Chapter 14: Generally Accepted Accounting Principles (GAAP)
Generally Accepted Accounting Principles or GAAP: is a defined set of rules and procedures
that needs to be followed in order to create financial statements, which are consistent with the
industry standards.
GAAP is developed by the Financial Accounting Standards Board (FASB)
Need of Accounting Principles:
1. To make the accounting information meaningful to both internal and external users. .
2. To bring uniformity and consistency in accounting process.
3. GAAP helps in ensuring that financial reporting is transparent and uniform across industries.
4. As financial information is based on historical data, therefore in order to facilitate comparison
between data from various sources, GAAP must be followed.
Types of Accounting Principles: The principles based on assumptions, conventions, concepts,
doctrines, postulates etc. can be categorized into :
I. Accounting Concepts or Assumptions: The concepts on the basis of which the financial
statements are prepared and are agreed upon by the accountants, acting as a foundation for
accounting are accounting concepts. As per Accounting Standard-1 (AS-1), there are three
fundamental concepts:
1. Going Concern Concept
2. Consistency Concept
3. Accrual Concept
II. Other Concepts
1. Business Entity Concept
2. Money Measurement Concept
3. Accounting Period Concept
4. Cost Concept or Historical Cost Concept
5. Matching Concept
6. Dual Aspect Concept
7. Objectivity Concept
8. Revenue Recognition Concept
III. Accounting Conventions: Accounting Conventions are the customs or general practices
accepted by agreement or consent.
1. Convention of Full Disclosure
2. Convention of Materiality
3. Convention of Conservatism or Prudence
Accounting Concepts
1. Going Concern Concept: The business will continue for an indefinite period and there is no
intention to close the business.
It enables the firms to enter into long-term contracts.
It enables for the charge or depreciation on assets which have fixed life.
Due to this concept, prepaid expenses are treated as assets. It helps in the classification of assets
and liabilities.
2. Consistency: Accounting practices once selected and adopted should be applied consistently year
after year.
The concept helps in better understanding of accounting information and makes it comparable with
that of previous years.
They need to be consistence n valuation of stock, depreciation and provisions, to enable better
decision making by the management.
It doesn't mean that the accounting methods should not be changed, but the nature, effect and the
reason for change should be stated.
3. Accrual Assumption: Transactions are recorded when they have been entered into and not
when the settlement in cash takes place.
According to this concept, the revenue and expenses are recorded at the time when they are made,
not depending on whether the cash is received or paid or not.
Such revenues and payments need not be specifically mentioned. It helps in ascertaining true profit
or loss.
4. Business Entity/ Accounting Entity Principle: Business is treated as a separate entity distinct
from its owner. Business transactions, therefore, are recorded in the books of accounts from the
business point of view and not from that of the owners.
Capital is treated as the amount that needs to be paid back to the owner(s).
Interest on Capital is treated as expense and Interest on Drawings is treated as revenue.
If this concept is absent, the true financial position of the business cannot be known.
5. Money Measurement Principle: Transactions and events that can be expressed in monetary
terms are recorded in the books of accounts.
This enables to make accounting information relevant, simple, homogenous and understandable.
The worth of the business can be measured in a single term, i.e., money.
Non-monetary events are not recorded even if they are important for the business.
6. Accounting Period Principle: Life of an enterprise is divided into regular time intervals which is
usually of one year are known as accounting periods, at the end of which financial statements are
prepared.
This period is known as Accounting Period and it may be either a calendar year or a fiscal year of the
Government.
It helps the business to know its financial position at the end of every period.
7. Historical Cost Concept : As per this concept, all assets except inventory and investment, are
recorded in the books of accounts at their original cost.
The subsequent increase or decrease in value will not be shown in the records except the
depreciation of the assets.
Justifications:
As it is from the actual transaction, it can be verified easily.
The going concern concept assumes that the business lasts for a long period.
The market value varies a lot.
Valuation of each expert may be different.
Drawbacks:
The profits of the firm will be distorted due to inflation.
Information based on historical cost may not be useful to management, creditors, investors and
other users.
8. Matching concept: Costs incurred during a particular period should be set out against the
revenue of that period to ascertain profits.
The expenses pertaining to a revenue, recorded in the profit and loss account, whether paid or not
needs to be recorded as well.
The expense pertaining to next year should be recorded under the asset side of the Balance sheet.
The cost of goods unsold and the relating expenses are carried forward to next year.
Income receivables must be added, and advance incomes need to be deducted.
9. Dual Aspect Concept: Every transaction has two aspects: one aspect of a transaction is debited
while the other is credited.
It is underlying principle for Double Entry System.
Assets are always equal to the sum of Liabilities and Capital.
Every transaction will effect to at least one credit account and one debit account.
10. Objectivity Concept : Each Transaction recorded in books should be supported by verifiable
documents and vouchers as they provide the objective basis for verifying the transaction.
