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Generally AcceptedAccounting Principles

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Generally AcceptedAccounting Principles

What is the primary objective of financial Accounting and Reporting?

Generally Accepted Accounting Principles and Basic Concepts

• If every accountant used his or her own rules for recording transactions, the financial statements would be useless in making comparisons.

• Therefore, accountants have agreed to apply a common set of measurement principles (a common language) to record information for financial statements.

The rules that govern accounting are called GAAP(generally accepted accounting principles).

• GAAP - a term that applies to the broad concepts or guidelines and detailed practices in accounting, including all the conventions, rules, and procedures that make up accepted accounting practice at a given time

Generally Accepted Accounting Principles

ACCOUNTING PRINCIPLES

“Accounting principles are the rules of action or the methods and procedures of accounting commonly adopted while recording business transactions.”

Accounting principles are general decision rules, derived from objectives and concepts of accounting which govern the development of accounting techniques.

Accounting principles are classified into two parts.(A) Accounting concepts.(B) Accounting conventions.


Accounting concepts

Accounting conventions


(A)ACCOUNTING CONCEPTS

These are basic assumptions or fundamental proposition concerning the economic, political and sociological environment in which accounting must operate.

1. Business entity concept 2. Going concern concept3. Money measurement concept4. Double entry concept5. Accounting period concept6. Cost concept7. Realization concept8. Matching of cost & Revenue concept9. Accrual concept10. The Reliability Concept

(A)ACCOUNTING CONCEPTS

B) ACCOUNTING CONVENTIONS

Accounting conventions are traditions and customs which guide the accountant while preparing the accounting statements.

1. Convention of Full disclosure2. Convention of conservatism3. Convention of consistency4. Convention of Materiality

B) ACCOUNTING CONVENTIONS

1. Business entity concept (separate entity concept)

In accounting, the business is considered to be a separate entity from the proprietor(s)/owner(s).

It is helpful in keeping business affairs strictly free from the effect of private affairs of the proprietor(s). Consequently :

Amount invested by proprietor is shown as a “liability” in the books of the business.Amount paid for personal expenses of proprietor are shown as drawings from capital of the proprietor.

It is applicable to all forms of business organisations


•Assume that John decides to open up a gas station and coffee shop.

•The gas station made Rs 250,000 in profits, while the coffee shop lost Rs 50,000.•How much money did John make?


2. Going concern concept

According to this concept it is assumed that the business will continue for a fairly long time to come.

There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future.

The entity will continue to operate in the forseeable future.

Accordingly:•Fixed assets are recorded at cost not liquidation value.•Depreciation on fixed assets is charged over the expected lives.•Deferred costs are amortized over appropriate period•Prepaid expenses as treated as assets.

•NOTE: This concept does not imply permanent continuance of the enterprise.


•If the continuity of an entity is in doubt, a liquidation approach to the balance sheet is taken, and the assets and liabilities are valued as if the entity were to be liquidated in the near future.


3. Money measurement concept

Money is the common denominator for quantifying the effects of transactions.

Accounting records only monetary transactions.

Events or transactions which cannot be expressed in money do not find place in the books of account though they may be very useful for the business.

This concept helps in understanding the state of affairs of the business in a much better way.

3. Money measurement concept

Each transaction has two aspects:

a) Receiving of a benefit

b) The giving of that benefit

The recognition of the two aspects to every transaction is known as a dual aspect analysis.

4. Double entry concept (Dual Aspect

Concept)

There must be a double entry to have a complete record of each business transaction.

An entry being made in the receiving account (debit) and an entry of the same amount in the giving account (credit).

Thus every debit must have a equal and corresponding credit and vice-versa and upon this dual aspect has been based the double entry system of accounting.


Concept)

It follows from the dual aspect concept that at any time:

This relationship is called “accounting equation.”


Concept)

Assets = Equity + Liability

It requires that accounting information be reported at regular intervals (accounting periods).

