38  Accounting Principles and Financial Statements

38.1 What is Accounting?

The American Institute of Certified Public Accountants (AICPA, 1941) defined 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”. Luca Pacioli, the 15th-century Italian friar and mathematician, codified the double-entry system in his Summa de Arithmetica (1494) — and is called the father of accounting.

TipWorking definitions
Author / body Definition
AICPA (1941) “The art of recording, classifying, summarising… and interpreting financial transactions.”
AAA (American Accounting Association) “The process of identifying, measuring and communicating economic information to permit informed judgements and decisions.”
Robert N. Anthony “Accounting is a means of collecting, summarising, analysing and reporting in monetary terms, information about a business.”
Smith & Ashburne “Accounting is the science of recording and classifying business transactions and events and the art of making significant summaries, analyses and interpretations.”

38.2 Branches of Accounting

TipFour branches of accounting
Branch Focus Audience
Financial Accounting Recording and reporting past transactions; statements External — investors, creditors, tax
Cost Accounting Ascertain cost of products/services Internal management
Management Accounting Decision-support, planning, control Internal management
Tax Accounting Compliance with Income-tax Act, GST Tax authorities
Social / HR / Forensic / Environmental Accounting Specialised disciplines Various

38.3 Users of Accounting Information

TipUsers — internal and external
  • Owners / Shareholders — returns, growth.
  • Managers — operations, performance.
  • Lenders / Bankers — creditworthiness.
  • Suppliers / Creditors — payment ability.
  • Customers — continuity of supply.
  • Employees — job security, bargaining.
  • Government / Regulators — tax, statistics.
  • Tax authorities — compliance.
  • Society — social responsibility.

38.4 Accounting Principles — GAAP

Generally Accepted Accounting Principles (GAAP) = the body of concepts and conventions that underpin accounting practice. They are split into Concepts (assumptions) and Conventions (modifying principles).

38.4.1 Accounting Concepts (Assumptions)

TipMajor accounting concepts
Concept What it says
Business entity Business and owner are separate accounting entities
Money measurement Only money-measurable items are recorded
Going concern Business will continue indefinitely (basis for non-current/current split)
Cost concept (Historical cost) Assets recorded at acquisition cost, not current value
Dual aspect / Accounting equation Every transaction has two-fold effect — Assets = Liabilities + Capital
Accounting period Indefinite life split into periods (typically 1 year)
Accrual / Matching Recognise revenues when earned and expenses when incurred — match expenses with revenues
Realisation Revenue recognised when realised (sale completed, risk transferred)
Periodicity Periodic reporting of business performance
Objective evidence Each transaction backed by verifiable evidence

38.4.2 Accounting Conventions (Modifying Principles)

TipMajor accounting conventions
  • Consistency — same methods year-on-year.
  • Conservatism / Prudence — anticipate losses, not gains (“expect no profit but provide for all losses”).
  • Materiality — disclose what could influence decisions.
  • Full disclosure — financial statements and notes must reveal all material facts.
  • Substance over form — economic reality, not legal form.
NotePYQ cue — Convention of Conservatism

“Anticipate no profit but provide for all possible losses” — this proverb is the convention of conservatism / prudence. It explains why we make provisions for doubtful debts and value stock at lower of cost or market value.

38.5 The Accounting Equation

Assets = Liabilities + Capital (Owners’ Equity) — this is the fundamental accounting equation. Every transaction preserves it. In an extended form:

Assets = Liabilities + Capital + Revenues − Expenses − Drawings

38.6 Double-Entry Bookkeeping

Luca Pacioli (1494) — every transaction affects at least two accounts: one debited, one credited; debits = credits.

38.6.1 Rules — by Account Type

TipGolden rules of debit and credit
Account type Debit Credit
Personal (persons, firms) Receiver Giver
Real (assets) What comes in What goes out
Nominal (incomes, expenses, gains, losses) All expenses & losses All incomes & gains

38.6.2 Modern (American) Approach

TipModern approach — five account categories
Category Increase Decrease Normal balance
Assets Debit Credit Debit
Liabilities Credit Debit Credit
Capital / Equity Credit Debit Credit
Revenues Credit Debit Credit
Expenses Debit Credit Debit

