Elementary Principles of Accounts
Nine concepts, one equation and three golden rules. Everything else in IC-26's accounts is built on them.
IC-26 opens with plain bookkeeping before it gets to a life insurer's accounts. The reason is simple: premium accounting, claims accounting and the final accounts all rest on a handful of ideas about when something counts, what it is worth, and how each transaction is recorded twice.
Accounting principles are split into two groups: accounting concepts and accounting conventions. A concept is one of the basic assumptions that periodic accounts are built on. This page covers the concepts and the mechanics of double entry. A good principle, the source says, should be relevant, objective and feasible (able to change as business practice changes).
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The Accounting Concepts
| Concept | What it says |
|---|---|
| Business entity | The business is separate from its owners or managers. Applies to every form of business, whether the law treats it as separate (a company) or not (a sole proprietorship or partnership) |
| Going concern | The business is assumed to carry on for the foreseeable future, with no intention to liquidate or sharply cut back |
| Accruals (matching) | Revenue and costs are recognised when earned or incurred, not when cash moves, and matched in the period they relate to |
| Verifiable objective evidence | Every entry should be backed by business documents called vouchers |
| Prudence | Where there is a choice, pick the most cautious presentation. Do not anticipate profit; provide for all known liabilities and losses, even if only estimated |
| Consistency | Treat similar items alike within one set of accounts, and the same way from one period to the next, so periods can be compared |
| Money measurement | Accounts record only what can be given a money value, at its value when recorded. Later inflation or deflation is not taken into account |
| Dual aspect | Every transaction affects at least two items. The Delhi University text calls it perhaps the most important concept |
| Realisation | Profit is earned when goods or services are furnished for consideration, or a third party becomes legally liable to pay. For goods, that is shipment or delivery |
Prudence in Practice
- check_circleStock bought for $2,400 that is likely to fetch only $1,800 is valued at $1,800.
- check_circleThe $600 loss is recognised when it is foreseen, not when the stock is finally sold.
- check_circlePrudence has a limit: it must not lead to a material overstatement of liabilities or losses either.
Realisation and Its Exceptions
Profit on goods is not recognised when an order arrives, a contract is signed or the goods are made. The Delhi University text lists four exceptions.
- check_circleRevenue measurable earlier: mined metal has a specified value, so revenue is recognised when it is mined, not sold.
- check_circleHire purchase and instalment sales: revenue is recognised only as instalments come in, because the final amount is uncertain.
- check_circleAfter-sale service in the contract: full revenue is not taken; the probable cost of repairs is provided out of realised profit.
- check_circleProduction alone earns the profit and selling takes no effort: profit is treated as realised when the goods are made.
The Accounting Equation
Assets are what the business owns. Equities are the claims on those assets, and they come in two kinds: owner's equity (capital) and creditors' equity (liabilities). Every asset is claimed by someone, so total assets always equal total equities, and total claims can never exceed the assets.
That gives Assets = Equities, written as Capital + Liabilities = Assets. The expanded form is Capital + Revenue + Liabilities = Assets + Expenses. Because no event can change just one item, accounting is properly called a double entry system.
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Single Entry vs Double Entry
What is kept
Single entry
Only a cash book and personal accounts of debtors and creditors
Double entry
Two entries for every transaction, an equal debit and credit
Trial balance
Single entry
Cannot be prepared
Double entry
Total debits equal total credits, which helps find errors and prepare final accounts
Completeness
Single entry
A complete record is not possible
Double entry
A complete record; the system used to record business transactions in India
| Single entry | Double entry | |
|---|---|---|
| What is kept | Only a cash book and personal accounts of debtors and creditors | Two entries for every transaction, an equal debit and credit |
| Trial balance | Cannot be prepared | Total debits equal total credits, which helps find errors and prepare final accounts |
| Completeness | A complete record is not possible | A complete record; the system used to record business transactions in India |
The Golden Rules of Debit and Credit
The traditional approach divides accounts into real, personal and nominal. Whichever approach is used, the double effect on the books is the same.
Real
What it holds
Assets
Debit
What comes in
Credit
What goes out
Personal
What it holds
Persons and organisations dealt with, such as debtors and creditors
Debit
The receiver
Credit
The giver
Nominal
What it holds
Revenue, expenses, losses and gains
Debit
All expenses and losses
Credit
All incomes and gains
| Account | What it holds | Debit | Credit |
|---|---|---|---|
| Real | Assets | What comes in | What goes out |
| Personal | Persons and organisations dealt with, such as debtors and creditors | The receiver | The giver |
| Nominal | Revenue, expenses, losses and gains | All expenses and losses | All incomes and gains |
From Transaction to Trial Balance
The modern (accounting equation) approach uses five heads instead: asset, liability, capital, expenses/losses and income/gains. The recording steps are the same.
- 1
Journal
Record each transaction in date order, with its debit and credit.
- 2
Ledger
Post each entry to the ledger accounts it affects.
- 3
Trial balance
Summarise every ledger account. It helps locate errors and is the base for the financial statements.
Where This Shows Up in a Life Insurer's Accounts
The accruals idea is the rule behind premium income. IRDA's financial statements regulations (2000) say "Premium shall be recognised as income when due", so a premium that has fallen due is income even before the cash arrives, and cash received before anything is due is not yet income.
The same regulations say acquisition costs are expensed in the period they are incurred. The cost of selling a policy is not carried forward and spread over the years the policy runs.
Exam Traps
Real accounts: debit what comes in. Personal accounts: debit the receiver. Nominal accounts: debit expenses and losses. Do not swap them. Money the owner puts in is capital, not income. Profit on goods is realised on delivery, not on order, contract or manufacture. Single entry cannot produce a trial balance. The traditional approach has three account types; the modern approach has five heads.
FAQs
What is the dual aspect concept?expand_more
Every transaction affects at least two items in the accounts, so a single change is impossible. It is the basis of double entry and of the equation Capital + Liabilities = Assets.
What are the golden rules of accounting?expand_more
Real accounts: debit what comes in, credit what goes out. Personal accounts: debit the receiver, credit the giver. Nominal accounts: debit all expenses and losses, credit all incomes and gains.
What does the prudence concept require?expand_more
Do not anticipate profit, provide for all known liabilities and losses even if estimated, and do not overstate assets or profits, without overstating losses either.
Why can a trial balance not be prepared under single entry?expand_more
Single entry keeps only a cash book and personal accounts, so the records are incomplete and there is no full set of equal debits and credits to total.
How does the accruals concept apply to insurance premium?expand_more
Premium is recognised as income when it is due, under IRDA's financial statements regulations, not when the cash is received.
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