Theoretical Framework

The One Thing

Accounting is a systematic process that extends beyond bookkeeping: it identifies, measures, records, classifies, summarises, analyses, interprets and communicates financial information. Its theoretical framework uses concepts, conventions and standards to produce information that is consistent, reliable, relevant, comparable and useful for economic decision-making.

Definitions and Results

• Accounting: The process of recording, classifying, summarising, analysing and communicating financial transactions and events.
• Bookkeeping: The systematic recording of financial transactions in the books of account; it is a part of accounting.
• Objectives of Accounting: To maintain systematic records, calculate profit or loss, determine financial position, provide information for decision-making and help meet legal requirements.
• Accounting Information: Financial information presented through records and reports to help users understand the performance and position of a business.
• Internal Users: People within the organisation, mainly management and employees, who use accounting information for planning, control and decision-making.
• External Users: People or organisations outside the business, such as investors, lenders, suppliers, customers, government agencies and the public, who use accounting information for different decisions.
• Business Entity Concept: The business is treated as separate from its owner or owners, so business transactions are recorded separately from personal transactions.
• Money Measurement Concept: Only transactions and events that can be measured reliably in monetary terms are recorded in accounting.
• Going Concern Concept: It is assumed that the business will continue operating for the foreseeable future and will not close or significantly reduce its activities soon.
• Accounting Period Concept: The continuous life of a business is divided into shorter periods, usually one year, to measure performance and financial position. In India, the accounting period is commonly the financial year from 1 April to 31 March, although other appropriate periods may be used when required.
• Cost Concept: Assets are generally recorded at their acquisition cost, including costs necessary to bring them into usable condition.
• Dual Aspect Concept: Every financial transaction has two aspects, and both aspects are recorded. This forms the basis of the accounting equation.
• Accounting Equation:

$$\text{Assets}=\text{Capital}+\text{Liabilities}$$

• Capital:

$$\text{Capital}=\text{Assets}-\text{Liabilities}$$

• Revenue Recognition Concept: Revenue is recognised when it is earned, generally when goods or services are provided, rather than simply when cash is received.
• Matching Concept: Expenses are recognised in the same accounting period as the revenues they help to generate. The cost of goods sold and other related expenses are matched with the revenue earned during the same period.
• Accrual Concept: Income and expenses are recorded when they are earned or incurred, not necessarily when cash is received or paid. Outstanding expenses, prepaid expenses, accrued income and income received in advance are adjusted so that the correct period’s income and expenses are reported.
• Profit or Loss:

$$\text{Profit or Loss}=\text{Revenue}-\text{Expenses}$$

• Conservatism or Prudence Convention: Expected losses should be recognised, but anticipated profits should not be recorded until they are reasonably certain.
• Consistency Convention: The same accounting methods should be used from one period to another so that financial results can be compared.
• Materiality Convention: Items that could influence users’ decisions should be shown separately or given proper attention, while insignificant items may be treated more simply.
• Full Disclosure Convention: All significant information necessary for understanding financial statements should be disclosed clearly.
• Objectivity Principle: Accounting records should be based, as far as possible, on verifiable evidence such as invoices, receipts, contracts and bank statements.
• Generally Accepted Accounting Principles: The commonly accepted concepts, principles, conventions and procedures used as the foundation for preparing accounts.
• Accounting Standards: Formal written guidelines that prescribe how particular accounting transactions and events should be recognised, measured, presented and disclosed.
• Comparability: The quality that allows users to compare financial information across different periods or between different businesses.
• Reliability: The quality of accounting information that makes it dependable, supported by evidence and free from significant error or bias.
• Relevance: The quality of information that makes it useful for predicting outcomes, confirming past decisions or making present decisions.
• Understandability: Financial information should be presented clearly so that users with reasonable knowledge of business and accounting can understand it.

Worked Methods

1. Applying the accounting process

The accounting process proceeds in the following order:

• Identify financial transactions and events.
• Measure those transactions in monetary terms.
• Record them in the accounting records.
• Classify them into appropriate accounts.
• Summarise the information.
• Analyse and interpret the results.
• Communicate the results to users.

