Generally Accepted Accounting Principles (GAAP) Unit 2 Theory Base of Accounting Generally accepted accounting principles (GAAP) refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards or standard accounting practice. These include the standards, conventions, and rules that accountants follow in recording and summarizing and in the preparation of financial statements. Meaning Accounting Concepts The term concept is used to denote accounting postulates, i.e., basic assumptions or conditions upon the edifice of which the accounting super-structure is based. 1. Business Entity Concept: A business unit is an organization of persons established to accomplish an economic goal. Business entity concept implies that the business unit is separate and distinct from the persons who provide the required capital to it. This concept can be expressed through an accounting equation, viz., Assets = Liabilities + Capital. The equation clearly shows that the business itself owns the assets and in turn owes to various claimants. It is worth mentioning here that the business entity concept as applied in accounting for sole trading units is different from the legal concept. The expenses, income, assets and liabilities not related to the sole proprietorship business are excluded from accounting. However, a sole proprietor is personally liable and required to utilize non-business assets or private assets also to settle the business creditors as per law. Thus, in the case of sole proprietorship, business and non-business assets and liabilities are treated alike in the eyes of law. In the case of a partnership, firm, for paying the business liabilities the business assets are used first and it any surplus remains thereafter, it can be used for paying off the private liabilities of each partner. Similarly, the private assets are first used to pay off the private liabilities of partners and if any surplus remains, it is treated as part of the firm s property and is used for paying the firm s liabilities. In the case of a company, its existence does not depend on the life span of any shareholder. 2. Money Measurement Concept: In accounting all events and transactions are recode in terms of money. Money is considered as a common denominator, by means of which various facts, events and transactions about a business can be expressed in terms of numbers. In other words, facts, events and transactions which cannot be expressed in monetary terms are not recorded in accounting. Hence, the accounting does not give a complete picture of all the transactions of a business unit. This concept does not also take care of the effects of inflation because it assumes a stable value for measuring www.vipinmks.com Page 1
3. Going Concern Concept: Under this concept, the transactions are recorded assuming that the business will exist for a longer period of time, i.e., a business unit is considered to be a going concern and not a liquidated one. Keeping this in view, the suppliers and other companies enter into business transactions with the business unit. This assumption supports the concept of valuing the assets at historical cost or replacement cost. This concept also supports the treatment of prepaid expenses as assets, although they may be practically unsaleable. 4. Dual Aspect Concept: According to this basic concept of accounting, every transaction has a twofold aspect, Viz., 1.giving certain benefits and 2. Receiving certain benefits. The basic principle of double entry system is that every debit has a corresponding and equal amount of credit. This is the underlying assumption of this concept. The accounting equation viz., Assets = Capital + Liabilities or Capital = Assets Liabilities, will further clarify this concept, i.e., at any point of time the total assets of the business unit are equal to its total liabilities. Liabilities here relate both to the outsiders and the owners. Liabilities to the owners are considered as capital. 5. Periodicity Concept: Under this concept, the life of the business is segmented into different periods and accordingly the result of each period is ascertained. Though the business is assumed to be continuing in future (as per going concern concept), the measurement of income and studying the financial position of the business for a shorter and definite period will help in taking corrective steps at the appropriate time. Each segmented period is called accounting period and the same is normally a year. The businessman has to analyse and evaluate the results ascertained periodically. At the end of an accounting period, an Income Statement is prepared to ascertain the profit or loss made during that accounting period and Balance Sheet is prepared which depicts the financial position of the business as on the last day of that period. During the course of preparation of these statements capital revenue items are to be necessarily distinguished. 6. Historical Cost Concept: According to this concept, the transactions are recorded in the books of account with the respective amounts involved. For example, if an asset is purchases, it is entered in the accounting record at the price paid to acquire the same and that cost is considered to be the base for all future accounting. It means that the asset is recorded at cost at the time of purchase but it may be methodically reduced in its value by way of charging depreciation. However, in the light of inflationary conditions, the application of this concept is considered highly irrelevant for judging the financial position of the business. 7. Matching Concept: The essence of the matching concept lies in the view that all costs which are associated to a particular period should be compared with the revenues associated to the same period to obtain the net income of the business. Under this concept, the accounting period concept is relevant and it is this concept (matching concept) which necessitated the provisions of different adjustments for recording outstanding expenses, prepaid expenses, outstanding incomes, incomes received in advance, etc., during the course of preparing the financial statements at the end of the accounting period. 8. Realisation Concept: This concept assumes or recognizes revenue when a sale is made. Sale is considered to be complete when the ownership and property are transferred from the seller to the buyer and the consideration is paid in full. However, there are two exceptions to this www.vipinmks.com Page 2
