UNIT 4

BASIC ACCOUNTING PRINCIPLES

BY- PROF.TANVI BAGGA

ACCOUNTING PRINCIPLES
Accounting principles are the set guidelines and rules issued by accounting standards like
GAAP and IFRS for the companies to follow while recording and presenting the financial
information in the books of accounts. These principles help companies present a true and
fair representation of financial statements.
1 – Accrual principle: The company should record accounting
transactions,in the same period it happens, not when the cash flow
was earned. For example, let’s say that a company has sold products
on credit. As per the accrual principle, the sales should be recorded
during the period, not when the money would be collected.

2 – Consistency principle: If a company follows an accounting

principle, it should keep following the same principle until a better
one is found. If the consistency principle is not followed, the company
will jump around here and there, and financial reporting will be messy.
As a result, it would be difficult for investors to see where the
company has been going and how it is approaching its long-term
financial growth.
3 – Conservatism principle: As per the conservatism principle, accounting faces
two alternatives – one, report a more significant amount, or two, report a lesser amount.

Let’s say that Company A has reported that it has machinery worth $60,000 as its cost. Now,
as the market changes, the selling value of this machinery comes down to $50,000. Now the
accountant has to choose one from two choices – first, ignore the loss the company may
incur on selling the machinery before it’s sold; second, report the loss on machinery
immediately.

As per the conservatism principle, the accountant should go with the former choice, i.e., to
report the loss of machinery even before the loss would happen. Conservatism principle
encourages the accountant to report more significant liability amount, lesser asset amount,
and also a lower amount of net profits.
4.Seperate/single entity principle- The accounting entity concept (or entity
concept or separate entity concept) is the principle that financial records are prepared
for a distinct unit or entity regarded as separate from the individuals that own it.

5 – Matching principle: The matching principle is the basis of the accrual

principle we have seen before. As per the matching principle, it’s said that if a company
recognizes and records revenue, it should also record all costs and expenses related to
it. So, for example, if a company records its sales or revenues, it should also record the
cost of goods sold and also other operating expenses.

6 – Full disclosure principle: As per this principle, a company should disclose

all financial information to help the readers see the company transparently. Without the
full disclosure principle, the investors may misread the financial statements because
they may not have all the information available to make a sound judgment.
ACCOUNTING PROCEDURE/PROCESS
Double Entry Bookkeeping
JOURNAL
● A journal is a detailed record of all transactions done by a business.
● The information recorded in a journal is used to reconcile accounts.
● Entries are usually recorded using a double-entry method.
● The double-entry method records a transaction in two (or more)
entries. Each entry identifies the account affected, and whether the
account is a credit or a debit. The totals of credits and debits must be
equal.
● The Journal, also called the Book of Primary Entry, is the first record of any
transaction in a business. The information in these simple journal entries is then
transferred to the other books of accounts.

Each journal entry contains the data significant to a single business

transaction, including the date, the amount to be credited and debited, a
brief description of the transaction and the accounts affected.
It’s crucial to accurately enter complete
journal data so that the general ledger and
financial reports based on this information
are also accurate and complete.
Journal entries are made in chronological
order and follow the double-entry
accounting system, meaning each will have
both a credit and a debit column.
EXAMPLE OF A JOURNAL BOOK
LEDGER
Ledger in accounting records and processes a firm’s financial
data, taken from journal entries. This becomes an important
financial record for future reference. It is used for creating
financial statements. It is also known as the second book of
entry.
All ledger balances are transferred to the trial balance.
Ledgers contain important data— income statements and
balance sheets are formulated based on that
information.
 Following are some examples of ledger accounts

1. Accounts receivable
2. Cash
3. Depreciation
4. Accounts payable
5. Salaries and wages
6. Revenue
7. Debt
8. Inventory
9. Stockholders’ equity
10. Office expenses
FORMAT OF A LEDGER
TRIAL BALANCE
A trial balance is a bookkeeping worksheet in which the balances of all
ledgers are compiled into debit and credit account column totals that
are equal. A company prepares a trial balance periodically, usually at
the end of every reporting period. The general purpose of producing a
trial balance is to ensure that the entries in a company’s bookkeeping
system are mathematically correct.
● Debits and credits of a trial balance must tally to ensure that there
are no mathematical errors, but there could still be mistakes or
errors in the accounting systems.
● A company’s transactions are recorded in a general ledger and later
summed to be included in a trial balance.
FORMAT OF A TRIAL BALANCE
The main objectives of a Trial Balance are as follows:

● It helps in ascertaining arithmetic errors that occur while preparing accounts.

