Accounting Concepts

Accounting concepts are the set of principles that lay the foundation of accounting. They exist to do two things: ensure the financial statements give a true and fair view of the state of affairs of the company, and maintain consistency while recording transactions and preparing statements. Every mechanical rule in Modules 1 and 2 traces back to one of the concepts below.

3.1 Money Measurement Concept

Only transactions expressed in monetary terms can be recorded in the books of accounts.

This is a boundary, not a preference. An event that clearly matters to the business but carries no monetary measurement is simply outside the accounting system. A national HR survey that moves the company from 10th place to 2nd place is genuinely valuable, but nothing was paid and no amount can be attached to it, so no entry is made.

3.2 Entity Concept

The business and the owner are separate entities. Transactions are recorded on the premise that the two are different, and the personal transactions of the owner cannot be mixed with business transactions.

Worked example: apportioning rent.

Given: the owner rents a house for Rs. 40,000 and uses the front portion to run a retail store. The accountant pays the rent from the firm's account. 20% of the total area is used for the store.

Answer: Rs. 8,000 is charged to the business as rent expense and Rs. 32,000 is charged to the owner's account as drawings.

Worked example: two branches of one bank.

Bank of Dreamland has Branch A and Branch B. Branch A draws Rs. 50 lakhs from Branch B.

Memory hook: the entity concept is applied wherever a separate set of books is kept, not just at the boundary of the legal company. Two branches of the same bank owe each other money on paper, and the balances cancel only on consolidation.

3.3 Going Concern Concept

The going concern concept assumes the business will continue indefinitely while the financial statements are prepared.

This is why a business buys equipment intended for long-term use, and why it charges depreciation over a service life rather than writing the asset off at once. It is also why semi-finished items are carried forward: work in progress of Rs. 20 lakhs sitting on the shop floor at the year end is recorded as closing work-in-progress inventory, because production is expected to continue and finish it.

Two exceptions taught in this course:

3.4 Cost Concept

Assets are recorded at the cost at which the initial purchase was made, and depreciation is charged on the original cost. A fair useful life is estimated and the cost of the asset is systematically allocated over that life in the form of depreciation.

Worked example. A machine is bought for Rs. 20 lakhs with a useful life of 10 years.

Answer: after four years the net book value is Rs. 12 lakhs, while the gross book value stays at Rs. 20 lakhs.

Common trap: the gross book value never changes. Depreciation accumulates in a separate contra account. A student who writes down the asset account itself loses the original cost information the cost concept exists to preserve.

Exceptions to the cost concept

• Fair value accounting: some accounting standards require assets to be recorded at fair value (market value), especially where mandated by regulation. Non-monetary assets like land, building and equipment are recorded at cost; monetary assets like investments are recorded at cost but revalued to fair value at the reporting date under the applicable rules.
• Impairment: if an event significantly reduces an asset's value, for example fire damage, an impairment loss is recognised and the asset is written down.
• Monetary assets: assets like cash and investments are typically reported at current realisable value, with fluctuations recognised in income or in other comprehensive income.
• Intangible assets: initially recorded at acquisition cost. Amortised over useful life if the life is finite (a patent has a limited life, so its cost is amortised). If the life is indefinite, as with an acquired brand, it is tested annually for impairment and written down if needed. Self-created intangibles are generally not recognised in the books at all.

3.5 Dual Aspect Concept

Every accounting transaction has a two-fold effect. Every debit has a corresponding credit. Double-entry bookkeeping is simply the dual aspect concept turned into a procedure.

Worked example. A firm takes a loan from a bank.

The accounting equation rests directly on the dual aspect.

Because every transaction changes exactly two things by equal and offsetting amounts, the equation can never go out of balance. That is the arithmetic guarantee the concept delivers.

3.6 Accounting Period Concept

An accounting period is usually a year, a half-year or a quarter. An entity prepares and summarises its financial transactions and activities for that specific period, and the revenues and expenses related to the period are recorded to determine the income of the period.