concept, viz., 1. Hire purchase system where the ownership is transferred to the buyer when the last installment is paid and 2. Contract accounts, in which the contractor is liable to pay only when the whole contract is completed, the profit is calculated on the basis of work certified each year. 9. Accrual Concept: According to this concept the revenue is recognized on ts realization and not on its actual receipt. Similarly the costs are recognized when they are incurred and not when payment is made. This assumption makes it necessary to give certain adjustments in the preparation of income statement regarding revenues and costs. But under cash accounting system, the revenues and costs are recognized only when they are actually received or paid. Hence, the combination of both cash and accrual system is preferable to get rid of the limitations of each system. 10. Objective Evidence Concept: This concept ensures that all accounting must be based on objective evidence, i.e., every transaction recorded in the books of account must have a verifiable document in support of its, existence. Only then, the transactions can be verified by the auditors and declared as true or otherwise. The verifiable evidence for the transactions should be free from the personal bias, i.e., it should be objective in nature and not subjective. However, in reality the subjectivity cannot be avoided in the aspects like provision for bad and doubtful debts, provision for depreciation, valuation of inventory, etc., and the accountants are required to disclose the regulations followed. Accounting Conventions The following conventions are to be followed to have a clear and meaningful information and data in accounting: 1. Consistency: The convention of consistency refers to the state of accounting rules, concepts, principles, practices and conventions being observed and applied constantly, i.e., from one year to another there should not be any change. If consistency is there, the results and performance of one period can he compared easily and meaningfully with the other. It also prevents personal bias as the persons involved have to follow the consistent rules, principles, concepts and conventions. This convention, however, does not completely ignore changes. It admits changes wherever indispensable and adds to the improved and modern techniques of accounting. 2. Disclosure: The convention of disclosure stresses the importance of providing accurate, full and reliable information and data in the financial statements which is of material interest to the users and readers of such statements. This convention is given due legal emphasis by the Companies Act, 1956 by prescribing formats for the preparation of financial statements. However, the term disclosure does not mean all information that one desires to get should be included in accounting statements. It is enough if sufficient information, which is of material interest to the users, is included. 3. Conservatism: In the prevailing present day uncertainties, the convention of conservatism has its own importance. This convention follows the policy of caution or playing safe. It takes into account all possible losses but not the possible profits or gains. A view opposed to this www.vipinmks.com Page 3
convention is that there is the possibility of creation of secret reserves when conservatism is excessively applied, which is directly opposed to the convention of full disclosure. Thus, the convention of conservatism should be applied very cautiously. Basis of Accounting There are three bases of accounting in common usage. Any one of the following bases may be used to finalize accounts. 1. Accounting on Cash basis: Under cash basis accounting, entries are recorded only when cash is received or paid. No entry is passed when a payment or receipt becomes due. Income under cash basis of accounting, therefore, represents excess of receipts over payments during an accounting period. Government system of accounting is mostly on cash basis. Certain professional people record their income on cash basis, but while recording expenses they take into account the outstanding expenses also. In such a case, the financial statements prepared by them for determination of their income are termed as Receipts and Expenditure Account. 2. Accrual Basis of Accounting or Mercantile System: Under accrual basis of accounting, accounting entries are made on the basis of amounts having become due for payment or receipt. Incomes are credited to the period in which they are earned whether cash is received or not. Similarly, expenses and losses are detailed to the period in which, they are incurred, whether cash is paid or not. The profit or loss of any accounting period is the difference between incomes earned and expenses incurred, irrespective of cash payment or receipt. All outstanding expenses and prepaid expenses, accrued incomes and incomes received in advance are adjusted while finalising the accounts. Under the Companies Act 1956, all companies are required to maintain the books of accounts according to accrual basis of accounting. 