Accounting records generally include only transactions that can be measured in monetary terms. Consequently, qualitative factors such as employee morale or brand reputation are not ordinarily recorded.

2. Applying the accounting equation

For every financial transaction, identify both aspects and maintain:

$$\text{Assets}=\text{Capital}+\text{Liabilities}$$

When assets and liabilities are known, calculate capital as:

$$\text{Capital}=\text{Assets}-\text{Liabilities}$$

The dual aspect concept requires both aspects of every transaction to be recorded.

3. Determining profit or loss

• Identify the revenue earned during the relevant accounting period.
• Identify the expenses relating to that period.
• Apply:

$$\text{Profit or Loss}=\text{Revenue}-\text{Expenses}$$

Under the matching concept, the cost of goods sold and other related expenses must be matched with the revenue earned during the same period.

4. Applying accrual accounting

• Record income when it is earned and expenses when they are incurred.
• Do not restrict recognition to the dates on which cash is received or paid.
• Adjust for:

- outstanding expenses; - prepaid expenses; - accrued income; and - income received in advance.

• Report the income and expenses belonging to the correct accounting period.

5. Preparing information for users

Accounting information is prepared for:

• Internal users, particularly management and employees, for planning, control and decision-making.
• External users, including owners, investors, lenders, suppliers, customers, government agencies and the public, for decisions concerning investment, lending, supply, regulation and other economic matters.

Financial statements generally communicate information about profitability, financial position, cash-related information, accounting policies and significant disclosures.

6. Applying accounting principles, conventions and standards

• Treat the business as separate from its owner under the business entity concept.
• Record only reliably measurable monetary transactions under the money measurement concept.
• Assume continued operation under the going concern concept.
• Divide the life of the business into accounting periods.
• Record assets generally at acquisition cost.
• Apply the dual aspect concept and accounting equation.
• Recognise revenue when earned.
• Match related expenses with revenue.
• Apply accrual accounting.
• Apply prudence, consistency, materiality and full disclosure in presentation.
• Support records with objective evidence.
• Follow applicable Generally Accepted Accounting Principles and accounting standards.

Accounting standards improve uniformity, reduce alternative treatments, increase transparency and support comparison between financial statements.

Where It Goes Wrong

• Treating accounting as only the recording of transactions and omitting classification, summarising, analysis, interpretation and communication.
• Recording personal transactions with business transactions, contrary to the business entity concept.
• Recording events that cannot be measured reliably in monetary terms, or forgetting that qualitative factors such as employee morale and brand reputation are generally excluded.
• Recognising revenue merely when cash is received instead of when goods or services are provided.
• Recording income and expenses on a cash basis without adjusting for outstanding expenses, prepaid expenses, accrued income and income received in advance.
• Forgetting that the same accounting methods should be used from one period to another, or failing to disclose significant information required for understanding financial statements.

What Gets Asked

This material supports questions requiring students to:

• Define accounting, bookkeeping, accounting information, accounting standards and the main accounting concepts and conventions.
• Distinguish accounting from bookkeeping.
• State the objectives of accounting and identify internal and external users.
• Explain and apply the accounting equation:

$$\text{Assets}=\text{Capital}+\text{Liabilities}$$

• Rearrange the equation to calculate:

$$\text{Capital}=\text{Assets}-\text{Liabilities}$$

• Calculate profit or loss using:

$$\text{Profit or Loss}=\text{Revenue}-\text{Expenses}$$

• Explain the business entity, money measurement, going concern, accounting period, cost, dual aspect, revenue recognition, matching and accrual concepts.
• Explain the treatment of outstanding expenses, prepaid expenses, accrued income and income received in advance under accrual accounting.
• Explain the conventions of prudence, consistency, materiality and full disclosure.
• Discuss the importance of objectivity, Generally Accepted Accounting Principles and accounting standards.
• Explain how accounting information supports decision-making by owners, managers, investors, lenders, employees, suppliers, customers, government authorities and the public.
• Discuss the qualities of comparability, reliability, relevance and understandability.
• Explain the limitations of accounting, including dependence on monetary measurement, the use of estimates and judgments, the possible influence of accounting methods, and the inability to record many qualitative factors.