38.7 The Accounting Cycle

flowchart LR
  T[Transactions] --> J[Journal<br/>book of original entry]
  J --> L[Ledger<br/>book of secondary entry]
  L --> TB[Trial Balance]
  TB --> AdJ[Adjusting Entries]
  AdJ --> FS[Financial Statements<br/>P&L, BS, Cash Flow]
  FS --> C[Closing Entries]
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

TipSteps of the accounting cycle
  1. Identify and analyse transactions (with vouchers).
  2. Record in the Journal (book of original entry).
  3. Post to the Ledger (book of secondary entry).
  4. Prepare the Trial Balance.
  5. Pass adjusting entries (accruals, prepayments, depreciation, provisions).
  6. Prepare the Adjusted Trial Balance.
  7. Prepare the Financial Statements — P&L, Balance Sheet, Cash Flow.
  8. Closing entries — close nominal accounts to P&L.
  9. Carry forward balances of real and personal accounts.

38.8 Financial Statements — Three Statements

TipThree core financial statements
Statement What it shows Period
Income Statement (P&L) Revenues − Expenses = Profit For the period
Balance Sheet (Statement of Financial Position) Assets = Liabilities + Equity At a point in time
Cash Flow Statement Sources and uses of cash For the period
Statement of Changes in Equity Movement in shareholders’ funds For the period
Notes to Accounts Disclosures and policies —

38.8.1 Income Statement Structure

TipIncome statement — common format
  • Revenue from operations
  • Less: Cost of goods sold (COGS) — Opening stock + Purchases − Closing stock
  • = Gross Profit
  • Less: Operating expenses — admin, selling, distribution
  • = Operating Profit (EBIT)
  • Less: Interest
  • = Profit Before Tax (PBT / EBT)
  • Less: Tax
  • = Profit After Tax (PAT / Net Profit)

38.8.2 Balance Sheet Structure (Indian Schedule III format)

TipBalance Sheet — Schedule III (Companies Act 2013)
Side Items
EQUITY & LIABILITIES (1) Shareholders’ funds — Share Capital + Reserves & Surplus
(2) Non-current liabilities — Long-term borrowings, deferred tax
(3) Current liabilities — Trade payables, short-term borrowings, provisions
ASSETS (1) Non-current assets — Fixed assets (Tangible/Intangible), Investments, Loans
(2) Current assets — Inventory, Receivables, Cash, Short-term investments

38.8.3 Cash Flow Statement — Three Activities

AS-3 / Ind AS-7 — classify cash flows into:

TipThree activities in cash-flow statement
Activity Examples
Operating Receipts from customers, payments to suppliers/employees, tax paid
Investing Purchase/sale of fixed assets, investments, loans given
Financing Issue/buy-back of shares, borrowings, dividends paid

Two methods of preparing operating activities — Direct (each major cash receipt/payment shown) and Indirect (start from PAT and adjust). Most listed firms use indirect.

38.9 Inventory Valuation Methods

TipInventory valuation — common methods
  • FIFO (First-in-First-out) — oldest stock issued first.
  • LIFO (Last-in-First-out) — newest stock issued first (not permitted under IFRS/Ind AS).
  • Weighted Average — average cost across stock.
  • Specific Identification — actual cost of each item (jewellery, automobiles).
  • Standard Cost.
  • Lower of Cost or Net Realisable Value (NRV) — convention of conservatism; AS-2.

38.10 Depreciation

Depreciation = systematic allocation of the depreciable amount of a tangible asset over its useful life. Governed by AS-10 / Ind AS-16.

TipDepreciation methods
Method Formula
Straight-Line (SLM) (Cost − Scrap) / Useful Life
Written-Down Value (WDV) / Reducing Balance % rate on book value each year
Units of Production Based on output / hours used
Sum-of-Years’ Digits (SYD) Accelerated; based on weighted years
Double-Declining Balance Twice the SLM rate on WDV
Annuity / Sinking Fund Considers interest on capital invested

Causes: wear and tear, obsolescence, time, accidents, depletion (for wasting assets). Companies Act 2013 Schedule II — useful-life-based depreciation replaced rates-based Schedule XIV (2014).

