GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

A widely accepted set of rules, conventions, standards, and procedures for reporting
financial information, as established by the Financial Accounting Standards Board are
called Generally Accepted Accounting Principles (GAAP).
These are the common set of accounting principles, standards and procedures that
companies use to compile their financial statements.
GAAP are a combination of standards (set by policy boards) and simply the commonly accepted ways
of recording and reporting accounting information.
GAAP is to be followed by companies so that investors have an optimum level of consistency in the
financial statements they use when analysing companies for investment purposes. GAAP cover such
aspects like revenue recognition, balance sheet item classification and outstanding share
measurements.

Let us imagine a situation where you are a proprietor and you take copies of your books of account to
five different accountants. You ask them to prepare the financial statement on the basis of the above
records and to calculate the profits of the business for the year. After few days they are ready with the
financial statements and all the five accountants have calculated five different amounts of profits and
that too with wide variations among them. Guess in such situation what impact would it leave on you
about the accounting profession. To avoid this, a generally accepted set of rules have been developed.
This generally accepted set of rules provides unity of understanding and unity of
approach in the practice of accounting and also in better preparation and presentation
of the financial statements.

Accounting principles are basic guidelines that provide standards for scientific accounting practices
and procedures. They guide as to how the transactions are to be recorded and reported. They assure
uniformity and understandability. Accounting concepts lay down the foundation for accounting
principles.

A. BASIC ASSUMPTIONS
(a) Business Entity Concept
As per this concept, the business is treated as distinct and separate from the individuals who
own or manage it. For example, if the owner pays his personal expenses from business cash,
this transaction can be recorded in the books of business entity. This transaction will take the
cash out of business and also reduce the obligation of the business towards the owner.
 The entity concept requires that all the transactions are to be viewed, interpreted and
recorded from ‘business entity’ point of view. An accountant steps into the shoes of the
business entity and decides to account for the transactions. The owner’s capital is the
obligation of business and it has to be paid back to the owner in the event of business closure.
Also, the profit earned by the business will belong to the owner and hence is treated as
owner’s equity.

(b) Going Concern Concept

Business is assumed to exist for an indefinite period and is not established with the objective of closing
it down. So unless there is good evidence to the contrary, the accountant assumes that a business entity
is a ‘going concern’ - that it will continue to operate as usual for a longer period of time. It will keep
getting money from its customers, pay its creditors, buy and sell goods, use assets to earn profits in
future. If this assumption is not considered, one will have to constantly value the worth of the assets
and resource. This is not practicable. This concept enables the accountant to carry forward the values
of assets and liabilities from one accounting period to the other without asking the question about
usefulness and worth of the assets and recoverability of the receivables.
The going concern concept forms a sound basis for preparation of a Balance Sheet. The valuation of
assets of a business entity is dependent on this assumption. Traditionally, accountants follow
historical cost in majority of the cases.

(c) Money Measurement Concept

A business transaction will always be recoded if it can be expressed in terms of money. The advantage
of this concept is that different types of transactions could be recorded as homogenous entries with
money as common denominator. A business may own 3 Lacs cash, 1500 kg of raw material, 10 vehicles,
3 computers etc. Unless each of these is expressed in terms of money, we cannot find out the assets
owned by the business. When expressed in the common measure of money, transactions could be added
or subtracted to find out the combined effect. In the above example, we could add values of different
assets to find the total assets owned.
The application of this concept has a limitation. When transactions are recorded in terms of money,
we only consider the absolute value of the money. The real value of the money may fluctuate from
time to time due to inflation, exchange rate changes, etc. This fact is not considered when recording
the transaction.

(d) The Accounting Period Concept

We have seen that as per the going-concern concept the business entity is assumed to have an indefinite life.
Now if we were to assess whether the business has made profit or loss, should we wait until this indefinite
period is over? Would it mean that we will not be able to assess the business performance on an ongoing
basis? Does it deprive all stakeholders the right to the accounting information? Would it mean that the
business will not pay income tax as no income will be computed?

To circumvent this problem, the business entity is supposed to be paused after a certain time interval.
This time interval is called an accounting period. This period is usually one year, which could be a
calendar year i.e. 1st January to 31st December or it could be a fiscal year in India as 1st April to 31st
March. The business organizations have the freedom to choose their own accounting year. For certain
organizations, reporting of financial information in public domain are compulsory. In India, listed
companies must report their quarterly unaudited financial results and yearly audited financial
statements. For internal control purpose, many organizations prepare monthly financial statements.
The modern computerized accounting systems enable the companies to prepare real-time online
financials at the click of button.

