Accounting principles and the accounting cycle

In short

Accounting principles are the agreed concepts, conventions and standards that decide *when* a transaction is recorded, *at what amount*, and *in which period* it belongs — so that two different accountants reading the same facts produce comparable statements. The accounting cycle is the repeating sequence of steps that converts source documents into a trial balance, adjusted figures and finally the Balance Sheet and Statement of Profit and Loss. In India the framework is set by the Companies Act 2013 (Sections 128–129, Schedule III), the ICAI's Accounting Standards (AS) and Ind AS notified under the Companies (Indian Accounting Standards) Rules 2015, and AS 1 "Disclosure of Accounting Policies". This is the first chapter of every B.Com financial accounting paper, carries guaranteed theory marks, and is the standard opening round in interviews for Big-4 audit associates, bank POs, GST/Tally executives and finance analysts.

Explained

Book-keeping, accounting and the regulatory framework

• Book-keeping is the recording of transactions; accounting adds classifying, summarising, analysing and communicating; accountancy is the whole body of knowledge.
• Branches: financial accounting (reporting to outsiders), cost accounting (product/process cost), management accounting (internal decisions), tax accounting, social responsibility accounting.
• Users: owners/shareholders, lenders and banks, employees, suppliers, customers, government (Income-tax, GST), regulators (SEBI, RBI, IRDAI), researchers.
• Who sets the rules in India: ICAI (issues AS, Ind AS recommendations, Guidance Notes), NFRA (National Financial Reporting Authority, formed under Section 132 of the Companies Act 2013, recommends standards and oversees auditors of large companies), MCA (notifies standards), SEBI (LODR disclosures for listed firms).
• Section 128, Companies Act 2013: every company must keep books of account on accrual basis and double entry, at the registered office, preserved for 8 years; books may be kept in electronic form.
• Section 129 + Schedule III: financial statements must give a true and fair view and follow the Schedule III format (vertical Balance Sheet, Statement of Profit and Loss; Division I for AS companies, Division II for Ind AS companies, Division III for NBFCs).
• AS vs Ind AS: AS (Companies (Accounting Standards) Rules, 2021) apply to most non-listed, smaller companies; Ind AS (IFRS-converged) applies to listed companies, companies with net worth ≥ ₹250 crore, and their holding/subsidiary/associate companies, in phases from FY 2016-17. Non-corporate entities (sole trader, partnership firm) follow ICAI AS and, since 1 April 2024, the ICAI's AS for Non-company Entities tiered framework.

Accounting concepts (the assumptions behind the numbers)

• Business entity: the business is separate from its owner; owner's capital is a liability of the business and drawings reduce it.
• Money measurement: only transactions measurable in money are recorded — staff morale or a strike is not, however material.
• Going concern: the entity will continue in operation for the foreseeable future, so assets are carried at cost less depreciation rather than break-up value. (One of the three fundamental assumptions in AS 1.)
• Cost concept (historical cost): assets are recorded at acquisition cost, not market value; Ind AS dilutes this with fair value for financial instruments, investment property option and revaluation models.
• Dual aspect: every transaction has two sides — the basis of double entry and of Assets = Liabilities + Capital.
• Accounting period: results are reported for a fixed period; under Section 2(41) the Indian financial year is 1 April to 31 March for companies.
• Accrual (mercantile) basis: revenue and expense are recognised when earned/incurred, not when cash moves. Mandatory for companies; opposed to cash basis (receipts and payments only, used by small professionals and NPOs' R&P account) and hybrid basis.
• Matching: expenses of a period are matched against the revenue of that same period — the reason adjusting entries exist.
• Revenue recognition (realisation): revenue is recognised when the risks and rewards pass / performance obligation is satisfied, not when the order is received. AS 9 governs this under AS; Ind AS 115 uses the five-step model (identify contract, identify performance obligations, determine price, allocate price, recognise on satisfaction).
• Objective evidence / verifiability: every entry must be supported by a voucher, invoice, challan or bank statement.
• Periodicity and matching give rise to the concepts of capital and revenue expenditure — capital expenditure is capitalised and depreciated; revenue expenditure is charged off in the year; deferred revenue expenditure is heavy revenue spend whose benefit was traditionally spread (now largely written off at once, as AS 26 / Ind AS 38 disallow capitalising most such items).

