Accounting Principles: Concepts, Conventions and Standards

Ravi opens a kirana store with ₹5,00,000 of his savings. A month later he pays ₹5,000 of his daughter’s school fee from the shop’s cash. Is that a cost of running the shop?

Entity. Ravi’s ₹5,00,000 is not the shop’s own money. The shop owes it to him, and the books call it capital. When he takes ₹5,000 for the school fee, the shop’s cash falls to ₹4,95,000 and so does his capital. The fee is not an expense of the shop; it is a drawing.

Money measurement. The shop’s books will record the refrigerator, the stock and the rent. They will not record that its best employee is unhappy, that a rival opened nearby, or that Ravi’s regular customers trust him. These matter, but a rupee value cannot be put on them reliably.

Cost. Ravi buys a refrigerator for ₹40,000. The books show ₹40,000, even if a new one costs ₹46,000 next year or he could sell this one for ₹30,000. Cost is a fact on a bill; the other values are opinions.

Don’t confuse the accounting entity with the legal one. A sole proprietor is not legally separate from his shop; he is personally liable for its debts. His accounts still keep the two apart. A company is separate in both law and accounts.

Where it breaks. In years of inflation, cost understates old assets: a building bought in 1990 for ₹10 lakh may now be worth ₹2 crore, yet the books show ₹10 lakh less depreciation. Under Ind AS 16 a company may choose to revalue some assets. Money measurement leaves out people, brands and customer trust, which are often a firm’s main strengths.

For exams. Be ready to say which concept a case shows: private spending from business cash is entity; an unrecorded labour dispute is money measurement; a machine shown at purchase price is cost.

Entity: the owner stands apart. Money: only what a rupee can measure. Cost: what you paid.

Ravi buys ₹2,00,000 of goods on credit from a supplier. No cash has moved, yet the books must change. How do they stay in balance?

Follow Ravi’s store through four transactions. After each one, assets equal liabilities plus capital.

Each line shows a different kind of change. In 2, one asset rises and another falls. In 3, an asset and a liability rise together. In 4, an asset and a liability fall together. A fourth kind moves between liabilities: if the supplier agrees to turn the ₹50,000 owed into a loan, creditors fall and loans rise.

In debit and credit. Transaction 3 is written as a journal entry: Debit Stock ₹2,00,000; Credit Creditors ₹2,00,000. Debit increases an asset or an expense. Credit increases a liability, capital or an income.

Don’t think a balanced set of books is a correct one. The two sides can agree and still be wrong. If Ravi books the school fee as a shop expense, debits and credits still match; the mistake is in the choice of account. Chapter 2 lists the errors a trial balance cannot catch.

Where it breaks. The equation holds by construction, so it proves nothing about whether each entry is true. Only checking against bills, bank statements and stock counts does that.

For exams. Write the equation, say which two accounts a given transaction touches, and state whether each rises or falls.

Two sides, one amount: debit equals credit, assets equal what is owed.

A textile mill in Surat has run for 60 years and expects to run for 60 more. Its owners want to know every year whether it is doing well. They cannot wait for the mill to close before they find out.

Going concern. The mill buys a machine for ₹7,00,000 and pays ₹70,000 more for transport and installation. Under the cost concept the machine is recorded at ₹7,70,000. If it will last ten years with no scrap value, the books charge ₹77,000 a year. They do not write it down to what a scrap dealer would pay this month, because the mill is not selling it; it is using it.

Periodicity. In India most businesses report for the financial year, 1 April to 31 March, and a company must close its books on 31 March, with narrow exceptions. A year is usual, but a firm may also report each quarter. Equal periods let owners compare this year with last year.

Don’t read going concern as a promise that the firm will survive. It is a starting assumption. If the firm is likely to close, the accounts must be prepared on a different basis, and the basis must be disclosed. Auditors report a “material uncertainty related to going concern” when there is real doubt.

Where it breaks. Cutting life into years forces estimates: how long a machine will last, which sales belong to March. These estimates are judgements, and a year’s profit depends on them. Short periods can also push managers to favour this year’s profit over long-term value.

For exams. Going concern explains why fixed assets are depreciated, not shown at sale value. Periodicity explains why accounts are made every period, and why it is the base for matching revenue with cost.

Going concern: the business goes on, so spread the cost. Periodicity: cut the life into years.

A furniture maker in Jaipur delivers a sofa set worth ₹1,20,000 on 28 March. The customer pays on 10 April. Which year’s income is it? And what about the timber that went into it?

