Introduction - Accounting Principles Commerce Notes | EduRev

Crash Course of Accountancy - Class 11

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Accounting Principles

Generally Accepted Accounting Principles

(GAAP) refers to the rules or guidelines adopted for recording and reporting of business transactions in order to bring uniformity in the preparation and the presentation of financial statements. These principles are also referred as concepts and conventions.

The term concept refers to the necessary assumptions and ideas which are fundamental to accounting practice. Convention connotes customs or traditions as a guide to the preparation of accounting

statements. I

1. Business entity/ Separate entity Concept

- The concept of business entity assumes that business has a distinct and separate entity from its owners, creditors and mangers.

- As per this concept the business and its owners are to be treated as two separate entities and the book of accounts are made in the point of view of the business unit and not that of the owner. And the assets of business are separate from the assets of the business men

- Keeping this in view, when a person brings in some money as capital into his business, in accounting records, it is treated as liability of the business to the owner.

- Similarly, when the owner withdraws any money from the business for his personal expenses (drawings), it is treated as reduction of the owner’s capital and consequently a reduction in the liabilities of the business.

-  Lastly personal transactions of the owner are not recorded in the books of the business, unless it involves inflow or outflow of business funds.

2. Money measurement concept

- Only those transactions and events will be recorded which can be expressed in terms of money

- An event, even though it may be very important for the business, will not be recorded in the books of

the business unless it effects can be measured in terms of money.

- For example, the appointment of a manager, strike by employees will not be recorded.

- Records of the transactions are to be kept not in the physical units but in the monetary unit. Like we will record the value of 5 tables and 4 chairs instead of their units, 5 tables= Rs.5,000 and 4 chairs= Rs.800.

3. Going concern concept

- This principle assumes that our business going to run for a very long period of time.

- The transactions are recorded on the assumption of a continuing enterprise.

- It is due to this concept outside parties come into contract with the business sell goods on credit and purchases shares of the company.

- For ex: the full cost of the machinery is not debited to profit and loss account in the year of purchase it will be divided over 10 years for calculating profit and loss of each year.

4. Accounting period Concept:

- As it is assumed that the business is intended to continue for a long period of time, the true results of the business will be ascertained only when the business is completely wound off.

- But ascertainment of profit after a long time will not be of any use.

- Due to which the entire life of the business is divided into small parts.
- Each part is usually of 12 months and every business unit has to follow the financial year which starts from 1st April and ends on 31st march.

- Accounting period refers to the span of time at the end of which the financial statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that period.

5. Historical cost principle:

- All assets are recorded in the book of accounts at their purchase price, which includes cost of acquisition, transportation, installation and making the asset ready to use.

- To illustrate, on June 2005, an old plant was purchased for Rs. 50 lakh. An amount of Rs. 10,000 was spent on transporting the plant to the factory site. In addition, Rs. 15,000 was spent on repairs for bringing the plant into running position and Rs. 25,000 on its installation. The total amount at which the plant will be recorded in the books of account would be the sum of all these, i.e. Rs. 50,50,000.

- The concept of cost is historical in nature as it is something, which has been paid on the date of acquisition and does not change year after year.

- For example: a building was purchased for Rs.5,000,000 it would be recorded in the books at this value.

After two years the market value of the building shoots up to Rs.6,000,000, even then the increased value will not be recorded in the books of accounts.

Justification:

a. Market value of the assets is difficult to be determined.

b. Market value of the assets changes from time to time.

c. It is justified by going concern concept as it assumes that the business will run for a long period of time so there

is no need of using the market values.

Drawbacks of historical cost concept:

a. Assets for which nothing is paid will not be recorded ex: brand name, knowledge and technical skills

b. Information is not useful for the management, investors and creditors

6. Dual aspect concept/ double entry system / principle of Duality:

- This concept states that every transaction has a dual or two-fold effect and should therefore be recorded at two places. In other words, at least two accounts will be involved in recording a transaction.

- Assets = Liabilities + Capital

- For example. Ram started business by investing in a sum of Rs. 50,00,000 The amount of money brought in by Ram will result in an increase in the assets (cash) of business by Rs. 50,00,000. At the same time, the owner’s equity or capital will also increase by an equal amount. It may be seen that the two items that got affected by this transaction are cash and capital account.

7. Matching concept:

- Expenses incurred in an accounting period should be matched with revenues during that period.

