9  Basic Accounting Principles

9.1 Meaning and Definition of Accounting

Accounting is the language of business. It records the financial story of an enterprise so that owners, managers, lenders and the state can read it. The American Institute of Certified Public Accountants (AICPA) offers the most cited definition: accounting is “the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof” (aicpa1953?).

The American Accounting Association (AAA) modernises the focus on users: accounting is “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information” (aaa1966?).

Three working ideas anchor every textbook treatment.

  • Accounting deals only with financial transactions, expressed in money.
  • It is a process — transactions move through identification, recording, classification, summarising, communication and interpretation.
  • Its purpose is to aid decisions by users inside and outside the firm.
TipThree Authoritative Definitions of Accounting
Source Working definition Foregrounded idea
AICPA (1953) “Art of recording, classifying, summarising and interpreting financial transactions” The process
AAA (1966) “Process of identifying, measuring and communicating economic information for informed decisions” The user
R.N. Anthony “A means of collecting, summarising, analysing and reporting in monetary terms, information about a business” Information system

9.2 Objectives and Functions of Accounting

Accounting serves six recurring objectives (maheshwari2022?; anthony2017?):

  • Maintain a systematic record of all financial transactions.
  • Ascertain results of operations — profit or loss for the period.
  • Ascertain financial position — what the firm owns and owes at a point in time.
  • Provide information to users — owners, managers, lenders, investors, regulators, the state.
  • Help in decision-making — pricing, investment, financing, taxation.
  • Comply with legal requirements — Companies Act, GST, Income Tax, Sectoral regulators.

The functions follow naturally: recording, classifying, summarising, analysing, interpreting, communicating, complying. The first three are bookkeeping; the rest are accounting proper.

9.3 Branches of Accounting

Accounting has progressively specialised into several branches.

TipSix Branches of Accounting
Branch Primary purpose Primary user
Financial accounting Records past transactions; produces financial statements External users
Cost accounting Ascertains the cost of products and services Management
Management accounting Provides information for managerial planning and control Management
Tax accounting Computes tax liabilities under the Income-Tax Act and GST Tax authorities
Social responsibility accounting Measures social and environmental impact Society, regulators
Human-resource accounting Values the firm’s human capital Internal management

9.4 Users of Accounting Information

The same set of statements speaks to many audiences.

TipInternal and External Users
Type Users Working question
Internal Owners, management, employees How is the firm performing? Should we change strategy?
External Investors, lenders, suppliers, customers, government, public Should we invest, lend, supply, regulate?

9.5 Bookkeeping vs Accounting vs Accountancy

Three closely related terms are routinely tested together.

TipBookkeeping, Accounting and Accountancy
Term Scope Activities
Bookkeeping Routine recording Identifying, recording, classifying
Accounting Wider analysis Bookkeeping + summarising, analysing, interpreting, communicating
Accountancy Profession and discipline The whole field — body of knowledge, principles, practice

A useful one-line memory aid: bookkeeping is part of accounting; accounting is part of accountancy.

9.6 Basic Accounting Terminology

TipTwelve Foundational Terms
Term Meaning
Transaction An event measurable in money causing a change in financial position
Asset Resource owned and controlled by the firm with future economic benefit
Liability Present obligation arising from past events
Capital Owner’s claim on the assets of the firm
Revenue / Income Inflow of economic benefits from ordinary activities
Expense Outflow of economic benefits to earn revenue
Profit Excess of revenue over expense
Drawings Cash or goods withdrawn by the proprietor for personal use
Debtor Person who owes the firm
Creditor Person to whom the firm owes
Goods Items in which the firm trades
Stock / Inventory Goods held for resale or in process

9.7 The Accounting Equation

The single equation underlying all financial accounting is:

\[ \text{Assets} = \text{Liabilities} + \text{Capital} \]

Every transaction preserves this identity — that is the dual aspect of accounting. Equivalently, Capital = Assets − Liabilities (the net worth equation).

TipWorked Example — Effect of Five Transactions on the Equation
Transaction Assets = Liabilities + Capital
Owner brings ₹1,00,000 cash + 1,00,000 = 0 + + 1,00,000
Buys goods for cash ₹40,000 + 40,000 cash − 40,000 = 0 + 0
Buys goods on credit ₹20,000 + 20,000 stock = + 20,000 creditor + 0
Sells goods (cost ₹30,000) for cash ₹45,000 + 45,000 cash − 30,000 stock = 0 + + 15,000 profit
Pays creditor ₹20,000 − 20,000 cash = − 20,000 creditor + 0

After all five entries: Assets ₹1,15,000 = Liabilities ₹0 + Capital ₹1,15,000. The equation balances after every step.