• In India, companies follow an accounting period beginning 1 April and ending 31 March of the next year.
• Statutes in many other countries run 1 January to 31 December.
• Adjustment entries are passed because of this concept. Without a defined period there would be nothing to accrue to or prepay from.

Worked example. Tuition fees are paid for one year running October to September. The financial year ends on 31 March.

3.7 Conservatism Concept

Recognise all possible expenses and losses immediately, but recognise gains and revenue only when they are certain.

Applications:

• Making a provision for bad and doubtful debts.
• Recognising inventory at cost or net realisable value, whichever is lower.
• Recognising revenue on credit sales only when there is reasonable certainty of collection.

Worked example. As at 31 March a firm holds:

Answer: total inventory is carried at Rs. 142 lakhs. The unrealised gain of Rs. 14 lakhs on steel is ignored; the unrealised loss of Rs. 8 lakhs on copper is recognised at once. That asymmetry is conservatism.

3.8 Matching Concept

Purpose: to determine profit accurately, all expenses incurred to generate revenue must be recognised in the same accounting period as that revenue.

Focus on incurrence, not payment. When an expense is paid is irrelevant. What matters is when the expense was incurred to generate revenue. Salaries for work done in the current month are expensed in the current month even if paid in the following month.

Worked example. 1,000 units are produced in a period at a cost of Rs. 1,00,000 and 800 units are sold.

Answer: only Rs. 80,000 is matched against the revenue from 800 units. The Rs. 20,000 cost of the 200 unsold units stays in inventory as an asset until they are sold.

Provisions and the matching concept. The need for provisions such as warranty expense and gratuity also stems from matching. Even though these are paid in the future, they relate to products sold or services rendered in the current period. Since the exact future cost is uncertain, an estimate (a provision) is used so that the cost still lands in the right period.

3.9 Consistency Concept

If a company chooses to follow an accounting policy or method, that method should be followed consistently over the years. This enables a fair comparison of one period against another.

Examples:

• Depreciation: if straight-line depreciation is chosen, it should be used every year, not switched to declining balance.
• Inventory: if FIFO is chosen for inventory valuation, it should be followed consistently, not switched to LIFO.

Changing an accounting method is permissible, but once changed the new method must itself be followed consistently, and the change and its impact on net income must be disclosed.

Worked example of the disclosure.

Answer: the company must disclose all three figures. Reported income rose from 200 to 220, but on a like-for-like basis it actually fell to 190. Without the third number an investor would read a 10% improvement where there was in fact a 5% decline.

Frequent changes in accounting methods are discouraged: they make comparison difficult and raise concerns about earnings manipulation.

3.10 Materiality Concept

Items that are material must be recorded and disclosed properly in the financial statements. Items that are not material can simply be charged as expense.

Normally, purchases of items are treated as assets and their cost is gradually expensed as they are used. However, if the value of an item is insignificant, it can be expensed immediately even though it has some future use, because the cost of tracking it exceeds the benefit.

Examples:

• Stationery: instead of tracking each pen and expensing it when used, the entire cost of a pack of pens is expensed immediately.
• Small parts: bolts and nuts in an automobile assembly are expensed at the time of purchase. Gearboxes, however, are capitalised. Both are components of the same vehicle; only value separates them.
• Wall painting against art piece: a cheap wall painting is expensed, but an expensive piece of art is capitalised.

Accountants often use a monetary limit, for example Rs. 5,000, to decide materiality. Anything below the limit is treated as immaterial and expensed directly; anything above is treated as an asset.

3.11 Accounting Standards

The Accounting Standards Board (ASB), set up by the Institute of Chartered Accountants of India (ICAI), develops accounting standards applicable to Indian companies. The ASB has so far published 38 accounting standards. The important ones cover inventory valuation, revenue recognition, valuation of fixed assets, intangible assets, leased assets, cash flow statements and financial instruments. Some standards relate to measurement and accounting; others relate to disclosure.

