Accounting Concepts:

Learning objectives:

1. Explain important accounting principles.

The term concepts includes those basic assumptions or conditions upon which accounting is
based. The following are the important accounting concepts:

1. Business Entity Concept

2. Going Concern Concept

3. Money Measurement Concept

4. Cost Concept

5. Duel Aspect Concept

6. Accounting Period Concept

7. Matching Concept

8. Realisation / Realization Concepts

The explanation of these concepts are as follows:

Business Entity Concept:

In accounting, business is treated as separate entity from its owners. Accounts are prepare
to give information about the business and not about those who own it. a distinction is
made between business transactions and personal transactions. Without such a distinction,
the affairs of the business will be mixed up with the private affairs of the proprietor and the
true picture of the firm will not be available. The 'Business' and 'owner' are taken as two
separate entities. The accountant is interested to record transactions relating to business
only. The private transactions of the owner will be recorded separately and will have no
bearing on the business transactions. All the transactions of the business are recorded in
the books of the business from the point of view of the business as an entity and even the
proprietor is treated as a creditor to the extent of his capital.

The concept of separate entity is applicable to all of business organizations. For example, in
case of a sole proprietorship business or partnership business, though the sole proprietor or
partners are not considered as separate entities in the eyes of law, but for accounting
purposes they will be considered as separate entities. In the case of joint stock company,
the business has a separate legal entity than the shareholders. The coming and going
shareholders don not affect the entity of the business. Thus, the distinction between owner
and the business unit has helped accounting in reporting profitability more objectively and
fairly. It has also led to the development of 'responsibility accounting' which enables us to
find out the profitability of even the different sub-units of the main business.

Going Concern Concept:

According to going concern concept it is assumed that the business will exist for a long
time to come. Transactions are recorded in the books keeping in view the going concern
aspect of the business unit. A firm is said to be going concern when there is neither the
intention nor necessary to wind up its affairs. In other words, it should continue to operate
at its present scale in the future. On account of this concept the fixed assets are shown in
the balance sheet at a diminishing balance method i.e., going concern value. There is no
need to show assets at market value because these have been purchased for use in future
and earn revenues and for sale purpose. If the business is not to continue then market
value will have significance. Since business is to continue, fixed assets will be shown at cost
less depreciation basis. It is due to the concept that the fixed assets are depreciated on the
basis of their expected life than on the basis of market value. The concept also necessitates
distinction between expenditure that will render benefit over a long period and that whose
benefit will be exhausted quickly, say within one year. The going concern concept also
implies that existing liabilities will be paid at maturity.

Money Measurement Concept:

Accounting to records only those transactions which can be expressed in terms of money.
Transactions or events which cannot be expressed  in money do not find place in the books
of accounts though they may be very useful for the business. For example, if a business has
got a team of dedicated and trusted employees, it is definitely an asset to the business, but
since their monetary measurement is not possible, they are not shown in the books of
business. It should be remembered that money enables various things of diverse nature to
be added up together and dealt with. The use of a building and the use of clerical service
can be aggregated only through money values and not otherwise.

Cost Concept:
This concept is closely related to the going concern concept. According to this concept, an
asset in ordinarily recorded in the books at the price at which it was acquired i.e., at its cost
price. This cost serves the basis for the accounting of this asset during the subsequent
period. The 'cost' should not be confused with 'value'. It must be remembered that as the
real worth of the assets changes from time to time, it does not mean that the value of such
an asset is wrongly recorded in the books. The book values of the assets as recorded do not
reflect their real value. They do not signify that values noted therein are the values for
which they can be sold. Though the assets are recorded in the books at cost, in course of
time, they are reduced in value on account of depreciation charges. The idea that the
transactions should be recorded  at cost rather than at a subjective or arbitrary value is
known as cost concept. With the passage of time, the market value of fixed assets like land
and buildings vary greatly from their cost. These changes in the value are generally ignored
by the accountants and they continue to value them in the balance sheet at historical cost.
The principle of valuing the fixed assets at cost and not at market value is the underlying
principle in cost concept. According to them the current values alone will fairly represent the
cost to the entity. The cost principle is based on the principle of objectivity. There is no
room for personal assessment in showing the figures in accounting records. If subjectivity is
flowed in records the same assets will be valued at different figures by different individual.
Every body will have his own views about various assets. The cost concept is helpful in
making truthful records. The records becomes more reliable and comparable.

