provided in the books of account.  Therefore, an accountant should not give a different picture of the business either by inflating or deleting the value of the transaction.

12.  Materiality Concept: According to this guiding principle, accounting should focus on material facts. Efforts should not be wasted in recording and presenting facts, which are immaterial in the determination of income. This principle is the exception of the full disclosure principle. According to the American Accounting Association (AAA), “An item should regard as material if there is reason to believe that knowledge of it would influence the decision of the informed investor.” For example, money spent on the creation of additional capacity of production would be a material fact as it is going to increase the future earning capacity of the enterprise.

13.  Objectivity Concept: According to this guiding principle, accounting transaction should be recorded objectively, free from the bias of accountants and others. This can be possible when verifiable documents or vouchers support each of the transaction. For example, the transaction for the purchase of materials may be supported by the cash receipt for the money paid or copy of invoice and delivery challan for credit purchase.

 

ACCOUNTING STANDARDS

Accounting Standards (AS’s) provide frameworks and standardize accounting policies so that the financial statements of different enterprise become comparable. In short, Accounting standards are the rules and regulations that are issued by accounting and governing bodies of the countries. The intention is to make sure all companies and organizations follow the same rules for accounting and have the same format for their financial statements.

These accounting standards are implemented in the whole country. So this means the entire national economy can implement the same standards and can adopt similar accounting terminology. So all organizations and business units have a uniform, precise and correct financial statements and records.

Accounting Standards are written policy document issued by ICAI (Institute Of Chartered Accountants of India), covering the aspects of recognition, measurement, presentation and disclosure of accounting transactions in Financial Statements.

These Accounting Standards are named as well as numbered almost similar to the IFRS. They are based on and adapted from the GAAP with modifications necessary for the Indian economy.

These standards deal with conflicting accounting issues, detailing the accounting treatment, rules, and directives. They are detailed and informative so to avoid any confusion or uncertainty.

Mainly Accounting Standards deals with four aspects:

i)      Recognition of events and transaction in the financial statements.

ii)    Measurements of these transactions and events.

iii)   Presentation of transactions and events in the financial statements in a manner that is meaningful and understandable to the reader and

iv)   A disclosure relating to these transactions and events to enable the public at large and the stakeholder and the potential investors, in particular, to get an insight into what these financial statements are trying to reflect and thereby, facilitating them to make sensible and informed business decisions.

In brief, Accounting Standards aims at improving the quality of financial reporting by promoting comparability, consistency and transparency, in the interest of users of financial statements. Good financial reporting not only promotes a healthy financial market, but it also helps in the reduction of the cost of capital because investors can have faith in financial reports and consequently perceive lesser risk.

The following are the 32 Accounting Standards issued by Institute of Chartered Accountants of India out of which AS 6, 8, 30, 31 and 32 are deleted, revised or being merged with other Accounting Standards:

 

AS-1                Disclosure of Accounting Policies

AS-2®              Valuation of Inventories

AS-3                Cash Flow Statements

AS-4®              Contingencies and Events occurring after the balance sheet date

AS-5®              Net Profit/ Loss for the Period, Prior Period Items and Changes in Accounting Policies

AS-6®              Depreciation Accounting

AS-7                Accounting for Construction Contracts

AS-8                Accounting for research and development

AS-9                Revenue Recognition

AS-10               Property, Plant and Equipment

AS-11®            The Effects of Changes in Foreign exchange rates

AS-12               Accounting for Govt. Grants

AS-13               Accounting of Investments

AS-14               Accounting for Amalgamations

AS-15               Accounting for Employees Benefits

AS-16               Borrowings costs

AS-17               Segment reporting

AS-18               Related Party Disclosures

AS-19               Leases

AS-20               Earnings per Share (EPS)

AS-21               Consolidated Financial Statements

AS-22               Accounting for taxes on Income

AS-23               Accounting for Investments in Associates in Consolidated Financial Statements

AS-24               Discontinuing operations

AS-25               Interim Financial Statement

AS-26               Intangible Assets

AS-27               Financial Reporting of Interest in Joint Ventures

AS-28               Impairment of Asset

AS-29               Provisions, Contingent liabilities and contingent assets

AS-30               Financial Instruments: Recognition & measurement

AS-31               Financial Instruments: Presentation

AS-32               Financial Instruments: Disclosures

 

IFRS AS GLOBAL STANDARDS

IFRS stands for International Financial Reporting Standards is an international framework for accounting records and financial statements. These are developed by the independent accounting body from London, known as the International Accounting Standards Boards (IASB).