The life of the business is divided into appropriate segments (accounting periods) for studying the results shown by the business after each segment.

5. Accounting period concept (periodicity concept)

Accounting period is a period to measure business performance.



at the end of which financial statements are prepared

Accounting period is the span of time

to throw light on

the results of operation during the relevant period and

the financial position at the end of the relevant period.

Importance: Though the life of the business is considered to be indefinite (according to going concern concept), the measurement of income and studying of the financial position of the business after a very long period would not be helpful in taking proper corrective steps at the appropriate time.


6. Cost concept

Assets and liabilities should be recorded at historical cost i.e. costs as on acquisition.

6. Cost concept

This does not mean the the assets will always be shown at cost. It may be systematically reduced in its values by charging depreciation.

This cost is the basis for all subsequent accounting for the assets.

Advantage: This concept brings objectivity in the preparation and presentation of financial statements.

Limitation: •It distorts the true worth of an asset by sticking to its original cost.•Financial statements become irrelevant in case of inflation•Removes cost of fixed assets by writing off their cost while asset may be in good condition•Assets for which no payment has been made are not shown e.g knowledge ,skill of Human Resources.

6. Cost concept

7. Realization concept

The revenue principle governs two things:

When to record revenue and…

the amount of revenue to record.

.

It deals with the determination of the point of time when revenues are earned


photos

Disney

World

Situation 2The client has taken a trip arranged by

Air & Sea Travel. – Record Revenue

Air & SeaTravel, Inc.

April 2

Air & SeaTravel, Inc.

Situation 1No transaction has occurred.

– Do Not Record Revenue

March 12I plan to have youmake my travelarrangements.



•To be recognized, revenue must be:–Earned - goods are delivered or a service is performed–Realized - cash or a claim to cash (credit) is received in exchange for goods or services

•Revenue does not have to be received in cash.

7. Realization conceptWhen is revenue recognized?

Revenue from sales transaction

Revenue from services

When the seller of goods has transferred to the buyer property (ownership ) in the goods, for a price and the buyer becomes legally liable to pay.

When service has been rendered.

When no uncertainty exists as to its measurability and collectability.

7. Realization conceptWhen is revenue recognized?

Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends

8. Matching Principle

Revenues earned during an accounting period is compared with the expenditure incurred during the same period for earning that revenue.

The Matching Principle

It is the basis for recordingexpenses and includes two steps:

•Identify all the expenses incurred during the accounting period.

•Measure the expenses and match expenses against revenues earned.


Revenue – Expense = Net income


Revenue – Expense = (Net loss)


The determination of profit of a particular accounting period is essentially a process of matching the revenue recognized during the period and the expenses incurred during the same period to obtain the revenue.

8. Matching PrincipleRevenue is total amount realised from

sale of goods or provision of services earnings from interest, dividend and other items of income.

Expenses are costs incurred in connection with the earning of revenues.


Matching concept is based on accounting period concept.

On account of matching concept, adjustments are made for all prepaid expenses outstanding expenses, accrued incomes while preparing financial statements.

9. Accrual concept

Incomes and expenses should be recognised as and when they are earned and incurred, irrespective of whether the money is received or paid for it.

9. Accrual concept

Revenue is recognised when it is realised, i.e. when sale is complete or services are given irrespective of whether cash is received or not.

Similarly expenses are recognised when assets or benefits are used rather than when they are paid for and in the accounting period in which they help in earning the revenue whether cash is paid or not.

9. Accrual concept

TWO METHODS

Reporting Revenue and ExpenseReporting Revenue and Expense

Cash Basis of AccountingAccrual Basis of Accounting

Cash Basis of AccountingCash Basis of Accounting

Revenue reported when cash is received Expense reported when cash is paid Does not properly match revenues and

expenses

Accrual Basis of AccountingAccrual Basis of Accounting

Revenue reported when earned Expense reported when incurred Properly matches revenues and expenses

in determining net income Requires adjusting entries at end of period

for outstanding expenses and incomes while preparing final accounts

This concept is used by all businesses that disclose their financial statements to various interestsed parties.