Businesses are living, continuous organisms. The splitting of the continuous stream of business events
into time periods is thus somewhat arbitrary. There is no significant change just because one
accounting period ends and a new one begins. This results into the most difficult problem of
accounting of how to measure the net income for an accounting period. One has to be careful in
recognizing revenue and expenses for a particular accounting period. Subsequent section on
accounting procedures will explain how one goes about it in practice.

(e) The Accrual Concept

The accrual concept is based on recognition of both cash and credit transactions. In case of a cash
transaction, owner’s equity is instantly affected as cash either is received or paid. In a credit transaction,
however, a mere obligation towards or by the business is created. When credit transactions exist (which
is generally the case), revenues are not the same as cash receipts and expenses are not same as cash paid
during the period.
When goods are sold on credit as per normally accepted trade practices, the business gets the legal right
to claim the money from the customer. Acquiring such right to claim the consideration for sale of goods
or services is called accrual of revenue. The actual collection of money from customer could be at a later
date.
Similarly, when the business procures goods or services with the agreement that the payment will be
made at a future date, it does not mean that the expense effect should not be recognized. Because an
obligation to pay for goods or services is created upon the procurement thereof, the expense effect also
must be recognized.
Today’s accounting systems based on accrual concept are called as Accrual System or Mercantile
System of Accounting.

B. BASIC PRINCIPLES
(a) The Revenue Realisation Concept
While the conservatism concept states whether or not revenue should be recognized, the concept of
realisation talks about what revenue should be recognized. It says amount should be recognized only to
the tune of which it is certainly realizable. Thus, mere getting an order from the customer won’t make
it eligible to recognize as revenue. The reasonable certainty of realizing the money will come only when
the goods ordered are actually supplied to the customer and he is billed. This concept ensures that
income unearned or unrealized will not be considered as revenue and the firms will not inflate profits.
Consider that a store sales goods for ` 25 lacs during a month on credit. The experience and past data
shows that generally 2% of the amount is not realized. The revenue to be recognized will be ` 24.50 lacs.
Although conceptually the revenue to be recognized at this value, in practice the doubtful amount of `
50 thousand (2% of ` 25 lacs) is often considered as expense.

(b) The Matching Concept

As we have seen the sale of goods has two effects:
(i) A revenue effect, which results in increase in owner’s equity by the sales value of the
transaction and
(ii) An expense effect, which reduces owner’s equity by the cost of goods sold, as the goods go
out of the business. The net effect of these two effects will reflect either profit or loss. In
order to correctly arrive at the net result, both these aspects must be recognized during
the same accounting period. One cannot recognize only the revenue effect thereby
inflating the profit or only the expense effect which will deflate the profit. Both the effects
must be recognized in the same accounting period. This is the principle of matching
concept.

To generalize, when a given event has two effects – one on revenue and the other on expense, both
must be recognized in the same accounting period.

(c) Full Disclosure Concept

As per this concept, all significant information must be disclosed. Accounting data should properly be
clarified, summarized, aggregated and explained for the purpose of presenting the financial statements
which are useful for the users of accounting information. Practically, this principle emphasizes on the
materiality, objectivity and consistency of accounting data which should disclose the true and fair view
of the state of affairs of a firm. This principle is going to be popular day by day as per Companies Act,
1956 major provisions for disclosure of essential information about accounting data and as such,
concealment of material information, at present, is not very easy. Thus, full disclosure must be made
for such material information which are useful to the users of accounting information.
(d) Dual Aspect Concept
The assets represent economic resources of the business, whereas the claims of various parties on
business are called obligations. The obligations could be towards owners (called as owner’s equity) and
towards parties other than the owners (called as liabilities).
When a business transaction happens, it will involve use of one or the other resource of the business
to create or settle one or more obligations. E.g. consider Mr. Suresh starts a business with the
investment of ` 25 lacs. Here, the business has got a resource of cash worth ` 25 lacs (which is its
asset), but at the same time it has created an obligation of business towards Mr. Suresh that in the
event of business closure, the money will be paid back to him. This could be shown as:

This is the fundamental accounting equation shown as formal expression of the dual aspect concept.
This powerful concept recognizes that every business transaction has dual impact on the financial
position. Accounting systems are set up to simultaneously record both these aspects of every
transaction; that is why it is called as 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. Suresh, now let us consider he borrows ` 15 lacs from bank. The
dual aspect of this transaction-on one hand the business cash will increase by ` 15 lacs and a liability
towards the bank will be created for ` 15 lacs.