Accountants can make mistakes while recording financial transactions under the
double-entry bookkeeping system. When the debit and credit sides of a Trial Balance
do not match, it means one of two things. One, there was an error in either recording
the account balance. Or two, there is an accounting mistake made while recording
the transaction in the ledgers.
● It helps in preparing the financial statements of a company at the end of a financial
year. The final balance of expenses and revenue accounts is taken from the Trial
Balance and used in the Profit and Loss Account. Similarly, the accounts related to
Assets, Liabilities and Capital gets recorded in the Balance Sheet.
● A Trial Balance helps in summarising the financial transactions done while running a
business. It is a consolidated summary of the financial transactions that have taken
place within a financial year. It can help the management in making business
decisions as well.
CASH BOOK
Cash book is a special type of book that is only concerned with the recording of cash transactions
of an organisation. It performs the dual role of both journal and a ledger for all the cash
transactions taking place in a business organisation.

.It offers easy verification of cash by matching the balance in the cash book with actual cash in
hand and is therefore helpful in identifying mistakes in the entry.

.It helps in creating a regular record of transactions date wise for the convenience of accounting
personnel.

. As it is maintained date wise, any cash payments or the transaction can be correctly traced back
in the cash book.

. It is helpful in detecting any cash frauds in the organisation.

.It helps in saving time and labour by reducing the workload

FORMAT OF A CASH BOOK
 Trading Account
Trading account is used to determine the gross profit or gross loss of a business
which results from trading activities. Trading activities are mostly related to the
buying and selling activities involved in a business. Trading account is useful for
businesses that are dealing in the trading business. This account helps them to
easily determine the overall gross profit or gross loss of the business. The
amount thus determined is an indicator of the efficiency of the business in buying
and selling.

The trading account considers only the direct expenses and direct revenues while
calculating gross profit. This account is mainly prepared to understand the profit
earned by the business on the purchase of goods.
Gross profit occurs when the sales proceeds exceed the cost of goods sold. Gross profit refers to overall profit,
which means operating expenses such as administrative and selling expenses are not deducted from it.

Sales proceeds less than the cost of the goods sold incur a gross loss. The balance of the trading account
representing either gross profit or gross loss is transferred to the profit and loss account.

The balance of the trading account indicates the gross profit or gross loss. Credit balance represents a gross
profit, while debit balance represents a gross loss.
PROFIT AND LOSS ACCOUNT
Profit and loss (P&L) statement refers to a financial statement that summarizes the
revenues, costs, and expenses incurred during a specified period, usually a quarter
or fiscal year. These records provide information about a company’s ability or
inability to generate profit by increasing revenue, reducing costs, or both. Company
managers and investors use P&L statements to analyze the financial health of a
company.

P&L statements are also referred to as a(n):

● Statement of profit and loss

● Statement of operations
● Statement of financial results or income
● Earnings statement
● Expense statement
● Income statement
Profit and loss account shows the net profit and net loss of
the business for the accounting period. This account is
prepared in order to determine the net profit or net loss that
occurs during an accounting period for a business concern.
Net profit is the amount of money your business
earns after deducting all operating, interest, and tax
expenses over a given period of time. A net loss
occurs when the sum total of expenses exceeds the
total income or revenue generated by a business,
project, transaction, or investment.
BALANCE SHEET
A balance sheet summarizes a company's assets, liabilities and shareholders’ equity at a specific
point in time (as indicated at the top of the statement). It is one of the fundamental documents that
make up a company’s financial statements.

Your balance sheet gives you a summary of your company’s financial position at a point in time
and provides a clear picture of what you own and what you owe.

Balance Sheet has two main heads –assets and liabilities.

Let’s understand each one of them. What are assets? Assets are those resources or things which the company
owns. They can be divided into current as well as non-current assets or long term assets.

