Generally Accepted Accounting Principles (GAAP) and Accounting Concepts

Hello Friends. In this blog we discuss  Generally Accepted Accounting Principles (GAAP) and Accounting Concepts. Accounting is commonly described as a language of business. As rules of grammar exist for language, similarly accounting principles exist for accounting.Accounting principles, concepts, conventions commonly known as Generally Accepted Accounting Principles(GAAPs). GAAPs are those principles which are the theory base of accounting, under these principles financial statements are prepared, or say they are the guidelines to prepare the financial statements.

Meaning of Generally Accepted Accounting Principles

The Generally Accepted Accounting Principles(GAAPs) are the accounting rules that are accepted by accountants based on which transactions are recorded in the books of accounts and financial statements are prepared.These rules or guidelines adopted for recording and reporting business transactions, in order to bring uniformity and consistency in the preparation and presentation of financial statements. These principles are classified into two categories:-

• Accounting Concepts
• Accounting Conventions

Accounting Concepts- Accounting concepts are the basic assumptions in which accounting operates. They are generally accepted accounting rules based on which transactions are recorded and financial statements are prepared. It is important to follow the accounting concepts because it helps the users of financial statements to understand them better.

Accounting Conventions- Accounting conventions is the result of accounting practices or accounting principles being followed by the enterprise over a period of time. Conventions are not fixed they undergo a change with time to bring about improvement in the quality of accounting information.

Features of Accounting Principles

1. Accounting Principles are Man-Made

Accounting Principles are made by humans, Humans find the best possible suggestions based on their practical experiences. They are recommended for use by all enterprises to ensure uniformity and understandability.

2. Accounting Principles are Flexible

Accounting principles are rigid but flexible. Whenever a situation arises that requires a solution, accountants find a reasonable decision which gradually become the accepted accounting principle. It must be kept in mind that Accounting Principles are not permanent in nature they get changed according to time and need.

 3. Accounting Principles are Generally Accepted

Accounting Principles are the basis and guidelines for accounting and these principles are generally accepted. The general acceptance and criteria of Accounting principles depends on how they meet the three needs: Relevance, Objectivity and Feasibility. Let us discuss this as under:

• Relevance- We say accounting principles relevant if they result in information that is useful to the users of accounting information.
• Objective- Accounting principles are objective if they are not related with any personal bias of the persons who are preparing the accounting information.
• Feasible- Accounting Principles are only feasible when they can be applied without undue complexity and cost.

Need of Accounting Principles

Accounting information is better understood if it is prepared by the different sets of Accounting Principles uniformily. By making the Accounting Principles, it means the same Accounting Principles are followed by all entities in preparing their particular Final Accounts. Accounting information is meaningful and useful for users of Accounting information if the accounting records and financial information are prepared according to Generally Accepted Accounting Principles(GAAPs) in standard forms which are understandable.

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Accounting Assumptions or Concepts

Accounting Assumptions or Concepts are those assumptions which are presumed  to have been followed in preparing the final accounts at the end of the financial year. The entities which do not follow any of the fundamental accounting assumptions are required to disclose which of these assumptions have not been followed and the reason for not following the same. So it is very important to follow these concepts for preparing the final accounts and these assumptions are as under:-

• Going Concern Assumption
• Consistency Assumption
• Accrual Assumption

1. Going Concern Assumption- 

According to this assumption, it is assumed that business shall continue for a foreseeable period and there is no intention to close the business or scale down its operations significantly. This means a business entity will not be forced to halt its operations and liquidate its assets on short term basis This states that the business will not be dissolved in the immediate future unless their is a clear legal document of closure of business. In short, Business is running continuously and don't stop their operations until they get the clear evidence regarding closure of business.

2. Consistency Assumption-

Consistency Assumption tells that practices of accounting once selected and adopted, should be applied consistently year after year. This concept helps in better understanding of accounting information and able to make comparative study with that of previous years which is also a qualitative characteristic of accounting. Consistency eliminates personal bias and helps in achieving results that are comparable. The concept is particularly important when alternative accounting methods are equally acceptable, like two methods of charging depreciation on fixed assets(Written Down Value Method and Straight line Method), these both are equally acceptable. Under this consistency assumption, method once chosen and applied should be applied year after year. But it doesn't mean that practice once adopted cannot be changed. 