Accounting conventions and qualitative characteristics

• Consistency: the same policies are followed year after year; a change must be disclosed with its effect (AS 1, AS 5).
• Conservatism / prudence: anticipate no profit, provide for all possible losses — closing stock at lower of cost or net realisable value (AS 2), provision for doubtful debts, no unrealised gain.
• Full disclosure: all material information must be disclosed in the statements or notes; Schedule III and AS 1 (disclosure of significant accounting policies at one place) implement this.
• Materiality: an item is material if its omission or misstatement could influence a user's decision; immaterial items may be grouped (Schedule III requires separate disclosure of any item of income or expenditure exceeding 1% of revenue from operations or ₹10,00,000, whichever is higher).
• Comparability, relevance, reliability, understandability, faithful representation — the qualitative characteristics in the ICAI/Ind AS conceptual framework.
• AS 1's three fundamental accounting assumptions: going concern, consistency, accrual — if any is *not* followed, the fact must be disclosed.
• Conflicts: prudence vs. faithful representation (excess provisions create secret reserves); historical cost vs. relevance in inflation; consistency vs. adopting a better policy.

The accounting cycle, step by step

1. Identify and verify the transaction from source documents — invoice, cash memo, receipt, debit/credit note, bank pay-in slip, cheque counterfoil — and prepare a voucher (cash, bank, journal, purchase, sales).
2. Analyse which accounts are affected and apply the rules: traditional (debit the receiver / what comes in / all expenses and losses) or the modern accounting-equation approach.
3. Journalise — record in the journal or subsidiary books (cash book, purchases book, sales book, returns books, bills books, journal proper) in chronological order with a narration.
4. Post to the ledger — group entries account-wise; balance each account.
5. Prepare the (unadjusted) trial balance at period end to test arithmetical accuracy of posting.
6. Pass adjusting entries — outstanding and prepaid expenses, accrued and unearned income, depreciation, closing stock, bad debts and provisions, interest on capital and drawings, goods taken by proprietor.
7. Prepare an adjusted trial balance / worksheet (ten-column worksheet: trial balance, adjustments, adjusted trial balance, P&L, balance sheet columns).
8. Prepare financial statements — Trading and Profit & Loss Account (or Statement of Profit and Loss, Schedule III), Balance Sheet, Cash Flow Statement (AS 3 / Ind AS 7, mandatory for companies other than OPC, small company and dormant company), and Notes.
9. Pass closing entries — transfer all nominal (revenue and expense) accounts to the Trading/P&L Account and the net result to Capital (or Retained Earnings), so nominal accounts start the next year at zero. Real and personal accounts are carried forward.
10. Post-closing trial balance — contains only assets, liabilities and capital; confirms the books are balanced for the next period.
11. Reversing entries (optional, next period's start) — reverse certain accruals so routine payments can be recorded without reference to last year's adjustment.

Steps 1–5 happen continuously through the year; steps 6–11 are the period-end close. In a Tally/SAP environment steps 4, 5, 7 and 10 are automatic — the judgment work is steps 1, 2, 6 and 8.

Classification of accounts and the accounting equation

• Traditional classification: Personal (natural, artificial, representative — e.g. Outstanding Salary A/c), Real (tangible and intangible assets), Nominal (expenses, losses, incomes, gains).
• Golden rules: Personal — debit the receiver, credit the giver; Real — debit what comes in, credit what goes out; Nominal — debit expenses and losses, credit incomes and gains.
• Modern classification: Assets, Liabilities, Capital, Revenue, Expenses — debit increases assets and expenses; credit increases liabilities, capital and revenue.
• The accounting equation Assets = Liabilities + Capital holds after every transaction; expanded: Assets = Liabilities + (Opening Capital + Revenue − Expenses − Drawings).

Limitations, and a quick AS/Ind AS map for this chapter

• Historical cost ignores inflation and current values; money measurement ignores qualitative factors; personal judgment enters depreciation method, useful life, provisions; window dressing and creative accounting are possible; accounting is not an exact science.
• Relevant standards: AS 1 / Ind AS 1 (disclosure and presentation), AS 2 / Ind AS 2 (inventories), AS 5 (prior period and change in policy) ≈ Ind AS 8, AS 9 ≈ Ind AS 115 (revenue), AS 6/AS 10 ≈ Ind AS 16 (PPE and depreciation), AS 3 ≈ Ind AS 7 (cash flow), AS 4 ≈ Ind AS 10 (events after the reporting period).
• The threshold values and Ind AS applicability phases have been amended several times; check the latest MCA notification before quoting a net-worth or turnover limit in practice.

