Theory Base of Accounting

Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XI (Financial Accounting Part I), Chapter 2.

Two identical shops, two different profits

Two cloth shops in Indore each sell ₹5,00,000 of cloth in a year and spend ₹3,00,000 on running costs. One reports a profit of ₹2,00,000. The other reports ₹1,40,000. The businesses are the same, so who is right?

Both followed their own rules. The first counted a sale on the day it was made and a cost on the day it arose. The second counted money only when cash actually moved. If every firm chose its own method, no bank, investor or tax officer could compare any two sets of accounts. This chapter is the answer: a shared set of rules, called the theory base, that makes accounts uniform and comparable.

GAAP and the basic concepts

Generally Accepted Accounting Principles (GAAP) are the rules and guidelines used to record and report business transactions so that financial statements look alike across firms and years. They are not a statute. They grow out of past practice, custom, professional pronouncements and government regulation, and they change as law and business change. The terms principles, postulates, conventions, modifying principles and assumptions are used loosely for the same ideas, and the chapter groups them as basic accounting concepts. There are thirteen.

Which concept is it?

Scenario questions usually give away one "issue dimension". Spot it and the answer follows.

Several concepts interlock, and the exam exploits that. Going concern is the reason depreciation exists at all: if the firm will keep running, a machine's cost is spread over the years it serves. Accounting period then says that the spreading is reported once a year. Matching decides which year gets each slice. Cost and objectivity are closely tied because historical cost is preferred precisely because it rests on a bill that anyone can check.

Revenue recognition has two familiar exceptions. In long term construction contracts, revenue is recognised in proportion to work completed. In hire purchase, each instalment is recognised as it falls due.

Conservatism is the rule of playing safe. Expected losses are provided for even when the chance is small. Profits are not recorded until they are realised. Excess is its own fault: if a business keeps understating profits and overstating costs, it builds hidden reserves and misleads readers in the other direction.

Beyond the textbook. For the exam: closing stock is valued at cost or market value, whichever is lower. In reality: the accounting standard on inventories says lower of cost and net realisable value, which is the expected selling price less the costs still to be incurred to complete and sell. Why it matters: the idea is the same, but a question that says "net realisable value" expects the same lower-of rule.

Beyond the textbook. For the exam: the business entity concept separates the owner and the business for accounting. In reality: in law, a sole proprietor and the proprietorship are the same person, so creditors can reach the owner's personal property if the business cannot pay. A company is different: it is a separate legal person. Why it matters: the accounting separation protects clarity of records, not the owner's personal assets.

Pause and predict: A trader values closing stock at ₹3,40,000, the market price, although it cost him ₹3,00,000. Which concept is broken?

Check your answer: Conservatism. He has recorded a profit of ₹40,000 that has not been realised, because the goods are still unsold. Stock stays at cost when the market price is higher.

Pause and predict: A shop buys a packet of erasers for ₹60. Should it appear as an asset at year end?

Check your answer: No. By materiality the amount is too small to affect any decision, so it is charged as an expense in the year.

Systems and bases of accounting

The system is about how many sides of a transaction you record. The basis is about when you record it.

Dual aspect is the concept. Double entry is the technique that puts it into practice.

Accounting standards

Accounting standards are written policy documents on recognition, measurement, treatment, presentation and disclosure. In India they are issued by the Institute of Chartered Accountants of India (ICAI). The wider picture of who does what is a common trap.

Standards exist to remove differences in accounting treatment, to require disclosure beyond the law where it helps investors and the public, to make accounts comparable between firms and between years, and to make financial statements more reliable. They also have limits. They can make the choice between alternative treatments more complicated, they can be rigid, and they cannot override the law of the land.

GST in one page

Goods and Services Tax (GST) is a tax on the consumption of goods and services. It is charged at every stage from manufacture to final sale, but each seller can set off the tax already paid on inputs (input tax credit). So only the value added at each stage is effectively taxed, and the burden lands on the final consumer. It is destination based, meaning the tax goes to the State where the goods are consumed.