The accounting practice may be changed if the law of Accounting Standard requires it or by changing the practice it will result in more meaningful result. If an entity desires to adopt an alternative practice, it must disclose the change and also the impact on the financial statements.

3. Accrual Assumption-

Accrual Assumption says that a transaction is recorded in the books of accounts at the time when it is happened or when it is entered into and not when the settlement takes place. It means we assume that revenue is recognized when it is realised. Let us take an example - ABC Ltd. sell their goods to Vandana Pvt. Ltd. on  payment terms of 15days, it means payment is received on later by ABC Ltd after the completion of 15days. But they sell their goods, Here ABC Ltd. records this receipt on earlier basis in their books of accounts as the transaction of sale takes place before payment, it is immaterial whether cash received or not. Similarly, expenses are recognized as expenses in the accounting period in which the revenue related to it is recognized, whether paid in cash or not.

The concept is particularly important because it recognises the assets, liabilities, incomes and expenses as and when transactions related to it are entered into. Under this concept, profit is regarded as earned at the time the goods or services are sold to the customer or the legal title of goods or services are passed to the customer, who, in turn has an obligation to pay for them. Similarly, expense is regarded as incurred when the goods or services are purchased and an obligation to pay for them is assumed.

👉Also read difference between bookkeeping and accounting.

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Accounting Principles

1. Accounting Entity/ Business Entity Principle
2. Money Measurement Principle
3. Accounting Period Principle
4. Full Disclosure Principle
5. Materiality Principle
6. Prudence/Conservatism Principle
7. Cost Concept/Historical cost Principle
8. Matching Concept/Matching Principle
9. Dual Aspect/Duality Principle
10. Revenue Recognition Concept
11. Verifiable Objective Concept

For a successful accounting process these principles are followed genuinely. Let us take a detailed view of all these above mentioned principles for further understanding:

1. Accounting Entity/Business Entity Principle

Business Entity Principle says that the Business and the owner of the business are distinct from each other. Business transactions recorded in the books of accounts from the business point of view and not from the owner's view. Owners of the business being regarded as separate and distinct from the business, owners are considered as creditors of the business to the extent of their capital. Their account with the business is credited with the capital introduced and profit earned during the year etc, and also debited by the drawings made by owner. The amount invested by the owner in the form of capital is a liability towards the business and this principle applies to every form of enterprise including proprietorship firms. 

2. Money Measurement Principle

As the name suggests, money measurement principle says that transactions and events that can be measured in terms of money are recorded in the books of accounts. As we discussed accounting can be done for only those transactions which are financial in nature and measured in terms of money, like Cash of Rs 50,000/- , 6 sets of Computers, 4 trucks etc etc. These all are assets for the company but these assets cannot be recorded and shown in the Financial statements unless their monetary values are ascertained.

Limitations of Money Measurement Principle-

• Those transactions and events which cannot be measured in terms of money are not recorded in the books of accounts, no matter how much important they may be to the business. For Example, Human resources are most important part of any enterprise but are not shown in financial statements because their value cannot be measured in terms of money.
• The value of money is considered to have static value as the transactions are recorded at the value on the transaction date.

3. Accounting Period Principle

According to the Accounting Period Principle, the life of the enterprise is broken into smaller periods so that the performance of the enterprise shall be measured time to time and the correct action can be taken to increase its performance if needed. As per the Going Concern Concept, business shall continue its activities for the forseeable future until the legal notice of disclosure took place, but what happened when we prepare final accounts at the end of his life. It is possible to do so, but the users of financial statements and many of them, how they access the performance of the business?

 Especially the management and the bankers because management requires the information at regular intervals to access the performance, funds requirement. Banks require financial information because they have invested money and have to ensure its safety and returns. Government have to assess the taxes dues from the enterprise.

For this problem, the life of the enterprise is broken into smaller periods(usually one year) which is known as Accounting Period, at the end of which final accounts are prepared to know the results and position of the business.

4. Full Disclosure Principle

Full disclosure principle says that there should be complete and understandable reporting on the financial statements of all significant information relating to the economic affairs of the entity. Good accounting practice requires all material and significant information to be disclosed as it is because it makes the financial statements more meaningful, and disclosure of material information will result in better understanding, like- the reason for low turnover should be disclosed so that the meaningful action can be taken on time.

