ACCOUNTING PRINCIPLES
➢ Introduction
To maintain uniformity in recording transactions and
preparing financial statements,
accountants should follow Generally Accepted Accounting
Principles.
➢ Accounting Principles
Accounting principles are the rules of action or conduct
adopted by accountants
universally while recording accounting transactions. GAAP
refers to the rules or
guidelines adopted for recording and reporting of business
transactions, in order to bring
uniformity in the preparation and presentation of financial
statements. These principles
are classified into two categories:
1) Accounting Concepts: They are the basic assumptions
within which accounting
operates.
2) Accounting Conventions: These are the outcome of the
accounting practices or
principles being followed over a long period of time.
• Features of accounting principles
(1) Accounting principles are manmade.
(2) Accounting principles are flexible in nature.
(3) Accounting principles are generally accepted.
• Necessity of accounting principles
Accounting information is meaningful and useful for users if
the accounting records and
financial statements are prepared following generally
accepted accounting information in
standard forms which are understood.
• Types of Accounting Principles
1) Accounting Entity or Business Entity Principle:
An entity has a separate existence from its owner. According to this principle, business is treated as an entity, which is separate and distinct from its owner. Therefore, transactions are recorded andanalyzed, and the financial statements are prepared from the point of view of business and not the owner. The owner is treated as a creditor (Internal liability) for his investment in the business, i.e. to the extent of capital invested by him. Interest on capital is treated as an expense like any other business expense. His private expenses are treated as drawings leading to reductions in capital.
2) Money Measurement Principle: According to this principle,
only those transactions that
are measured in money or can be expressed in terms of money
are recorded in the books
of accounts of the enterprise. Non-monetary events like
death of any employee/Manager,
strikes, disputes etc., are not recorded at all, even though
these also affect the business
operations significantly.
3) Accounting Period Principle:
According to this principle, the life of an enterprise is
divided into smaller periods so that its performance can be measured at regular
intervals. These smaller periods are called accounting periods. Accounting
period is defined as the interval of time, at the end of which the profit and
loss account and the balance sheet are prepared, so that the performance is
measured at regular intervals and decisions can be taken at the appropriate
time. Accounting period is usually a period of one year, which may be a
financial year or a calendar year.
4) Full Disclosure Principle:
According to this principle, apart from legal requirements,
all significant and material information related to the economic affairs of the
entity should be completely disclosed in its financial statements and the
accompanying notes to accounts. The financial statements should act as a means
of conveying and not concealing the information. Disclosure of information will
result in better understanding and the parties may be able to take sound
decisions on the basis of the information provided.
5) Materiality Principle:
According to this principle, only those items or information should be disclosed that have a material effect and are relevant to the users. Disclosure of all material facts is compulsory but it does not imply that even those figures which are irrelevant are to be included in the financial statements. Whether an item is material or not depends on its nature. So, an item having an insignificant effect or being irrelevant to user need not be disclosed separately, it may be merged with other item. If the knowledge about any information is likely to affect the user’s decision, it is termed as materialInformation.
6) Prudence or Conservatism Principle:
According to this principle, prospective profit should not
be recorded but all prospective losses should immediately be recorded. The
objective of this principle is not to overstate the profit of the enterprise in
any case and this concept ensures that a realistic picture of the company is
portrayed. When different equally acceptable alternative methods are available,
the method having the least
favorable immediate effect on profit should be adopted.
7) Cost Principle or Historical cost concept:
According to this Principle, an asset is recorded in the
books of accounts at its original cost comprising of the cost of acquisition
and all the expenditure incurred for making the assets ready to use. This cost
becomes the basis of all subsequent accounting transactions for the asset.
Since the acquisition cost relates to the past, it is referred to as the
Historical cost.
8) Matching Principle:
According to this principle, all expenses incurred by an
enterprise during an accounting period are matched with the revenues recognized
during the same period. The matching principle facilitates the ascertainment of
the amount of profit earned or loss incurred in a particular period by
deducting the related expenses from the revenue recognized in that period. It is
not relevant when the payment was made or received. This concept should be
followed to have a true and fair view of the financial position of the company.
9) Dual Aspect Principle:
According to this principle, every business transaction has
two aspects - a debit and a credit of equal amount. In other words, for every
debit there is a credit of equal amount in one or more accounts and vice-versa.
The system of recording transactions on the basis of this principle is known as
“Double Entry System”. Due to this principle, the two sides of the Balance
Sheet are always equal and the following accounting equation will always hold
good at any point of time.