Dual Aspect Concept:

This is the basic concept of accounting. Modern accounting system is based on dual aspect
concept. Dual concept may be stated as "for every debit, there is a credit". Every
transaction should have two sided effect to the extent of same amount. For example, if A
starts a business with a capital of $10,000. There are two aspects of the transaction. On the
one hand the business has assets of $10,000 while on the other hand the business has to
pay to the proprietor a sum of $10,000 which is taken as proprietor's capital. This
expression can be shown in the form of following equation:
 

Capital (Equities) = Costs (Assets)

10,000 = 10,000

The term 'assets' denotes the resources owned by a business while the term 'equities'
denotes the claims of various parties against the assets. Equities are of two types. They are
owners equity and outsiders equity. Owner's equity (or capital) is the claim of the owner's
against the assets of the business while outsiders equity (liabilities) is the claim of outside
parties against the assets of the business. Since all assets of the business are claimed by
someone (either owners or outsiders), the total of assets will be equal to total of liabilities.
Thus:
 

  Equities = Assets    
OR Liabilities + Capital =
Assets

Suppose if the business borrows $5000 from a bank, dual aspect of this transaction will be
 

Capital + Liabilities = Assets

A  Loan    
10,000 = 15,000

Thus the accounting Equation states that at any point of time the assets of any entity must
be equal (in monetary terms) to the total of owner's equity and outsider's liabilities. As a
mater of fact the entire system of double entry accounting is based on this concept.

Accounting period concept:

According to this concept, the life of the business is divided into appropriate segments for
studying the results shown by the business after each segment. Since the life of the
business is considered to be indefinite (according to going concern concept) the
measurement of income and studying financial position of the business according to the
above concept, after a very long period would not be helpful in taking proper corrective
steps at the appropriate time. It is, therefore, absolutely necessary that after each segment
or time interval the businessman must stop and see, how things are going on. In accounting
such a segment or time interval is called accounting period. It is usually of a year.

 At the end of each accounting period and income statement/profit & loss Account and a
Balance Sheet are prepared. The income statement discloses the profit or loss made by the
business during the accounting period while Balance Sheet discloses the financial position of
the business as on the last day of the accounting period. While preparing these statements
a proper distinction has to be made between capital and revenue expenditure.

Matching concept:
The aim of business is to earn profit. In order to ascertain the profit the costs (expenses)
are matched to revenue. The difference between income from sales and costs of producing
the goods will be the profit. When business is taken as a going concern then it becomes
necessary to evaluate the performance periodically.
A correct statement of income requires a distinction between past, present and future
expenditures. A distinction between capital and revenue expenditure is also necessary. The
revenues and costs of same period are matched. In other words, income made by the
business during a period can be measured only when the revenue earned during a period is
compared with the expenditure incurred for earning that revenue. The question when the
payment was received or made is irrelevant.

Realization Concept:
This concept emphasises that profit should be considered only when realised. The question
is at what stage profit should be deemed to have accrued? Whether at the time of receiving
the order or at the time of execution of the order or at the time of receiving the cash? For
answering this question the accounting is in conformity with the law and Recognises the
principle of law i.e., the revenue is earned only when the goods are transferred. It means
that profit is deemed to have accrued when property i goods passes to the buyer, viz., when
sales are made.

Basic Accounting Principles and Guidelines

Since GAAP is founded on the basic accounting principles and guidelines, we can better
understand GAAP if we understand those accounting principles. The table below lists the ten
main accounting principles and guidelines together with a highly condensed explanation of each.

Basic Accounting Principle What It Means in Relationship to a Financial Statement

1. Economic The accountant keeps all of the business transactions of a sole proprietorship
Entity separate from the business owner's personal transactions. For legal purposes, a
Assumption sole proprietorship and its owner are considered to be one entity, but for
accounting purposes they are considered to be two separate entities.
2. Monetary Unit Economic activity is measured in U.S. dollars, and only transactions that can
Assumption be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's

purchasing power has not changed over time. As a result accountants ignore
the effect of inflation on recorded amounts. For example, dollars from a 1960
transaction are combined (or shown with) dollars from a 2009 transaction.
3. Time Period This accounting principle assumes that it is possible to report the complex and
Assumption ongoing activities of a business in relatively short, distinct time intervals such
as the five months ended May 31, 2009, or the 5 weeks ended May 1, 2009.
The shorter the time interval, the more likely the need for the accountant to
estimate amounts relevant to that period. For example, the property tax bill is
received on December 15 of each year. On the income statement for the year
ended December 31, 2009, the amount is known; but for the income statement
for the three months ended March 31, 2009, the amount was not known and an
estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the
heading of each income statement, statement of stockholders' equity, and
statement of cash flows. Labeling one of these financial statements with
"December 31" is not good enough—the reader needs to know if the statement
covers the one week ending December 31, 2009 the month ending December
31, 2009 the three months ending December 31, 2009 or the year ended
December 31, 2009.
4. Cost Principle From an accountant's point of view, the term "cost" refers to the amount spent
(cash or the cash equivalent) when an item was originally obtained, whether
that purchase happened last year or thirty years ago. For this reason, the
amounts shown on financial statements are referred to as historical cost
amounts.