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 the application in 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 preparation of Profit and Loss Account or Income Statement.
(e) Verifiable Objective Evidence Concept
Under this principle, accounting data must be verified. In other words, documentary evidence of
transactions must be made which are capable of verification by an independent respect. In the absence
of such verification, the data which will be available will neither be reliable nor be dependable, i.e., these
should be biased data. Verifiability and objectivity express dependability, reliability and trustworthiness
that are very useful for the purpose of displaying the accounting data and information to the users.
(f) Historical Cost Concept
Business transactions are always recorded at the actual cost at which they are actually undertaken. The
basic advantage is that it avoids an arbitrary value being attached to the transactions. Whenever an
asset is bought, it is recorded at its actual cost and the same is used as the basis for all subsequent
accounting purposes such as charging depreciation on the use of asset, e.g. if a production equipment
is bought for ` 1.50 crores, the asset will be shown at the same value in all future periods when disclosing
the original cost. It will obviously be reduced by the amount of depreciation, which will be calculated
with reference to the actual cost. The actual value of the equipment may rise or fall subsequent to the
purchase, but that is considered irrelevant for accounting purpose as per the historical cost concept.
The limitation of this concept is that the Balance Sheet does not show the market value of the assets
owned by the business and accordingly the owner’s equity will not reflect the real value. However, on
an ongoing basis, the assets are shown at their historical costs as reduced by depreciation.
(g) Balance Sheet Equation Concept
Under this principle, all which has been received by us must be equal to that has been given by us and
needless to say that receipts are clarified as debits and giving is clarified as credits. The basic equation,
appears as:-
Debit = Credit
Naturally every debit must have a corresponding credit and vice-e-versa. So, we can write the above in
the following form –
Expenses + Losses + Assets = Revenues + Gains + Liabilities
And if expenses and losses, and incomes and gains are set off, the equation takes the following form –
Asset = Liabilities
Or, Asset = Equity + External Liabilities
i.e., the Accounting Equation.

C. MODIFYING PRINCIPLES
(a) The Concept of Materiality
This is more of a convention than a concept. It proposes that while accounting for various
transactions, only those which may have material effect on profitability or financial status of the
business should have special consideration for reporting. This does not mean that the accountant
should exclude some transactions from recording. E.g. even ` 20 worth conveyance paid must be
recorded as expense. What this convention claims is to attach importance to material details and
insignificant details should be ignored while deciding certain accounting treatment. The concept of
materiality is subjective and an accountant will have to decide on merit of each case. Generally, the
effect is said to be material, if the knowledge of an event would influence the decision of an informed
stakeholder.

The materiality could be related to information, amount, procedure and nature. Error in description of
an asset or wrong classification between capital and revenue would lead to materiality of information.
Say, If postal stamps of ` 500 remain unused at the end of accounting period, the same may not be
considered for recognizing as inventory on account of materiality of amount. Certain accounting
treatments depend upon procedures laid down by accounting standards. Some transactions are by
nature material irrespective of the amount involved. E.g. audit fees, loan to directors.

(b) The Concept of Consistency

This concept advocates that once an organization decides to adopt a particular method of revenue or
expense recognition in line with the other concepts, the same should be consistently applied year after
year, unless there is a valid reason for change in the method. Lack of consistency would result in the
financial information becoming non-comparable between the different accounting periods. The
insistence of this concept would result in avoidance of window dressing the results by choosing the
accounting method by convenience and thereby either inflating or understating net income.
Consider an example. An asset of ` 10 lacs is purchased by a business. It is estimated to have useful life
of 5 years. It will follow that the asset will be depreciated over a period of 5 years at the rate of ` 2 lacs
every year. The estimate of useful life and the rate of depreciation cannot be changed from one period
to the other without a valid reason. Suppose the firm applies the same depreciation rate for the first
three years and due to change in technology the asset becomes obsolete, the whole of the remaining
amount could be expensed out in the fourth year.
However, it may be difficult to be consistent if the business entities have two factories in different
countries which have different statutory requirement for accounting treatment.