Key points

• Accounting principles - the concepts, conventions and standards that make statements comparable and verifiable.
• AS 1 fundamental assumptions - going concern, consistency, accrual; departure from any must be disclosed.
• Business entity - owner and business are distinct; capital and drawings flow through the owner's account.
• Dual aspect - every debit has an equal credit; the source of double entry and of the accounting equation.
• Accrual vs cash basis - accrual records when earned/incurred; Section 128 makes accrual compulsory for companies.
• Matching principle - period expenses against period revenue; justifies outstanding, prepaid and depreciation adjustments.
• Realisation/revenue recognition - record revenue on transfer of risks and rewards (AS 9) or satisfaction of a performance obligation (Ind AS 115).
• Conservatism - provide for all losses, anticipate no profit; closing stock at lower of cost or NRV.
• Materiality - disclose separately what could change a user's decision; Schedule III threshold is 1% of revenue from operations or ₹10,00,000, whichever is higher.
• Consistency - same policy each year; disclose any change and its monetary effect (AS 5).
• Capital vs revenue expenditure - capitalise and depreciate the former, charge the latter to P&L; wrong split distorts both profit and balance sheet.
• Accounting cycle - source document → voucher → journal/subsidiary books → ledger → trial balance → adjustments → financial statements → closing entries → post-closing trial balance.
• Trial balance - proves arithmetical accuracy only; compensating errors, errors of principle and complete omission survive it.
• Adjusting entries - no cash moves; they re-cut income and expense to the right period.
• Closing entries - zero out nominal accounts into Trading/P&L and transfer the net result to Capital/Retained Earnings.
• Post-closing trial balance - only real and personal accounts remain; it is the next year's opening position.
• Indian framework - Companies Act 2013 Sections 128/129, Schedule III, ICAI AS/Ind AS, NFRA oversight, 1 April–31 March financial year, books preserved 8 years.
• Limitations - historical cost, non-monetary items ignored, scope for judgment and window dressing.

Formulas and examples

(Symbols: all amounts in ₹; "period" means the accounting year 1 April–31 March unless the entity states otherwise.)

Example 1 — Accounting equation through a series of transactions. Mehta starts a trading business on 1 April 2025.

Closing position: Cash = 5,00,000 − 80,000 + 95,000 − 15,000 − 20,000 = ₹4,80,000; Furniture ₹80,000; Stock = 1,20,000 − 70,000 = ₹50,000. Total assets = 4,80,000 + 80,000 + 50,000 = ₹6,10,000. Liabilities ₹1,20,000 + Capital (5,00,000 + 25,000 − 15,000 − 20,000 = ₹4,90,000) = ₹6,10,000. Equation holds.

Example 2 — Accrual vs cash basis profit. A consultancy in FY 2025-26: fees received in cash ₹9,00,000 (of which ₹1,00,000 relates to work to be done in 2026-27); fees earned but not yet billed ₹1,50,000. Expenses paid ₹5,20,000, including ₹40,000 insurance for the year to 30 June 2026; salaries for March 2026 of ₹60,000 unpaid.

Prepaid insurance = 40,000 × 3/12 = ₹10,000 (April–June 2026 falls in the next year). Accrual profit = 9,50,000 − 5,70,000 = ₹3,80,000; cash profit = ₹3,80,000. Here the two coincide by arithmetic coincidence, but the *composition* differs — the accrual balance sheet additionally shows unearned income ₹1,00,000 and outstanding salaries ₹60,000 as liabilities, and accrued fees ₹1,50,000 and prepaid insurance ₹10,000 as assets, i.e. ₹3,20,000 of items the cash basis never reports.

Example 3 — Adjusting and closing entries from a trial balance extract (31 March 2026). Trial balance shows: Sales ₹12,00,000; Purchases ₹7,80,000; Opening stock ₹90,000; Salaries ₹1,40,000; Rent ₹1,20,000; Debtors ₹2,00,000; Machinery ₹5,00,000; Capital ₹6,00,000. Adjustments: closing stock ₹1,10,000 (NRV ₹1,25,000); rent includes ₹20,000 paid for April–May 2026 (₹10,000 per month, so 2 months prepaid); salaries of March ₹15,000 unpaid; provision for doubtful debts at 5% of debtors; depreciate machinery at 10% SLM.