Because of this accounting principle asset amounts are not adjusted upward for
inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any
type of increase in value. Hence, an asset amount does not reflect the amount
of money a company would receive if it were to sell the asset at today's market
value. (An exception is certain investments in stocks and bonds that are
actively traded on a stock exchange.) If you want to know the current value of
a company's long-term assets, you will not get this information from a
company's financial statements—you need to look elsewhere, perhaps to a
third-party appraiser.
5. Full If certain information is important to an investor or lender using the financial
Disclosure statements, that information should be disclosed within the statement or in the
Principle notes to the statement. It is because of this basic accounting principle that
numerous pages of "footnotes" are often attached to financial statements.
 As an example, let's say a company is named in a lawsuit that demands a
significant amount of money. When the financial statements are prepared it is
not clear whether the company will be able to defend itself or whether it might
lose the lawsuit. As a result of these conditions and because of the full
disclosure principle the lawsuit will be described in the notes to the financial
statements.

A company usually lists its significant accounting policies as the first note to
its financial statements.
6. Going Concern This accounting principle assumes that a company will continue to exist long
Principle enough to carry out its objectives and commitments and will not liquidate in
the foreseeable future. If the company's financial situation is such that the
accountant believes the company will not be able to continue on, the
accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its prepaid
expenses until future accounting periods.
7. Matching This accounting principle requires companies to use the accrual basis of
Principle accounting. The matching principle requires that expenses be matched with
revenues. For example, sales commissions expense should be reported in the
period when the sales were made (and not reported in the period when the
commissions were paid). Wages to employees are reported as an expense in
the week when the employees worked and not in the week when the employees
are paid. If a company agrees to give its employees 1% of its 2009 revenues as
a bonus on January 15, 2010, the company should report the bonus as an
expense in 2009 and the amount unpaid at December 31, 2009 as a liability.
(The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as

advertisements (and thereby we cannot match the ad expense with related
future revenues), the accountant charges the ad amount to expense in the
period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting

Entries and Drills for Adjusting Entries.)
8. Revenue Under the accrual basis of accounting (as opposed to the cash basis of
Recognition accounting), revenues are recognized as soon as a product has been sold or a
Principle service has been performed, regardless of when the money is actually received.
Under this basic accounting principle, a company could earn and report
$20,000 of revenue in its first month of operation but receive $0 in actual cash
in that month.
 For example, if ABC Consulting completes its service at an agreed price of
$1,000, ABC should recognize $1,000 of revenue as soon as its work is done
—it does not matter whether the client pays the $1,000 immediately or in 30
days. Do not confuse revenue with a cash receipt.
9. Materiality Because of this basic accounting principle or guideline, an accountant might be
allowed to violate another accounting principle if an amount is insignificant.
Professional judgement is needed to decide whether an amount is insignificant
or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer

by a highly profitable multi-million dollar company. Because the printer will
be used for five years, the matching principle directs the accountant to expense
the cost over the five-year period. The materiality guideline allows this
company to violate the matching principle and to expense the entire cost of
$150 in the year it is purchased. The justification is that no one would consider
it misleading if $150 is expensed in the first year instead of $30 being
expensed in each of the five years that it is used.

Because of materiality, financial statements usually show amounts rounded to

the nearest dollar, to the nearest thousand, or to the nearest million dollars
depending on the size of the company.
10. Conservatism If a situation arises where there are two acceptable alternatives for reporting an
item, conservatism directs the accountant to choose the alternative that will
result in less net income and/or less asset amount. Conservatism helps the
accountant to "break a tie." It does not direct accountants to be conservative.
Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate

or disclose losses, but it does not allow a similar action for gains. For example,
potential losses from lawsuits will be reported on the financial statements or in
the notes, but potential gains will not be reported. Also, an accountant may
write inventory down to an amount that is lower than the original cost, but will
not write inventory up to an amount higher than the original cost.

Accounting Principles       | Money Measurement Concept | Going Concern Concept | Cost

Concept | Conservative Concept |
| Accounting Period Concept | Accrual Concept | Matching Principle | Consistency Principle |      

Money Measurement Concept

Accounting records state only those facts about a business firm, which can be expressed in
monetary terms. In other words, business events and facts that cannot be expressed in monetary
terms, howsoever important they may be, are excluded.

For example, the death of the managing director who was guiding the destiny of the company
since its inception, the emergence of a better product at a lower price in the market, the
emergence of a new technology and so on (though very significant from the future perspective of
business) are ignored.

The operational implication of the Money Measurement Concept is that financial statements do
not provide all information about the business.

Going Concern Concept

The Going Concern Concept implies that the firm will continue to operate in the foreseeable
future. The operational implication of this assumption is that assets are not shown in Balance
Sheet at their realisable market value, which implies liquidation value.

Instead, evaluation of assets is with reference to the value of goods and services they are likely to
produce in future years to come.

Cost Concept

Assets/resources owned by the firm are shown at their acquisition cost and not at current market
value/current worth.

The rationale for this assumption is that it provides objective and verifiable basis for accounting
records. Market valuation of assets in use is not only difficult to be made but also is related to
subjectivity. Besides, market values may be constantly subject to change.

