Basic Principles of Accounting and Concepts
So, first What is Generally Accepted Accounting Principles (GAAP):
Generally accepted accounting principles or GAAP, A broadly accepted algorithm, conventions, requirements, and procedures for reporting monetary data, as established by the Financial Accounting Standards Board are called Generally Accepted Accounting Principles (GAAP).
These are the widespread set of accounting rules, requirements, and procedures that firms use to compile their monetary statements.
GAAP is a mixture of requirements (set by policy boards) and easily the generally accepted methods of recording and reporting accounting info.
GAAP is to be adopted by firms in order that buyers have an optimum degree of consistency within the monetary statements they use when analyzing firms for funding functions.
GAAP covers such points as income recognition, stability sheet merchandise classification, and excellent share measurements.
Also, financial statements prepared without the generally accepted accounting principles (GAAP) as their base will be unsuitable for inter-period and inter-firm comparison.
It is for this reason that when accounts are audited by the auditors, they see to it that the financial statements are prepared in accordance with generally accepted accounting principles (GAAP) and they also certify that the statements have been prepared in accordance with generally accepted accounting principles (GAAP).
What are the Principles of Accounting:
Principles of Accounting are fundamental guidelines that present requirements for scientific accounting practices and procedures. The information as to how the transactions are to be recorded and reported.
They assure uniformity and understandability. Principles of Accounting ideas lay down the foundation for accounting ideas.
They are ideas essentially at the mental level and are self-evident. These ideas guarantee to record financial information on sound bases and logical considerations.
There are ample confusion and controversy as to the meaning and nature of the Principles of Accounting. There is a school of thought which believes that the term principles connote fundamental belief or a general truth and as such, it is incorrect to use this term with reference to accounting because accounting, merely as an art, is only an adoption for the attainment of some useful and beneficial results.
Adaptation, inherently, implies the changing nature and, hence, a sharp contradiction to the meaning of the term principles which stands for the fundamental truth.
There is another school of thought which feels that the term principles mean the only rule of action or conduct and as such can be very correctly used with reference to rules used in accounting.
The American Institute of Certified Public Accountants (AICPA) has also supported the use of the word principles in the sense in which it means the rule of action.
It has defined the principle as a general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice.
Pato and Littleton, in order to avoid the confusion as to the meaning of the term principles, have purposely used new term standards in place of principle.
Principles would generally suggest a universality and a degree of permanence that cannot exist in a human service institution such as accounting.
The essential features of Principles of Accounting:-
Principles of Accounting are acceptable when they, in general, satisfy the following three basic norms:-
- Usefulness- Principles of Accounting satisfy the first basic feature of use as much as because of these, the accounting records become more meaningful and useful to the reader. In other words, an accounting rule, which does not increase the utility o the records to its readers, is not accepted as a Principles of Accounting.
- Objectivity- Principles of Accounting is that which is objective in nature. It is said to be objective when it is solidly supported by facts. It is objective when it cannot be influenced by personal bias and whims.
- Feasibility- Principles of Accounting should be such as are practicable. It will be seen that assets in the accounts are recorded at cost less depreciation as against at market price. This Principles of Accounting are practicable and feasible because it does not entail the difficult work of ascertaining the market price of that asset. It does not make it obligatory for the accountant to record all fluctuation in the price of that asset.
Kinds of Principles of Accounting:
To distinguish Principles of Accounting, from the sense in which the term principles are used in physical science, various other terms like postulates, concepts, conventions, doctrines, tenets, axioms, assumptions, etc., have been used by writers of accounting theory.
Instead of wasting our time to discuss the precise meaning of these generic terms, we should concern ourselves with the significance and importance of these ideas in the practical work of the accountants.
However, a slight distinction is made between the two terms concepts and conventions. The term Concept is used to connote the accounting postulates, i.e., necessary assumptions and ideas which are fundamental to accounting practice.
The term Convention is used to signify customs or traditions as a guide to the preparation of accounting statements.
Read Also: Importance of Accounting Conventions.