Concepts against standards

This distinction is examinable and is easy to blur.

Memory hook: a concept tells you why; a standard tells you exactly how. Conservatism says be cautious about revenue. Ind AS 115 says precisely when a performance obligation is satisfied.

3.12 Accounting Concepts in Practice

Six scenarios, each restated as Challenge, Options and Preferred approach.

1. Electricity bill accrual

• Challenge: meter readings are taken in early April, but the accounting period ends on 31 March. How should electricity consumed in late March but billed in April be accounted for? Customer 1's bill of Rs. 15,000 is dated 2 April; Customer 2's bill of Rs. 900 is dated 5 April.
• Options:
  • Precise calculation (tedious): assuming uniform daily consumption, deduct $15{,}000 \times \frac{2}{31}$ for Customer 1 and $900 \times \frac{5}{31}$ for Customer 2 from March revenue.
  • Midpoint assumption: use an average time period and deduct $\frac{3}{31}$ for everyone.
  • Materiality: if the difference is immaterial to the Electricity Board's overall revenue, recognise the entire bill in March.
• Preferred approach: the third. A similar difference in April of the prior year would have offset this year's, so the effect washes out. This can be ignored under materiality, and it still complies with the matching concept because expenses are aligned with the period when they most likely occurred.

2. Courier revenue recognition

• Challenge: a parcel is picked up on 30 March but delivered on 2 April. When is the revenue recognised?
• Preferred approach: recognise the entire revenue in March, assuming delivery patterns and the associated revenue and costs are similar across year ends. Consistent with the matching principle and justified by materiality.

3. Retainer fee allocation

• Challenge: a law firm receives a one-year retainer fee of Rs. 12 lakhs on 1 October. How is it allocated?
• Preferred approach: allocate proportionally on time, because a retainer is paid for availability over time. Rs. 6 lakhs to the current year and Rs. 6 lakhs to the next. This satisfies the accounting period and matching concepts.

4. Tour revenue recognition

• Challenge: Thomas Cook sells all seats for an international tour starting 10 April 2024 and collects the full amount by 20 March 2024. Tour design and marketing are its primary activities; the conduct of the tour is outsourced. Recognise revenue in the year ending March 2024 or March 2025?
• Argument for early recognition: the company has done everything it is required to do.
• Preferred approach: defer until the tour is completed. There is no assurance the tour will happen; a war at the destination would force a refund. Conservatism (prudence) wins over the argument from performance.

5. Book publisher and sales returns

• Challenge: a publisher sells 5,000 copies at Rs. 1,000 per copy on 1 January 2024 to a distributor, agreeing to take back unsold copies at the end of six months. On 31 March the distributor reports 2,000 copies sold. Is revenue Rs. 50 lakhs or Rs. 20 lakhs?
• Options:
  1. Record Rs. 50 lakhs and charge the full printing cost of 5,000 copies. This meets matching, but if 1,000 copies are unsold at the end of June the publisher must refund Rs. 10 lakhs, which hits next year with no revenue against it. A provision for sales returns could fix this, but with 3,000 copies still unsold at 31 March the estimate is unreliable.
  2. Record Rs. 20 lakhs and charge the printing expense of 5,000 copies less the scrap value of the 3,000 unsold copies. This meets conservatism on both sides: full cost recognised, uncertain revenue not recognised.
  3. Recognise nothing until June, when the exact quantity is known, but still expense the printing cost less scrap this year. Conservative, but it breaks matching by putting expense in one period and revenue in another.
• Preferred approach: option 2. Although Rs. 50 lakhs was collected, Rs. 30 lakhs is treated as unearned revenue because the distributor could return every unsold copy.
• Variant: if the publisher caps returns at 500 copies (10% of the quantity sold), then the maximum refund exposure is Rs. 5 lakhs.

Answer: revenue is Rs. 45 lakhs, and the cost is the printing expense of 500 copies less their scrap value. Any royalty, say Rs. 100 per copy sold, is shown as an expense against the revenue in every one of these cases.