5. Materiality Principle

Materiality Principle refers to the relative importance of a item or an event. An item is material or not will depend on its nature,amount and size of the business, it is a matter of exercising judgement to decide which item is material and which is not. And only those items should be disclosed in the materiality principle that have significant effect or relevant to the user. An item may be a material for one enterprise but may not be material for another. 

For Example- amount spent on repair of computers say 15000 is material for an enterprise having a turnover of Rs 1,20,000 but it is not material for an enterprise having a turnover Rs 12,00,00,000.

6. Prudence/Conservatism Principle

Prudence Principle simply says do not anticipate a profit, but provide for all possible losses. Conservatism does not record anticipated revenues and incomes but provides all anticipated expenses and losses, it may increase liabilities. Provision for Doubtful debts, Provision for Bad Debts, Discount on debtors in anticipation of actual bad debts and discount are the examples of prudence concept. 

We may not assure for profit but be get ready for losses in future. It has a drawback as it may be used to create excess secret reserves like Provision for Doubtful debts, depreciation etc, and thus financial statements may not derive a true and fair view of the business affairs.

The concept of conservatism needs to be applied with more caution and care so that the results reported  are not distorted.

7. Cost Concept/Historical Cost Principle

Cost concept says that an asset is recorded in the books of accounts at the price paid to purchase it and the cost is the basis for all subsequent accounting of the asset. It means assets are recorded at that value which is paid to vendor at the time of purchase but it is a reduction in value due to depreciation. As we know the market value of an asset may change time to time but for accounting purpose it continues to be shown in the books of accounts at its book value(purchase cost-depreciation provided up to the date). 

For example a Machinery is purchased for Rs 5,00,000 at the beginning but while preparing final accounts its market value is say Rs 3,50,000 or Rs 6,20,000, yet the asset shall be recorded at its purchase price which is Rs 5,00,000.

Cost concepts brings objectivity in the preparation of Financial Statements. They are not influenced by the personal bias or judgements.

8. Matching Concept/ Matching Principle

In Business an important objective is to determine profit periodically. It is necessary to match the incomes of the period with expenses of that same period to determine correct profit/loss for the accounting period. Profit earned by the business during a period can be correctly measured only when the incomes and revenues are matched with the expenses incurred to earn that income during the accounting period.

In short, expenses for an accounting period are matched against related revenues, rather than cash received and cash paid. After following this principle while preparing financial statements, give a true and fair view of the profitability and financial position of a business.

9. Dual Aspect/Duality Principle

As we study Double Entry System of Accounting, this principle is similar to that, according to Dual Aspect Concept, every transaction entered by an enterprise has two aspects, a debit and a credit of equal amount. It means, for every debit there is a credit of equal amount in one or more accounts and vice versa. For Example- If an enterprise borrows money from bank, then on one side company's assets will increase and one side the liability to repayment to bank is also increased.

10. Revenue Recognition Concept

According to Revenue Recognition Concept, revenue is considered to been realised when a transaction has been entered in the books of accounts and the obligation to pay the amount has been established. Revenue was recognized when sales take place, let us take an example- 

ABC Ltd sells goods in January 2019 and receives payment in March 2019 then ,Revenue of this sales should be recognised in January 2019 because sales are made in January 2019 and if the payment is received in advance by ABC Ltd. in the month of December 2018 against the sales made in January 2019 then, Revenue of the sales also considered in January 2019 because Revenue was recognised when sales take place.

11. Verifiable Objective Concept

This concept says that accounting should be free from personal bias. Measurements that are based on verifiable evidences are regarded as objectives. It means all transactions in the books of accounts should be evidenced by business documents and these documents are Cash memos, Sale Invoices, Purchase Invoices etc and they are become helpful in future accounting and audit.

So, these are all about Generally Accepted Accounting Principles(GAAP) and Accounting Concepts. I hope you all understand these Generally Accepted Accounting Principles (GAAP) and Accounting Concepts. Sometimes in exams a short note on any of these Concepts and principles are asked by examiner. So be ready for any question asked by examiner about Generally Accepted Accounting Principles(GAAP) and Accounting Concepts. I try to cover the concept of this topic, If you have any questions related to this post then please stay tuned in the comment section. Have a Nice Day, Thanks...