The following are the important generally acceptable concepts:-
- Entity Concept
- Going Concern Concept
- Money Measurement Concept
- Cost Concept
- Accounting Period Concept
- Dual Aspect Concept
- Matching Concept
- Realization Concept
- Full Disclosure Concept
- Balance Sheet Equation Concept
- Verification and Objective Evidence Concept
- Accrual Concept
The basic Principle of Accounting Concepts with examples:
1.Entity Concept
It is very important to note that for Principles of Accounting purposes the business is treated as a unit or entity apart from its owners, creditors, and others. In other words, the proprietor of an enterprise is always considered to be separate and distinct from the business which he controls.
All the transactions of the business are recorded in the books of the business(though they belong to the proprietor) from the point of view of the business as an entity and even the proprietor is treated as a creditor to the extent of his capital.
Capital is thus a liability like any other liability although the amount is owing only to the proprietor. In the case of sole trading and partnership concerns the proprietors may even draw the amounts out, thus reducing the liability of the business.
But in the case of corporate bodies, shareholders stand on a different footing. They cannot reclaim the amount they have invested. They can sell the shares to others if they desire to unload their investment.
Therefore, in the case of corporate bodies capital is paid out only at the time of winding up, provided surplus assets are available after paying off the creditors.
In the case of companies, the entity concept is more apparent, as in the eyes of law I have a separate legal entity independent of the persons who contribute its capital.
The concept of an accounting entity for every business determines the scope of what is to be recorded or what is to be excluded from the business books.
Therefore, whenever a business receives cash from the proprietor's cash account is debited as a business receives cash and the capital account is credited, capital account representing the personal account of the proprietor.
In the case of corporate bodies since there are too many contributors, the amount is shown under a single account called the share capital account.
In the case of non-corporate bodies, there is no separate legal entity. Still, the principle of business entity is observed for Principles of Accounting purposes. For example, although for legal and most practical purposes, we regard the sole trader and his business as one and the same thing, we nevertheless, for Principles of Accounting purposes, regard them as different entities.
Therefore in business, only the business assets and liabilities are recorded although legally there is no distinction between his business assets and liabilities and his private assets and liabilities.
Thus, the concepts of legal and business entities are not compatible with each other. This is also clear from the fact that in the case of big companies each department may be the base for Principles of Accounting although the legal entity is much larger and covers all the departments.
Likewise, in the case of consolidated statements Principles of Accounting entity are much larger than the legal entity.
2.Going Concern Concept:
This concept assumes the enterprise will continue to exist in the foreseeable future. This is in contrast with another view that the enterprise will be liquidated.
According to A.S.-1 relating to disclosure of Principles of Accounting policies, the going concern concept is a fundamental accounting assumption underlying the preparation of financial statements.
Under this assumption, the enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations.
The assumption implies the following:
a) Assets will be valued on the basis of going concern assumption. In other words, accountants do not record the values of goods and assets which will be fetched if a sale is forced. Certain assets that are specific to the particular enterprise may have a very low market value.
However, the value of such machines to the business is very great because of its productive potential and contribution to profits. In spite of this accountants prefer to record assets at historical cost rather than adopt the value-in-use approach which is favored by economists. This is because the historical cost approach satisfies the test of objectivity and verifiability.
b) Assets are depreciated on the basis of expected life rather than on the basis of market value. This facilitates the allocation of the cost of the asset over the expected period of the life of the asset and dispenses with the periodic consideration of market values. This concept strengthens and supports the view that depreciation is a process of allocation, not of valuation.
Thus the going concern concept is the basic to the valuation of assets and the provision of depreciation thereon.
3.Money Measurement Concept:
The money measurement concept underlines the fact that in Principles of Accounting every worth recording event happening or transaction is recorded in terms of money. In other words, a fact or a happening which cannot be expressed in terms of money is not recorded in the accounting books.
General health condition of the chairman of the company, working condition in which a worker has to work, sales policy pursued by the enterprise, quality of products introduced by the enterprise, etc., cannot be expressed in money terms and therefore are not recorded in the books.