6. Discount coupons and expense recognition

• Challenge: on 1 January 2024 a customer buys dresses worth Rs. 20,000 and receives 10 coupons, each worth Rs. 200 off a future purchase of Rs. 2,000 or more before 30 June. Past experience shows about 10% of such coupons are used. Which period's sales should bear the discount?
• Options:
  1. Recognise the expense against the Rs. 20,000 sale, arguing the scheme drove that purchase.
  2. Recognise it when the coupon is redeemed against the Rs. 2,000 purchase, arguing the coupon drove the return visit.
• Preferred approach: under matching, both are defensible. Conservatism breaks the tie in favour of option 1, especially where the expected redemption rate is high, which suggests current sales were boosted by the scheme. On a 10% expectation the charge is $10 \times 200 \times 10\% = 200$, just 1% of the Rs. 20,000 sale.
• Mechanism: create an allowance for discounts account based on the estimate and book claims against it. If redemption exceeds 10%, the excess is expensed next year; if it falls to 3%, the surplus allowance is released. This works exactly like a provision for bad debts or an allowance for sales returns.

3.13 Self-Review Exercise 3: Mars Chemicals, preparing a balance sheet

Balances of various accounts at 31 March 2024 are given in alphabetical order, and a balance sheet must be prepared. Retained earnings is not given: it is the balancing figure.

Method.

1. Label every balance as A (asset), L (liability) or E (equity). Accounts payable is L. Accounts receivable is A. Accrued expenses are L, being expenses not yet paid. Accumulated depreciation on building and on equipment are assets, but contra assets, so they carry a minus. Bonds payable is L. Building at cost is A. Capital stock is E. Cash is A. Equipment at cost is A. Estimated tax liability is L. Inventories, land at cost and marketable securities are A. Notes payable is L. Retained earnings is E and is missing.
2. Sort by label so that assets sit on one side and equity and liabilities on the other.
3. Order the assets from least liquid to most liquid, which is Indian practice: land first, then building net of accumulated depreciation, then equipment net of accumulated depreciation, then inventories, then receivables, then marketable securities, then cash last.
4. Order equity and liabilities as capital stock and retained earnings first, then non-current liabilities (bonds payable), then current liabilities.

Solving for retained earnings.

Answer: retained earnings is Rs. 50,000 and the balance sheet totals Rs. 3,20,000 on each side.

Memory hook: whenever one figure is missing from a balance sheet question, it is almost always retained earnings or equity, and the accounting equation is the tool that recovers it.

3.14 Self-Review Exercise 4: impact on assets, liabilities and owners' equity

For each transaction, state whether assets, liabilities and owners' equity increase, decrease or do not change.

Common trap: transactions 4 and 7 look like activity but net to no change on any of the three totals, because both legs sit inside assets with opposite signs. Transaction 6 must be split into two transactions, and marking it as a single Rs. 5,000 increase loses the mechanics entirely.

Depreciation (transaction 3) reaches owners' equity through the profit and loss account: the contra asset takes a minus 30,000 and the expense column takes a minus 30,000, which reduces revenue less expenses and therefore reduces equity.

3.15 Self-Review Exercise 5: Digisoft, opening balance sheet plus a month of transactions

Digisoft is an IT company. Its opening balance sheet, in thousands, is cash 6,000, receivables 4,000, investments 5,000 against equity 3,000, loan 7,000 and payables 5,000, a total of 15,000 each side. Ten events follow during April 2024.

Common trap: receiving an order is not a transaction. The order of 30,000 generates no entry at all. Only the advance of 5,000 is recorded, and it is a liability, because the work has not yet been done.

Insurance split. $\frac{1{,}200}{24} = 50$ per month, so 50 is expensed for April and 1,150 is prepaid.

Closing balance sheet as at 30 April 2024 (in thousands)

Cash working: $6{,}000 + 5{,}000 - 500 - 200 - 100 - 200 + 3{,}000 - 2{,}000 - 70 + 1{,}100 - 1{,}200 = 10{,}830$.