Above all, determination of objective and undisputed market price of assets, say of land and
buildings, plant and machinery, furniture and so on that are not intended for sale is fairly
expensive and time consuming. Further, it is important to note that these long-term assets are
acquired to be used in business and not for resale.

Clearly, Cost concept is a logical fall-out of Going Concern concept in which current market
value of assets does not hold relevance.

Evidently, individual assets (except cash and bank balances) shown in Balance Sheet do not
reflect their current market value. Some assets such as land and buildings in major cities may
have higher valuation than shown in books and some other assets, like plant and machinery may
have lower valuation than shown in records.

Conservative Concept

As the name suggests, Conservative Concept warrants use of conservatism in business records.
In relation to Income Statement, the principle is, "anticipate no profits unless realised but provide
for all probable future losses". Stock of finished goods is valued at the cost of the market price
whichever is lower.

Likewise, it is normal for the firms to provide for likely irrecoverable sum from debtors by
creating provisions for bad and doubtful debts at the end of accounting year. This assumption
safeguards over-estimation of profits.

  Accounting Principles

Accounting records state only those facts about a business firm, which can be expressed
in monetary terms.

The operational implication of the Money Measurement Concept is that financial

statements do not provide all information about the business.

The Going Concern Concept implies that the firm will continue to operate in the
foreseeable future. The operational implication of this assumption is that assets are not
shown in Balance Sheet at their realisable market value, which implies liquidation value.

Assets/resources owned by the firm are shown at their acquisition cost and not at current
market value/current worth. The rationale for this assumption is that it provides
objective and verifiable basis for accounting records.
 Cost concept is a logical fall-out of Going Concern concept in which current market
value of assets does not hold relevance.

Conservative Concept warrants use of conservatism in business records. In relation to

Income Statement, the principle is, "anticipate no profits unless realised but provide for
all probable future losses".

Accounting Period Concept requires that Income Statement should be prepared at

periodic intervals for purposes such as performance evaluation and determination of
taxes.

Accrual Concept is a fall-out of Accounting Period concept. This concept requires that
expenses incurred for a particular accounting period should be reckoned in the same
period, irrespective of the fact whether these expenses have been paid in cash or not in
that year.

The Matching concept is, in a way, an extension of Accrual concept.

It enumerates normative framework of income determination of an accounting period

of a business firm.

The Consistency Principle requires that there should be a consistency of accounting

treatment of items (say depreciation method used in respect of plant and machinery) in
all the accounting periods.

 
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Accounting Period Concept

Accounting Period Concept requires that Income Statement should be prepared at periodic
intervals for purposes such as performance evaluation and determination of taxes.
Conventionally, the time span covered is one year. Corporate firms, as per Companies Act, are
required to produce interim accounts and many business firms produce monthly or quarterly
accounts for internal purposes. Very often, the accounting period chosen is 1st April to 31st March
to conform to the financial year of Government. Other accounting periods adopted may be
calendar year (January 1  December 31), Diwali year, Dussehra year and so on.

 
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Accrual Concept

Accrual Concept is a fall-out of Accounting Period concept. This concept requires that expenses
incurred for a particular accounting period should be reckoned in the same period, irrespective of
the fact whether these expenses have been paid in cash or not in that year. The same holds true
for revenues, i.e., revenues earned in a specific accounting period are construed as incomes of
the same period, irrespective of their receipts.

This concept is very important to compute true income of a business firm for each accounting
period. Let us illustrate. Suppose, a business firm has salary bill of Rs 50 lakh per month. Due to
the cash shortage, even though employees worked, the firm could not pay salary for two months.
The salary paid is for 10 months only (Rs 50 lakh × 10 months = Rs 500 lakh). In the following
accounting year, the firm will be required to pay salaries for 14 months (including salary arrears
of 2 months of the preceding year) that is, Rs 50 lakh × 14 months = Rs 700 lakh. The question
we are to address is, how much should be considered as salary expenses in both these years.
Should it be on the basis of cash payment? If it is so, salary expenses in previous year is to be
reckoned as Rs 500 lakh and in the current year Rs 700 lakh. Or, should it be on accrual basis? In
the latter situation, it will be Rs 600 lakh in each of these two years.

Evidently, cash basis of expenses recognition has an inherent drawback of manoeuvring and
distorting income results of the accounting periods. Under this approach, other things being
equal, profit of the previous year will be higher (by Rs 200 lakh) as compared to the current year.
Obviously this misrepresents income/profit figures of both these years. Due to this, wrong
inferences are drawn about the better performance in the previous year compared to the current
year, which is not true. The correct approach obviously is to treat salary expenses of Rs 600 lakh
in both the years.

In the absence of Accrual accounting, the Income Statement may indicate more profit in one year
at the cost of the profits of some other year, which is entirely inappropriate and illogical. In other
words, cash basis of expense recognition will hamper comparison of profit figures over the years.
Clearly, there is a very strong case for a business firm to adopt accrual basis of accounting,
known as Accrual accounting to determine correct profits.