In view of the above condition, this concept puts a serious handicap on the usefulness of Principles of Accounting records for management decisions.
This concept has another serious limitation and is currently attracting the attention of accountants all over the world.
As per this concept, a transaction is recorded at its money value on the date of occurrence and the subsequent changes in the money value are conveniently ignored.
4.Cost Concept (historic):
The underlying idea of cost concept is that:
a) Assets are recorded at the price paid to acquire it, that is, at cost; and
b)This cost is the basis for all subsequent accounting for the asset.
When assets are recorded at cost price as said under point (1) above, the change in the real worth of assets (for a variety of reasons) with the passage of time is not ordinarily recorded in the account books.
For example, if a piece of land has been purchased for Rs.80, 000, then its market price (whether Rs.1,70,000 or Rs.50,000) at the time of preparation of final statements will not be considered.
Thus the balance sheet on a particular date, prepared on the basis of cost concept, does not ordinarily indicate what the assets could be sold for.
As an explanation of point (2) of the cost concept, it can be said that the cost concept does not mean that assets are always shown year after year for an indefinite period at the cost price.
The assets recorded at cost price at the time of purchase are systematically reduced by the process called depreciation. These assets ultimately disappear from the balance sheet when their economic life is over and they have been fully depreciated and sold as scrap.
Therefore, the book's assets figure at cost less depreciation written off and are called book values to distinguish from their market values which represent their true worth.
However, in the case of liquid assets like cash and book debts, there is no difference between the book values and current market values. But in the case of other current assets like stocks and investments, there may be some difference between the two values but the margin will not be as wide as it will be in the case of fixed assets.
Also Read: What is the depreciation in accounting?
In spite of the limitations of the cost concept referred to above, accountants prefer this approach to others for the following reasons:
There is too much subjectivity in current worth or market value or a realizable value approach.
a) Fixed assets are purchased for use in production and are not held for sale.
b) It is very difficult and time consuming for an enterprise to ascertain the market values.
c)There are objectivity and verifiability in cost an approach that is lacking in the other approaches.
5.Principle of Accounting Period Concept:
Strictly speaking, the net income can be measured by comparing the assets of the business existing at the time of its commencement with those existing at the time of its liquidation.
Since the life of the business is assumed to be indefinite (going concern concept), the measurement of income, according to the above concept, is not possible for a very, very long period.
The proprietor of the business cannot wait for such a long period as the determination of income at the end of the life of the business would render such a measurement of income useless in as much as it will be too late to take corrective steps at the time if it is disclosed that the business had all the time is running at a loss on account of certain reasons or business had not been using its full capacity to make more profits.
Thus, he needs to know at frequent intervals how things are going. Therefore, accountants choose some shorter and convenient time for the measurement of income.
A twelve-month period is normally adopted for this purpose. Under the Companies Act and Banking Regulation Act accounts are to be prepared for a 12-month period. These time intervals called the accounting period.
6.Dual Aspect Concept:
Financial accounting is transaction-based. Of course, we are only concerned with transactions and events involving financial elements. In every type of business, there are numerous transactions. If one takes a typical trading concern the main activity is the purchase of goods and their subsequent sale at a profit.
This involves several transactions like the purchase of goods from several suppliers, sales to several customers on cash and credit, payment to suppliers, collection from customers, payment of salaries to salesmen, purchasing assistants, payment of rent and taxes, etc. in each of the transactions listed above there are two aspects to be recorded from the point of view of the entity.
For example, if there is the purchase of goods- it involves two aspects: one aspect is the receipt of goods and the other aspect is the immediate payment of cash (in the case of cash purchase) or the acknowledgment of debt to the supplier (in the case of credit purchase).
The recognition of two aspects to every transaction is known as dual aspect analysis. Modern financial accounting is based on such recognition of the record of the two aspects of every transaction.
The term double-entry book-keeping has come into vogue because of every transaction two entries are made. One entry consists of debt to one account and another entry consists of credit to one or more accounts. However, the total amount debited always equals the total amount credited. The balancing of debits and credits is the cornerstone of modern book-keeping.