Liabilities on are debts or obligations of a company. It is the amount that the company owes to its creditors.
Liabilities can be divided into current liabilities and long term liabilities.
What are the main parts of a balance sheet?
1. Current assets
Cash, as well as other assets you expect to turn into cash within the next 12 months. Examples of
current assets include accounts receivable and inventory.
2. Fixed assets
Property or equipment the company owns and uses in its operations to generate income. Fixed
assets are purchased for long-term use (longer than one year). Their value decreases over time
because of wear and tear. This change is recorded as depreciation on the income statement.
3. Current liabilities
Debts and other obligations to creditors that will be due within the next 12 months. Examples of
current liabilities include accounts payable, credit card bills, sales taxes collected, payroll
liabilities and loan payments.
4. Long-term liabilities
Debts and other obligations to creditors that will not be due in the next 12 months. Examples of
long-term liabilities include term loans and mortgages.
5. Shareholders’ equity
This is made up of common and preferred stock, paid-in capital as well as retained earnings,
meaning the accumulated company profits that have not been distributed to shareholders.
When looking at your balance sheet, your total assets should always equal your
total liabilities plus shareholders' equity.

Let’s say you decide to buy a truck. That truck will

show up as an asset on the top of your balance
sheet, while the loan you took out to purchase the
truck will be shown as a liability at the bottom.
FORMAT OF A BALANCE SHEET
WHAT IS COST ACCOUNTING
Cost accounting is a managerial accounting process that involves
recording, analyzing, and reporting a company's costs. Cost
accounting is an internal process used only by a company to identify
ways to reduce spending.Cost accounting is helpful because it can
identify where a company is spending its money, how much it earns,
and where money is being wasted or lost. Having a clear idea of the
costs associated with running a business makes it easier for
management to boost profitability. Cost accounting is distinct and
separate from general financial accounting, which is designed for
outside audiences and heavily regulated.cost accounting is commonly called a
costing method, the scope of cost accounting is far broader than mere cost. Costing methods determine
costs, while cost accounting is an analysis of the different types of costs a company incurs.
How Cost Accounting Is Used
Cost accounting can be applied to many areas of a business. Here are some examples of how it is used.

Cost Controls Cost accounting is used to help with cost controls. Firms want to be able to spend less on their
inputs and charge more for their outputs. Cost accounting can be used to identify inefficiencies and apply the
necessary improvements needed to control costs. These controls can include budgetary controls, standard
costing, and inventory management.

Internal Costs Cost accounting can help with internal costs, such as transfer prices for companies that
transfer goods and services between divisions and subsidiaries. For example, a parent company overseas
might be the supplier for its U.S. subsidiary, meaning the U.S. company would be charged by the parent for
any purchases of materials.
Expansion Plans Companies looking to expand their product line need to understand their cost structure. Cost
accounting helps management plan for future capital expenditures, which are large plant and equipment
purchases.
Preparing Financial Statements Cost accounting can contribute to preparing required financial statements, an
area otherwise reserved for financial accounting. The prices and information developed and studied through
cost accounting will likely make it easier to gather information for financial accounting purposes. For
example, raw material costs and inventory prices are shared between both accounting methods.
Types of Costs in Cost Accounting
Direct Costs A direct cost is a cost directly tied to a product's production and typically includes direct
materials, labor, and distribution costs. Inventory, raw materials, and employee wages for factory
workers are all examples of direct costs.

Indirect Costs Indirect costs can't be directly tied to the production of a product and might include the
electricity for a factory.

Variable Costs Costs that increase or decrease with production volumes tend to be classified as
variable costs. A company that produces cars might have the steel involved in production as a
variable cost.

Fixed Costs Fixed costs are the costs that keep a company running and don't fluctuate with sales and
production volumes. A factory building or equipment lease would be classified as fixed costs.

Operating Costs Operating costs are the costs to run the day-to-day operations of the company.
However, operating costs—or operating expenses—are not usually traced back to the manufactured
product and can be fixed or variable.
COSTING
Costing refers to the process and technique of determining costs. It involves analysis of the
information so as to help management identify the cost of production and selling, i.e. the total
cost of various products and services, as well as to understand how the total cost is created.
Objectives of Costing
■ To determine the actual cost of each item, process, or operation
■ To identify profitable and unprofitable activities.
■ To act as a guide in fixing estimates and preparing quotations for the future.
■ To present relevant information for budgetary control.
■ To control costs.
■ To identify sources of wastes and leakages.
■ To determine the efficiency and productivity of labor and machines involved in the
process of production.