3. Mixed or Hybrid Basis of Accounting: When certain items of revenue or expenditure are recorded in the books of account on cash basis and certain items on mercantile basis, the basis of accounting so employed is called hybrid basis of accounting. For example, a company may follow mercantile system of accounting in respect of its export business. However, government subsidies and duty drawbacks on exports to be received from government are recorded only when they are actually received i.e., on cash basis. Such a method could be adopted because of uncertainty with respect of quantum, amount and time of receipt of such incentives and drawbacks. Such a method of accounting followed by the company is called the hybrid basis of accounting. In practice, the profit or loss shown under this basis will not be realistic. Conservative people prefer recognizing income when received but cautious to provide for all expenses, whether paid or not prefer this system. It is not widely practiced due to the inconsistency. www.vipinmks.com Page 4
Systems of Accounting Single Entry System Single entry accounting (single entry system, or single entry bookkeeping) is a simple form of bookkeeping and accounting in which each financial transaction is recorded with a single entry in a journal or transaction log. The single entry approach contrasts with double entry bookkeeping and accounting, in which every transaction results in two equal and offsetting entries, one a debit (DR) and the other a credit (CR). Single entry bookkeeping and accounting can be adequate for a small business practicing cash basis accounting. The single entry approach may, in fact, be preferred over a double-entry system for small companies where all or most of these conditions apply: The company uses cash basis accounting, not accrual accounting. The company has few financial transactions per day. The company does not sell on its own credit, meaning it does not deliver goods or services and then invoice customers for payment later. Customers must pay at the time of the sale either in cash, or by written check or bank transfer, or with a 3rd-party credit/debit card. The company has very few employees. The company owns few expensive business-supporting physical assets (e.g., it may own some product inventory, office supplies, and cash in a bank account, but it does not own buildings, substantial amounts of office furniture, large computer systems, production machinery, vehicles, etc.). The company is privately held or operates as a sole proprietorship or partnership (i.e., the company does not need to publish the income statement, balance sheet, or other financial statements that are required of publicly owned companies). Double Entry System When establishing an accounting system, entities choose to use either a single entry system or a double entry system. In business, the overwhelming majority of companies choose the double entry approach, by which each financial event brings at least two changes in the accounts: A credit entry in one account causes an equal, offsetting debit entry in another account. The practice of using two account entries for every transaction in this way serves two purposes: Double entries play an error-checking role. The sum of all debit entries in the account ledgers must equal the sum of all credit entries. That is, at all time: Total Debits = Total Credits www.vipinmks.com Page 5
Accounting Standards Professor Vipin 2014 Meaning Indian Accounting Standards (abbreviated as India AS) are a set of accounting standards notified by the Ministry of Corporate Affairs which are converged with International Financial Reporting Standards (IFRS). These accounting standards are formulated by Accounting Standards Board of Institute of Chartered Accountants of India. Now India will have two sets of accounting standards viz. existing accounting standards under Companies (Accounting Standard) Rules, 2006 and IFRS converged Indian Accounting Standards(Indian AS). The Indian AS are named and numbered in the same way as the corresponding IFRS. NACAS recommend these standards to the Ministry of Corporate Affairs. The Ministry of Corporate Affairs has to spell out the accounting standards applicable for companies in India. As on date the Ministry of Corporate Affairs notified 35 Indian Accounting Standards (Indian AS). But it has not notified the date of implementation of the same. Mandatory Accounting Standards AS 1 Disclosure of Accounting Policies AS 2 Valuation of Inventories AS 3 Cash Flow Statements AS 4 Contingencies and Events Occurring after the Balance Sheet Date AS 5 Net Profit or Loss for the period, Prior Period Items and Changes in Accounting Policies AS 6 Depreciation Accounting AS 7 Construction Contracts (revised 2002) AS 9 Revenue Recognition AS 10 Accounting for Fixed Assets AS 11 The Effects of Changes in Foreign Exchange Rates (revised 2003), AS 12 Accounting for Government Grants AS 13 Accounting for Investments AS 14 Accounting for Amalgamations AS 15 Employee Benefits (revised 2005) AS 16 Borrowing Costs www.vipinmks.com Page 6
AS 17 Segment Reporting AS 18 Related Party Disclosures AS 19 Leases AS 20 Earnings Per Share AS 21 Consolidated Financial Statements AS 22 Accounting for Taxes on Income. AS 23 Accounting for Investments in Associates in Consolidated Financial Statements AS 24 Discontinuing Operations AS 25 Interim Financial Reporting AS 26 Intangible Assets AS 27 Financial Reporting of Interests in Joint Ventures AS 28 Impairment of Assets AS 29 Provisions, Contingent` Liabilities and Contingent Assets www.vipinmks.com Page 7