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Theoretical Framework

Accounting is the language of business. Just like any language, it needs rules to be understood universally. This chapter introduces you to the "grammar" of accounting—the fundamental concepts, principles, and conventions that ensure financial statements are consistent, reliable, and comparable globally.

Unit 1: Meaning and Scope of Accounting

"Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof." — American Institute of Certified Public Accountants (AICPA)

What Does Accounting Actually Do?

Think of accounting as the GPS of business. It tells you:

Where you are (Financial Position via Balance Sheet)
How you got here (Profit/Loss via P&L Account)
Where you're headed (Forecasts and Budgets)

1. Identifying

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2. Recording

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3. Classifying

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4. Summarizing

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5. Analyzing

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6. Interpreting

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7. Communicating

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Objectives of Accounting

Note

What Accounting Achieves:

Systematic Record-Keeping: Every transaction is documented with proof.
Profit/Loss Calculation: Know if you're making money or burning it.
Financial Position: Snapshot of assets and liabilities on a specific date.
Decision Support: Provides data for investors, creditors, management, and government.
Legal Compliance: Required by law for companies (Companies Act, 2013).

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Sub-fields of Accounting

Financial Accounting: External reporting (P&L, Balance Sheet) for investors and regulators.
Cost Accounting: Internal cost analysis to control expenses and price products.
Management Accounting: Forward-looking data for strategic decisions (budgets, forecasts).
Tax Accounting: Preparation of tax returns and tax planning.
Auditing: Verification of financial statements for accuracy and compliance.

Unit 2: Accounting Concepts, Principles, and Conventions

These are the GAAP (Generally Accepted Accounting Principles) — the golden rules that make accounting consistent worldwide.

Key Distinction:

Concepts = Assumptions (What we assume to be true)
Principles = Rules (How we record)
Conventions = Traditions (Customs followed over time)

1. Accounting Concepts (The Assumptions)

A. Business Entity Concept

"The business and the owner are two separate persons."

This is the most fundamental concept in accounting.

Why it matters: If Mukesh Ambani buys a ₹5 Crore painting for his personal collection using Reliance's funds, it is recorded as Drawings (reducing his capital), NOT as a company asset.
Impact: This is why Capital appears on the Liabilities side of the Balance Sheet—the business "owes" this money back to the owner.
Example: You start a shop with ₹10 Lakhs. Accounting Entry:
```
Cash A/c       Dr.   ₹10,00,000
    To Capital A/c         ₹10,00,000
```
The business now has a ₹10 Lakh "debt" to you.

B. Money Measurement Concept

"Only what can be measured in money is recorded."

Accounting only captures transactions with a monetary value.

Recorded: Purchase of machinery for ₹50,000, Salary expense ₹30,000.
Not Recorded: The skill of your manager, employee morale, brand reputation (unless you're valuing Goodwill during acquisition).
Limitation: Ignores inflation. A factory purchased in 1990 for ₹1 Crore still appears at ₹1 Crore (less depreciation) in 2024 books, even if it's worth ₹50 Crores today.

C. Going Concern Concept

"The business will continue forever."

We assume the business won't shut down in the near future.

Why it matters: This is the entire reason we charge Depreciation. If we thought the business would close next month, we'd sell all assets at their liquidation value (what they'd fetch in a fire sale), not depreciate them over 10 years.
Example: Tata Motors invests ₹10,000 Crores in building a new factory. They're betting the factory will produce cars for decades, not just one year.
Exception: If a company is facing bankruptcy, auditors mention "Going Concern Doubt" in their report.

D. Accounting Period Concept

"Life of business is divided into small time intervals."

Since a business theoretically lives forever (Going Concern), we can't wait until it closes to calculate profit. We divide its life into periods—usually 1 year (April 1 to March 31 in India)—to measure performance.

Why: Investors want to know how you did this year, not in 2050.
Result: Financial statements are prepared annually (or quarterly for listed companies).

E. Cost Concept (Historical Cost)

"Assets are recorded at the price originally paid, not their current market value."

Example: Reliance purchased land in Mumbai for ₹10 Crores in 2005. Today, it's worth ₹500 Crores. In the Balance Sheet, it still appears at ₹10 Crores.
Why? Market values fluctuate daily and are subjective. Purchase price is a verified fact (you have the invoice).
Criticism: This makes Balance Sheets "outdated" in inflationary economies.

F. Dual Aspect Concept

"For every debit, there is an equal and opposite credit."

This is the heart of Double Entry Bookkeeping.

Formula: Assets = Liabilities + Capital
Example: You buy a laptop for ₹60,000 cash.
- Laptop (Asset) increases by ₹60,000.
- Cash (Asset) decreases by ₹60,000.
- Net effect on total assets: ZERO. The equation stays balanced.

