flowchart LR A[Assets<br/>What the firm owns] --- E[=] E --- L[Liabilities<br/>What the firm owes outsiders] L --- P[+] P --- O[Owner's Equity<br/>Owner's claim] style A fill:#E3F2FD,stroke:#1565C0 style L fill:#FFEBEE,stroke:#C62828 style O fill:#E8F5E9,stroke:#1B5E20
37 Accounting Principles and Financial Statements
37.1 What is Accounting?
Accounting is the systematic process of identifying, measuring, recording, classifying, summarising, analysing and communicating financial information about an economic entity to users who need it for decisions. The American Accounting Association’s classic definition: accounting is “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information” (aaa1966?).
The Indian standard text — S.N. Maheshwari and S.K. Maheshwari — defines accounting as “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” — the famous AICPA 1953 definition (maheshwari2018?).
TipThree Working Definitions
| Source | Definition | What it foregrounds |
|---|---|---|
| AICPA (1953) | “Art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events of a financial character, and interpreting the results.” | Process |
| AAA (1966) | “Process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users.” | Decision-usefulness |
| Maheshwari & Maheshwari | “Records all financial transactions of a business, classifies them, summarises them and interprets the results.” | Indian standard |
37.1.1 Branches of accounting
TipThree Main Branches of Accounting
| Branch | Concerned with | Primary user |
|---|---|---|
| Financial Accounting | Recording, classifying, summarising past transactions; preparing financial statements | External users — investors, creditors, regulators |
| Cost Accounting | Cost ascertainment, control and reporting | Internal management — operations and pricing |
| Management Accounting | Information for planning, decision-making, control | Internal management — strategic and tactical |
37.2 Accounting Concepts and Conventions (GAAP)
The body of rules governing financial-statement preparation is collectively known as Generally Accepted Accounting Principles (GAAP). GAAP is not a single document — it is a set of concepts (basic assumptions) and conventions (customary practices) developed over decades (maheshwari2018?; mukherjeehanif2017?).
37.2.1 Accounting concepts
TipEight Fundamental Accounting Concepts
| Concept | What it says |
|---|---|
| Business / Separate Entity | Business is a separate legal entity from its owners |
| Going Concern | The business will continue indefinitely; assets recorded at cost rather than break-up value |
| Money Measurement | Only transactions measurable in money are recorded |
| Cost / Historical Cost | Assets recorded at the price actually paid; not adjusted for market value |
| Dual Aspect | Every transaction has a debit and a credit; foundation of double-entry |
| Accounting Period | Continuous economic life is divided into periods (typically a year) |
| Realisation / Revenue Recognition | Revenue is recognised when goods are delivered or service rendered, not when cash is received |
| Matching | Expenses are matched against the revenue they helped earn in the same period |
37.2.2 Accounting conventions
TipFour Accounting Conventions
| Convention | What it says |
|---|---|
| Consistency | The same accounting policies are followed period to period |
| Conservatism / Prudence | Anticipate no profit but provide for all possible losses |
| Materiality | Items which would influence the decision of a reasonable user must be disclosed |
| Full Disclosure | All relevant information must be disclosed in or with the financial statements |
37.3 The Accounting Equation
The fundamental accounting equation:
\[\text{Assets} = \text{Liabilities} + \text{Owner's Equity}\]
This is the dual-aspect concept written as algebra. Every financial transaction can be expressed as a change in two or more elements that keeps the equation in balance.
37.4 Types of Accounts and Rules of Debit-Credit
The traditional Indian classification — anchored on the British double-entry tradition — sorts accounts into three types:
TipThree Traditional Types of Accounts and Their Rules
| Type | Examples | Debit Rule | Credit Rule |
|---|---|---|---|
| Personal | Names of persons, firms, organisations | Debit the receiver | Credit the giver |
| Real | Tangible and intangible assets — cash, goods, building, goodwill | Debit what comes in | Credit what goes out |
| Nominal | Expenses, losses, incomes, gains | Debit all expenses and losses | Credit all incomes and gains |
The modern (US-style) classification used by Indian texts in parallel: assets, liabilities, equity, income, expenses — with the rule “debits = credits” applied to each.
37.5 Books of Original Entry and Ledger
The accounting cycle moves transactions through a sequence of books and statements.
TipThe Accounting Cycle
| # | Step | Book / Output |
|---|---|---|
| 1 | Identify and document the transaction | Source documents (invoice, voucher) |
| 2 | Record in journal | Journal — book of original entry |
| 3 | Post to ledger | General ledger — book of accounts |
| 4 | Prepare trial balance | Trial Balance |
| 5 | Make adjustments | Adjusting entries (depreciation, prepayments, accruals) |
| 6 | Prepare financial statements | Statement of Profit and Loss; Balance Sheet; Cash-Flow Statement |
| 7 | Close the books and carry forward | Closing entries |
flowchart LR T[Transaction] --> J[Journal] J --> L[Ledger] L --> TB[Trial Balance] TB --> A[Adjustments] A --> FS[Financial Statements] FS --> CL[Closing Entries] style T fill:#E3F2FD,stroke:#1565C0 style FS fill:#E8F5E9,stroke:#1B5E20
37.6 Financial Statements
A complete set of financial statements under Indian and international standards comprises three primary statements plus notes.
