Fundamental Accounting Concepts and Core Principles

Chapter 1: Introduction to Accounting

Meaning of Accounting

Accounting is considered the art of identifying, measuring, recording, and communicating the required information relating to an organization's economic events to interested users of such information.

Definition of Accounting

According to the American Institute of Certified Public Accountants (AICPA) in 1941, "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 of financial character, and interpreting the results thereof."

Functions of Accounting

• Identification: This is the first step in accounting, where it is decided what to record, i.e., to identify the financial events to be recorded in the books of accounts. Only financial transactions are recorded in the books of accounts.
• Measurement: Transactions that can be measured in terms of money or are of a financial nature are recorded in the books of accounts. Any transaction that cannot be measured in monetary terms is not considered for recording in financial accounts.
• Recording: A transaction will be recorded in the books of accounts only if it is considered an economic event and can be measured in terms of money. Once economic events are identified and measured in financial terms, they are recorded in books of account in monetary terms and in chronological order. Recording should be done systematically so that information can be made available when required.
• Classifying: Once financial transactions are recorded in a journal or subsidiary books, all financial transactions are classified by grouping transactions of a similar nature in one place in a separate account. This is known as the preparation of a Ledger.
• Communication: The main purpose of accounting is to communicate financial information to users who analyze it according to their individual requirements. Providing financial information to users is a regular process.

Objectives of Accounting

1. To keep a systematic record of all business transactions.
2. Accounting is helpful in preventing and detecting errors and frauds.
3. Accounting plays an important role in calculating the profit or loss during a particular period by preparing a Trading Account and Profit & Loss Account.
4. Accounting is helpful in ascertaining the financial position of the business.
5. Accounting provides useful information to its users.

Chapter 2: Theoretical Framework of Accounting

Accounting Principles

An Accounting Principle is a generally accepted law and endorsed as a guide to action, a settled ground or basis of conduct or practice. Accounting principles are man-made. Unlike the principles of physics, chemistry, and other natural sciences, accounting principles were not derived from basic axioms, nor is their validity verifiable by observation and experiment. Instead, they have evolved. This evolutionary process is ongoing; accounting principles are not 'eternal truths'.

Business Entity Concept

This concept considers a business unit as a separate entity. The business and the business owner are two separate entities, and all business transactions are recorded in the books of accounts from the business's point of view.

Dual Aspect Concept

This concept signifies that every business transaction has a twofold effect, meaning every transaction affects at least two accounts. This concept is, in fact, the basis on which the Double Entry System of Bookkeeping is based. According to this principle, every debit has a corresponding credit.

Accounting Period Concept

According to this concept, the long life of a business is divided into justifiable accounting periods to help the business owner know the results of their investment during each such period. This period is known as the accounting period, and its length depends on the nature of the business. The accounting period may be either a calendar year (from January 1 to December 31) or the fiscal year of the government (April 1 to March 31).

Going Concern Concept

This concept assumes that every business has a long and indefinite life.

Cost Concept

According to this concept, all fixed assets are recorded in the books at cost, i.e., the price paid to acquire them. Any subsequent increase or decrease in their value is not shown in the records, except for the depreciation of these assets. In subsequent years, therefore, fixed assets are shown at cost less depreciation provided on them to date. Continuous charging of depreciation on the asset ultimately eliminates the asset from the books.

Money Measurement Concept

According to this concept, only those transactions that can be expressed in monetary terms are recorded in the books of accounts. Non-financial or non-monetary transactions do not find any place in the accounting records. Money is the common denominator used to measure the value of various assets of diverse natures to provide a meaningful total of these assets.

Matching Concept

This concept states that it is necessary to charge all expenses incurred to earn revenue during the accounting period against that revenue to ascertain the net income or trading results of the business. The matching concept is closely related to the accrual concept and the accounting period concept and helps a business owner realize their objective, i.e., ascertaining the trading results or profit or loss from the business.

Realisation Concept

According to this concept, income is treated as earned on the date it is realized, i.e., the date on which goods or services are transferred to customers. Since this exchange of goods or services may be for cash or on credit, it is not important whether cash has actually been received or not.

Objective Evidence Concept (Verifiable Object Concept)

This concept justifies the significance of verifiable documents supporting various transactions. According to it, each transaction should be supported by objective evidence, like vouchers. Objective evidence, here, means evidence free from the accountant's bias.

Materiality Principle

This principle emphasizes that only transactions material or relevant for determining the business's income should be recorded. All non-material facts should be ignored.

Full Disclosure Principle

This concept implies that financial statements should disclose all information required by the proprietor and other users to assess the business unit's final accounts.