G. Accrual Concept

"Revenue is recognized when earned, not when cash is received."

Example: You sold goods worth ₹1 Lakh to a customer on March 28th (credit sale). Customer pays on April 10th.
- Question: Which year does the revenue belong to?
- Answer: Current year (ending March 31st), because ownership transferred on March 28th.
Impact: This gives rise to Debtors (customers who owe you) and Creditors (suppliers you owe).

2. Accounting Principles (The Rules)

A. Matching Principle

"Match expenses to the revenue they helped generate."

To find true profit, deduct expenses of the same period as the revenue, regardless of cash payment.

Example: Zomato pays delivery boys' salaries on 5th April for deliveries made in March. The salary expense belongs to March (when revenue was earned).
Result: Creates Outstanding Expenses (unpaid but incurred) and Prepaid Expenses (paid but not yet incurred).

B. Realization Principle (Revenue Recognition)

"Revenue is booked when the sale is legally complete, not when cash is received."

Trigger: Transfer of ownership (delivery of goods or completion of service).
Not Trigger: Receiving cash.
Example: Amazon delivers your order on Dec 30th but you pay on Jan 5th. Amazon books revenue in December.

3. Accounting Conventions (The Traditions)

A. Convention of Conservatism (Prudence)

"Anticipate no profit, but provide for all possible losses."

This is the golden rule of "playing it safe." Never overstate profits or assets.

Application: Closing Stock is valued at Cost or Net Realizable Value (NRV), whichever is lower.
- You bought phones for ₹15,000 each. Market price drops to ₹12,000. Value them at ₹12,000 (lower).
- If market price rises to ₹18,000, keep them at ₹15,000 (cost). Don't book unrealized profit.
Example: Wipro has a lawsuit for ₹50 Crores pending against it. Even if lawyers say chances of losing are 30%, Wipro must disclose this as a Contingent Liability in footnotes.

B. Convention of Consistency

"Stick to one method year after year."

You can't change accounting methods just to manipulate profits.

Example: If you use Straight Line Method (SLM) for depreciation in 2023, you can't suddenly switch to Written Down Value (WDV) in 2024.
Exception: You can change if:
1. The law requires it, OR
2. It provides a fairer view (but you must disclose the change and its impact).

C. Convention of Materiality

"Don't sweat the small stuff."

Focus on information that is significant enough to influence decisions.

Example: A stapler costs ₹200. Technically, it's an asset with a 5-year life. But because it's immaterial, we expense it immediately as "Stationery" rather than depreciate ₹40/year for 5 years.
Impact: Keeps financial statements clean and readable.

D. Convention of Full Disclosure

"Hide nothing. Disclose all significant information."

Financial statements must honestly reveal all material facts.

Example: If Infosys is facing a major lawsuit or if a key client (contributing 40% revenue) is leaving, it MUST be mentioned in the Notes to Accounts.
Case Study: The Satyam Scam (2009) happened because the company violated Full Disclosure by hiding fake revenue.

Unit 3: Capital and Revenue Expenditures and Receipts

"Misclassify an expense, and you misstate your profit."

This is one of the most exam-critical topics. The difference between Capital and Revenue determines whether an item goes to the Balance Sheet (affecting your wealth) or the Profit & Loss Account (affecting your profit).

Capital vs Revenue Expenditure

Basis	Capital Expenditure	Revenue Expenditure
Purpose	To acquire or improve fixed assets.	To run and maintain the business.
Earning Capacity	Increases the earning capability of the business.	Maintains existing earning capability.
Period of Benefit	Long-term (benefit lasts more than 1 year).	Short-term (benefit within current year).
Frequency	Non-recurring (one-time).	Recurring (regular).
Accounting Treatment	Capitalized → Added to asset value → Shown in Balance Sheet.	Expensed → Charged to P&L → Reduces profit.
Depreciation	Depreciated over multiple years.	Fully expensed in the current year.
Examples	Buying machinery ₹5L, Installation charges ₹50K, Legal fees for land purchase.	Repairs ₹10K, Wages, Rent, Fuel, Office supplies.

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Real-Life Examples

You buy a truck for ₹10 Lakhs → Capital Expenditure (Asset).
You spend ₹5,000 on truck repairs → Revenue Expenditure (Expense).
You upgrade the truck engine for ₹1 Lakh → Capital Expenditure (increases earning capacity).

Deferred Revenue Expenditure

Some expenses are revenue in nature but benefit multiple years (e.g., ₹1 Crore spent on a nationwide ad campaign). You can write it off over 3–5 years instead of taking a massive hit in Year 1.

Catch: As per AS-26, only advertising that creates an identifiable intangible asset (like brand value) can be capitalized. Otherwise, it's expensed immediately.