38.11 Indian Accounting Standards (Ind AS)

TipIndian accounting standards landscape
  • ICAI issues Accounting Standards (AS) — since 1977.
  • NACAS (now NFRA) recommends to govt.
  • Indian Accounting Standards (Ind AS) = IFRS-converged standards; notified 2015; rolled out in phases from FY 2016-17.
  • NFRA (National Financial Reporting Authority) — set up under Companies Act 2013, Sec 132; operational from 2018.
  • Ind AS coverage — listed companies + unlisted with net worth ≥ ₹250 cr (mandatory).
  • AS coverage — small and medium companies, partnerships, etc.
NoteKey Ind AS / IFRS
  • Ind AS 1 / IAS 1 — Presentation of Financial Statements.
  • Ind AS 2 / IAS 2 — Inventories.
  • Ind AS 7 / IAS 7 — Statement of Cash Flows.
  • Ind AS 16 / IAS 16 — Property, Plant & Equipment.
  • Ind AS 115 / IFRS 15 — Revenue from Contracts with Customers (5-step model).
  • Ind AS 116 / IFRS 16 — Leases (operating leases now on balance sheet).
  • IFRS 9 — Financial Instruments (expected credit loss).

38.12 Companies Act 2013 — Accounting Provisions

TipCompanies Act 2013 — key accounting provisions
  • Sec 2(40) — definition of financial statement.
  • Sec 128 — books of accounts to be kept at registered office.
  • Sec 129 — financial statements to give a true and fair view.
  • Schedule III — format of balance sheet and P&L.
  • Schedule II — useful-life-based depreciation.
  • Sec 132 — NFRA.
  • Sec 134 — board’s report.
  • Sec 135 — CSR (2 % of net profit for eligible companies).
  • Sec 138 — internal audit.
  • Sec 139-148 — auditor provisions.
  • Sec 143 — auditor’s duties.

38.13 Audit and Audit Reports

Audit = independent examination of financial statements to express an opinion on truth and fairness.

TipTypes of audit reports (SA-700 series)
  • Unmodified / Unqualified (Clean) — fair view; no reservations.
  • Qualified — “except for” certain matters.
  • Adverse — financial statements do not give a true and fair view.
  • Disclaimer — auditor unable to obtain sufficient evidence.

Key Audit Matters (KAM) — SA-701 — significant audit issues highlighted in the report. Mandatory for listed entities from 2018.

38.14 True and Fair View

The cornerstone of financial reporting. Companies Act 2013 Sec 129(1) — every financial statement shall give a true and fair view of the state of affairs of the company. Where there is conflict between law and economic substance, substance over form prevails.

38.16 Practice Questions

Q 01 Pacioli Easy

The "father of accounting" credited with codifying the double-entry system in 1494 is:

  • ALuca Pacioli
  • BAdam Smith
  • CJohn Stuart Mill
  • DFrederick Taylor
View solution
Correct Option: A
Luca Pacioli, *Summa de Arithmetica* (1494) — Venice.
Q 02 Equation Easy

The fundamental accounting equation is:

  • AAssets = Liabilities − Capital
  • BAssets = Liabilities + Capital
  • CCapital = Assets + Liabilities
  • DLiabilities = Capital − Assets
View solution
Correct Option: B
Assets = Liabilities + Capital. Reflects the dual-aspect concept.
Q 03 Conservatism Medium

"Anticipate no profit but provide for all possible losses" is the:

  • AConvention of consistency
  • BConvention of conservatism
  • CConvention of materiality
  • DConvention of full disclosure
View solution
Correct Option: B
Convention of conservatism / prudence.
Q 04 Going concern Medium

The assumption that the business will continue indefinitely is the:

  • AMoney measurement concept
  • BCost concept
  • CGoing concern concept
  • DAccrual concept
View solution
Correct Option: C
Going concern — basis for non-current vs current classification.
Q 05 LIFO Medium

Which inventory valuation method is NOT permitted under Ind AS / IFRS?

  • AFIFO
  • BLIFO
  • CWeighted Average
  • DSpecific identification
View solution
Correct Option: B
LIFO is not permitted under IFRS / Ind AS-2.
Q 06 Cash flow Medium

Cash paid to suppliers is a cash flow under which activity?

