Accounting Principles and Concepts

Generally Accepted Accounting Principles

Accounting is governed by a set of rules, guidelines, and principles to ensure that financial statements are prepared in a standardised, consistent, and reliable manner. These are collectively known as Generally Accepted Accounting Principles (GAAP). GAAP provides a framework for preparing financial information, making it understandable and comparable across different entities and periods.

GAAP is not a single set of rules but rather a combination of:

• Basic Concepts or Principles: Fundamental assumptions and postulates that underlie accounting practice.
• Accounting Standards: Specific rules and guidelines issued by accounting bodies on how to account for specific transactions and events.
• Conventions or Doctrines: Practices that have evolved over time through common usage.

The main purpose of GAAP is to enhance the reliability, relevance, understandability, and comparability of financial information, which are the qualitative characteristics discussed in the previous chapter. Adherence to GAAP ensures that users of financial statements receive information that presents a "true and fair view" of the financial position and performance of an entity.

GAAP in the Indian Context

In India, the primary body responsible for issuing accounting standards is the Institute of Chartered Accountants of India (ICAI). The standards issued by ICAI are known as Accounting Standards (AS) and are mandatory for certain classes of entities under the Companies Act, 2013, and other statutes.

India has also largely adopted Indian Accounting Standards (Ind AS), which are based on the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). Ind AS is applicable to specified classes of companies in India, while other entities still follow the older Accounting Standards (AS).

While the terms GAAP and Accounting Standards are sometimes used interchangeably, GAAP is a broader term encompassing concepts, principles, and standards that guide accounting practice.

Basic Accounting Concepts

Basic accounting concepts, also known as accounting principles or assumptions, are the foundational ideas that underpin the entire system of accounting. These concepts provide the basic framework and logic for identifying, measuring, and recording transactions and preparing financial statements.

Business Entity Concept

This concept states that the business is treated as an entity separate and distinct from its owner(s). All transactions are recorded from the point of view of the business, not the owner. The owner is treated as a creditor to the extent of the capital invested.

Significance:

• Ensures that personal transactions of the owner are not mixed with business transactions.
• Helps in determining the true financial position and performance of the business itself.

Answer:

Money Measurement Concept

According to this concept, only those transactions and events that can be measured in monetary terms are recorded in the books of accounts. Non-monetary events, even if important for the business, are not recorded.

Significance:

• Provides a common unit of measurement (e.g., ₹) for recording diverse transactions, simplifying accounting.
• Allows for aggregation and comparison of different transactions.

Answer:

A limitation is that it ignores important non-monetary aspects like employee morale, customer satisfaction, or the quality of management, which can significantly impact the business. It also assumes the value of money is stable, which is not true due to inflation.

Going Concern Concept

This is the fundamental assumption that the business will continue to operate for a long period of time in the foreseeable future. It is assumed that the entity has no intention or necessity to liquidate or curtail the scale of its operations significantly.

Significance:

• Justifies the valuation of assets at historical cost rather than market or liquidation value. If the business were expected to close down, assets would be valued at what they would fetch on immediate sale.
• Allows for the recognition of expenses over multiple periods (e.g., depreciation of fixed assets).
• Supports the distinction between current and non-current assets and liabilities.

Unless there is specific evidence to the contrary (e.g., the company is facing bankruptcy), accounting is prepared on the assumption of a going concern.

Accounting Period Concept

The life of a business is assumed to be indefinite (Going Concern Concept), but for the purpose of measuring performance and financial position, this life is artificially divided into specific periods called accounting periods. Commonly, this is a year, but it can also be half-yearly or quarterly. In India, the financial year is typically from April 1st to March 31st.

Significance:

• Enables timely reporting of financial information (Profit and Loss Account and Balance Sheet).
• Allows for comparison of performance and financial position over different periods.
• Requires adjusting entries to correctly allocate revenues and expenses to the period in which they relate (e.g., for outstanding expenses or prepaid expenses).

This concept makes the measurement of profit or loss and financial position at regular intervals possible.