From the foregoing, it is apparent that deferring expenses, such as salary, cannot increase profits.
Likewise, profits cannot be lowered by advance payment of expenses such as, rent and
insurance. For instance, insurance payment of Rs 12 lakh as on January 1, for one full year is to
be pro-rated. Assuming the firm has the accounting period from April-March, insurance
expenses of Rs 3 lakh only (JanuaryMarch) will form part of income statement of the current
year and the balance sum of Rs 9 lakh will be reckoned as expenses of the following year.
What holds true for expenses, the same holds true for revenues. Revenues are recognised at the
time of sales and not at the time of receipts from debtors. In operational terms, cash surplus and
deficiency are not indicative of profit and loss situations respectively.

 
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Matching Principle

The Matching concept is, in a way, an extension of Accrual concept. In fact, this is the most
comprehensive Accounting Principle that enumerates normative framework of income
determination of an accounting period of a business firm.

In simple words, this principle requires matching of expenses/costs incurred to revenues realised
in an accounting period. The more perfect this matching is, more correct is the income
determination.

As per this principle, revenues as well as expenses are to be estimated for an accounting period.
As far as estimation of revenues is concerned, it is, by and large, a relatively simple task.
Revenues are equivalent to value of goods and services sold during the specified accounting
period, irrespective of actual receipt of cash.

However, cost estimation is a relatively difficult task. The example of Royal Industries was very
simple in this regard. In practice, there are many expenditures, which benefit several accounting
years. Therefore, these expenses cannot be charged to Income Statement of a single year. For this
purpose, it is useful to classify expenses into capital and revenue categories.

Capital expenditures (for instance purchase of plant and machinery) involve relatively large
investment sum and often have some sales value. Obviously, the purchase cost of plant and
machinery (say of 500 lakh) cannot be considered as an expense of a single accounting year in
which it is purchased; its cost needs to be spread-over (technically known as depreciation), on
some scientific basis, among all the years in which this machine is used. In practice, however,
there will be subjectivity involved on the amount of depreciation to be charged every year.

In contrast, revenue expenses, such as rent, salaries, stationary, repairs, etc., benefit one
accounting year only and, hence fully charged/written off against the revenues of the same year.
They require relatively small sums and do not have sales value. At the best, adjustment for
advance/arrears may be needed (already explained under Accrual concept). This adjustment is
simple arithmetic exercises and does not involve subjectivity. Thus, for revenue expenses items,
the Matching principle is easy to follow.
However, even in the revenue category, there are certain expenses, which are essentially revenue
in nature (in the sense that they do not have sales value) but the benefits from them extend to
more than one accounting year. For instance, massive advertisement expenditure incurred in
launching a new product needs to be shared by the subsequent year(s) also, as it promotes sales
of these years and hence augments revenues of these years. Evidently, it is very difficult to
apportion with precision the share of advertisement expenditure to be charged in Income
Statements of the affected accounting periods. Other notable examples are flotation costs
incurred while raising funds through issue of shares/debentures, and Research and Development
expenditures. The firms, in practice, are expected to evolve some scientific criterion to apportion
these expense items over the years. Howsoever-tall claims may be made about objectivity in this
regard, arbitrariness and subjectivity cannot be done away with. It remains in the system.

Above all, there are certain loss items (say loss by fire in godown when goods are not insured
and theft of cash/goods), which neither contributes towards generation of revenues of the current
period nor of future revenues. They are to be written off in the same accounting year in which
they occur, as per convention.

To summarise, Matching Principle clearly brings to fore the problems encountered by business
firms in its income determination. A logical corollary of this follows that income determination
of a business firm is more an estimate than the actual one.

 
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Consistency Principle

Matching principle has underlined the importance of treatment of capital expenditure items in
income determination process. It focuses on the equitable methods, which must be used to write
off the cost of plant and machinery (and in that way of other long-term assets) so that its cost is
fairly allocated as expense, in form of depreciation, to each accounting period throughout its
estimated useful life. There are various methods of charging depreciation. The two notables
methods are, Straight-Line Method (SLM) and Written Down Value Method (WDV).

The assumption underlying the SLM is that depreciation is basically a function of time.
Accordingly, the cost of depreciation is allocated equally to each year of the estimated useful life
of plant and machinery. The sum of depreciation is obtained by dividing the depreciable cost of
machine (Purchase price of machine - Estimated Salvage Value) by the number of estimated
economic useful life (in years).

In contrast, according to the WDV method, a fixed rate (say 25%) is applied to the cost of the
machine (disregarding salvage value) of the first year to determine depreciation charge. In each
subsequent period, the depreciation expense is determined with reference to the same fixed rate
(25 %) to the written down balance (cost of machine less depreciation in the first year).
Obviously, both the methods will provide different answers towards depreciation charges.

The Consistency Principle requires that there should be a consistency of accounting treatment of
items (say depreciation method used in respect of plant and machinery) in all the accounting
periods. For instance, if Straight Line method of depreciation is used for plant and machinery,
the same should be used year after year. Switching over to Diminishing Balance method in any
of the subsequent years will obviously affect depreciation charges and, hence, their profits. As a
result, the profit picture will not be comparable over the years and, therefore, the justification and
relevance of consistency principle.