An ideal costing system is one that is accurate, simple, equitable, elastic, comparable,
prompt, and economic. It is one that fulfills all the objectives and provides periodical
results to the firm. It also helps in the reconciliation with financial accounts.
METHODS OF COSTING
1.Job Costing- In job costing, the cost of each job is calculated. Job costing is applicable
in all the industries wherein work is carried out when a customer’s order is received such
as a printing press, a motor workshop, and so forth. In this method, the job order given by
the customer is unique and needs various resources for the accomplishment of the job. It
is a task that is undertaken to produce a product or deliver a service that can be uniquely
identifiable. In this method, the collection of costs are undertaken on the basis of each
order. For Example Ship Building, Printing, Oilwell drilling, etc.
2.Batch Costing- Itis a variation of job costing, which is used in industries where
similar items are produced in batches of large quantities. A batch indicates the
consignment of goods produced in a factory at a time. In batch costing, each batch is
treated as a cost unit, and thus cost is ascertained separately. Hence, cost per unit is
ascertained by dividing the cost of the batch by the total number of units produced per
batch. Further, it is suitable for industries that manufacture general-purpose machine
tools, utility poles, bakery items, pharmaceuticals or drugs, toys, etc.
3.Contract Costing It is another version of job costing, which is
associated with building and civil engineering works. Contract costing is
helpful in determining the cost of each contract individually, as the costs
are duly accumulated for each order. It is applicable for firms engaged in
construction work of roads, buildings, flyovers, bridges, etc.

4.Process Costing In process costing, the cost of completing each stage

of work is determined. This method is appropriate for manufacturing
and producing entities, wherein a series of continuous as well as
repetitive activities, operations are involved. It manufactures thousands
of units of the same product, during a period, such as paper, soap,
textiles, bread, detergent, sugar, etc.
5.Operating Costing Those organizations which are engaged in
rendering services such as transport, water supply, retail trade,
railway, bus, boiler houses, hotels, power distribution, etc use this
method for ascertaining cost. Here, each service is treated as a
separate unit. In this method the cost of providing or operating
service is determined. Cost per unit is ascertained by dividing the
total cost by the units of services provided in operating costing.

6.Single Output Costing It is applicable to the industries that produce

a particular product like brick kilns, paper mills, flour mills, cement
industry, steel industry. Here, the whole production cycle is costed
and the cost per unit is derived by dividing total accumulated costs by
the number of units produced.
7. Multiple Costing
Otherwise called composite costing, in this a combination of two
or more methods of costing. This method is used by industries
where the manufacturing process used in the production of
products is complex in nature and any one method of costing
cannot be used for the ascertainment of costs a combination of
different costing methods is used which is called multiple costing.
Industries like radio, engines, automobiles, airplanes, refrigerators,
television, air conditioners, etc use this method.
TECHNIQUES OF COSTING
Techniques imply the principles to be followed for ascertaining the cost of the
products manufactured or services rendered.
Absorption Costing: The technique of costing in which cost is ascertained after
it is incurred. In this fixed and variable costs are allocated to the units of costs
and absorption of total overheads is carried out on the basis of activity level.

Standard Costing: Technique of costing in which standards are used for costs
and revenues so as to control cost by way of variance analysis. Hence, it
establishes standards for each cost element and for revenues and then they are
compared with the actual results to determine the variances as per the
originating causes. It is used in association with budgetary control. In budgetary
control, budgets are prepared and continuous comparison is made between the
actual result and the budgeted result.
Marginal Costing: A technique of costing in which all variable costs are charged to operations,
processes, or products, and all fixed costs are written off against profits for the period in
which they take place.

Lifecycle costing: Evaluation of total costs of production over its economic life. In order to
analyze cost, the entire useful life of the product is taken into consideration, right from the
stage when the product is launched to its end. Due to this very reason, it is known as cradle to
grave or womb to tomb costing. Further, along with the production costs, it also takes into
account pre-production costs.

Target Costing: This technique is used in a competitive environment so as to control the costs
period to its designing. This facilitates the organization to operate with market-based prices.
To put it simply, rather than developing a product and then making efforts for selling it to
customers, in target costing, companies find out what will be sold in the market at what price
and then designs the product accordingly. It indicates market-driven standards.
Uniform Costing: When the same costing principles are used
by various firms operating in the same industry, it is known
as uniform costing. It is regarded as a common system
wherein common accounting principles and practices are
adopted by identical firms.