Cost Concept

This concept states that an asset is ordinarily recorded in the books of accounts at the price actually paid for it or the cost incurred in acquiring it. This is known as the historical cost.

Significance:

• Provides an objective and verifiable basis for recording assets, as the cost is usually supported by vouchers and invoices.
• Avoids subjective valuation based on estimated market values, which can fluctuate.

Answer:

A limitation of the Cost Concept is that asset values in the Balance Sheet may not reflect their current market values, especially for long-held assets.

Dual Aspect Concept

This is the foundation of the double-entry system of accounting. It states that every business transaction has two effects, and both effects must be recorded in the books of accounts. For every debit, there is a corresponding credit of an equal amount.

Significance:

• Ensures the accuracy and completeness of accounting records.
• Leads to the fundamental Accounting Equation:

Assets = Liabilities + Capital

This equation signifies that the total claims against the assets of the business (claims of outsiders + claims of owners) are always equal to the total assets. Every transaction maintains this equality.

Answer:

Revenue Recognition (Realisation) Concept

This concept dictates when revenue should be recognised (recorded) in the Profit and Loss Account. Revenue is recognised when it is earned or realised, regardless of when cash is received. Revenue is considered earned when the entity has substantially completed its part of the transaction (e.g., delivered goods, rendered services).

Significance:

• Ensures that revenue is recorded in the period in which the earning activity takes place, leading to a correct calculation of profit.
• Adheres to the Accrual Basis of Accounting.

Answer:

Matching Concept

This concept requires that expenses incurred in an accounting period should be matched against the revenues earned in the same period to ascertain the correct profit or loss for that period. It is closely related to the Revenue Recognition concept.

Significance:

• Ensures that the profit or loss calculated is accurate, as it relates the costs incurred to the revenues generated within the same timeframe.
• Requires making adjustments for outstanding expenses (expenses incurred but not paid) and prepaid expenses (expenses paid but not yet incurred/consumed) at the end of the period.

Answer:

Full Disclosure Concept

This concept requires that all material and relevant information concerning the financial performance and position of the enterprise must be fully and completely disclosed in the financial statements and accompanying notes. The information should be presented in a fair and understandable manner.

Significance:

• Provides users with all information necessary to make informed decisions.
• Enhances the reliability and transparency of financial statements.

Answer:

Consistency Concept

This concept states that accounting policies and methods should be applied consistently from one accounting period to another. If a method is chosen (e.g., Straight Line Method of Depreciation), it should be used in subsequent periods as well.

Significance:

• Enables meaningful comparison of financial statements of the same entity over different periods (intra-firm comparison).
• Helps users identify trends in performance and financial position.

Changes in accounting policies are allowed only if required by law, accounting standards, or if the change will result in a more true and fair presentation. Any change must be disclosed in the financial statements.

Conservatism Concept (Prudence Concept)

This concept requires that accountants should be cautious or prudent when making judgments and estimates. It dictates that:

• Anticipate no future profits, but provide for all possible future losses.

Significance:

• Ensures that profits are not overstated and liabilities/losses are not understated.
• Leads to a safer and more realistic financial position, although it may result in understating net assets or profits in the short term.

Answer:

Materiality Concept

This concept states that financial statements should only show items that are material enough to influence the decisions of users. An item is considered material if its omission or misstatement could individually or collectively influence the economic decisions of users taken on the basis of the financial statements.

Significance:

• Avoids cluttering financial statements with insignificant details.
• Allows accountants to focus on important items.

Materiality is relative and depends on the size and nature of the item and the size of the business. A ₹5,000 expense might be material for a small shop but immaterial for a large corporation with crores of rupees in turnover. Small expenditures like the cost of a pen might be clubbed under 'Stationery' rather than recorded individually.

Objectivity Concept

This concept states that accounting transactions should be recorded based on objective evidence, free from personal bias of either the preparer or the user. Transactions should be supported by verifiable documents.

Significance:

• Ensures the reliability and accuracy of accounting records.
• Makes financial statements verifiable by auditors.

Answer:

These basic concepts provide the theoretical foundation and practical guidance for the entire accounting process.