Big picture
If every accountant recorded transactions their own way, nobody could trust or compare financial statements. So accounting follows a common set of rules: generally accepted accounting principles (GAAP), built on basic accounting concepts, and formalised in accounting standards.
These concepts explain why we record things the way we do: why the owner's capital is a liability of the business, why a building is shown at cost, why we expect losses but not gains. Exam questions give a situation and ask which concept applies or is violated.
Learning goals
Explain generally accepted accounting principles.
Explain each basic accounting concept with an example.
Distinguish the cash and accrual bases of accounting.
Explain accounting standards, Ind AS and IFRS.
Explain the basic features of the Goods and Services Tax (GST).
Core ideas
1. Generally accepted accounting principles (GAAP)
GAAP are the rules and guidelines adopted for recording and reporting business transactions, so that financial statements are uniform and consistent. They have evolved over time from experience, usage and the advice of professional bodies. They are not rigid laws; they change as business needs change.
2. Basic accounting concepts
Concept | Meaning | Example |
|---|---|---|
Business entity | The business is separate from its owner. Transactions are recorded from the business's point of view | The owner's capital is shown as a liability of the business; the owner's personal electricity bill is not a business expense |
Money measurement | Only transactions that can be expressed in money are recorded | The appointment of a skilled manager is not recorded, but their salary is |
Going concern | The business is assumed to continue for the foreseeable future | Fixed assets are shown at cost less depreciation, not at what they would fetch if sold today |
Accounting period | The life of the business is divided into periods (usually a year) for preparing statements | Financial statements are prepared for 1 April to 31 March |
Cost | Assets are recorded at the price paid to acquire them, including costs to bring them into use | Land bought for ₹10 lakh plus ₹50,000 registration is recorded at ₹10.5 lakh, even if its market value later rises to ₹15 lakh |
Dual aspect | Every transaction has two aspects, a debit and a credit, of equal amount. This gives the accounting equation: Assets = Liabilities + Capital | Buying machinery for cash: machinery increases and cash decreases |
Revenue recognition (realisation) | Revenue is recognised when it is earned, that is when goods are sold or services rendered, not when cash is received | Goods sold on credit in March are revenue for March, even if payment comes in April |
Matching | Expenses of a period are matched against the revenue of that period | March salaries paid in April are an expense of March |
Full disclosure | All material information must be disclosed in the financial statements | Notes to accounts on contingent liabilities and accounting policies |
Consistency | The same accounting policies are followed from year to year | A firm using the straight-line method of depreciation continues to use it; any change must be disclosed |
Conservatism (prudence) | Anticipate no profits, but provide for all possible losses | Making a provision for doubtful debts; valuing stock at cost or net realisable value, whichever is lower |
Materiality | Only items significant enough to affect users' decisions need separate attention | A stapler costing ₹200 is treated as an expense, not as a fixed asset |
Objectivity | Transactions should be recorded on the basis of verifiable evidence, free from personal bias | A purchase is recorded from the supplier's invoice |
Conservatism and stock. Closing stock costs ₹50,000 but its net realisable value is ₹45,000. It is valued at ₹45,000 (lower of the two). If its realisable value were ₹60,000, it would still be shown at the cost of ₹50,000, because unrealised profit is not recognised.
3. Cash basis and accrual basis
Basis | Meaning | Example |
|---|---|---|
Cash basis | Transactions are recorded only when cash is received or paid | Salary for March paid in April is recorded in April |
Accrual basis | Revenue is recorded when earned and expenses when incurred, whether or not cash is received or paid | Salary for March is recorded in March as outstanding, even though it is paid in April |
Example. In 2024-25 a firm earned fees of ₹5,00,000, of which ₹40,000 is still to be received. It paid expenses of ₹3,00,000, of which ₹20,000 relates to the previous year, and ₹15,000 of this year's expenses is outstanding.
Cash basis | Accrual basis | |
|---|---|---|
Revenue | 5,00,000 − 40,000 = 4,60,000 | 5,00,000 |
Expenses | 3,00,000 | 3,00,000 − 20,000 + 15,000 = 2,95,000 |
Profit | 1,60,000 | 2,05,000 |
The accrual basis gives a truer picture of the period's profit, and is required for companies. It applies the revenue recognition and matching concepts.
4. Accounting standards
Accounting standards are written statements of uniform accounting rules and guidelines issued by an expert body, to bring uniformity and comparability to financial statements. In India, the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI) formulates them, and the government notifies them.
Benefits: they bring uniformity, which helps comparison; increase reliability and credibility of statements; reduce scope for manipulation; and help auditors.
Limitations: they may be rigid and not suit every case; some leave room for alternative treatments; and they cannot override the law.
Ind AS and IFRS. International Financial Reporting Standards (IFRS) are issued by the International Accounting Standards Board so that financial statements are comparable worldwide. India has converged its standards with IFRS as Indian Accounting Standards (Ind AS), applicable to listed companies and companies above specified net worth. Benefits of convergence: global comparability, easier access to foreign capital, and better investor confidence.
5. Goods and Services Tax (GST)
GST, introduced on 1 July 2017, is a comprehensive, destination-based indirect tax on the supply of goods and services. It replaced many central and state taxes (excise duty, service tax, VAT and others). It is "one nation, one tax".
Component | Levied on | Collected by |
|---|---|---|
CGST (Central GST) | Intra-state supply (within a state) | Central government |
SGST (State GST) | Intra-state supply | State government |
UTGST | Intra-union territory supply | Union territory |
IGST (Integrated GST) | Inter-state supply (between states) and imports | Central government, which shares it with the destination state |
Example. A trader in Pune sells goods worth ₹10,000 with GST at 18%.
To a buyer in Mumbai (same state, intra-state): CGST 9% = ₹900 and SGST 9% = ₹900. Invoice total = ₹11,800.
To a buyer in Bengaluru (different state, inter-state): IGST 18% = ₹1,800. Invoice total = ₹11,800.
Input tax credit (ITC). A business can set off the GST it paid on purchases (input tax) against the GST it collects on sales (output tax), and pays only the difference. If the trader paid GST of ₹1,200 on its purchases and collected ₹1,800 on sales, it pays only ₹600. This removes the "tax on tax" (cascading effect) of the old system.
Advantages of GST: it removes the cascading effect of taxes; creates a common national market; simplifies compliance with online filing; and widens the tax base.
A reliable approach to case-based questions
Owner's personal expenses or capital: business entity.
Something important but not measurable in money: money measurement.
Assets at cost, not current market value: cost concept (and going concern).
Revenue or expense recorded when earned or incurred, not when cash moves: revenue recognition, matching and accrual.
Providing for losses but not for gains: conservatism.
Same method every year: consistency; small items expensed: materiality.
Connections that matter
Introduction to accounting defines the terms these concepts govern.
Recording of transactions uses the dual aspect concept and the accounting equation.
Depreciation, provisions and reserves applies conservatism and matching.
Financial statements apply accrual, matching and full disclosure through adjustments.
Common mistakes
Mixing up revenue recognition and matching. Revenue recognition decides when revenue is recorded; matching decides which expenses belong to that revenue.
Applying conservatism to profits. Conservatism anticipates losses, not profits.
Using market value for fixed assets. The cost concept records them at cost.
Calling GST a direct tax.
Using CGST and SGST for an inter-state sale. Inter-state sales attract IGST.
Revision checklist
I can explain GAAP and why it is needed.
I can explain all thirteen concepts with examples.
I can calculate profit on cash and accrual bases.
I can explain accounting standards, Ind AS and IFRS.
I can explain GST components, input tax credit and their advantages.