9.8 The Double-Entry System

Luca Pacioli’s Summa de Arithmetica (1494) is the first published account of double-entry bookkeeping; the system has powered commercial accounting ever since. Its central rule:

Every transaction has two aspects of equal magnitude — a debit and a credit.

The traditional English approach splits accounts into three classes; the modern American approach uses five.

TipTwo Approaches to Account Classification
Approach Account class Rule
English / Traditional Personal Debit the receiver; credit the giver
Real Debit what comes in; credit what goes out
Nominal Debit all expenses and losses; credit all incomes and gains
American / Modern Asset Debit increase, credit decrease
Liability Debit decrease, credit increase
Capital Debit decrease, credit increase
Revenue Debit decrease, credit increase
Expense Debit increase, credit decrease

9.9 The Accounting Cycle

The accounting cycle is the recurring sequence of steps that transforms transactions into financial statements.

flowchart LR
  T[Transactions] --> J[Journal]
  J --> L[Ledger]
  L --> TB[Trial Balance]
  TB --> ADJ[Adjusting Entries]
  ADJ --> FS[Financial Statements]
  FS --> CL[Closing Entries]
  CL --> NEXT[Next Period]
  style T fill:#FFEBEE,stroke:#C62828
  style J fill:#FFF8E1,stroke:#F9A825
  style L fill:#E3F2FD,stroke:#1565C0
  style TB fill:#E8F5E9,stroke:#2E7D32
  style FS fill:#F3E5F5,stroke:#6A1B9A

9.10 Generally Accepted Accounting Principles (GAAP)

The Generally Accepted Accounting Principles are the body of accepted rules, conventions, concepts and standards that govern the preparation of financial statements. GAAP has two layers:

  • Accounting concepts — the basic assumptions on which accounts are kept.
  • Accounting conventions — the customs, usage and policies that have evolved through practice.

9.10.1 Accounting concepts (the basic assumptions)

TipTen Accounting Concepts
Concept Working content
Business entity Owner and business are distinct — owner’s personal transactions are not business transactions
Money measurement Only items measurable in money are recorded
Going concern Firm is assumed to continue indefinitely; assets are valued accordingly
Accounting period Indefinite life is broken into shorter, definite periods (year/quarter) for reporting
Cost / Historical cost Assets are recorded at acquisition cost, not current market value
Dual aspect Every transaction has equal debit and credit; basis of the accounting equation
Realisation / Revenue recognition Revenue is recognised when it is realised — typically when goods or services are delivered
Matching Expenses are matched with the revenues they help to earn in the same period
Accrual Transactions are recorded when they accrue, not when cash moves
Objectivity / Verifiability Records are based on objective evidence (vouchers, invoices)

9.10.2 Accounting conventions

TipFour Accounting Conventions
Convention Working content
Consistency Same accounting policies followed from period to period; change requires disclosure
Full disclosure All material information is disclosed in or with the financial statements
Conservatism / Prudence Anticipate no profits, provide for all possible losses
Materiality Only items that influence decisions are accounted for in detail

9.11 Cash Basis vs Accrual Basis

Two systems of recording determine when a transaction enters the books.

TipCash Basis vs Accrual Basis of Accounting
Dimension Cash basis Accrual basis
Recognition When cash is received or paid When transaction occurs, irrespective of cash
Profit measurement Distorted; ignores receivables and payables Accurate; matches expenses with revenues
Compliance with GAAP / Companies Act Not permitted (except small entities) Mandatory for companies
Used by Some professionals, very small entities All companies and most enterprises

The Companies Act 2013, Section 128(1), and Indian Accounting Standards together require the accrual basis for company accounts.

9.12 Books of Original Entry and Final Accounts

The transaction journey through the books proceeds along a standard path.

  • Books of original entry: Journal and special journals (cash book, purchases book, sales book, returns books, bills book).
  • Ledger: Classified summary of journal entries; one account per item.
  • Trial balance: Tests arithmetical accuracy of the ledger.
  • Final accounts: Trading account, Profit and Loss account, Balance Sheet; for some entities, a Cash Flow Statement and Statement of Changes in Equity.

The Trading Account establishes gross profit; the P&L Account converts gross profit into net profit; the Balance Sheet states financial position on the closing date.