  • AOperating
  • BInvesting
  • CFinancing
  • DNon-cash
View solution
Correct Option: A
Operating activities (AS-3 / Ind AS-7).
Q 07 Schedule III Medium

The format of Indian company financial statements is prescribed by:

  • ASchedule I
  • BSchedule II
  • CSchedule III
  • DSchedule V
View solution
Correct Option: C
Schedule III — Companies Act 2013.
Q 08 Schedule II Hard

Useful-life-based depreciation under the Companies Act 2013 is prescribed in:

  • ASchedule I
  • BSchedule II
  • CSchedule III
  • DSchedule VI
View solution
Correct Option: B
Schedule II — useful-life-based; replaced Schedule XIV of 1956 Act.
Q 09 NFRA Hard

The National Financial Reporting Authority (NFRA) was set up under which section of the Companies Act 2013?

  • ASection 129
  • BSection 132
  • CSection 135
  • DSection 143
View solution
Correct Option: B
Section 132 — NFRA replaces NACAS; operational from 2018.
Q 10 Ind AS 116 Hard

Ind AS 116 / IFRS 16 covers:

  • ARevenue from contracts with customers
  • BLeases
  • CFinancial instruments
  • DInventories
View solution
Correct Option: B
Leases — operating leases now on balance sheet.
Q 11 Real account Easy

For a "real account" the golden rule is:

  • ADebit the receiver, Credit the giver
  • BDebit what comes in, Credit what goes out
  • CDebit all expenses, Credit all incomes
  • DDebit all incomes, Credit all expenses
View solution
Correct Option: B
Real account — Debit what comes in, Credit what goes out.
Q 12 Trial balance Medium

The Trial Balance is prepared:

  • ABefore posting to the ledger
  • BAfter posting to the ledger
  • CAs the first step of the cycle
  • DAfter preparing the balance sheet
View solution
Correct Option: B
Trial Balance comes after ledger posting and before financial statements.
Q 13 Accrual Medium

The matching concept relates revenues with:

  • ACash receipts
  • BExpenses incurred to earn them
  • CCapital introduced
  • DDrawings
View solution
Correct Option: B
Matching = revenue + the expenses incurred to earn it.
Q 14 Adverse audit Hard

When the auditor concludes that financial statements do NOT give a true and fair view, the report is:

  • AUnqualified
  • BQualified
  • CAdverse
  • DDisclaimer
View solution
Correct Option: C
Adverse report — financial statements do not give a true and fair view.
Q 15 XBRL Hard

XBRL stands for:

  • AeXtensible Business Reporting Language
  • BeXtra Business Records Ledger
  • CeXchange of Banking Receipts List
  • DeXtensible Balance-sheet Reporting Lite
View solution
Correct Option: A
eXtensible Business Reporting Language — mandatory for listed Indian companies via MCA.
Q 16 SLM Easy

Under SLM, depreciation is calculated as:

  • A% of book value each year
  • B(Cost − Scrap) ÷ Useful life
  • CCost ÷ Output produced
  • DAnnuity-based
View solution
Correct Option: B
SLM = (Cost − Scrap) ÷ Useful Life.
Q 17 Sec 135 Medium

Section 135 of the Companies Act 2013 mandates CSR spending of:

  • A1 % of 3-year avg net profit
  • B2 % of 3-year avg net profit
  • C5 % of revenue
  • D10 % of profit
View solution
Correct Option: B
2 % of 3-year average net profit for eligible companies.
Q 18 Integrated Reporting Hard

The Integrated Reporting (IR) Framework (2013) was issued by:

  • AIIRC
  • BGRI
  • CIFRS Foundation
  • DICAI
View solution
Correct Option: A
IIRC — International Integrated Reporting Council; now merged with SASB into Value Reporting Foundation, then ISSB.
Q 19 Substance over form Medium

When economic reality differs from legal form, accountants should report:

  • ALegal form
  • BSubstance over form
  • CTax form
  • DOwner's preference
View solution
Correct Option: B
Substance over form — economic reality prevails.
Q 20 Match standards Hard

Match the Ind AS / IFRS with its subject:

(i) Ind AS 2 / IAS 2 (a) Revenue from Contracts
(ii) Ind AS 7 / IAS 7 (b) Cash Flow Statement
(iii) Ind AS 115 / IFRS 15 (c) Inventories
(iv) Ind AS 116 / IFRS 16 (d) Leases
  • A(i)-(c), (ii)-(b), (iii)-(a), (iv)-(d)
  • B(i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
  • C(i)-(d), (ii)-(a), (iii)-(b), (iv)-(c)
  • D(i)-(b), (ii)-(c), (iii)-(d), (iv)-(a)
View solution
Correct Option: A
Inventories — IAS 2; Cash Flow — IAS 7; Revenue — IFRS 15; Leases — IFRS 16.

