Theory Base of Accounting

If every accountant recorded transactions in their own way, no two sets of books could be compared. To prevent this, accounting follows a common framework called GAAP — Generally Accepted Accounting Principles. GAAP is the set of rules, concepts and conventions that guide how transactions are recorded and reported. These are not laws of nature; they are agreed practices that have stood the test of time and are now widely accepted.

The principles are usually split into concepts (the basic assumptions on which records are built) and conventions (customs followed in preparing statements). Here are the foundation concepts:

• Business Entity Concept — the business is treated as separate from its owner. The owner's personal cash and the business cash are different. This is why the owner's investment is recorded as capital (a liability of the business towards the owner) and withdrawals as drawings.
• Money Measurement Concept — only transactions that can be expressed in money are recorded. The health of the managing director or the morale of staff, however important, is not recorded.
• Going Concern Concept — the business is assumed to continue for the foreseeable future, not to close down soon. This is why assets are shown at cost (less depreciation), not at their break-up sale value.
• Accounting Period Concept — the endless life of a business is split into fixed periods (usually one year) so that profit and position can be measured and reported regularly.
• Cost Concept (Historical Cost) — an asset is recorded at the price actually paid for it, not at its market value. A building bought for Rs 10,00,000 stays at Rs 10,00,000 (less depreciation) even if the market price rises.
• Dual Aspect Concept — every transaction has two aspects, a debit and a credit of equal amount. This is the basis of double-entry and of the accounting equation: Assets = Liabilities + Capital.

These six concepts are the bedrock; the next topic adds the matching, prudence and disclosure ideas that complete the framework.

Beyond the foundation concepts, accounting follows several more principles and conventions that decide when to record income and how to present statements.

• Revenue Recognition (Realisation) Concept — revenue is recorded when it is earned/realised (when goods are sold or services rendered), not necessarily when cash is received. A credit sale is income today even if cash comes next month.
• Matching Concept — to find the correct profit, the expenses of a period are matched against the revenues of the same period. This is why we add outstanding expenses and subtract prepaid expenses while preparing final accounts.
• Full Disclosure Convention — all material information must be fully disclosed so that statements are not misleading. Hence the notes and disclosures attached to accounts.
• Convention of Conservatism (Prudence) — "anticipate no profit but provide for all possible losses." This is why we create a provision for doubtful debts and value stock at cost or net realisable value, whichever is lower.
• Convention of Consistency — the same methods (e.g. of depreciation or stock valuation) are followed year after year, so results can be compared. A change is allowed only with disclosure.
• Convention of Materiality — only items important enough to affect decisions need detailed treatment; trivial items (a stapler, a few erasers) can be treated as expense at once.
• Objectivity Concept — records should be based on verifiable evidence (vouchers, bills), free from personal bias.

Out of all these, three are called the fundamental accounting assumptions (AS-1): Going Concern, Consistency, and Accrual. They are presumed to be followed; if any is NOT followed, the fact must be disclosed.

Concepts and conventions still leave some room for different treatments. To narrow this and make accounts uniform and comparable, professional bodies issue Accounting Standards (AS).

• Accounting Standards are written policy documents issued by an authority (in India, the ICAI / the National Financial Reporting Authority) that lay down how particular items must be recognised, measured, presented and disclosed.
• Need / objectives: to bring uniformity, improve reliability and comparability, reduce confusion and the chance of manipulation, and protect users.
• IFRS (International Financial Reporting Standards) are global standards issued by the IASB so that company accounts are comparable across countries. India has converged its standards with IFRS in the form of Ind AS.

A second theory idea is the basis (system) of accounting — when a transaction is recorded:

The accrual basis is the one required by the Companies Act and assumed by AS-1, because it matches revenues and expenses to the correct period and so shows the true profit. The cash basis is simple but unsuitable for most businesses. Together, GAAP, the standards and the accrual system give accounting its reliable, comparable theory base — the foundation for the recording you will now learn.