Objectivity cannot be adhered when assets are recorded on market value.
Transactions should be recorded in objective manner that should be free from biasness.
11. Revenue Recognition Concept: Revenue is recognized in the period in which it is earned
irrespective of the fact whether it is received or not during that period.
Revenue is deemed to be realized when the ownership of goods is transferred from the seller to the
buyer, It is not related with receipt of cash.
Revenue in case of incomes such as rent, interest, commission, etc, is recognized on a time basi.
12. Full Disclosure Principle: According to this convention, financial statements should be
honestly prepared and there should be full disclosure of all significant information which is required
by the proprietor and other users to assess the final accounts of the business unit.
The items that are not recorded in accounting statements are recorded in balance sheet as footnotes,
like : Contingent liabilities
Change in the method of depreciation, valuation of stock or provisions
Market value of investment
It does not mean leaking out business secrets.
13. Convention of Materiality: Items or events having a significant effect should be recorded in
the books which are material in nature or relevant for the determination of income of the business.
All non-material facts should be ignored.
14. Convention of Conservatism or Prudence: Do not anticipate profits but provide for all
possible losses. The application of this concept ensures that the financial statements present a
realistic picture of the state of affairs of the enterprise and do not paint a better picture than what is
actually is.
Application:
Provisions are made for liabilities
Valuation of closing stock is shown at cost price or market price, whichever is less
Insurance policy is shown at surrender value
Effects :
Lower profit shown in profit and Loss Account.
The assets will be understated.
Chapter 15: Bases of Accounting
Cash basis of Accounting: It means accounting of transactions on receipt of cash and payment of
cash. Thus, revenue is recognized when cash is received. Likewise, expenses are recorded only when
they have been paid. Outstanding and prepaid expenses and accrued incomes and incomes received
in advance are not determined and accounted.
Accrual basis of Accounting: Under it, income, if earned or accrued during the period, whether
received or not, is considered income of that period. For example- credit sales is included in the total
sales of the period irrespective of the fact whether amount has been received or not.
Similarly, if the firm has taken a service but has not paid, the expense will be accounted in the books
of account in the year when service is taken and not in the period when it is paid.
In brief, Outstanding and prepaid expenses and accrued incomes and incomes received in advance
are adjusted to ascertain profit accurately.
Chapter 16: Accounting Standards and International Financial Reporting Standards
(IFRS)
IFRS refers to the international financial reporting standards that are followed globally and
includes instructions on how certain transactions should be reported in financial statements. IFRS is
issued by the International Accounting Standards Board (IASB).
Chapter 17: Capital and Revenue
Capital Expenditure: It is the amount incurred by an enterprise for acquisition of fixed assets that
are used in the business to earn income and are not intended for resale. The benefit of Capital
expenditure extends beyond the financial year.
Revenue Expenditure: It is the amount incurred on running a business, i.e., benefit of such
expenses are consumed or exhausted within the accounting period. It is accounted as an expense
and is matched against revenues of the period to determine profit or loss of that period.
Capital Receipts: Capital receipts are the amounts received in the form of additional capital
introduced in the business, loans received and sale proceeds of the fixed assets. It is shown in
Balance Sheet.
Revenue Receipts: These are the amounts received in the normal course of the business, mainly
from sale of goods and services. It is shown on credit side of Trading or Profit and Loss Account.
Deferred Revenue Expenditure: Sometimes a business enterprise may incur heavy revenue
expenditure that the benefit of the same would last for number of years. In such case, the whole of
such expenditure should be spread over the number of accounting years over which the benefit is
likely to occur.
Heavy advertisement expenditure.
Expenditure on research and development.
Relocation of business.
Heavy repairs on fixed assets
Chapter 18: Reserves and Provisions
Provision: It is an estimated amount setting aside a part of the profits to meet a future known
liability. Example- Provision for bad and doubtful debts, Provision for depreciation.
Reserve: It is an appropriation of profit to strengthen the financial position. Example- General
Reserve, Debenture Redemption Reserve.
Capital Reserve: Any reserve which is created out of capital profits or is not available for
distribution as dividend to the shareholders is called Capital Reserve. Ex: Premium on issue of shares,
Premium on issue of debentures.
Revenue Reserve: Any reserve which is available for distribution as dividend to the shareholders is
called Revenue Reserve. Ex: General Reserve, Dividend Equalisation Reserve.
General Reserve: It is the amount set aside out of profits for no specific purpose.
Specific Reserve: It is the amount set aside out of profits for a specific purpose and can be utilized
only for that purpose..
Reserve Fund: If reserves are invested in outside securities and such securities are earmarked for a
particular purpose denoted by the reserve, the reserve will be called Reserve Fund.
Secret Reserve: It is a reserve the existence and/or amount of which is not disclosed in the Balance
Sheet.