Also Read: What is Journal in Accounting?
How this Principles of Accounting operates is illustrated with a few examples:
Mr. Joseph starts a business with an investment of 25 lakhs. Here, the business has got a resource of cash worth 25 lakhs (which is its asset), but at the same time, it has created an obligation of business towards Mr. Joseph that in the event of business closure, the money will be paid back to him. This could be shown as:
Assets = Liabilities + Capital
In other words, Cash brought in by Mr. Joseph (25 lakhs) = Liability of business towards Mr. Joseph ( 25 lakhs). We know that liability of the business could be towards owners and parties other than owners, this equation could be re-written as:
Assets = Liabilities + Owner’s equity
Cash 25,00,000 = Liabilities nil + Mr. Joseph’s equity 25,00,000. This is the fundamental accounting equation shown as a formal expression of the dual aspect concept. This powerful concept recognizes that every business transaction has a dual impact on the financial position.
Principles of Accounting systems are set up to simultaneously record both these aspects of every transaction; that is why it is called a Double-entry system of accounting. In its present form, the double-entry system of accounting owes its existence to an Italian expert Mr. Luca Pacioli in the year 1495.
Continuing with our example of Mr. Joseph, now let us consider the borrows 15 lakhs from the bank. The dual aspect of this transaction-on one hand the business cash will increase by 15 lakhs and liability towards the bank will be created for 15 lakhs.
Assets = Liabilities + Owner’s equity
Cash 40,00,000 = Liabilities 15,00,000 + Mr. Joseph’s equity ` 25,00,000
The student must note that the dual aspect concept entails recognition of the two effects of each transaction. These effects are of equal amount and reverse in nature. How to decide these two aspects?
The golden rules of accounting are used to arrive at this decision. After recording both aspects of the transaction, the basic accounting equation will always balance or be equal.
The above concepts find application in the preparation of the Balance Sheet which is the statement of assets and liabilities as on a particular date. We will now see some more concepts that are important for the preparation of a Profit and Loss Account or Income Statement.
7.Matching Concept:
This concept recognizes that the determination of profit or loss on a particular accounting period is a problem of matching the expired cost allocated to an activity period. In other words, the expenses which are actually incurred during a specific activity period, in order to earn the revenue for the period must be matched against the revenue which is realized for that period.
For this purpose, expenses which are specially incurred for earning the revenue of the related period are to be considered. In short, all expenses incurred during the activity period must not be taken.
Only relevant costs should be deducted from the revenue of a period for the periodic income statement, i.e., the expenses that are related to the accounting period shall be considered for the purpose of matching. This process of relating costs to revenue is called the matching process.
It should be remembered that the cost of fixed assets is not taken but only the depreciation on such fixed assets related to the accounting period is taken ( For the purpose of matching, prepaid expenses are excluded from the total cost but outstanding expenses are added to the total cost for ascertaining the cost related to the period).
Like costs, all revenues earned during the period are not taken, but revenue that is related to the accounting period is considered.
The application of the matching concept creates some problems which are noted below:
a) Some special items of expenses e.g. preliminary expenses, expenses in connection with the issue of shares and debentures, advertisement expenses, etc., cannot be easily identified and match against revenues of a particular period.
b) Another problem is that how much of the capital expenditure should be written off by the way of depreciation for a particular period for matching against revenue creates the problems of finding out the expected life of the asset. As such, accurate matching is not possible.
c) In the case of long-term contracts usually, the amount is not received in proportion to the work done. As a result, expenditures that are carried forward and not related to the income received may create some problems.
8.Realization Concept:
According to the concept, revenue is considered as earned on the date when it is realized. In other words, revenue realized (either by the sale of goods or by rendering services) during an accounting period should only be taken in the income statement (Profit and Loss Account). Unearned/Unrealised revenue is treated as earned on some specific matters or transactions.
