Class 11 Accountancy Notes Chapter 2 (Theory Base of Accounting) – Financial Accounting-I Book
Alright class, let's delve into Chapter 2: Theory Base of Accounting. This chapter is absolutely crucial because it lays the foundation upon which the entire structure of accounting rests. Understanding these concepts is vital, not just for your exams, but for correctly interpreting and preparing financial statements throughout your careers. For government exam preparation, a strong grasp of these fundamentals is non-negotiable.
Theory Base of Accounting: Detailed Notes
1. Meaning and Introduction
- Accounting aims to provide useful information to various stakeholders (owners, management, creditors, government, etc.) for decision-making.
- To ensure this information is reliable, comparable, and understandable, accounting practices must follow certain rules, principles, and conventions.
- This common set of rules is known as the Theory Base of Accounting or Generally Accepted Accounting Principles (GAAP).
2. Generally Accepted Accounting Principles (GAAP)
- Definition: GAAP refers to the rules and guidelines adopted for recording and reporting business transactions to bring uniformity and comparability in the preparation and presentation of financial statements.
- Nature/Features:
- Man-made: Developed over time from experience, reason, usage, and necessity. Not derived from natural laws.
- Flexible: Not rigid like laws of nature. They change over time in response to changes in the business environment, legal requirements, and user needs.
- Generally Accepted: Their authority depends on their general acceptance by the accounting profession and relevant bodies. Acceptance requires meeting criteria of relevance, objectivity, and feasibility.
- Need: To ensure financial statements prepared by different entities are comparable and that statements prepared by the same entity over different periods are consistent. They enhance reliability and understanding.
3. Fundamental Accounting Assumptions (Underlying Assumptions)
These are the basic assumptions that underlie the preparation and presentation of financial statements. They are usually not explicitly stated because their acceptance and use are assumed. If any of these are not followed, this fact must be disclosed.
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(a) Going Concern Assumption:
- Concept: Assumes that the business will continue its operations for the foreseeable future and has neither the intention nor the necessity of liquidation or scaling down its operations significantly.
- Implications:
- Distinction between capital expenditure (benefit over long period) and revenue expenditure (benefit within the accounting period).
- Classification of assets and liabilities into current and non-current.
- Charging depreciation on fixed assets over their useful life.
- Recording of prepaid expenses and outstanding incomes/expenses.
- Valuation of assets usually ignores their current realizable value if the business is continuing.
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(b) Consistency Assumption:
- Concept: Assumes that accounting policies and practices followed by an enterprise are uniform and consistent from one period to another.
- Implications:
- Enables meaningful comparison of financial statements over time.
- Helps management in decision-making by analyzing trends.
- Exception: Consistency doesn't mean practices can never be changed. A change is permissible if:
- Required by law.
- Required by an Accounting Standard.
- The change results in a more appropriate presentation of financial statements.
- Note: If a change is made, its effect on the financial statements must be disclosed.
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(c) Accrual Assumption:
- Concept: Assumes that revenue is recognized when it is earned (or accrued), and expenses are recognized when they are incurred, irrespective of whether cash is received or paid at that point.
- Implications:
- Recognition of outstanding expenses, prepaid expenses, accrued income, and income received in advance.
- Provides a more accurate picture of profit/loss for a period and the financial position at the end of the period compared to the cash basis.
- This is the basis mandated by the Companies Act, 2013 for most companies.
4. Basic Accounting Principles (Concepts & Conventions)
These are the more specific rules derived from the assumptions that guide how transactions are recorded and reported.
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(a) Business Entity Concept:
- Concept: The business is treated as a separate entity, distinct from its owner(s). Transactions are recorded from the viewpoint of the business, not the owner.
- Implications:
- Owner's investment (Capital) is treated as a liability of the business towards the owner.
- Owner's personal transactions are kept separate from business transactions. (Drawings are recorded when business funds are used for personal purposes).
- Profit is considered an increase in the business's liability towards the owner (increase in capital).
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(b) Money Measurement Concept:
- Concept: Only those transactions and events that can be measured and expressed in terms of money are recorded in the books of accounts.
- Implications:
- Provides a common unit of measurement for recording diverse transactions.