Likewise, there are different methods for valuation of inventory such as, Last-in-First-Out, First-
in-First-Out, Weighted Average Cost Method and so on. In order to maintain uniformity and
reveal true and fair view of the performance of business firm, the accounting policies should be
followed on a consistent basis. In case, there is a necessity to change, the impact of such a
change should be clearly mentioned.

From the foregoing discussion, it is apparent that accounting principles/concepts/conventions

have a marked bearing on preparation of both, the Income Statement and the Balance Sheet.

Double Entry System of Bookkeeping:

Learning Objectives:

1. Define and explain double entry system of book-keeping.

2. What are the advantages and disadvantages of double entry system of book-
keeping?

The double entry system of bookkeeping owes its origin to an Italian merchant named
Lucas Pacioli who wrote the first book on double entry bookkeeping entitled "Decomputis
et Scripturis". It was published in Venice in 1544. All modern methods of accounting are
simply adaptation of the system invented by that ancient pioneer.

Definition and Explanation:

The double entry theory of bookkeeping can be defined as the system of recording
transactions having two fundamental aspects - one involving the receiving of a benefit and
the other to giving the benefit - in the same set of books.

In this theory, as the two fold aspects of each transaction are recorded, the name "double
entry" has been given to this system.
Every transaction involves two fold aspects e.g., an aspect of receiving and an aspect of
giving. One who receives is a debtor (Dr) and one who gives is a creditor (Cr). Under the
double entry system, both the aspects of giving and receiving are recorded in terms of
accounts. The account which receives the benefit is debited and the account which gives the
benefit is credited. It is the ultimate result of this system that every debit must have
corresponding credit and vice versa and on any particular day the total of the debit entries
and the credit entries on the various accounts must be equal.

Advantages of Double Entry System:

The main advantages of double entry theory of book keeping are as follows:

1. Trial balance can be drawn up on any day to prove the arithmetical accuracy of
record.
2. The nominal sides of transactions being recorded: it is possible to prepare Trading
and Profit and Loss Account from which the Gross Profit and Net Profit made by the
business during a particular period can be easily ascertained.

3. As all personal accounts of debtors and creditors as well as real accounts are kept, it
is possible to prepare Balance Sheet.

4. The transactions being recorded in the most scientific and systematic way gives the
most reliable information of business.

5. It prevents fraud by rendering any alteration in any account more difficult.

6. It enables the trader to compare the different items, such as sales, purchases,
opening stock and closing stock of one period with similar items of preceding period
and the trader may thus know whether his business is progressing or not.

Disadvantages of Double Entry System:

The following are the main disadvantages of this system:

1. This system requires the maintenance of a number of books of accounts which is not
practical in small concerns.
2. The system is costly because a number of records are to be maintained.

3. There is no guarantee of absolute accuracy of the books of accounts inspite of

agreement of the trial balance.

Accounting Equation:
Learning Objective:

1. Define and explain accounting equation.

 2. Give an example of accounting equation.

Definition and Explanation of Accounting Equation:

Dual aspect may be stated as "for every debit, there is a credit." Every transaction should
have twofold effect to the extent of the same amount. This concept has resulted in
accounting equation which states that at any point of time the assets of any entity must
be equal (in monetary terms) to the total of equities. In other words, for every business
enterprise, the sum of the rights to the properties is equal to the sum of the properties
owned. The properties of the business are called "assets". The rights to the properties are
called "equities". Equities may be sub-divided into two principle types: The rights of the
creditors and the rights of the owners. The equity of the creditors represents debts of the
the business and are called liabilities. The equity of the owner is called capital, or
proprietorship or owner's equity.

The formula know as the accounting equation, thus arrived at is as follows:

Assets = Equities

OR

Assets = Liabilities + Proprietorship

Another method of demonstrating the mathematical relationship involves a simple variation

in the form of equation. Again it begins with the position that every business owns or has
interest in certain assets. It also owes certain amounts to its creditors. The difference
between what it owns and what it owes represents the owner's capital or proprietorship.
Thus the original equation is changed into:

Assets - Liabilities = Proprietorship

Effects of Transactions on the Accounting Equation:

Each and every business transaction affects the elements of accounting equation. The effect
is shown by the use of (+) or (-) placed against the elements affected. Note particularly that
the equation remains in balance after each transaction. The accounting equation can be
understood with the help of the following example:

Example:
Transaction 1:

Mr. Riaz commences his business with cash $50,000. This is an example of investment of
asset in the business by the owner. The effect of this transaction on the accounting equation
is that cash asset is increased by $50,000 and the proprietorship (Riaz's capital) is also
increased by the same amount such as:
 Assets = Liabilities + Proprietorship
Cash       Riaz, Capital
+ 50,000 = ----   + 50,000

Note that assets and equities increased by equal amounts

Transaction 2:

Purchased furniture on cash $10,000. This transaction effected accounting equation as the
increase in one new asset furniture and decreases in assets cash with the same amount.
Thus

Assets = Liabilities + Proprietorship

Cash Furniture       Riaz, Capital
+ 50,000   = ----   + 50,000
- 10,000 + 10,000        

40,000 + 10,000 =     50,000

Note that this transaction has affected assets side only and no change is made in equities side of the equation.