TipThe Three Primary Financial Statements
| Statement | Question it answers | Time view |
|---|---|---|
| Statement of Profit and Loss | How well did the business perform during the period? | For a period |
| Balance Sheet (Statement of Financial Position) | What does the business own and owe at this date? | At a date |
| Cash Flow Statement | Where did cash come from, and where did it go? | For a period |
A complete set also includes a Statement of Changes in Equity and Notes to the Accounts under Ind AS.
37.6.1 Schedule III of the Companies Act, 2013
In India, listed and registered companies present their financial statements in the format laid down by Schedule III of the Companies Act, 2013. The format prescribes specific line items and disclosures and has separate divisions for non-Ind AS and Ind AS preparers.
37.6.2 Cash Flow Statement — three activities
Cash flows are classified into three activities, defined by AS 3 / Ind AS 7:
TipThree Activities in the Cash Flow Statement
| Activity | What it captures |
|---|---|
| Operating | Cash from primary revenue-producing activities — sales, receipts from customers, payments to suppliers and employees |
| Investing | Acquisition and disposal of long-term assets and other investments |
| Financing | Activities that change the size and composition of equity and borrowings |
37.7 Indian Accounting Standards (Ind AS)
The Indian Accounting Standards (Ind AS) — converged with IFRS — apply mandatorily, since 2016, to listed companies and large unlisted companies above specified thresholds. Other companies still apply the older Accounting Standards (AS) issued by the ICAI.
TipInd AS — Applicability Thresholds (Phased)
| Phase | Effective from | Coverage |
|---|---|---|
| Phase I | 1 April 2016 | All listed companies and unlisted with net worth ≥ ₹500 crore |
| Phase II | 1 April 2017 | Other listed; unlisted with net worth ≥ ₹250 crore |
| Banks, NBFCs, insurers | Various dates | Sector-specific roadmaps |
ICAI is the Indian standard-setter; the Ministry of Corporate Affairs notifies the standards.
37.8 Capital and Revenue Items
A perennial NTA topic — the distinction between capital and revenue expenditure / receipt:
TipCapital vs Revenue — Items
| Type | Capital | Revenue |
|---|---|---|
| Expenditure | Long-term benefit (machinery, buildings) | Short-term benefit (salary, rent) |
| Where reflected | Balance Sheet (asset) | Statement of P&L (expense) |
| Receipt | One-time, from non-recurring source (sale of fixed asset) | Recurring (sales receipts) |
37.9 Practice Questions
Q 01
Concept
Easy
The accounting concept which states that the business is separate from its owners is the:
View solution
Correct Option: C
The business / separate-entity concept treats the firm as legally distinct from its owners. Personal transactions of the owner are not recorded in the firm's books.
Q 02
Equation
Easy
The basic accounting equation is:
View solution
Correct Option: B
Assets = Liabilities + Owner's Equity. The dual-aspect concept written as algebra.
Q 03
Conservatism
Medium
"Anticipate no profit but provide for all possible losses" is the essence of:
View solution
Correct Option: C
The convention of conservatism (prudence) requires recognising probable losses while deferring recognition of probable gains.
Q 04
Account Type
Medium
"Salary paid" account is best classified as a:
View solution
Correct Option: C
Expenses, losses, incomes and gains go to nominal accounts. Rule: debit all expenses and losses; credit all incomes and gains.
Q 05
Cash Flow
Medium
Under AS 3 / Ind AS 7, the purchase of a new piece of plant and machinery is classified under cash flows from:
View solution
Correct Option: B
Acquisition or disposal of long-term assets belongs to investing activities. Borrowings and equity issues are financing; payments to suppliers / employees are operating.
Q 06
Schedule III
Medium
The format for the financial statements of a company in India is laid down in:
View solution
Correct Option: B
Schedule III prescribes the format for the Balance Sheet and the Statement of Profit & Loss. (Schedule VII covers eligible CSR activities.)
Q 07
Ind AS
Medium
India's Indian Accounting Standards (Ind AS) are largely:
View solution
Correct Option: B
Ind AS is converged with IFRS (with limited carve-outs). Notified by the MCA based on standards drafted by ICAI.
Q 08
Branches
Easy
The branch of accounting most concerned with providing information to internal management for planning and control is:
View solution
Correct Option: B
Management accounting serves internal management. Financial accounting serves external users; cost accounting tracks costs.
ImportantQuick recall
- Accounting = identify, measure, record, classify, summarise, communicate financial information for decisions (AAA, 1966).
- Three branches: Financial · Cost · Management. Financial → external; Management → internal.
- GAAP = concepts (assumptions) + conventions. Eight concepts: business entity, going concern, money measurement, cost, dual aspect, accounting period, realisation, matching. Four conventions: consistency · conservatism · materiality · full disclosure.
- Accounting equation: Assets = Liabilities + Owner’s Equity.
- Three account types: Personal, Real, Nominal. Rules: receiver / what comes in / expenses & losses to debit; giver / what goes out / incomes & gains to credit.
- Three primary statements: P&L · Balance Sheet · Cash Flow. Cash flow has three activities: Operating · Investing · Financing (AS 3 / Ind AS 7).
- India: Schedule III of Companies Act 2013 prescribes financial-statement format. Ind AS converged with IFRS, notified by MCA, drafted by ICAI.