Capital vs Revenue Receipts

Basis	Capital Receipts	Revenue Receipts
Source	Non-operating (loans, sale of assets, owner's capital).	Operating (sales, interest, dividends).
Frequency	Non-recurring.	Recurring.
Treatment	Shown in Balance Sheet.	Shown in P&L Account (increases profit).
Examples	Loan taken ₹50L, Sale of old machinery ₹2L, Additional capital ₹10L.	Sale of goods ₹5L, Commission received ₹50K, Rent received ₹20K.

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Unit 4: Contingent Assets and Contingent Liabilities

"Possible obligations and possible assets that might happen."

Contingent Liabilities

A possible or present obligation where the outflow of resources is uncertain.

Accounting Treatment: DO NOT record in books. Disclose in Notes to Accounts (unless remote).
Examples:
1. Pending lawsuit against the company (₹10 Cr claim).
2. Guarantee given for a loan taken by a subsidiary.
3. Bills discounted but not yet matured.

Real Case: When Facebook acquired WhatsApp, it had to disclose contingent liabilities from ongoing privacy lawsuits.

Contingent Assets

A possible asset arising from past events.

Accounting Treatment: NEVER recognized (Prudence). Only disclosed if inflow is virtually certain.
Example: You've filed a ₹5 Crore insurance claim for fire damage. You're confident you'll win, but until the insurance company pays, it's a contingent asset.

Unit 5: Accounting Policies

"The specific rules a company chooses to follow."

Accounting Standards give options (e.g., FIFO vs Weighted Average for inventory). The choice you make becomes your Accounting Policy.

Common Accounting Policies

Depreciation Method: SLM vs WDV.
Inventory Valuation: FIFO, Weighted Average, Specific Identification.
Revenue Recognition: Point in time vs Over time.

Disclosure Requirement (AS-1)

Companies must disclose their significant accounting policies in the Notes to Accounts.

When Can You Change a Policy?

ONLY if:

Required by law or an Accounting Standard, OR
Change results in more appropriate presentation.

Effect: Must be disclosed, and comparative figures must be adjusted.

Unit 6: Accounting as a Measurement Discipline

"What's the 'value' of an asset?"

There are multiple ways to measure value:

Historical Cost: What you originally paid (₹50,000 for a machine).
Current Cost (Replacement Cost): What it would cost to buy the same machine today (₹75,000).
Net Realizable Value: What you'd get if you sold it today (₹40,000).
Present Value: Discounted value of future cash flows the machine will generate.

Most Common: Historical Cost (due to Cost Concept).

Accounting Estimates

Many figures are estimates, not exact:

Useful life of machinery (5 years? 10 years?)
Provision for bad debts (5% of debtors? 10%?)
Residual value of an asset.

These are based on judgment and past experience.

Unit 7: Accounting Standards (AS)

"The rulebook issued by ICAI."

Accounting Standards are written policy documents that standardize accounting practices.

Note

Objectives of Accounting Standards:

Harmonization: Bring uniformity across companies.
Comparability: Make it easy to compare Company A vs Company B.
Transparency: Ensure reliable and fair disclosure.
Compliance: Mandated by law (Companies Act, 2013, Section 133).

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Key Accounting Standards (AS) for CA Foundation

AS-1: Disclosure of Accounting Policies.
AS-2: Valuation of Inventories.
AS-6: Depreciation Accounting.
AS-9: Revenue Recognition.
AS-10: Accounting for Fixed Assets.

Indian Accounting Standards (Ind AS)

To integrate with the global economy, India converged with IFRS (International Financial Reporting Standards). These are called Ind AS.

Applicability:
1. Listed companies.
2. Unlisted companies with Net Worth ≥ ₹250 Crores.
Key Difference from AS: Ind AS is more principles-based; AS is more rules-based.

Summary Table

Concept/Principle	The Rule	Real-World Impact
Business Entity	Owner ≠ Business	Capital is a Liability.
Going Concern	Business runs forever	Depreciation is charged.
Money Measurement	Only ₹ transactions	Employee morale not recorded.
Accrual	Recognize when earned	Creates Debtors/Creditors.
Matching	Match revenue & expenses	Outstanding/Prepaid adjustments.
Prudence	Provide for losses, ignore uncertain gains	Stock at Cost or NRV, lower.
Consistency	Same method every year	Can't flip depreciation methods.
Materiality	Ignore trivial items	₹100 pen = Expense, not Asset.

Quiz: Test Your Understanding

Test Your Knowledge

Question 1 of 5

1. Legal fees paid to acquire land should be treated as:

Revenue Expenditure

Capital Expenditure

Deferred Revenue Expenditure

Prepaid Expense

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