For example, when goods are sold to customers, they are legally liable to pay, i.e. as soon as the property of goods passes from the seller to the buyer. In short, when order is simply received from customers, it does not mean that the revenue is earned or realized.
On the other hand, when advance payment is made by a customer, the same cannot be treated as revenue realized or earned.
In the case of hire-purchase transactions, however, the title or ownership of the goods is not transferred from the seller to the buyer until the last installment is paid.
As such, the down payments and the installment received or due should be treated as an actual sale, i.e., revenue earned.
9.Full Disclosure Concept:
10.Balance Sheet Equation Concept:
The Historical Cost Concept needs the support of two other concepts for practical purposes viz. (i) the Money Measurement Concept (ii) the Balance Sheet Equation Concepts.
Principles of Accounting processes, however, conform to an algebraic equation which, in other words, is involved in two laws of nature, i.e., the law of constancy of matter and the law that every effect originates from a case.
In relation to the former, it may be deduced that all that has been received by us must be equal to (=) all that has been given to us (In accounts, receipts are classified as debits and giving or sacrifices are classified as credits).
Here, the equation comes Debit=Credit (That is, in other words, every debit must have a corresponding equal credit or vice versa).
All receipts (referred to above) may again be classified into:
a) Benefits/services received and totally consumed (which are known expenses),
b) Benefits or services received but not used properly or misused (which are known as losses) and
c) Benefits or services received but kept to be used in the future (which are known as assets).
Similarly, in the opposite case, all that has been given by others may also be classified into:
a) What has been given to us but are not to be repaid (which are known as incomes or gains) and
b) What has been given by others but has to be repaid at a later date ( which are known as liabilities).
Therefore, the above equation may again be re-written as under:
Expenses + Loss + Assets = Income + Gains + Liabilities
Or, Asset = Net Profit (-) Net Loss + Liabilities.
Liabilities become due either to outsiders or to the owner, viz. The proprietors, in the case:
Asset = Net Profit or (-) Net Loss + External liabilities + Dues to Proprietors.
We know that proprietors' due increases with the amount of net profit whereas decreases with the amount of net loss. The same is known as equity in the business. So, the above equation comes down to Assets = Equity + External Liabilities.
Again, from the proprietor’s point of view, the equation can also, be re-written as under:
Proprietor’s Fund or Equity = Assets – Liabilities.
E = A – L
From the above, it may be said that the entire Principles of Accounting process depends on the above accounting equation.
11.Verifiable and Objective Evidence Concept:
It expresses that Principles of Accounting data are subject to verification by independent experts i.e. there must be documentary evidence of transactions that are capable of verification. Otherwise, the same will neither be verifiable nor be realizable or dependable.
In other words, Principles of Accounting data must free from any basic. Because verifiability and objectivity imply reliability, trustworthiness, dependability which are very useful for conveying the accounting data and information furnished in periodical accounting reports and statements.
There should always be some documentary evidence in establishing the truth reflected in the said reports or statements.
Entries that are recorded in accounting from the transactions and data which are reported in financial statements must be based on objectively determined evidence.
The confidence of users of the financial statement cannot be maintained until there is close adherence to this principle, invoices, and vouchers for purchases, sales, and expenses, physical checking of stock in hand.
12.Accrual Concept:
An associated concept to be discussed in the context of the matching principle is the accrual system of accounting which is favored by the modern accountants as against the cash system of accounting.
Under this method, revenue recognition depends on its realization and not the actual receipt. Likewise, costs are recognized when they are incurred and not when paid.
This necessitates certain adjustments in the preparation of the income statements. In relation to revenue, the accounts should exclude amounts relating to the subsequent period and provide for revenue recognized but not received in cash.
Likewise, in relation to cost provide for costs incurred but not paid and exclude costs paid for the subsequent period. Under the cash system of Principles of Accounting, revenue recognition does not take place until cash is received and costs are recorded only after they are paid.
From the discussion, it is clear that the matching principle is not followed in the case of the cash system of accounting and the operating results prepared on this basis are not in conformity with generally accepted accounting principles(GAAP).
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