GST is dual: the Centre and the States levy it together on a common base.

For an intra state sale the rate is split equally: at 18%, CGST is 9% and SGST is 9%. For an inter state sale or an import the full rate is charged as IGST. A supplier in one State billing a buyer in another therefore collects one tax, not two.

Beyond the textbook. For the exam: use the rate given in the question (18% in the standard examples). In reality: GST rates differ by product and service and are decided by the GST Council, so a rate you remember may not match what an invoice shows. Why it matters: solve with the numbers given and never bring in a rate from memory.

Worked examples

Worked example: cost of a plant. A firm buys plant with a list price of ₹50,00,000. It pays ₹10,000 transport, ₹15,000 for repairs needed before use and ₹25,000 for installation. At what value is the plant recorded?

Common wrong entry. Recording only ₹50,00,000 and charging the other ₹50,000 to expenses. That cuts this year's profit by ₹50,000 and understates the asset, which will give benefit for years.

Worked example: a computer charged to one year. Ruchica's father runs "Friends Gifts" and buys a computer for ₹70,000 with an expected life of 5 years. His profit before this item is ₹1,00,000. He charges the whole ₹70,000 to the current year. What should he have done?

Common wrong entry. Debiting "Computer expenses" with ₹70,000. The year's profit drops by ₹56,000 more than it should, and the later four years carry no cost at all, breaking both going concern and matching.

Worked example: cash basis against accrual basis. A firm has sales of ₹5,00,000, of which ₹4,00,000 has been received. Its expenses for the year are ₹3,00,000, of which ₹2,60,000 has been paid. The unpaid ₹40,000 is March rent ₹12,000 and wages ₹28,000. Compare the profits.

The Indore shops at the start of the chapter are exactly these two. Accrual gives the true picture because it matches what the year earned with what the year cost. To bring the unpaid costs into the books:

Common wrong entry. Leaving the ₹40,000 unrecorded because "no cash has gone". The year's profit is overstated by ₹40,000, and the firm's liability is hidden from the balance sheet.

Worked example: stock and doubtful debts under prudence. At year end, closing stock cost ₹3,00,000 and could now be sold for ₹2,75,000. A second lot cost ₹2,00,000 and could be sold for ₹2,40,000. Debtors are ₹1,20,000 and the firm expects 5% to prove bad. Find the figures and the entry.

Common wrong entry. Averaging cost and market, or valuing the second lot at ₹2,40,000. Averaging has no basis, and writing stock up books a profit before a single unit has been sold.

Worked example: GST with input credit. Ramesh of Madhya Pradesh buys goods worth ₹10,00,000 within the State at 18% GST. He sells them within the State for ₹12,00,000 at 18% GST, and also sells goods worth ₹10,00,000 to Anand in Rajasthan. Record the three transactions and find the GST he must pay for the first two.

Common wrong entry. Crediting the whole invoice value to Sales, for example ₹14,16,000 on the second entry, or charging CGST and SGST on the sale to Rajasthan. Output tax is not Ramesh's revenue; he holds it for the government. An inter state sale carries only IGST.

Worked example: the equation holds after every transaction. Ramesh starts a business. Track assets, liabilities and capital.

Each row satisfies $\text{Assets} = \text{Liabilities} + \text{Capital}$: for the last row, $2{,}50{,}000 + 10{,}40{,}000 = 12{,}90{,}000$. Each transaction moved at least two items, which is the dual aspect.

Common wrong step. Showing the credit purchase as changing assets only. Stock rises, but so does a liability. A transaction that touches only one account would break the equation.

Exam traps

Formula and format sheet

60-second revision

Where this chapter connects

These concepts decide how every entry is made. The next chapters apply them hands on: Introduction to Accounting supplies the vocabulary behind them, and Recording of Transactions I turns dual aspect into the debit and credit rules. Matching and prudence return in Depreciation, Provisions and Reserves, and GST columns appear again in Recording of Transactions II.