Consistency Principle

This principle requires that accounting practices, methods, and techniques used by a business unit should be consistent. A business unit can adopt any accounting practice, but once a particular practice is chosen, it must be consistently used for several years.

Conservatism (Prudence) Principle

This principle is a formal expression of the maxim: "Anticipate no profits and provide for all possible losses." In other words, it considers all possible losses but ignores all possible profits.

Timeliness of Information

Accounting information should be supplied to management promptly and frequently so that rational decisions can be made. If information is not supplied in time, it will obstruct the undertaking's quick decision-making process.

Accounting Standards

Meaning of Accounting Standards

Accounting standards are written policy documents covering the aspects of recognition, measurement, treatment, presentation, and disclosure of accounting transactions in financial statements.

Features of Accounting Standards

1. Provide guidance to accountants.
2. Bring uniformity in accounting work.

Basic Accounting Terminology

Assets

An asset is a resource controlled by an enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.

Current Assets

Current assets are those assets held by an enterprise for a maximum period of one accounting cycle. Some examples of current assets include:

• Debtors: Persons who owe an enterprise an amount for buying goods and services on credit.
• Bills Receivable: Amount to be received against bills (from debtors).
• Cash in hand
• Cash at bank
• Cheques in hand
• Drafts in hand
• Stock
• Prepaid Expenses

Liabilities

These are certain obligations or dues that a firm has to pay. Liabilities can be divided into two categories: Non-Current Liabilities and Current Liabilities.

Non-Current Liabilities

(The provided text mentions Non-Current Liabilities as a category but does not provide specific examples in this section.)

Current Liabilities

Examples of current liabilities include:

• Creditors: Persons who have to be paid by an enterprise an amount for providing the enterprise goods and services on credit.
• Bills Payable: Amount payable against bills (to creditors).

Trade Payables

Trade Payables consist of the sum of Creditors and Bills Payable.

Capital

The amount invested by the owner in the firm is known as capital.

Sales

Sales are total revenues from goods or services sold or provided to customers. They may be cash sales or credit sales.

Revenue

It is the amount which is earned by selling products or providing services.

Expense

It is known as the cost of assets consumed or services used in the process of earning revenue.

Expenditure

It means spending money or incurring a liability for some benefit. Expenditure can be classified as Capital Expenditure or Revenue Expenditure.

Capital Expenditure

Capital expenditure refers to an outlay resulting in the acquisition of an asset or an increase in the earning capacity of the business. It is incurred for the purpose of enjoying long-term advantages for the business. This expenditure is mostly incurred for buying assets (tangible or intangible) which can later be sold and converted into cash, thereby increasing the business's earning capacity. Some examples of capital expenditure include:

• Legal charges incurred for legal documents for setting up a business.
• Purchase of land and building.
• Purchase of furniture.
• Purchase of any fixed asset for permanent use in the business.

Revenue Expenditure

If the benefit of an expenditure is exhausted within a year, it is termed Revenue Expenditure. Administrative expenses, manufacturing costs, selling expenses, office expenses, and all day-to-day expenses of the current year are examples of revenue expenditure.

Profit

The excess of revenue over expenses is called profit.

Gain

A gain generates from incidental transactions such as the sale of a fixed asset or winning a court case.

Loss

The excess of expenses over revenue is termed as loss.

Discount

It is defined as a concession or deduction in the price of goods sold.

Voucher

It is documentary evidence in support of a transaction.

Goods

It refers to the products in which the business unit is dealing, i.e., in terms of which it is buying and selling or producing and selling.

Drawings

The amount of goods or cash which is withdrawn from the business for personal use by the proprietor.

Purchases

It means the procurement of goods on credit or cash.

Stock

It is a part of unsold goods. It can be divided into two categories:

• Opening stock
• Closing stock

Balance Sheet

A Balance Sheet is prepared at the end of each accounting period to ascertain the financial position of the business.

Debit and Credit Fundamentals

Meaning of Debit and Credit

Debit refers to the left side of an account, and credit refers to the right side of an account. In abbreviated form, Dr. stands for debit and Cr. stands for credit. An item recorded on the debit side of an account is said to be debited to the account. An item recorded on the credit side of an account is said to be credited to the account.

Both debit and credit may represent either an increase or decrease depending upon the nature of an account. The rules of debit and credit depend on the nature of the account.

Rules of Debit and Credit

Under the Double Entry System of accounting, each transaction has two aspects. One aspect is debit, i.e., the receiving or incoming aspect. Another aspect is credit, i.e., the giving or outgoing aspect. Debit and credit aspects of a transaction form the basis of the Double Entry System.