Transaction 3:

Purchased merchandise for cash $10,000. This transaction will introduce a new element
(merchandise) on the assets side and decrease the cash by $10,000.

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise       Riaz, Capital
+ 40,000 + 10,000   = ----   + 50,000
-10,000 -- + 10,000        

30,000   + 10,000 =     50,000

Note that this transaction has affected assets side only and no change is made in equities side of the equation.

Transaction 4:

Purchased merchandise on account (on credit) $5,000.

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise   Creditors   Riaz, Capital
+ 30,000 + 10,000 + 10,000 =     + 50,000
    + 5,000   + 5,000    
 30,000 +10,000 + 15,000 = + 5,000   + 50,000

Note that this transaction has affected assets side  and liabilities. Both the sides of equation has increased with the same
amount.

Transaction 5:

Sold merchandise for cash $2,000 cost of these merchandise were $1,500.

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise   Creditors   Riaz, Capital
+ 30,000 + 10,000 + 15,000 = + 5,000   + 50,000
+ 2,000   - 1,500       + 500 (Profit)

+ 32,000 +10,000 + 13,500 = + 5,000   + 50,500

Note that this transaction has affected assets side  and also the proprietorship. Difference between sales price and cost
price is treated as profit and has been added to capital.

Transaction 6:

Sold merchandise on credit for $4,000 costing $3,000.

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise Debtors   Creditors   Riaz, Capital
+ 32,000 + 10,000 + 13,500   = + 5,000   + 50,500
    - 3,000 + 4,000       + 1,000

32,000 +10,000 + 10,500 + 4000 = + 5,000   + 51,500

Note that this transaction has affected assets side  and also the proprietorship. Anew element "debtors" has been
introduced. Difference between sales price and cost price is treated as profit and has been added to capital.

Transaction 7:

Paid $1,000 to creditors for merchandise purchased.

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise Debtors   Creditors   Riaz, Capital
+ 32,000 + 10,000 + 10,500 + 4,000 = + 5,000   + 51,500
- 1,000         - 1,000    

31,000 +10,000 + 10,500 + 4000 = + 4,000   + 51,500

 Transaction 8:

Received cash from a debtor $ 1,000 whom a sale on credit was made earlier. This is an
example of collection from debtors. This transaction is an exchange of one asset for
another. the effect is on one side of the equation, i.e., asset side. Thus:

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise Debtors   Creditors   Riaz, Capital
+ 31,000 + 10,000 + 10,500 + 4,000 = + 4,000   + 51,500
+ 1,000     - 1,000        

32,000 +10,000 + 10,500 + 3000 = + 4,000   + 51,500

Transaction 9:

Paid salaries $1,000 in cash. This transaction affected the equation by decrease in a cash
asset and decrease in proprietorship (i.e., capital). Thus:

Assets = Liabilities + Proprietorship

Cash Furniture Merchandise Debtors   Creditors   Riaz, Capital
+ 32,000 + 10,000 + 10,500 + 4,000 = + 4,000   + 51,500
- 1,000             - 1,000

31,000 +10,000 + 10,500 + 3000 = + 4,000   + 50,500

Effects of all the transactions explained above are presented in the following table:

Assets = Liabilities + Proprietorship

  Cash + Furniture + Merchandise + Debtors   Creditors   + Riaz, Capital

1 + 50,000             +50,000

50,000 = + 50,000
2 - 10,000 + 10,000            
 
  40,000  10,000     =   + 50,000

3 - 10,000   + 10,000          
 
  30,000 10,000 10,000   =   + 50,000

4     + 5,000     + 5,000    
 
30,000 10,000 15,000 = 5,000 + 50,000
5 + 2,000 - 1,500 + 500 (Profit)

32,000 10,000 13,500 = 5,000 + 50,500

6 - 3,000 + 4,000 + 1,000 (Profit)
 32,000 10,000 10,500 4,000 = 5,000 + 51,500
7 - 1,000 - 1,000

31,000 10,000 10,500 4,000 = 4,000 + 51,500

8 +1,000 1,000

32,000 + 10,000 + 10,500 + 3,000 4,000 + 51,500

9 1,000 1,000
 
31,000 10,000 10,500 3,000 = 4,000 + 50,500

The elements of the equation of Mr. Riaz that is,

Cash + Furniture + Merchandise + Debtors = Creditors + Capital

31,000 + 10,000 + 10,500 + 3,000 = 4,000 + 50,500

This may also be stated in vertical form as shown below:

EQUITIES   ASSETS  
Creditors $4,000 Cash $31,000
Capital $50,500 Debtors 3,000
Merchandise 10,500
    Furniture 10,000

  $54,500   $54,500

The presentation of the effects of transactions in tabular form is only a device which helps
beginners to understand the analysis of different types of transactions. It is not practically
feasible to record the effects of transactions in this form. The increases and decreases in the
various elements are recorded in the journal in a special technical form.