• Closing stock at lower of cost (1,10,000) and NRV (1,25,000) = ₹1,10,000.
• Prepaid rent = ₹20,000; Rent charged to P&L = 1,20,000 − 20,000 = ₹1,00,000.
• Salaries charged = 1,40,000 + 15,000 = ₹1,55,000; outstanding salaries ₹15,000 shown as a liability.
• Provision for doubtful debts = 5% × 2,00,000 = ₹10,000; Debtors in balance sheet = ₹1,90,000.
• Depreciation = 10% × 5,00,000 = ₹50,000; Machinery = ₹4,50,000.

COGS = 90,000 + 7,80,000 − 1,10,000 = ₹7,60,000 → Gross Profit = 12,00,000 − 7,60,000 = ₹4,40,000. Indirect expenses = 1,55,000 + 1,00,000 + 10,000 + 50,000 = ₹3,15,000 → Net Profit = 4,40,000 − 3,15,000 = ₹1,25,000. Closing entries: Sales A/c Dr 12,00,000 to Trading A/c; Trading A/c Dr to Purchases and Opening Stock; Trading A/c Dr 4,40,000 to P&L A/c; P&L A/c Dr to each expense account; P&L A/c Dr 1,25,000, To Capital A/c 1,25,000. Capital becomes 6,00,000 + 1,25,000 = ₹7,25,000 (no drawings given).

Example 4 — Capital vs revenue expenditure and its effect on profit. A firm spends: (i) ₹4,00,000 on a second-hand machine, (ii) ₹60,000 on its transport and installation, (iii) ₹25,000 on overhauling the machine before first use, (iv) ₹18,000 on annual maintenance after it started working, (v) ₹1,50,000 on whitewashing the factory, (vi) ₹2,20,000 on an extension to the factory building.

• Capitalised: 4,00,000 + 60,000 + 25,000 + 2,20,000 = ₹7,05,000 (machine cost ₹4,85,000 under AS 10/Ind AS 16 — all costs to bring the asset to working condition; building extension ₹2,20,000 as it enhances capacity).
• Revenue: 18,000 + 1,50,000 = ₹1,68,000 charged to P&L.
• If the ₹25,000 overhaul had been wrongly treated as revenue, profit would be understated by ₹25,000 and assets by ₹25,000 — an error of principle that the trial balance would still balance on.

Example 5 — Closing Capital and missing profit (single entry). Opening capital ₹3,40,000; drawings ₹85,000; fresh capital introduced ₹50,000; closing assets ₹8,20,000; closing liabilities ₹3,45,000.

• Closing capital = 8,20,000 − 3,45,000 = ₹4,75,000.
• Net profit = 4,75,000 − 3,40,000 + 85,000 − 50,000 = ₹1,70,000.

Where it is used

• Audit and assurance (Deloitte, PwC, EY, KPMG, Grant Thornton, BDO, mid-size CA firms): audit juniors test the cycle itself — vouching source documents, checking cut-off and accrual completeness, re-performing closing entries, and verifying compliance with AS/Ind AS and Schedule III.
• Accounts executive / Tally-ERP and SAP FICO roles: voucher entry, month-end close, prepaid and provision schedules, GST reconciliation of books with GSTR-2B/GSTR-3B before finalising the trial balance.
• Banking (SBI/IBPS PO, credit analysts) and NBFCs: reading borrower balance sheets, spotting policy changes and window dressing, and knowing that accrual-basis statements, not cash flow, drive reported profit.
• Shared service centres and GCCs (Genpact, WNS, Accenture, Infosys BPM, Amazon, Wells Fargo India): record-to-report (R2R) teams run exactly this cycle on a monthly close calendar with journal-approval workflows.
• Startups and MSMEs: founders and CS/CA consultants apply the entity and accrual concepts to separate personal and business money, and the capital/revenue split to decide what is depreciated.
• Exams: B.Com/BBA Financial Accounting I, CA Foundation Paper 1, CS/CMA Foundation, UGC-NET Commerce, and the quantitative/accounting sections of bank and SSC recruitment tests.