As we know many countries around the world follow their versions of the GAAP. The USA, Canada, Australia, UK all have their own GAAPs. India has the Indian Accounting Standards. This lacks uniformity. Also, it creates a problem for Multi-National Companies which are having branches in many countries. Hence the IFRS was developed, so all nations could adopt one global accounting standard.

NEED FOR IFRS

i)      IFRS helps to prevent material manipulation or errors in financial statements.

ii)     It helps in global harmonization and promotes global standards for business growth.

iii)   It also facilitates global investment.

Currently around 120 countries globally have started following the IFRS. Soon many more are to follow. As a result, all companies across the world will report their accounts and financial statements following the same rules and regulations. This will lead to uniformity, ease of comparison, less confusion and better compatibility among nations.

To uniform accounting policies and procedures, almost all countries (including India) have agreed to apply IFRS. But the name of this IFRS has been converged as Ind AS. Practically, Ind AS is not different from IFRS. Ind AS is accounting standard notified by the ministry of corporate affairs and has a wide range of convergence as compared to existing accounting standards.

List of Ind AS lined in as IFRS

 

Ind As No	Name of Indian Accounting Standards
Ind AS 101	First-time adoption of Ind AS
Ind AS 102	Share-Based Payment
Ind AS 103	Business Combination
Ind AS 104	Insurance Contracts
Ind AS 105	Non-Current Assets Held for Sale and Discontinued Operations
Ind AS 106	Exploration for and Evaluation of Mineral Resources
Ind AS 107	Financial Instruments: Disclosures
Ind AS 108	Operating Segments
Ind AS 109	Financial Instruments
Ind AS 110	Consolidated Financial Statements
Ind AS 111	Joint Arrangements
Ind AS 112	Disclosure of Interests in Other Entities
Ind AS 113	Fair Value Measurement
Ind AS 114	Regulatory Deferral Accounts
Ind AS 115	Revenue from Contracts with Customers(Applicable from April 2018)
Ind AS 116	Leases (Applicable from April 2019)
Ind AS 1	Presentation of Financial Statements
Ind AS 2	Inventories
Ind AS 7	Statement of Cash Flows
Ind AS 8	Accounting Policies, Changes in Accounting Estimates and Errors
Ind AS 10	Events occurring after the Reporting Period
Ind AS 11	Construction Contracts (Omitted by the Companies (Indian Accounting Standards) Amendment Rules, 2018)
Ind AS 12	Income Taxes
Ind AS 16	Property, Plant and Equipment
Ind AS 17	Leases (Omitted by the Companies (Indian Accounting Standards) Amendment Rules,2019)
Ind AS 18	Revenue (Omitted by the Companies (Indian Accounting Standards) Amendment Rules, 2018)
Ind AS 19	Employee Benefits
Ind AS 20	Accounting for Government Grants and Disclosure of Government Assistance
Ind AS 21	The Effects of Changes in Foreign Exchange Rates
Ind AS 23	Borrowing Costs
Ind AS 24	Related Party Disclosures
Ind AS 27	Separate Financial Statements
Ind AS 28	Investments in Associates and Joint Ventures
Ind AS 29	Financial Reporting in Hyperinflationary Economies
Ind AS 32	Financial Instruments: Presentation
Ind AS 33	Earnings per Share
Ind AS 34	Interim Financial Reporting
Ind AS 36	Impairment of Assets
Ind AS 37	Provisions, Contingent Liabilities and Contingent Assets
Ind AS 38	Intangible Assets
Ind AS 40	Investment Property
Ind AS 41	Agriculture

 

BASIS OF ACCOUNTING

From the point of view the timing, for recognition of revenue and costs, there can be two broad approaches to accounting. These are:

(i) Cash basis; and

(ii) Accrual basis.