(c) The Conservatism Concept

Accountants who prepare financial statements of the business, like other human being, would like to
give a favourable report on how well the business has performed during an accounting period. However,
prudent reporting based on skepticism builds confidence in the results and in the long run best serves
all the divergent interests of users of financial statements. This philosophy of prudence leads to the
conservatism concept.
The concept underlines the prudence of under-stating than over-stating the net income of an entity for
a period and the net assets as on a particular date. This is because business is done in situations of
uncertainty. For years, this concept was meant to “anticipate no profits but recognize all losses”. This
can be stated as
(i) Delay in recognizing income unless one is reasonably sure
(ii) Immediately recognize expenses when reasonably sure
This, of course, does not mean to overdo and create window dressing in reporting. e.g. if the business
has sold ` 20 Lacs worth goods on the last day of accounting period and also received a cheque for the
same, one cannot argue that the revenue should not be recognized as it is not certain whether the cheque
will be cleared by the bank. One cannot stretch the conservatism concept too much. But at the same
time, if the business has to receive ` 5 lacs from a customer to whom goods were sold quite some time
ago and no payments are forthcoming, then while determining the net income for the period, the
accountant must judge the likelihood of the recoverability of this money and the prudence will prevail
to make a provision for this amount as doubtful debtors.
Let us take another example. A business had purchased goods for ` 10 lacs before the end of an
accounting period. If sold at the usual selling price, the goods would fetch the price of ` 12.50 lacs.
Due to innovative product introduced by the competition, the goods are likely to be sold for ` 9 lacs
only. At what value should the goods be shown in the balance sheet? Would it be at ` 10 lacs being the
actual cost of buying? Or would it be at 9 lacs? Here, the conservatism principle will come in play. The
stock of goods will be valued at ` 9 lacs, being the lower of cost or net realisable value, as per AS-2.

(d) Timeliness Concept

Under this principle, every transaction must be recorded in proper time. Normally, when the
transaction is made, the same must be recorded in the proper books of accounts. In short, transaction
should be recorded date-wise in the books. Delay in recording such transaction may lead to
manipulation, misplacement of vouchers, misappropriation etc. of cash and goods. This principle is
followed particularly while verifying day to day cash balance. Principle of timeliness is also followed by
banks, i.e. every bank verifies the cash balance with their cash book and within the day, the same must
be completed.
(e) Industry Practice
As there are different types of industries, each industry has its own characteristics and features. There
may be seasonal industries also. Every industry follows the principles and assumption of accounting to
perform their own activities. Some of them follow the principles, concepts and conventions in a
modified way. The accounting practice which has always prevailed in the industry is followed by it. E.g.
Electric supply companies, Insurance companies maintain their accounts in a specific manner.
Insurance companies prepare Revenue Account just to ascertain the profit/loss of the company and not
Profit and Loss Account. Similarly, non-trading organizations prepare Income and Expenditure
Account to find out Surplus or Deficit.
CONCLUSION
The above paragraphs bring out essentially broad concepts and conventions that lay down principles to
be followed for accounting of business transaction. While going through the different topics, students
are advised to keep track of concepts applicable for various accounting treatment. One would have by
now understood the importance of these concepts in preparation of basic financial statements. More
clarity will emerge as one explores the ocean of different business transactions arising out of complex
business situations. The legal and professional requirements also have their say in deciding the
accounting treatment. Let us see if you can apply these concepts in the following illustrations.
Exercise:
Recognise the accounting concept in the following:
(1) The business will run for an indefinite period.
(2) The business is distinct and separate from its owners.
(3) The transactions are recorded at their original cost.
(4) The transactions recorded are those that can be expressed in money terms.
(5) Revenues will be recognized only if there is reasonable certainty that it will be paid for.
(6) Accounting treatment once decided should be followed period after period.
(7) Every transaction has two effects to be recorded in books of accounts.
(8) Transactions are recorded even if an obligation is created and actual cash is not involved.
(9) Stock of goods is valued at lower of its cost and realizable value.
(10) Effects of an event must be recognized in the same accounting period.