Interview questions

• Q: What is the difference between the cash basis and the accrual basis of accounting? A: Cash basis records income and expense only when money is received or paid; accrual records them when earned or incurred. Section 128 of the Companies Act 2013 requires companies to keep books on the accrual basis.
• Q: Which three fundamental accounting assumptions does AS 1 identify? A: Going concern, consistency and accrual. If any one is not followed, the fact must be specifically disclosed.
• Q: Why is closing stock valued at the lower of cost and net realisable value? A: Because of the prudence convention, codified in AS 2 — anticipated losses are provided for, while unrealised gains are not recognised.
• Q: How does the going concern assumption affect asset valuation? A: Assets are carried at cost less accumulated depreciation over their useful lives, not at liquidation value; if going concern fails, assets must be restated at net realisable value and the fact disclosed.
• Q: A trial balance agrees. Can the books still be wrong? A: Yes — errors of omission (entire entry missed), errors of principle (capital expenditure booked as revenue), compensating errors and wrong-account-same-side errors all leave the trial balance in agreement.
• Q: Give an example of a conflict between two accounting principles. A: Prudence versus faithful representation: creating excess provisions satisfies conservatism but understates profit and assets, producing secret reserves and a less faithful picture.
• Q: What is the matching principle, and name two adjustments that follow from it? A: Expenses must be matched with the revenue of the same period; outstanding/prepaid expenses and depreciation are two adjustments created purely to achieve this.
• Q: Why are closing entries needed, and which accounts are closed? A: To measure the period's result and reset the books — nominal accounts (incomes, expenses, gains, losses) are transferred to Trading/P&L and the net result to Capital or Retained Earnings; real and personal accounts are carried forward.
• Q: Distinguish capital, revenue and deferred revenue expenditure. A: Capital expenditure creates or enhances a long-term asset and is capitalised; revenue expenditure is consumed in the period and charged to P&L; deferred revenue expenditure is heavy revenue spend once spread over years, now largely written off immediately since AS 26 / Ind AS 38 bar capitalising most such costs.
• Q: When is revenue recognised under Ind AS 115? A: On satisfaction of each performance obligation — i.e. when control of the goods or services transfers to the customer — using the five-step model, which can be at a point in time or over time.
• Q: What is materiality, and is there a numeric threshold in India? A: Materiality means an omission or misstatement that could influence a user's decision; there is no general numeric rule, but Schedule III of the Companies Act 2013 requires separate disclosure of items of income or expenditure exceeding 1% of revenue from operations or ₹10,00,000, whichever is higher.
• Q: Where does a post-closing trial balance differ from the ordinary trial balance? A: It is prepared after closing entries and contains only assets, liabilities and capital accounts — all nominal accounts stand at nil — so it doubles as the opening position of the next year.
• Q: Who sets accounting standards in India today? A: The ICAI formulates them, NFRA (Section 132, Companies Act 2013) recommends standards and oversees auditors of large and listed entities, and the MCA notifies AS and Ind AS by rules; SEBI adds disclosure requirements for listed companies.

Common mistakes

• Confusing a concept with a convention, or listing "double entry" as a principle — it is the *system* that implements the dual aspect concept.
• Treating the trial balance as proof of correctness, and therefore not looking for errors of principle or omission.
• Forgetting the second effect of an adjustment: charging outstanding salary to P&L but not showing it as a current liability, or deducting prepaid rent without putting it on the asset side.
• Mis-splitting capital and revenue expenditure — expensing installation or overhaul charges, or capitalising routine repairs and whitewashing.
• Computing prepaid or outstanding amounts on the wrong number of months (count only the months falling outside the accounting year, 1 April–31 March).
• Ignoring the entity concept — netting the proprietor's personal expenses against business expenses instead of debiting Drawings.
• Quoting Ind AS applicability limits or AS numbers from memory; net-worth thresholds and the AS/Ind AS mapping have been amended repeatedly, so the live MCA notification should be cited.
• Valuing closing stock at market price when market price exceeds cost, which breaches both prudence and AS 2.

Related topics

Journal, ledger and trial balance · Final accounts · Depreciation · Company accounts and Ind AS basics · Key Ind AS standards explained · Bank reconciliation statement