- Facilitates totaling and comparison.
- Limitations:
- Qualitative aspects like employee morale, management efficiency, market reputation, labour relations are ignored, even though they significantly affect the business.
- The value of money (purchasing power) is assumed to be stable, which is unrealistic due to inflation/deflation.
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(c) Accounting Period Concept:
- Concept: The entire life of a business (which is assumed to be indefinite under Going Concern) is divided into shorter, specific time intervals for measuring performance and financial position. This interval is called the accounting period.
- Implications:
- Allows for regular assessment of performance (profit/loss) and financial status (Balance Sheet).
- Facilitates comparison of results across periods.
- Needed for tax calculations and reporting to external users.
- Usual Period: Typically one year (e.g., April 1st to March 31st in India).
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(d) Cost Concept (Historical Cost Concept):
- Concept: An asset is ordinarily recorded in the books of account at the price at which it was acquired (purchase price plus all acquisition costs). This cost becomes the basis for all subsequent accounting for the asset (e.g., depreciation).
- Justification: Cost is objective and verifiable from source documents.
- Limitations:
- Ignores changes in the market value or replacement cost of assets.
- During periods of inflation, assets may be significantly undervalued in the Balance Sheet.
- Does not reflect the true 'worth' of the business if assets' market values have changed substantially.
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(e) Dual Aspect Concept (Duality Principle):
- Concept: Every transaction has two aspects – a receiving aspect (debit) and a giving aspect (credit) – of equal amount. For every debit, there is a corresponding credit.
- Implications:
- Forms the basis of the double-entry system of bookkeeping.
- Leads to the fundamental Accounting Equation:
Assets = Liabilities + Capital
This equation always holds true for the business at any point in time.
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(f) Revenue Recognition Concept (Realisation Concept):
- Concept: Revenue (income from sales or services) is considered earned and should be recorded only when the legal right to receive it arises, i.e., when the sale is complete or the service is rendered. The actual receipt of cash is not the determining factor under the accrual basis.
- Point of Recognition: Generally, revenue is recognized:
- For sale of goods: When goods are delivered or ownership is transferred to the buyer.
- For rendering services: When the services have been performed.
- For income like interest, rent, commission: Usually on a time basis.
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(g) Matching Concept:
- Concept: Expenses incurred in an accounting period should be matched with the revenues earned during that same period to determine the correct profit or loss.
- Implications:
- Costs are recognized as expenses in the period when the related revenue is recognized.
- Requires adjustments for outstanding expenses, prepaid expenses, accrued income, and income received in advance.
- Depreciation on fixed assets is charged as an expense against the revenue generated by using those assets.
- Cost of goods sold is matched against sales revenue.
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(h) Full Disclosure Concept:
- Concept: Financial statements should disclose all significant information that is relevant to the users (investors, creditors, etc.) for making informed decisions. Information should be presented honestly and completely.
- Implications:
- Disclosure can be within the body of financial statements (Balance Sheet, Profit & Loss Account) or through accompanying notes, schedules, or supplementary statements.
- Requires disclosure of accounting policies followed, contingent liabilities, market value of investments, etc.
- Aims to make statements understandable and not misleading.
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(i) Materiality Concept:
- Concept: Focus should be on items that are significant or material enough to likely influence the decisions of users of financial statements. Insignificant items can be ignored or merged with others. This is an exception to the Full Disclosure principle.
- Implications:
- Avoids cluttering financial statements with trivial details.
- Whether an item is material depends on its nature and/or amount in the context of the specific business. (e.g., a Rs. 500 expense might be immaterial for a large corporation but material for a small shop).
- Allows for practical approximations (e.g., treating small-value items like stationery as expense when purchased, rather than tracking inventory).
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(j) Prudence Concept (Conservatism Concept):
- Concept: Accountants should exercise caution and not overstate assets or profits, nor understate liabilities or losses. It means: "Anticipate no profits, but provide for all possible losses."
- Implications:
- Valuing closing stock at cost or net realizable value (market value), whichever is lower.
- Creating provisions for doubtful debts on debtors.
- Not recognizing unrealized gains, but providing for potential losses (e.g., on pending lawsuits).