1) Cash Basis: Under the cash basis, entries in the book of accounts are made when cash is received or paid and not when the receipt or payment becomes due. For example, if office rent for December 2019, were paid in January 2020, it would be recorded in the book of account only in January 2020. Similarly, the sale of goods on credit in January 2020 would not be recorded in January but in the month, when the payment for the same is received. Thus, this system is incompatible with the matching principle, which states that the revenue of a period must be matched with the cost of the same period. Though it is simple, this method is inappropriate for most organizations as profit is calculated as a difference between the receipts and payments for the given period rather than on happening of the transactions.

2) Accrual Basis: Under the accrual basis, however, revenues and costs are recognised in the period in which they occur rather when they are paid. A distinction is made between the receipt of cash and the right to receive cash and payment of cash and legal obligation to pay cash. Thus, under this system, the monitory effect of a transaction is taken into account in the period in which they are earned rather than in the period in which cash is received or paid by the enterprise. This is a more appropriate basis for the calculation of profits as expenses are matched against the related period’s revenue.

 

ACCOUNTING SYSTEMS

The systems of recording transactions in the book of accounts are generally classified into two types They are: single entry system and double entry system

1.     Single entry system: This method of recording transaction is unscientific and incomplete. Some experts consider that it is not at all a system of accounting. Under this system, only one aspect of the transaction is recorded instead of two aspects. Hence this system is called a single entry system. Under this system, an only cash account and personal account is maintained ignoring real account and nominal accounts.

Limitations:

i)      All transactions are not recorded.

ii)    Only a few accounts are maintained.

iii)   Trail balance cannot be prepared at the end of the year to know the arithmetical accuracy.

iv)   Final accounts cannot be prepared to find out operational results and financial position of the business accurately.

2.     Double-entry system: The procedure of recording both the receiving and giving aspects related to business transaction is called the Double Entry System. This means for every debit or credit there will be a corresponding credit or debit respectively. Under this system, three accounts are maintained i.e., Personal Account, Real Account and Nominal Account.

Advantages

The following are the advantages of the double-entry system of accounting:

i)      It records all transaction of the business.

ii)    It gives correct and accurate information.

iii)   It helps to check the arithmetical accuracy by preparing a trial balance.

iv)   It helps in the ascertainment of the financial position of the business concern.

v)     It provides accounting information readily.

vi)   It helps in preventing frauds as the recording of the transactions is based on vouchers.

Disadvantages

i)      The following are the disadvantages of the double-entry system of accounting:

ii)    Many numbers of accounts are to be maintained.

iii)   It is too expensive.

iv)   Its accuracy always cannot be relied upon.

DIFFERENCE BETWEEN DOUBLE ENTRY SYSTEM AND SINGLE ENTRY SYSTEM

DOUBLE ENTRY SYSTEM	SINGLE ENTRY SYSTEM
All transaction is recorded in the books. Hence this is a comprehensive system.	Only Some transactions are recorded leaving the others. Hence this is an incomplete system.
Accurate profit/loss can be ascertained by preparing trading, profit and loss account.	It is not possible to arrive at the accurate profit through profit and loss account.
The real financial position can be derived by preparing the balance sheet with all relevant information.	The real financial position cannot be ascertained as the balance sheet is prepared with incomplete information.
The trader can obtain full information about the business as they maintain personal, real and nominal accounts.	The trader cannot obtain the total information as they maintain only cash and personal accounts leaving the nominal accounts.
Errors and frauds can easily detect.	Errors and frauds committed by the accountants cannot be located.
It is possible to compare the balance of two accounts of two different periods.	It is not possible to compare the balance of two different periods. As the trader does not maintain all the necessary accounts.

 

 

WHAT IS MEANT BY GST?

