Accounting Concepts and Conventions

GAAP

Accounting as a Language of Business

GAAP - Generally Accepted Accounting Principles - those rules of action or conduct which are derived from experience and practice and when they prove useful, they become accepted as principles of accounting According to the American Institute of Certified Public Accountants (AICPA), the principles which have substantial authoritative support become a part of the generally accepted accounting principle. Accounting principles or standards are the general rules which are used as a guide in accounting and as a basis of practice.

Broad Principles of Accounting

A.

B.

Accounting Concepts necessary assumptions and ideas which are fundamental to accounting practice. Accounting Conventions customs or traditions which are used as guide to the preparation of accounting reports and statements.

Accounting Concepts - Separate Business Entity Concept

Theoretically applicable to all forms of business organisation Legally, applicable only to the Company form . A business unit is separate and distinct accounting entity. A company is a complete person having a distinct identity in the eyes of the law even though it has no biological existence. Benefit separates the transactions of the organisation with that of the owners

Money Measurement Concept

Only those transactions can be recorded whose value can be determined in units of money or which have a monetary value attached to it. In spite of this limitation, this concept is indispensable Money a common denominator to record heterogeneous facts about a business This concept imparts the essential flexibility for measurement and interpretation of accounting data. This drawback of financial accounting is sought to be compensated by integrating Human Resource Accounting, into it, BHEL being one of the pioneer organisations to make this effort in 1969.

Going Concern Concept or Continuity of Activity Concept

Once an organisation comes into existence, it is assumed to have perpetual or indefinite life. A direct extraction from the separate entity concept Even though all the owners may change/die, still the organisation will keep on living legally, till the time it is liquidated by a court of law or declared bankrupt. This is why fixed assets are recorded at their original cost and not at their current realizable value.

Dual Aspect Concept or Accounting Equivalence Concept

This concept signifies that each transaction involves a two-fold aspect

a. b.

The yielding of a benefit and The giving of that benefit

For every debit there is a credit core concept of accountancy basis of Double Entry System of book-keeping. Assets = Equities

Cost Concept

Closely related to Going Concern concept Any item purchased by an organisation and defined as a resource shall be recorded in account books at the actual money involved i.e. at cost. Assets may be systematically reduced by the process of depreciation. Loss of relevance nowadays

Prevents true and fair view of business affairs No place for good human assets no acquisition cost Rising trend of prices

But very difficult to apply market value or current value concept continuously keep track of ups and downs of market prices. Cost concept leads to a system that is much more feasible. Sacrifice some degree of relevance (usefulness) in exchange for greater objectivity and greater feasibility

Accounting Period Concept or Periodicity Concept

Definite accounting period True result of operations only at the end But parties interested in operating results cant wait till the end. Moreover, if a corrective action is required, it can be taken within appropriate time frame Need reports after short periods usually after twelve months may vary Each such period is called accounting period. This concept fixes up the time span for which performance is to be measured and financial position is to be appraised.

Realization Concept

This concept revolves around the determination of the point of time when revenues are earned. Revenues are generally recognized in the period in which

Goods are delivered to the customer or Legal ownership has been passed from seller to buyer Services are rendered.

Amount of revenue is the amount that is realized in

Cash or Legal obligation to pay that has been assumed by the customer.

Prevents business firms from inflating their profits by recording sales and incomes that are likely to accrue.

Accrual Concept

Profits are best measured by changes in owners equity This concept enables us to define income and expense. Any item (other than contributions by the owner himself) which leads to an increase in owners equity is income or profit. Any item (other than withdrawals) which results in the reduction of owners equity is expense or loss. A transaction which does not have any of these effects is neither income nor an expense, but is

Merely conversion of one form of asset into other, or Application of assets to pay-off outsiders claims etc.

Matching Concept

Match expenses with revenues earned during an accounting period. Expenses shown in an income statement must refer to the same accounting period, production unit, division or department of business entity to which revenue refers.

Direct association between cost and revenue e.g. purchases Direct association with the activities of the period itself e.g. operating expenses When costs can not be associated with the revenue of a future period e.g. loss from fire or theft or from sale of fixed assets etc.

Adjust prepaid or outstanding expenses & accrued or unearned incomes.

Verifiable Objective Evidence Concept

All accounting transactions should be evidenced and supported by business documents, e.g. invoices, vouchers etc. Significant concept keeping in mind the requirements of external users of information, especially the tax authorities. Categories of evidences

With the organisation least authentic and reliable With second parties more reliable With financial intermediaries e.g. banks, non-banking financial institution most reliable

Conventions of Accounting

Convention of Materiality Convention of Consistency Convention of Conservatism Convention of Full Disclosure

Convention of Materiality

Materiality refers to the relative importance of an item or event. Depends on its amount and its nature. According to American Accounting Association, an item should be regarded as material if there is a reason to believe that knowledge of it would influence the decision of informed investor Varies according to the company, circumstances, period etc. Thats why low-cost assets are immediately recognized as an expense.

Convention of Consistency

Use of same policies and procedures by a firm No frequent changes If required, Change is possible but only with due reporting. Serves to eliminate personal bias Increases accuracy and comparability of accounting information for predictions and decision-making.

Convention of Conservatism

Anticipate no profit and provide for all possible losses. Examples

Valuing inventory at cost or market price whichever is lower Creating provision for doubtful debts No true & fair view Creation of secret reserves Lack of comparability No uniform standards for implementation Harms the interest of shareholders investors.

Objections

and

Convention of Full Disclosure

Accounting statements should be honestly prepared and all significant information should be disclosed therein. Through footnotes To communicate all material and relevant information to end users Financial statements become more useful and less subject to misinterpretation.