- In other words first the revenue are recognized and then the costs incurred for generating those revenues should be recognized {revenue and costs must belong to the same accounting period}.

Examples/ justification:

a. Expenses such as salaries, rent and insurance are recognized on the basis of period to which they relate and not when these are paid.

Outstanding expenses (expenses due but not paid) are shown in P & L A/C

Prepaid expenses(expenses paid in advance will shown as expense in the next year)

Depreciation is also included is shown in P & L A/C

b. Closing stock is deducted from the cost of goods sold in this year and will be treated as an opening stock for the next year.

c. Similarly incomes receivable will be added in the revenues and income received in advance will be deducted from the revenues.

8. Principle of Full disclosure :

- Principle of full disclosure requires that all material and relevant facts concerning financial performance of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes.

- This is to enable the users to make correct assessment about the profitability and financial soundness of the enterprise and help them to take informed decisions.

- Ex: market value of the investments (securities) is given in the foot notes.

- Contingent liabilities(those liabilities about which the firm is not sure that they will arise in future or not, like guarantee given for a loan of a sister concern, a claim on the company pending in a court case) are also shown in the foot notes.

9. Consistency Concept

- Accounting policies and practices followed by enterprises should be kept uniform and consistent year after year. Consistency helps in making comparisons and drawing conclusions regarding the working of an enterprise.

- Ex: there are several methods for recording depreciation i.e. straight line and written down value method, it is expected from the firm that the method once selected will be followed year after year.

- However, consistency does not prohibit change in accounting policies. Necessary required changes are fully disclosed by presenting them in the financial statements.

10. Conservatism Concept/ principle of prudence:

- All anticipated losses should be recorded in the books of accounts but all the anticipated gains should be ignored . This is a policy of Playing Safe.

- Due to this principle, provisions are made for all the known losses and liabilities with the help of judgments.

- Examples of application of principle of conservatism

a. Closing stock is recorded at the cost price or the realizable value which-ever is less.

b. Provision for bad debts is created in anticipation of the actual bad debts

11. Materiality Concept:

- The concept of materiality requires that accounting should focus on material facts or information, all the irrelevant information should be left out or merged out with others items

- The materiality of a fact depends on its nature and the amount involved and its capability to influence the decisions of the investors

- For example, stock of erasers, pencils, scales, etc. are not shown as assets, whatever amount of stationery is bought in an accounting period is treated as the expense of that period, whether consumed or not.

12. Accrual concept:

- Revenues and costs are recognized in the period in which they occur rather when they are paid.

- Incomes are recorded when they are earned whether the cash is received or not and similarly the expenses are recorded when they are incurred or become due and whether the cash is paid for them or not.

- Profit or loss is the result of difference between incomes earned and expenses incurred.

- This basis makes into consideration the outstanding expenses, prepaid expenses, accrued incomes and unearned incomes

13. Revenue Recognition Concept:

- Revenue refers to the money that the firm receives from any re-occuring source i.e. the sale of goods or services.

- Concept of revenue recognition determines the period in which the amount of revenue (sales) will be realized.

- Example: Suppose a firm sells goods in January 2015, but receives the amount in March 2015. As per the principle of revenue recognition, revenue from this sale should be recognised in January 2015 itself as the legal obligation to pay the amount has been established on this date. However, if the firm had received only an advance in January

2015 for sale of goods in April, 2015, then revenue from this sale shall be recognised in April, 2015.

- Thus it can be conculed that sales or revenue will be recorded at a point of time when it had been made, whether cash is received or not received , revnue will be recorded at the time of sales.

14. Verifiable Objective Concept

According to this concept, all transactions should be recorded in an objective manner and they should be free from personal bias.

• It implies that all accounting transactions should be supported by documentary evidence or vouchers.

• These supporting documents include cash memo, invoices, bills, etc.

• For example, cash purchase of goods should be supported by a Cash Memo and credit purchase by an invoice.

Complete the following work sheet:

(i) If a firm believes that some of its debtors may ‘default’, it should act on this by making sure that all possible losses are recorded in the books. This is an example of the ___________ concept.

(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the ___________ concept.

(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the ___________ concept.

(iv) The ___________ concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.

(v) A firm may hold stock which is heavily in demand. Consequently, the market value of this stock may be increased. Normal accounting procedure is to ignore this because of the ___________.

(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the ___________.

(vii) The management of a firm is remarkably incompetent, but the firms accountants can-not take this into account while preparing book of accounts because of ___________ concept.

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