A year in Meera’s shop. Meera buys 1,000 sarees at ₹800. She sells 800 at ₹1,200, taking ₹8,00,000 in cash and leaving ₹1,60,000 due from customers. Her rent is ₹10,000 a month; she has paid for 11 months.

The cash view shows a loss of ₹1,10,000. The accrual view shows a profit of ₹2,00,000. The accrual view is the better guide to how the shop did. It counts all ₹9,60,000 of sales, it counts the cost of the 800 sarees sold and carries the other 200 forward as stock, and it counts a full year of rent.

Matching. Some costs link directly to sales, like the saree’s purchase price. Others link to time, like rent, and are charged to the period they cover. Both are matched to the period in which the revenue is counted. This is what creates prepaid and outstanding expenses and accrued and unearned income at year-end.

Don’t confuse profit with cash. Meera’s profit is ₹2,00,000 but her cash fell by ₹1,10,000. The difference is ₹1,60,000 owed by customers, ₹1,60,000 tied up in unsold stock, less ₹10,000 of rent not yet paid. This is why a profitable business can still run out of cash.

Where it breaks. Accrual needs judgement about when a sale is earned, how much will be returned and how many customers will pay. Firms can bring sales forward to look better. Ind AS 115 sets a five-step test for revenue, recognised as control passes to the customer; AS 9 was the older rule.

For exams. Know Revenue − Expenses = Profit, and be able to turn a cash record into an accrual profit.

Earn it, count it. Use it, count it. Match cost to the sale.

A company changes how it depreciates its machines and its profit jumps by ₹40 lakh. Nothing in the business has changed. Should readers be told? And should the company be free to change every year?

Conservatism, worked. A trader’s stock cost ₹2,40,000. If its net realisable value (what it can be sold for, less selling costs) falls to ₹2,10,000, the books value it at ₹2,10,000 and show a loss of ₹30,000 now. If its value rises to ₹2,70,000, the books keep it at ₹2,40,000. The gain of ₹30,000 appears only when the stock is sold. Losses are recognised early; gains wait.

Don’t confuse concepts with conventions. Concepts, like entity and accrual, are basic assumptions about how accounting is structured. Conventions, like consistency and materiality, are accepted practices that shape how information is presented. Textbooks use the two words loosely, so give the example if asked.

Don’t treat conservatism as permission to understate profit. Prudence means taking care not to overstate. Deliberately understating profit, by building hidden reserves, is also a misstatement.

Where it breaks. Conservatism can make accounts biased downward, and gains and losses are treated unevenly. Consistency can lock in an outdated method. Materiality has no fixed rupee limit; it depends on the size of the firm and the nature of the item.

For exams. Recall the phrase for conservatism and the stock rule: lower of cost and net realisable value (AS 2 and Ind AS 2).

Disclose it. Keep it consistent. Provide for losses, not for gains. Ignore the trivial.

Two companies buy identical machines. One writes the cost off in five years, the other in twenty. Their profits are not comparable. Standards exist so that similar events are accounted for in the same way.

Who makes them. ICAI recommends a standard. The Central Government notifies it as rules, after consulting the National Financial Reporting Authority (NFRA). The Accounting Standards are notified in the Companies (Accounting Standards) Rules, first issued in 2006. The Ind AS are in the Companies (Indian Accounting Standards) Rules, 2015.

Who follows which. Ind AS apply to listed companies and to larger unlisted ones, decided by net-worth limits. Other companies follow AS. The limits have been revised, so check the current notification before you rely on a number.

Don’t mix the two numbering systems. AS 3 and Ind AS 7 both deal with cash flows; AS 9 and Ind AS 115 both deal with revenue. An exam question that gives only a number needs you to know which set it comes from.

Where it breaks. Ind AS bring in fair values and expected-loss models, which need more judgement and make profits less steady. Smaller firms find the full set costly to apply, which is why they keep AS.

For exams. Recall: AS 2 inventories, AS 3 cash flows, AS 9 revenue, AS 19 leases, AS 20 earnings per share; Ind AS 109 financial instruments, 110 consolidation, 113 fair value, 115 revenue, 116 leases.

Links. Chapter 3 takes Ind AS and IFRS further: the phases of adoption, how they differ from IFRS and a longer list of standards.

ICAI recommends, the Government notifies. AS for most, Ind AS for the large and listed.