The Accounting Equation

The ability to read financial statements requires an understanding of the items they include and
the standard categories used to classify these items. The accounting equation identifies the
relationship between the elements of accounting.

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Assets. An asset is something of value the company owns. Assets can be tangible or intangible.
Tangible assets are generally divided into three major categories: current assets (including cash,
marketable securities, accounts receivable, inventory, and prepaid expenses); property, plant, and
equipment; and long-term investments. Intangible assets lack physical substance, but they may,
nevertheless, provide substantial value to the company that owns them. Examples of intangible
assets include patents, copyrights, trademarks, and franchise licenses. A brief description of
some tangible assets follows.

 Current assets typically include cash and assets the company reasonably expects to use,
sell, or collect within one year. Current assets appear on the balance sheet (and in the
numbered list below) in order, from most liquid to least liquid. Liquid assets are readily
convertible into cash or other assets, and they are generally accepted as payment for
liabilities.
1. Cash includes cash on hand (petty cash), bank balances (checking, savings, or
money-market accounts), and cash equivalents. Cash equivalents are highly
liquid investments, such as certificates of deposit and U.S. treasury bills, with
maturities of ninety days or less at the time of purchase.
2. Marketable securities include short-term investments in stocks, bonds (debt),
certificates of deposit, or other securities. These items are classified as marketable
securities—rather than long-term investments—only if the company has both the
ability and the desire to sell them within one year.
3. Accounts receivable are amounts owed to the company by customers who have
received products or services but have not yet paid for them.
 4. Inventory is the cost to acquire or manufacture merchandise for sale to
customers. Although service enterprises that never provide customers with
merchandise do not use this category for current assets, inventory usually
represents a significant portion of assets in merchandising and manufacturing
companies.
5. Prepaid expenses are amounts paid by the company to purchase items or services
that represent future costs of doing business. Examples include office supplies,
insurance premiums, and advance payments for rent. These assets become
expenses as they expire or get used up.
 Property, plant, and equipment is the title given to long-lived assets the business uses
to help generate revenue. This category is sometimes called fixed assets. Examples
include land, natural resources such as timber or mineral reserves, buildings, production
equipment, vehicles, and office furniture. With the exception of land, the cost of an asset
in this category is allocated to expense over the asset's estimated useful life.
 Long-term investments include purchases of debt or stock issued by other companies
and investments with other companies in joint ventures. Long-term investments differ
from marketable securities because the company intends to hold long-term investments
for more than one year or the securities are not marketable.

Liabilities. Liabilities are the company's existing debts and obligations owed to third parties.
Examples include amounts owed to suppliers for goods or services received (accounts payable),
to employees for work performed (wages payable), and to banks for principal and interest on
loans (notes payable and interest payable). Liabilities are generally classified as short-term
(current) if they are due in one year or less. Long-term liabilities are not due for at least one year.

Owner's equity. Owner's equity represents the amount owed to the owner or owners by the
company. Algebraically, this amount is calculated by subtracting liabilities from each side of the
accounting equation. Owner's equity also represents the net assets of the company.

In a sole proprietorship or partnership, owner's equity equals the total net investment in the
business plus the net income or loss generated during the business's life. Net investment equals
the sum of all investment in the business by the owner or owners minus withdrawals made by the
owner or owners. The owner's investment is recorded in the owner's capital account, and any
withdrawals are recorded in a separate owner's drawing account. For example, if a business
owner contributes $10,000 to start a company but later withdraws $1,000 for personal expenses,
the owner's net investment equals $9,000. Net income or net loss equals the company's revenues
less its expenses. Revenues are inflows of money or other assets received from customers in
exchange for goods or services. Expenses are the costs incurred to generate those revenues.
Capital investments and revenues increase owner's equity, while expenses and owner
withdrawals (drawings) decrease owner's equity. In a partnership, there are separate capital and
drawing accounts for each partner.

Stockholders' equity. In a corporation, ownership is represented by shares of stock, so the

owners' equity. is called stockholders' equity or shareholders' equity. Corporations use several
types of accounts to record stockholders' equity activities: preferred stock, common stock, paid-
in capital (these are often referred to as contributed capital), and retained earnings. Contributed
capital accounts record the total amount invested by stockholders in the corporation. If a
corporation issues more than one class of stock, separate accounts are maintained for each class.
Retained earnings equal net income or loss over the life of the business less any amounts given
back to stockholders in the form of dividends. Dividends affect stockholders' equity in the same
way that owner withdrawals affect owner's equity in sole proprietorships and partnerships.