Accounting Principles (GAAP)

Accounting principles may be defined as those rules of action or conduct which are adopted by the accountants universally while recording accounting transactions.

Accounting Principles are classified as:

Accounting Concepts

Accounting Conventions

Important criteria for GAAP :

(a) Relevance : The principle is relevant to the extent it results in information that is meaningful and useful to the user of the accounting information.

(b) Objectivity : A principle is objective to the extent the accounting information is not influenced by personal bias or judgement of those who provide it.

(c) Feasibility : A Principle is feasible to the extent it can be implemented without much complexity or cost.

Accounting Concepts

Accounting Concepts refers to those basic assumptions or postulates or conditions upon which the science of accounting is based.

Balance Sheet - related concepts Profit & Loss - related concepts

Balance Sheet – Basic Concepts

The Business Entity Concept Going Concern Concept Monetary Unit Concept Cost Concept Conservatism Concept Accounting Equivalence Concept

The Profit & Loss Account and Related Concept

The Accounting Period Concept Realization Concept Accrual Concept Matching Expenses with Revenue concept

The Business entity concept

This concept implies that the affairs of a business are to be treated as being quite separate from the non-business activities of its owners

Personal transactions of the owner should not be included. In short as business has its own existence and therefore

business and owners both should be consider as different persons.

For e.g. A director’s private car should not be included in the fixed assets of the company.

Going Concern Concept

Accountant has to assume that business will continue to operate in future for indefinite period of time until it is liquidated in the immediate future.

Continuing activity and not liquidation. For example: In case of basis for depreciation the cost of

a fixed assets is allocated over its useful life and it will not be considered as the current year only.

Thus it does not imply permanent continuance of an enterprise but it presumes that the enterprise will continue in operations long enough to charge against income.

Monetary Unit Concept Transactions or events which can not be expressed in terms

of money, do not find a place in the books of accounts even though they may be very useful for the business.

This concept introduces many difficulties in accounting in the sense that those assets which cannot be accurately expressed in terms of monetary units reflected in business accounts.

For e.g. It is hardly possible to add thousands of square feet of buildings space with tons of coal and numbers of bank notes, effective sales policy because of physical nature of their measurement units.

Cost Concept

Concept deals that purpose of accounting all transaction are recorded at their monetary cost of acquisition.

Assets are normally shown at their original costs of acquisition.

Any changes in the market value after the purchase are ignored.

Historical cost is the most objective measure of the value of an asset. However, it cannot reflect the current value of an asset.

Cost Concept

E.g. A fixed asset acquired at a cost of $100,000 would be recorded at this amount in the books. Even if its market value may have gone up or down in future, it should be recorded at its original cost $100,000.

Conservatism Concept The accountant should always be on the side of safety. The Conservatism concept means that normally he will

take the figure which will understate rather than overstate the profit.

Provision is made for all known liabilities. “Anticipate no profits and provide for all possible losses

and if in doubt write off.”

Accounting Equivalence Concept Assets = Owners Equity + Liabilities For e.g. Mr. X had provided Rs10,00000 as the capital to start a business,

the assets owned by that company at that stage would be a cash balance of Rs10,00000.

Corresponding to this amount would be the equity; i.e. an amount which could be claimed by Mr. X this relationship is expressed as:

Assets = Equities (Claims)In accounting terms: Assets EquitiesCash Rs.10,00000 = Mr. A’s Equity (Capital) Rs.10,00000

The Profit & Loss Account and Related Concept

The Accounting Period Concept The life of business is divided into appropriate segments

for studying the results shown by the business after each segment.

The measurement of income & studying financial position of the business after a very long period would not be helpful in taking corrective steps at the appropriate time of business with losses. Thus it requires to know at frequent intervals ‘Stop and, see back’.

Realization Concept

This concept holds to the view that profit can only be taken into account when realization has occurred.

When goods produced are transferred or required services are rendered to a customer either for cash or for some other assets or for a promise to pay cash in future.

Generally, sales revenue arising from the sale of goods is recognized when the goods are delivered to the customers.

For e.g. Profit is earned when goods or services are provided to customers. Thus it is incorrect to record profit when order is received, or when the customer pays for the goods.

Accrual concept

The accrual concept says that net profit is the difference between revenues and expenses.

Income and costs are recognized as they are earned and incurred but not as they are received or paid.

For e.g. Income due but not received, outstanding expenses, Prepaid expenses etc.

Matching Expenses with Revenue concept

To ascertain the actual profit or loss of a given period, total revenue of the given accounting period is compared (matched) with total expenses for that period.

If the income or revenue is more than the expenses than the difference is known as profits & vice a versa.

In matching process, adjustments are to be made for all outstanding expenses, and unearned incomes etc.

Accounting Conventions

An accounting convention is defined as, “a rule of practice, which has been sanctioned by general custom or usage. They are lamp posts to procedures employed in the collection, measurement and reporting of financial data.”

Accounting Conventions

Conservatism/Prudence Consistency Materiality Full Disclosure

Conservatism/Prudence

It is a policy of “Playing safe.”

Prudence also means early recognition of unfavorable events.

Working rule relating to the conservatism is – “Anticipate no profits and provide for all possible losses and if in doubt write off.”

Examples: Making provisions for doubtful debts in anticipation of

actual Bad debts. Creating Investment Fluctuation Reserve Applying Written Down Value (WDV) Method of

depreciation as against Straight line method. Providing for the loss on issue of debenture, when the

same are issued at par but redeemable at premium.

Consistency The consistency convention principle implies

that accounting practices and methods remain unchanged from on accounting period to another accounting period.

For example, using only one method for valuation in accountancy for longer duration of time.

Types of Consistency Vertical Consistency: is maintained within the

interrelated financial statement of the same date. Horizontal Consistency: is maintained between financial

statements from one year to another year and subsequent years.

Third Dimensional Consistency: enables the comparison of the performance of a business enterprise with the performance of another business enterprise in the same type of industry, and preferably on the same date.

Materiality The AAA defines the term materiality as – “An item

should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor.”

It is observed that an item, material in one year may not be material in the next year.

For example, an item, Bad debts shown in the previous accounting periods, the same amount may not become important in the subsequent year.

Full Disclosure Disclosure may be defined as “the communication of

financial information about the activities of a business enterprise to the interested parties for facilitation of their economic decisions.”

Sacher Committee Report on this aspect emphasises that – “Openness in company affairs is the best way to secure responsible behavior.”

Basis for measurement

The basis for measuring the items in the financial statement should be

Reliability Relevance Consistency Comparability Understandability and Standardization

Short Questions

True/False The “Entity concept of accounting” is not applicable to

sole trading concerns and partnership concerns. The Accounting equivalence concept results in the

accounting equation = Capital + Liabilities = Assets The conservatism has usually the effect of “anticipate no

losses & provide for possible profits.” “Monetary Unit Concept” takes into account monetary as

well as non monetary units.

Composition of financial statements

Financial Statements

Summary of Financial transactions which can be classified into

Capital Nature Revenue Nature

Classification

Items of capital nature are reflected in the

Items of revenue nature are reflected in the

Balance Sheet Profit & Loss account

The impact on Cash Balances due to the operations and financing activities during the period.

Cash Flow Statement