GST stands for Goods and Services Tax. It is based on one country one tax concept. GST is a destination-based tax and levied/charged at a single point at the time of consumption (place of supply) of goods and services by the end consumer.

Taxes are mainly classified into two types:

Direct Taxes and

Indirect Taxes

1. Direct Taxes: Direct tax is the tax paid to the government directly by the person known as Assessee. Income tax, Capital Gains Tax, Corporate Tax, Securities transaction Tax etc. are examples of Direct taxes

2. Indirect Taxes: An Indirect tax is a tax collected by an intermediary from the person/consumer, who bears the ultimate economic burden of the tax. India as a Federal Nation both Centre, as well as State Government, have the power to impose and collect taxes through appropriate legislation as they both have individual responsibilities. Earlier, Centre Government collects Indirect taxes such as Service Tax, Excise Duty, CST, Customs etc. and State Government collect separate indirect taxes such as VAT, Entry, Octroi, Luxury tax etc. which is now replaced by GST (Goods and Service Tax). Hence, GST is an Indirect tax, which came into effect on 1^st July 2017.

GST is called as a multi-tiered system because it currently has four slab rates (distributed evenly between Central Government and State Government) that is 5%, 12%, 18%, and 28% unlike one tax rate in other countries.

5% GST is charged for Mass Consumption items such as edible oils, branded cereals, insulin etc.

12% GST is charged for Processed Food items such as pasta, butter and other fats etc.

18% GST is charged for electronic items such as Refrigerators, TV, mobiles etc.

28% GST is charged for Luxury Items such as Luxury Cars, AC, tobacco, aerated drinks etc.

.

TAX STRUCTURE UNDER GST

There are three main components of GST which are CGST, SGST, IGST

To determine whether CGST, SGST or IGST will be applicable in a taxable transaction, it is important that first, you know if the transaction is an Intra State or an Inter-State.

1.     The intra-State supply means when the location of the supplier/seller and the place of supply i.e., the location of the buyer are in the same state. In Intra-State transactions, a seller has to collect both CGST and SGST from the buyer. The CGST gets deposited with Central Government and SGST gets deposited with State Government.

2.     The inter-State supply means when the location of the supplier/seller and the place of supply i.e., the location of the buyer are in different states. Also, in cases of export or import of goods or services or when the supply of goods or services is made to or by an SEZ unit, the transaction is assumed to be Inter-State. In an Inter-State transaction, a seller has to collect IGST from the buyer.

First, let’s see what is CGST?

CGST means Central Goods and Services Tax. Taxes collected under CGST will constitute the revenues of the Central Government. The present central taxes like central excise duty, additional excise duty, special excise duty, central sales tax etc., will be included under CGST.

Next, what is SGST?

SGST means State Good and Services Tax. A collection of SGST is the revenue of the State Government. With GST all-state taxes like VAT, entertainment tax, luxury tax, entry tax etc, will be merged with GST

Let’s see an example of these two components: Mr. ‘A’ a dealer in Punjab sell goods to Mr. ‘B’ in Punjab worth 10,000 – Sale within the State. If the GST rate is 18%, that is 9% CGST and 9% SGST, the dealer will collect 900 CGST, which will go to Central Government and 900 SGST, which will go to the Punjab Government.

Now let’s see what is IGST?

IGST means Integrated Goods and Services Tax. Revenue collected under IGST is divided between Central and State Government as per the rates specified by the Government. IGST is charged on transfer of goods and services from one state to another. Import of goods and services are also covered under IGST.

For Example, Mr. ‘A’ in Telangana sell goods to Mr. ‘B’ in Mumbai worth 1,00,000. Applicable GST rate is 18% that is  9% CGST and 9% SGST. In this case, the dealer will charge a full 18% as IGST and 18,000 will go to the Central Government. Later Central Government will give the Mumbai State it’s share.

Hence if the Sale is within the State – CGST+SGST is charged and if the Sale is made outside the State – only IGST is charged.

That is it in this lesson!

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Coming Up Next – Accounting Terminology.

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