Equity working: $3{,}000 - 100 - 200 - 70 + 100 - 50 = 2{,}680$.

Answer: the closing balance sheet totals 17,680 on each side.

3.16 Self-Review Exercise 6: AutoComp, adjustment entries and the profit and loss account

AutoComp manufactures automobile components. Prepare the profit and loss account for August 2024, passing all required adjustments. All figures in Rs. lakhs.

Common trap: where a purchase does not say whether it was for cash or on credit, the convention is to assume a cash purchase.

The write-off of 3 does not touch the profit and loss account. The expense was already taken when the provision was created; the write-off simply consumes it.

Profit and Loss Account for the month of August 2024

Answer: profit for August 2024 is Rs. 216 lakhs. Note that a balance sheet could not be prepared from this data, because the opening balance sheet is not given.

3.17 Self-Review Exercise 7: partnership with four partners

Ajay, Bala and Chandran start a digital marketing partnership contributing 20, 30 and 50 lakhs and agreeing to share profit in the ratio of capital contributed, that is 20 : 30 : 50. Total profit over the first five years is 600 lakhs, all realised in cash. Partners withdraw 80% of the profit due to them. At the start of year 6 Ajay retires, goodwill is valued at six times the average profit of five years, and Divakar joins with 300 lakhs, whose contribution is used to pay Ajay out.

Goodwill is shared in the existing ratio: Ajay 144, Bala 216, Chandran 360.

Partners' capital accounts

Answer: Ajay is paid out Rs. 188 lakhs.

After the payout, cash is $100 + 600 - 480 + 300 - 188 = 332$, plus goodwill of 720, giving total assets of 1,052, matched by Bala 282 plus Chandran 470 plus Divakar 300. The new profit-sharing ratio is derived from those capital balances:

Common trap: the recorded solution shows Bala at 272 and a total of 1,042, which does not reconcile. Bala's balance is $30 + 180 - 144 + 216 = 282$, and the three capital balances must equal total assets of 1,052. Always re-add the capital column before dividing.

3.18 Self-Review Exercise 8: eBag, company accounts with oversubscription and forfeiture

Mr. James established eBag to produce environmentally friendly bags and cardboard for e-commerce companies. He and his relatives contributed 200 lakhs initially. After five years the company, with SEBI approval, offered 100 lakh equity shares of Rs. 10 at a premium of Rs. 60, so Rs. 70 per share, collected as:

Applications were received for 160 lakh shares, so the issue was oversubscribed. 100 lakh shares were allotted and the application money of the other 60 lakh applicants refunded. Of the allottees, 98 lakh paid the allotment money and 2 lakh did not, so their shares were forfeited.

Check: $1{,}180 + 5{,}880 + 60 = 7{,}120$, equal to cash.

Answer: capital reserve on forfeiture is Rs. 60 lakhs and the totals are Rs. 7,120 lakhs. The capital reserve stays in the company and cannot be used to pay a dividend, because it arose from a capital transaction. If the 2 lakh shares are later reissued at the same Rs. 70, cash of 140 would be split Rs. 20 to capital and Rs. 120 to premium. Only if they were reissued at a discount would the capital reserve be drawn on, and that is a remote possibility after a successful premium issue.

3.19 Self-Review Exercise 9: Titan, equity as the missing figure

Balances for Titan for the year ended 31 March 2015 are given, ordered by liquidity for presentation: fixed assets and marketable securities together, then inventories, then receivables, then cash. Total assets come to 4,992 crore. On the other side there is a loan of 100 and payables of 2,346, and equity is missing.

Answer: equity is Rs. 2,546 crore.

Presentation note: Indian practice lists equity and liabilities first and assets second, while many other countries put assets on the left and equity and liabilities on the right. The items are identical; only the ordering differs. Within assets, run from least liquid to most liquid: fixed assets, inventories, receivables, marketable securities, cash. Within the other side, equity first (the most permanent capital), then non-current liabilities, then current liabilities.

