Unit 1: Accounting foundations and policy
Accounting Theory notes · PTU syllabus (MCOP104-18)
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Unit summary
Accounting theory explains why accounts are kept the way they are. This unit covers the history and evolution of accounting thought, approaches to accounting theory, financial vs cost vs management accounting, the concepts of income, revenue, expense, gains and losses, single vs double entry, GAAP, and accounting policy for depreciation and inventories.
After this unit you can
- Trace the evolution of accounting thought and approaches to accounting theory
- Define income, revenue, expense, gains and losses
- Compare single and double entry systems and explain GAAP
- Explain accounting policies for depreciation and inventories (AS 10/Ind AS 16, AS 2)
PTU syllabus topics
- History and evolution of accounting thought
- approaches to accounting theory
- financial vs cost vs management accounting
- concepts of income/revenue/expense/gains/losses
- single vs double entry systems
- GAAP nature/scope/merits/limitations
- accounting policy for depreciation and inventories
Deductive
From objectives and postulates to rules
Inductive
From observed practice to principles
Ethical
Fairness and truth
Sociological
Impact on society
Economic
Impact on economic welfare
Decision-usefulness
What users need
Topic 1
History and evolution of accounting thought
- 1
Ancient records
Mesopotamia, Egypt; Kautilya's Arthashastra on royal accounts
- 2
Double entry codified (1494)
Luca Pacioli's Summa de Arithmetica, Venice
- 3
Industrial revolution
Cost accounting, depreciation, corporate reporting
- 4
20th century
Professional bodies (AICPA, ICAI 1949), standard setting (FASB 1973, IASC 1973)
- 5
Globalisation (2000s)
IFRS adoption, Ind AS (2016)
- 6
Digital age
XBRL, integrated and sustainability reporting (BRSR), AI and blockchain
- Indian tradition: the Bahi-khata (mahajani) system of double-sided records predates European methods in practice.
- Accounting theory is a set of broad principles providing a general frame of reference for evaluating accounting practices and guiding new practices (Hendriksen).
Topic 2
Approaches to accounting theory
Non-theoretical
Pragmatic (what works), authoritarian (rules by professional bodies)
Deductive
Start from objectives and postulates, derive principles logically
Inductive
Observe practices and generalise
Ethical
Fairness, truth and justice
Sociological
Social effects of accounting (social accounting)
Economic
Macro-economic consequences
Eclectic
Combination of approaches — basis of standard setting
Positive accounting theory (Watts and Zimmerman)
Explains and predicts why managers choose policies (bonus, debt, political cost hypotheses)
- Normative vs positive theory: normative says what accounting should be; positive explains and predicts what it is.
Topic 3
Financial vs cost vs management accounting
| Basis | Financial accounting | Cost accounting | Management accounting |
|---|---|---|---|
| Purpose | Report position and performance to outsiders | Ascertain and control cost | Help management plan and decide |
| Users | External — shareholders, lenders, tax | Internal | Internal |
| Compulsion | Statutory | Required for specified industries | Voluntary |
| Time focus | Past | Past and present | Future |
| Rules | GAAP, standards | Cost accounting standards (CAS) | No fixed rules |
Topic 4
Income, revenue, expense, gains and losses
- Income (Conceptual Framework): increases in assets or decreases in liabilities that increase equity, other than contributions from owners — includes revenue and gains.
- Revenue: income arising in the course of ordinary activities (sales, fees, interest, dividends, royalties) — Ind AS 115 five-step model: identify contract → identify performance obligations → determine transaction price → allocate price → recognise revenue when obligation is satisfied.
- Expenses: decreases in assets or increases in liabilities that reduce equity, other than distributions to owners.
- Gains and losses: increases or decreases from peripheral or incidental transactions (sale of a fixed asset, foreign exchange).
Basis
Realised transactions, historical cost
Change in wealth (Hicks: amount one can consume and be as well off)
Measurement
Objective, verifiable
Subjective (present values)
Includes unrealised gains
Generally no
Yes
Use
Financial reporting, tax
Economic analysis, valuation
- Capital maintenance concepts: financial capital maintenance (money or purchasing power) vs physical capital maintenance (operating capability).
Topic 5
Single vs double entry and GAAP
Recording
Only personal accounts and cash (incomplete)
Both aspects of every transaction
Trial balance
Not possible
Possible — checks arithmetical accuracy
Profit
Estimated by statement of affairs (capital comparison)
Accurate P&L account
Acceptability
Not accepted for companies or tax audit
Universally accepted
- GAAP: rules, conventions and procedures defining accepted accounting practice. Nature: man-made, flexible, evolving. Scope: recognition, measurement, presentation, disclosure. Merits: comparability, consistency, credibility. Limitations: alternatives allowed, historical cost bias, judgement and manipulation possible.
Topic 6
Accounting policy for depreciation and inventories
Depreciation (AS 10 / Ind AS 16)
- Depreciation: systematic allocation of the depreciable amount (cost − residual value) of an asset over its useful life.
- Methods: straight line, written down value, units of production, sum-of-years' digits; component accounting for significant parts; Schedule II of the Companies Act prescribes useful lives.
- Change in method is a change in accounting estimate (prospective) under Ind AS 16 / AS 10 (revised).
- Revaluation model (Ind AS 16) — surplus to OCI/revaluation reserve.
Inventories (AS 2 / Ind AS 2)
- Measured at the lower of cost and net realisable value (NRV).
- Cost = purchase cost + conversion cost + other costs to bring inventory to its present location and condition (excluding abnormal wastage, storage, selling costs, administrative overheads).
- Cost formulas: FIFO or weighted average; specific identification for non-interchangeable items; LIFO not permitted.
Example
Item cost ₹500; estimated selling price ₹540; cost to sell ₹60 → NRV = ₹480; inventory valued at ₹480 (write-down ₹20).
Key terms
- Accounting theory
- Principles providing a framework to evaluate and develop accounting practice
- Positive accounting theory
- Theory explaining and predicting accounting choices
- Revenue
- Income arising from ordinary activities
- GAAP
- Generally accepted accounting principles
- NRV
- Estimated selling price less estimated costs of completion and sale
Quick revision
- Pacioli 1494; Bahi-khata; IASC/IFRS; Ind AS 2016.
- Approaches: deductive, inductive, ethical, sociological, economic, eclectic, positive.
- Income = revenue + gains; Ind AS 115 five steps.
- Double entry allows trial balance and accurate profit.
- Depreciation (AS 10/Ind AS 16); inventories at lower of cost and NRV (AS 2).
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Who is the father of double-entry book-keeping?
- Q2.Distinguish deductive and inductive approaches.
- Q3.What is positive accounting theory?
- Q4.Distinguish revenue and gains.
- Q5.What is GAAP?
- Q6.How are inventories valued under AS 2?
Long-answer questions
- Q1.Trace the evolution of accounting thought.
- Q2.Explain the various approaches to accounting theory.
- Q3.Explain the concepts of income, revenue, expenses, gains and losses.
- Q4.Explain accounting policies for depreciation and inventories.
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