- Leads to understatement of profits and assets in certain situations, which some critics argue creates hidden reserves.
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(k) Objectivity Concept:
- Concept: Accounting transactions and measurements should be based on objective evidence, free from personal bias of the accountant or management. The information should be verifiable.
- Implications:
- Enhances the reliability and trustworthiness of financial statements.
- Requires transactions to be supported by source documents (invoices, vouchers, cash memos, etc.).
- Historical cost principle is preferred partly because cost is more objective than market value.
5. Bases of Accounting
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(a) Cash Basis:
- Concept: Revenue is recognized only when cash is received, and expenses are recognized only when cash is paid. No adjustments for outstanding/prepaid items.
- Suitability: Simple, often used by professionals (doctors, lawyers) or small non-profit organizations where credit transactions are minimal.
- Limitation: Does not give a true and fair view of profit/loss and financial position as it violates the Matching and Accrual principles. Not generally accepted for most businesses.
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(b) Accrual Basis:
- Concept: Revenue is recognized when earned, and expenses are recognized when incurred, regardless of cash flow. (As explained under Accrual Assumption).
- Suitability: Used by most business enterprises. Mandated by law for companies.
- Advantage: Provides a more accurate picture of financial performance and position, consistent with GAAP.
6. Accounting Standards
- Meaning: Authoritative statements issued by regulatory bodies (like the Institute of Chartered Accountants of India - ICAI, through its Accounting Standards Board - ASB) that specify how particular types of transactions and events should be recognized, measured, presented, and disclosed in financial statements.
- Need: To harmonize diverse accounting policies and practices, improve comparability, and enhance reliability. They provide specific guidelines on applying the general principles (GAAP).
Multiple Choice Questions (MCQs)
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The convention of 'anticipate no profit and provide for all possible losses' stems from which accounting concept?
a) Consistency
b) Prudence (Conservatism)
c) Matching
d) Materiality -
Recording fixed assets at their cost of acquisition is based on which principle?
a) Money Measurement Concept
b) Business Entity Concept
c) Historical Cost Concept
d) Dual Aspect Concept -
The assumption that a business will continue to operate for an indefinite period in the future is known as:
a) Accounting Period Assumption
b) Accrual Assumption
c) Going Concern Assumption
d) Business Entity Assumption -
Which accounting principle requires that personal expenses of the owner should be kept separate from business expenses?
a) Money Measurement Concept
b) Business Entity Concept
c) Full Disclosure Concept
d) Matching Concept -
GAAP stands for:
a) Generally Accepted Auditing Practices
b) Generally Applied Accounting Procedures
c) Generally Accepted Accounting Principles
d) Government Approved Accounting Principles -
Valuing inventory at cost or net realizable value, whichever is lower, is an application of:
a) Consistency Concept
b) Prudence (Conservatism) Concept
c) Materiality Concept
d) Accrual Concept -
The accounting equation (Assets = Liabilities + Capital) is a result of which concept?
a) Matching Concept
b) Dual Aspect Concept
c) Going Concern Concept
d) Accounting Period Concept -
Recognizing revenue only when it is earned (irrespective of cash received) and expenses when incurred (irrespective of cash paid) is based on:
a) Cash Basis Accounting
b) Accrual Basis Accounting
c) Consistency Assumption
d) Materiality Concept -
Which concept states that only transactions measurable in monetary terms are recorded in accounting?
a) Business Entity Concept
b) Cost Concept
c) Money Measurement Concept
d) Objectivity Concept -
The practice of appending notes regarding contingent liabilities in accounting statements is pursuant to:
a) Convention of Consistency
b) Money Measurement Concept
c) Convention of Full Disclosure
d) Going Concern Concept
Answers to MCQs:
- b) Prudence (Conservatism)
- c) Historical Cost Concept
- c) Going Concern Assumption
- b) Business Entity Concept
- c) Generally Accepted Accounting Principles
- b) Prudence (Conservatism) Concept
- b) Dual Aspect Concept
- b) Accrual Basis Accounting
- c) Money Measurement Concept
- c) Convention of Full Disclosure
Remember to thoroughly revise these concepts. They are the building blocks for everything else you will learn in accountancy. Good luck with your preparation!