3.20 Self-Review Exercise 10: a six-month gadget business

A friend has been selling electronic gadgets to an e-commerce portal for six months from 1 January and wants a view on how the business is doing. All figures in Rs. lakhs.

Common trap: VAT (today GST) is not revenue. It is money collected on behalf of the government and remitted to it. Revenue is 480 less 20, that is 460. Treating the full 480 as revenue overstates both revenue and profit.

Interest. $30 \times 20\% \times 0.5 = 3$. Nothing says it was paid, so it is recorded as a payable.

Cost of sales. $380 - 60 = 320$.

Profit and Loss Account for the six months ended 30 June

Balance Sheet as at 30 June

Answer: profit before tax is Rs. 84 lakhs on an investment of Rs. 20 lakhs. Even after tax at, say, 20%, roughly Rs. 67 lakhs would remain, which is a very strong return on the capital employed. The business is doing well.

3.21 Self-Review Exercise 11: reading a year-on-year balance sheet movement

Explain how the numbers changed from year 1 to year 2.

Loan waiver explained. If a business owes Rs. 100 crore and is loss-making, the bank may negotiate to write off, say, Rs. 80 crore against payment of the remaining Rs. 20 crore. The Rs. 80 crore then disappears from the balance sheet without any cash leaving.

Overall reading: the business is not doing well. It is loss-making and is undergoing both asset restructuring (selling fixed assets) and financial restructuring (reducing liabilities and share capital). Whether year 3 improves depends entirely on the outcome of that restructuring.

3.22 Self-Review Exercise 12: identify the accounting concept

The highest-value item in the module. Match each transaction to the concept or convention it rests on. Item 8 maps to two concepts.

Why item 8 needs two concepts. Two separate decisions are being made. Treating the fee as an asset rather than an expense rests on going concern: the business is assumed to survive long enough to use the spectrum over 20 years. Recording it at the amount paid rests on the historical cost concept. One concept justifies the classification, the other justifies the measurement.

Common trap: item 6 is inventory, and inventory is valued at cost or net realisable value, whichever is lower. Fixed assets may be revalued upward under current rules; inventory is not. A student who applies the fair-value exception here will pick the wrong concept.

3.23 Self-Review Exercise 13: retained earnings roll-forward for a pharmaceutical company

Balance sheets over three years, all values in millions. The company declared dividends of 30 in year 3 and 45 in year 4.

Rearranged to find the missing profit.

Answer: profit was 23 million in year 3 and 65 million in year 4.

How was the profit used?

Year 3: profit of 23 against a dividend of 30. The company distributed more than it earned, drawing 7 out of accumulated reserves. That is why reserves fell from 196 to 189.

Year 4: profit of 65 was used as follows.

Answer: in year 4 the company used part of its profit to expand the business and part to reduce debt, whereas in year 3 it paid out the entire profit and more as dividend.

3.24 Module Summary

• Accounting is the language of business, and accounting concepts are its grammar. They exist to make the statements true and fair and to make one period comparable with the next.
• Money measurement sets the boundary of what can be recorded. Entity sets the boundary of whose transactions are recorded. Going concern and accounting period set the time frame. Dual aspect sets the mechanics.
• Cost, conservatism, matching, consistency and materiality govern measurement. Conservatism and matching sometimes pull in opposite directions, and the practical examples in this module are almost all about which one wins.
• Accounting standards are not concepts. Concepts state the principle; standards such as Ind AS 115 on revenue recognition state the detailed rule.
• The eleven self-review exercises rehearse the whole of Modules 1 to 3: balance sheet preparation with a balancing figure, the impact grid, opening-to-closing balance sheets, a full adjustment-entry problem, partnership retirement and admission, share issue with forfeiture, GST exclusion from revenue, movement analysis, concept matching, and the reserves roll-forward.