Assets = Liabilities + Capital
Example: Ram started business with cash Rs. 1,00,000. It
increases cash in assets side
and capital in liabilities- side by Rs. 1,00,000.
Assets Rs. 1,00,000 = Liabilities + Capital Rs. 1,00,000.
10) Revenue Recognition Concept:
This principle is concerned with the revenue being
recognised in the Income Statement of an enterprise. Revenue is the grass
inflow of cash, receivables or other considerations arising in the course of
ordinary activities of an enterprise from the sale of goods, rendering of services
and use of enterprise resources by others yielding interests, royalties and
dividends. It excludes the amount collected on behalf of third parties such as
certain taxes. Revenue is recognised in the period in which it is earned
irrespective of the fact whether it is received or not during that period.
11) Verifiable Objective concept:
This concept holds that accounting should be free from
personal bias. This means that all business transactions should be supported by
business documents like cash memo, invoices, sales bills etc.
➢ Fundamental Accounting Assumptions
1) Going Concern Assumption:
This concept assumes that an enterprise has an indefinite
life or existence. It is assumed that the business does not have an intention
to liquidate or to scale down its operations significantly. This concept is
instrumental for the company in:
1. making a distinction between capital expenditure and
revenue expenditure.
2. Classification of assets and liabilities into current and
non-current.
3. providing depreciation charged on fixed assets and
appearance in the Balance Sheet at
book value, without having reference to their market value.
4. It may be noted that if there are good reasons to believe
that the business, or some part
of it, is going to be liquidated or that it will cease to
operate (say within a year or two),
then the resources could be reported at their current values
(or liquidation values).
2) Consistency Assumption:
According to this assumption, accounting practices once selected and adopted, should be applied consistently year after year. This will ensure a meaningful study of the performance of the business for a number of years. Consistency assumption does not mean that particular practices, once adopted, cannot be changed. The only requirement is that when a change is desirable, it should be fully disclosedin the financial statements along with its effect on income statement and Balance Sheet. Any accounting practice may be changed if the law or Accounting standard requires so,
to make the financial information more meaningful and
transparent.
3) Accrual Assumption:
As per Accrual assumption, all revenues and costs are
recognized when they are earned or incurred. This concept applies equally to
revenues and expenses. It is immaterial, whether the cash is received or paid
at the time of transaction or on a later date.
➢ Bases of Accounting
There are two bases of ascertaining profit or loss, namely:
1) Cash basis
Under this, entries in the books of accounts are made when
cash id received or paid and
not when the receipt or payment becomes due. For example, if
salary Rs. 7,000 of
January 2010 paid in February 2010 it would be recorded in
the books of accounts only in
February, 2010.
2) Accrual basis
Under this however, revenues and costs are recognized in the
period in which they occur
rather when they are paid. It means it record the effect of
transaction is taken into book in
the when they are earned rather than in the period in which
cash is actually received or
paid by the enterprise. It is more appropriate basis for
calculation of profits as expenses
are matched against revenue earned in the relation thereto.
For example, raw materials
consumed are matched against the cost of goods sold for the
accounting period.
➢ Accounting Standards (AS)
“A mode of conduct imposed on an accountant by custom, law
and a professional body.”
– By Kohler
• Concept of Accounting Standards
Accounting standards are written statements, issued from
time-to-time by institutions of
accounting professionals, specifying uniform rules and
practices for drawing the financial
Statements.
• Nature of accounting standards
1) Accounting standards are guidelines which provide the
framework credible financial
statement can be produced.
2) According to change in business environment accounting
standards are being changed or
revised from time to time.
3) To bring uniformity in accounting practices and to ensure
consistency and comparability
is the main objective of accounting standards.
4) Where the alternative accounting practice is available,
an enterprise is free to adopt. So
accounting standards are flexible.
5) Accounting standards are amendatory in nature.
• Objectives of Accounting Standards
1) Accounting standards are required to bring uniformity in accounting practices and
policies by proposing standard treatment in preparation of
financial statements.
2) To improve reliability of the financial statements:
Statements prepared by using
accounting standards are reliable for various users, because
these standards create a sense
of confidence among the users.
3) To prevent frauds and manipulation by codifying the
accounting methods and
practices.
4) To help Auditors: Accounting standards provide uniformity
in accounting practices, so
it helps auditors to audit the books of accounts.
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