Direct Costing: A practice of costing in which all direct costs

are charged to operations, processes, or products, and all
indirect costs are left to be written off against profits for the
period in which they take place, is direct costing.
COST SHEET
A cost sheet is a statement that records all the costs a
business incurs from production to sales.
Using this information, a company can fix the price of
its products and services.
The main advantage of a cost sheet is that you can
compare it with previous cost sheets to measure
performance.
You can then decide whether the cost of an item can be
increased or decreased according to your costs.
A cost sheet has to contain the following information:

● Cost per unit of a product

● Total cost
● The four main components of a cost sheet:
○ Prime Cost
○ Works Cost
○ Cost of Production
○ Total Cost or Cost of Sales
● Percentage incurred on every expense to the total cost
● If the cost sheet is prepared using historical cost sheets, record of discrepancies, if
any
● If two cost sheets of any period are compared, record of discrepancies, if any
● Details about the management for cost control
● Summary of the total cost of the product
COMPONENTS OF COST SHEET
1.Prime Costs Under this header, you have to record all the expenses involved in
the production process. This is also known as basic or first cost. For example, if
you have a textile store, your prime costs will be the costs of purchasing fabric
from weavers, employee salaries, packaging, implements needed to measure and
cut cloth, etc. The formula for calculating prime costs is:
Prime Costs= Direct Labour + Direct Raw Material+Direct Expenses

2.Works Cost Works cost is the sum of prime costs and overhead costs including
factory expenses. Overhead costs are those costs that are not directly related to
the production of a product but are required nevertheless. For example, you need
to pay electricity bills to keep your production going. Similarly, there are several
other taxes and utility costs that fall under the overhead costs category.
3.Cost of Production Under this header, you should include all the expenses
involved in business operations, including rents and work costs. The formula for
calculating the cost of production is:
Cost of Production= (Work Costs)+(Administration Overhead Costs)-(Opening and
Closing Stock of Finished Goods)
4.Cost of Sales Cost of sales or total cost contains the details of all the expenses
involved in the production and other costs involved in selling and distribution. This
value will help you understand how much you spend on a product according to the
resources used for producing it. You can decide your selling price according to the
cost of sales and know how much profit you will earn from it.
How to Prepare a Cost Sheet?
Step 1: Prime Cost = Direct Material Consumed + Direct Wages + Direct
Expenses

Direct Material Consumed = Direct Material Purchased + OP

Stock of Raw Material – CL Stock of Raw Material

Step 2: Works Cost = Prime Cost + Factory Overheads + OP Stock Work in

Progress – CL Stock Work in Progress

Step 3:Cost of Production = Works Cost + Office and Administration Overhead +

OP Stock of Finished Goods – CL Stock Finished Goods

Step 4: Total Cost = Cost of Production + Selling and Distribution Overheads

Profit: Sales – Total Cost

BREAK-EVEN ANALYSIS

A break-even analysis is an economic tool that is used to determine the cost

structure of a company or the number of units that need to be sold to cover the
cost. Break-even is a circumstance where a company neither makes a profit nor
loss but recovers all the money spent.

The break-even analysis is used to examine the relation between the fixed cost,
variable cost, and revenue. Usually, an organisation with a low fixed cost will
have a low break-even point of sale.

Break-even point = Fixed cost/Price per cost – Variable cost

Importance of Break-Even Analysis
● Manages the size of units to be sold: With the help of break-even analysis, the company or the owner
comes to know how many units need to be sold to cover the cost. The variable cost and the selling price
of an individual product and the total cost are required to evaluate the break-even analysis.
● Budgeting and setting targets: Since the company or the owner knows at which point a company can
break-even, it is easy for them to fix a goal and set a budget for the firm accordingly. This analysis can
also be practised in establishing a realistic target for a company.
● Manage the margin of safety: In a financial breakdown, the sales of a company tend to decrease. The
break-even analysis helps the company to decide the least number of sales required to make profits.
With the margin of safety reports, the management can execute a high business decision.
● Monitors and controls cost: Companies’ profit margin can be affected by the fixed and variable cost.
Therefore, with break-even analysis, the management can detect if any effects are changing the cost.
● Helps to design pricing strategy: The break-even point can be affected if there is any change in the
pricing of a product. For example, if the selling price is raised, then the quantity of the product to be sold
to break-even will be reduced. Similarly, if the selling price is reduced, then a company needs to sell
extra to break-even.
THANK YOU