Introduction - Accounting Principles - Commerce PDF Download

Generally Accepted Accounting Principles

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

1. Business entity/ Separate entity Concept

• The concept of business entity assumes that a business has a distinct and separate entity from its owners, creditors, and managers.
• As per this concept, the business and its owners are to be treated as two separate entities, and the book of accounts is made from the point of view of the business unit and not that of the owner. And the assets of the business are separate from the assets of the businessmen.
• Keeping this in view, when a person brings in some money as capital into his business, in accounting records, it is treated as a 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 a 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 its effects can be measured in terms of money.
• For example, the appointment of a manager and strikes by employees will not be recorded.
• Records of the transactions are to be kept not in the physical units but 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 is 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 contact with the business, sell goods on credit and purchase shares of the company.
• For example, the full cost of the machinery is not debited to the profit and loss account in the year of purchase it will be divided over 10 years to calculate the profit and loss of each year.

4. Historical cost principle:

• All assets are recorded in the book of accounts at their purchase price, which includes the 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 that has been paid on the date of acquisition and does not change year after year.
• For example: if a building were 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. Eg: brand name, knowledge, and technical skills. 

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

5. 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 the 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 the 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.

6. Matching concept:

• Expenses incurred in an accounting period should be matched with revenues during that period.
• In other words, first, the revenue is recognized, and then the costs incurred for generating those revenues should be recognized (revenue and costs must belong to the same accounting period).

Justification:

a. Expenses such as salaries, rent, and insurance are recognized on the basis of the 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 show as expenses 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 this year and will be treated as an opening stock for the next year.

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

7. Accounting period Concept:

• The 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.
• 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 on 1st April and ends on 31st March.

8. Principle of Full disclosure :

• The principle of full disclosure requires that all material and relevant facts concerning the 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 a correct assessment of the profitability and financial soundness of the enterprise and help them to make informed decisions.
• For example, the market value of the investments (securities) is given in the footnotes.
• Contingent liabilities(those liabilities about which the firm is not sure that they will arise in the future or not, like a guarantee given for a loan of a sister concern or a claim on the company pending in a court case) are also shown in the footnotes.

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.
• For example, 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 a 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 the principle of conservatism:
  Closing stock is recorded at the cost price, or the realizable value which-ever is less.
  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 with other 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 than 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 a difference between incomes earned and expenses incurred. 
• This basis takes 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-occurring source i.e. the sale of goods or services.
• The concept of revenue recognition determines the period in which the amount of revenue (sales) will be realized.
• For 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 recognized 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 the sale of goods in April 2015, then revenue from this sale shall be recognized in April 2015.
• Thus it can be concluded that sales or revenue will be recorded at a point of time when it had been made, whether cash is received or not received, revenue will be recorded at the time of sales.

14. Verifiable Objective Concept

• According to this concept, all transactions should be recorded objectively, 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 memos, invoices, bills, etc.
• For example, cash purchase of goods should be supported by a Cash Memo and credit purchase by an invoice.