9.13 Exam-Pattern MCQs

Q 01
Which of the following is not an objective of financial accounting?
  • AMaintaining a systematic record of transactions
  • BAscertaining the results of operations
  • CDetermining managerial bonuses through subjective discretion
  • DReporting the financial position to external users
View solution
Correct Option: C
Bonuses follow from objectively-measured results; "subjective discretion" is not an objective of accounting.
Q 02
Match the accounting concept with its content:
Concept Content
(i) Business entity (a) Revenue is recognised when it is earned, not when cash is received
(ii) Going concern (b) The firm and its owner are treated as separate persons
(iii) Realisation (c) The firm is assumed to continue indefinitely
(iv) Matching (d) Expenses are matched with the revenues they help to earn
  • A(i)-(b), (ii)-(c), (iii)-(a), (iv)-(d)
  • B(i)-(c), (ii)-(b), (iii)-(d), (iv)-(a)
  • C(i)-(a), (ii)-(d), (iii)-(b), (iv)-(c)
  • D(i)-(d), (ii)-(a), (iii)-(c), (iv)-(b)
View solution
Correct Option: A
Q 03
A firm purchases a machine for ₹5,00,000 in cash. Immediately after the transaction, which of the following statements is true?
  • ATotal assets rise by ₹5,00,000
  • BTotal assets remain unchanged
  • CTotal liabilities rise by ₹5,00,000
  • DCapital falls by ₹5,00,000
View solution
Correct Option: B
Cash falls by ₹5,00,000 and Machinery rises by ₹5,00,000 — total assets are unchanged. The accounting equation continues to balance.
Q 04
Match each English-approach rule with the type of account it governs:
Account type Rule
(i) Personal account (a) Debit what comes in; credit what goes out
(ii) Real account (b) Debit all expenses and losses; credit all incomes and gains
(iii) Nominal account (c) Debit the receiver; credit the giver
  • A(i)-(c), (ii)-(a), (iii)-(b)
  • B(i)-(a), (ii)-(b), (iii)-(c)
  • C(i)-(b), (ii)-(c), (iii)-(a)
  • D(i)-(c), (ii)-(b), (iii)-(a)
View solution
Correct Option: A
Q 05
"Anticipate no profits and provide for all possible losses." This statement reflects the convention of:
  • AMateriality
  • BConsistency
  • CConservatism
  • DFull disclosure
View solution
Correct Option: C
The conservatism (prudence) convention.
Q 06
Match the accounting term with its meaning:
Term Meaning
(i) Asset (a) Owner's claim on the firm
(ii) Liability (b) Resource controlled by the firm with future economic benefit
(iii) Capital (c) Cash or goods withdrawn by the owner for personal use
(iv) Drawings (d) Present obligation arising from past events
  • A(i)-(b), (ii)-(d), (iii)-(a), (iv)-(c)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(c), (ii)-(d), (iii)-(b), (iv)-(a)
  • D(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
View solution
Correct Option: A
Q 07
Arrange the following steps of the accounting cycle in correct order: (i) Posting to the ledger (ii) Journalising the transactions (iii) Preparing the trial balance (iv) Preparing the financial statements
  • A(ii), (i), (iii), (iv)
  • B(i), (ii), (iv), (iii)
  • C(iii), (iv), (i), (ii)
  • D(iv), (iii), (ii), (i)
View solution
Correct Option: A
Journal → Ledger → Trial Balance → Financial Statements is the textbook sequence.
Q 08
Match the basis with its rule of recognition:
Basis Rule of recognition
(i) Cash basis (a) Recognise when transaction accrues, irrespective of cash
(ii) Accrual basis (b) Mandatory under the Companies Act 2013 for companies
(iii) Companies Act requirement (c) Recognise only when cash is received or paid
(iv) Distortion of profit (d) Highest in pure cash-basis records
  • A(i)-(c), (ii)-(a), (iii)-(b), (iv)-(d)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
  • D(i)-(d), (ii)-(c), (iii)-(a), (iv)-(b)
View solution
Correct Option: A
ImportantQuick recall
  • Accounting = identify, measure, record, classify, summarise, analyse, interpret, communicate financial information.
  • Bookkeeping ⊂ Accounting ⊂ Accountancy.
  • The accounting equation: Assets = Liabilities + Capital. It balances after every transaction (dual aspect).
  • Six branches: Financial, Cost, Management, Tax, Social, HR accounting.
  • Double-entry — English rules: Personal (debit receiver, credit giver); Real (debit what comes in, credit what goes out); Nominal (debit expenses/losses, credit incomes/gains).
  • Ten concepts: Business entity, Money measurement, Going concern, Accounting period, Cost, Dual aspect, Realisation, Matching, Accrual, Objectivity.
  • Four conventions: Consistency, Full disclosure, Conservatism, Materiality. Mnemonic: “CFCM”.
  • Accrual basis mandatory for companies (Companies Act 2013, Sec. 128(1)); cash basis distorts profit.
  • Accounting cycle: Journal → Ledger → Trial Balance → Adjusting Entries → Financial Statements → Closing Entries.