The Companies Act, 1956 provides that accrual concept has to be maintained for practically all accounting purposes.

The law in India provides that in cases where accrual concept cannot be followed under any circumstances, cash basis may be followed.

9. Accrual concept

The Reliability Concept

(Objective Evidence)

RELIABILITY-The quality of information that assures decision makers that the information captures the conditions or events it purports to represent.

Reliable data are supported by convincing evidence that can be verified by independent parties.The impact of events should be measured in a systematic, reliable manner.



Information mustbe reasonably

accurate.

Information mustbe free from bias.

Information must report what

actually happened.

Individuals wouldarrive at similar

conclusions usingsame data.

The Reliability (Objectivity) concept



Entries in accounting records and data reported in financial statements must be based on objectively determined evidence so as to be reliable.

Objectively determined evidence includes:

•invoices and vouchers for purchase and sale,

•bank statement for amount of cash at bank,

•physical checking of stock in hand.



The Reliability Concept(Objective Evidence)

Sometimes judgement is used, for example provision for doubtful debts but estimation should be made based on objective factors, such as past experience in collecting debts and reliable forecasts of future business activities.



Without this concept users of financial statements would not have confidence in them.

1. Convention of Full disclosureAccounting reports should disclose fully and fairly the information they purport to represent.

Significant information should be disclosed in financial statements.

Such disclosures can also be made through footnotes.eg.about

•contingent liabilities•Market value of investmetns •The basis of valution of fixed assets, investments and stock.

Financial statements should be honestly prepared and sufficiently disclose information which is of material interest to proprietors, present and potential creditors and investors.

1. Convention of Full disclosure

2. Convention of Conservatism(Prudence)

“ Anticipate no profits but provide for all possible losses”

Prudence is the “inclusion of a degree of caution in the exercise of judgement needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not under stated.”

2. Convention of Conservatism

(Prudence)

•Policy of ‘caution’ & ‘playing safe’

•Policy of safeguarding against possible losses in world of uncertainty

•Assets or income are not overstated and liabilities or expenses are not under stated.

•Anticipated losses are shown in the form of provisions.

2. Convention of Conservatism

(Prudence)

As a result of this convention :Revenues and gains are recognized only when realized

in form of cash or assets the ultimate cash realization of which can be assessed with reasonable certainty.

Provisions must be made for all known liabilities, expenses and actual and probable losses.eg. Provision for doubtful debts is made

Closing stock is valued at lower of cost and market price.

2. Convention of Conservatism(Prudence)

3. Convention of Consistency

Accounting practices should remain unchanged from one accounting period to another.


This convention requires that once a firm has decided on certain accounting policies and methods and has used these for some time, it should continue to follow the same methods or procedures for all subsequent similar events and transactions unless it has a sound reason to do otherwise.


•The comparison of one accounting period with that in the past is possible.

•Eliminates personal bias.


Consistency does not forbid introduction of improved accounting technique.The effect of the change (inflating or deflating the figures of profit as compared to the previous period) must be clearly stated in the financial statements by way of a note.


Consistency also implies external consistency i.e. the financial statements of one enterprise should be comparable with another

Every enterprise should follow same accounting methods and procedures of recording and reporting business transactions.

4. Convention of Materiality

The accountant should attach importance to material details and ignore insignificant details.

A financial statement item is material:

•if there is reason to believe that knowledge of it would influence the decision of the informed investor.(AAA)

•if its omission or misstatement would tend to mislead the reader of the financial statements under consideration.


Deciding what constitutes a material detail is left to the discretion of the accountant. Materiality often depends on:•The size of the organization – what is material to one company might not be material to another company.•Purpose - An item may be material for one purpose while immaterial for another. •Amount involved - Materiality may or may not depend upon amount.•Customs – only round figures may be shown in financial statements to make figures manageable without affecting accuracy.