38.16.1 Advanced Format Questions

AR 1Assertion-ReasonHard

A: Going concern assumption underpins historical cost.
R: Firm is assumed to continue operations indefinitely.

  • ABoth true; R explains A
  • BBoth true; R does not explain A
  • CA true, R false
  • DA false, R true
View solution
Correct Option: A
S 1Statement-basedMedium

Accounting concepts: (i) Going concern. (ii) Accrual. (iii) Consistency. (iv) Prudence.

  • AAll four
  • B(i) and (ii) only
  • C(iii) and (iv) only
  • D(i), (ii), (iii) only
View solution
Correct Option: A
N 1NumericalMedium

Assets ₹10 lakh; Liabilities ₹4 lakh. Owner's Equity is:

  • A₹6 lakh
  • B₹14 lakh
  • C₹4 lakh
  • D₹40 lakh
View solution
Correct Option: A
A = L + E → E = 10 − 4 = 6.
N 2NumericalHard

Cost ₹1,00,000; salvage ₹10,000; life 5 yrs. SLM depreciation per year:

  • A₹18,000
  • B₹20,000
  • C₹22,000
  • D₹10,000
View solution
Correct Option: A
(1,00,000 − 10,000)/5 = 18,000.

38.17 Quick Recall

ImportantQuick recall
  • Pacioli (1494) — father of accounting; double-entry; Summa de Arithmetica.
  • AICPA 1941 definition: art of recording, classifying, summarising, interpreting financial transactions.
  • Branches: Financial · Cost · Management · Tax · Forensic · HR · Social · Environmental.
  • Concepts: Business entity · Money measurement · Going concern · Cost · Dual aspect (A = L + C) · Accounting period · Accrual/Matching · Realisation · Periodicity · Objective evidence.
  • Conventions: Consistency · Conservatism/Prudence (“no profit, all losses”) · Materiality · Full disclosure · Substance over form.
  • Accounting equation: Assets = Liabilities + Capital (+ Revenue − Expenses − Drawings).
  • Golden rules — Personal (Receiver/Giver) · Real (Comes in/Goes out) · Nominal (Expenses-Losses/Incomes-Gains).
  • Modern rules by 5 categories: Asset, Liability, Equity, Revenue, Expense.
  • Accounting cycle: Transaction → Journal → Ledger → TB → Adjusting → FS → Closing.
  • 3 statements: P&L · Balance Sheet · Cash Flow (+ Statement of Changes in Equity + Notes).
  • Income statement flow: Revenue → COGS → GP → Opex → EBIT → Interest → PBT → Tax → PAT.
  • Indian BS: Schedule III — Equity & Liabilities + Assets, with non-current and current split.
  • Cash Flow (AS-3 / Ind AS-7): Operating · Investing · Financing; Direct vs Indirect method.
  • Inventory: FIFO · Weighted Avg · Specific ID · NRV; LIFO not allowed under IFRS/Ind AS-2.
  • Depreciation (AS-10 / Ind AS-16): SLM · WDV · Units of Production · SYD · Annuity. Companies Act 2013 Schedule II — useful-life-based.
  • Ind AS (IFRS-converged) — phased from FY 2016-17 for listed + ≥ ₹250 cr.
  • NFRA — Sec 132, replaced NACAS (2018).
  • Key Ind AS: 1 (Presentation) · 2 (Inventory) · 7 (Cash Flow) · 16 (PPE) · 115 (Revenue, 5-step) · 116 (Leases, on-BS).
  • Companies Act 2013: Sec 128 (books) · 129 (true & fair view) · 132 (NFRA) · 134 (board report) · 135 (CSR 2 %) · 138 (internal audit) · 143 (auditor).
  • Audit reports: Unqualified · Qualified · Adverse · Disclaimer; KAM (SA-701).
  • Modern trends: IFRS convergence · Integrated Reporting (IIRC 2013) · ESG/sustainability · AI in audit · Blockchain · Cloud accounting · XBRL · Forensic accounting.