Basic Accounting Concepts, Conventions, and Standards
Meaning of GAAP
GAAP (General Accepted Accounting Principles) are the rules, conventions, and procedures that accountants must follow to prepare external reports that are subjected to an audit by an independent auditor.
BASIC ACCOUNTING CONCEPT
Business Separate Entity Concept
In accounting, we make a distinction between business and the owner—all the books of accounts record day-to-day financial transactions from business prosperity rather than from the owners. The proprietor is considered a creditor to the extent of the capital he brought into the business. For instance, when a person invests Rs. 10 lakhs into a business, it will be treated that a business that has borrowed that much money from the owner, and it will be shown as a 'liability' in the books of accounts of the business. Similarly, if the shop owner were to take cash from the cash box for meeting certain personal expenditures, the accounts would show that cash had been reduced even though it does not make any difference to the owner himself. Thus, in recording a transaction, the vital question is how does it affect the business? For example, if the owner puts cash into the business, he has a claim against the business for capital brought in.
Money Measurement Concept
In accounting, only those business transactions are recorded, which can be expressed in terms of money. In other words, a fact or transaction, or happening which cannot be expressed in terms of money is not recorded in the accounting books. As money is accepted not only as a medium of exchange but also as a store of value, it has a significant advantage since several assets and equities, which are otherwise different, can be measured and expressed in terms of a common denominator.
We must realize that this concept imposes two severe limitations. Firstly, there are several facts that though essential to the business, cannot be recorded in the books of accounts because they cannot be expressed in money terms. For example, the general health condition of the Managing Director of the company, working conditions in which a worker has to work, the sales policy pursued by the business firm, quality of products introduced by the enterprise, though exert a significant influence on the productivity and profitability of the enterprise, are not recorded in the books.
Similarly, the fact that a strike is about to begin because employees are dissatisfied with the poor working conditions in the factory will not be recorded, even though this event is of great concern to the business. However, it will agree that all these have a bearing on the company's future profitability. Secondly, using money implies that we assume a stable or constant value of the rupee. Taking this assumption means that the changes in the money value on future dates are conveniently ignored. For example, a piece of land purchased in 1990 for Rs. 2 lakh and another bought for the same amount in 1998 are recorded at the same price, although the first purchase in 1990 may be worth two times higher than the value recorded in the books because of rising in land prices. Most accountants know fully well that purchasing power of the rupee does change, but very few recognize this fact in accounting books and make allowance for changing price levels.
Going Concern Concept
Accounting assumes that the business entity will continue to operate for a long time unless there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, continuing in operations, at least in the foreseeable future. In other words, there is neither the intention nor the necessity to liquidate the particular business venture in the predictable future. Because of this assumption, the accountant, while valuing the assets, does not consider their forced sale value. The assumption that the business does not desire to be liquidated in the foreseeable future establishes the basis for many of the valuations and allocations in accounting. For example, the accountant charges depreciation on fixed assets. It is this assumption that underlies the decision of investors to commit capital to the enterprise. Only based on this assumption accounting process can remain stable and achieve the objective of correctly reporting and recording the capital invested, the efficiency of management, and the position of the enterprise as a going concern.
Accounting Period Concept
This concept requires that the life of the business should be divided into appropriate segments for studying the financial results shown by the enterprise after each segment. Although the results of operations of a specific enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off, and liabilities paid off, the knowledge of the results periodically is also necessary. Those who are interested in the operating results of business obviously cannot wait till the end. The requirements of these parties force the businessman 'to stop' and 'see back' how things are going on. Thus, the accountant must report for the changes in a firm's wealth for short periods. A year is the most common interval for prevailing practice, tradition, and government requirements. Some firms adopt the government's financial year and other calendar years. Although twelve months is adopted for external reporting, a shorter interval span, say one month or three months is applied for internal reporting purposes.
Accounting principles are recognized common sets of accounting standards and procedures. These general rules and concepts are followed while reporting financial data.
The term 'assets' denotes the resources, land building, machinery, etc., owned by a business. The money values assigned to assets are derived from the cost concept. According to this concept, an asset is ordinarily entered into the accounting records at a price paid to acquire it. For example, if a business buys a plant for Rs. 5 lakh, the asset would be recorded in the books at Rs. 5 lakhs, even if its market value at that time happens to be Rs. 6 lakhs. Thus, assets are recorded at their original purchase price, and this cost is the basis for all subsequent accounting for the business. The assets shown in the financial statements do not necessarily indicate their present market values. The term' book value' is used for the amount shown in the accounting records. The cost concept does not mean that all assets remain on the accounting records at their original cost for all times to come. The asset may systematically be reduced in value by charging 'depreciation,' which will be discussed in detail in a subsequent lesson. Depreciation has the effect of reducing the profit of each period. The prime purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost. However, a balance sheet based on this concept can be very misleading as it shows assets at a cost even when there is a vast difference between their costs and market values. Despite this limitation, you will find that the cost concept meets all three basic norms of relevance, objectivity, and feasibility.
The Matching concept:
This concept is based on the accounting period concept. In reality, we match revenues and expenses during the accounting periods. Matching is the entire process of periodic earnings measurement, often described as matching expenses with revenues. In other words, income made by the enterprise during a period can be measured only when the revenue earned during a period is compared with the expenditure incurred for earning that revenue. Revenue is the total amount realized from the sale of goods or services, together with earnings from interest, dividends, and other items of income. Expenses are costs incurred in connection with the earnings of revenues. Costs incurred do not become expenses until the goods or services are exchanged. Cost is not synonymous with expense since the expense is a sacrifice made or resource consumed concerning revenues earned during an accounting period. Only costs that have expired during an accounting period are considered expenses. For example, if a commission is paid in January 2002 for services enjoyed in November 2001, that commission should be taken as the cost for services rendered in November 2001. This concept makes adjustments for all prepaid expenses, outstanding expenses, accrued income, etc., while preparing periodic reports.
Accounting generally accepts that the basis of reporting income is accrual. The accrual concept distinguishes between the receipt of cash, the right to receive it, the payment of cash, and the legal obligation to pay it. This concept provides a guideline to the accountant on how he should treat the cash receipts and the related rights. The accrual principle evaluates every transaction in terms of its impact on the owner's equity. The essence of the accrual concept is that net income arises from events that change the owner's equity in a specified period and are not necessarily the same as the change in the cash position of the business. Thus, it helps in the proper measurement of income.
The realization is technically understood as converting non-cash resources and rights into money. As an accounting principle, it is used to identify precisely the amount of revenue to be recognized and the amount of expense to be matched to such revenue for income measurement. According to the realization concept, revenue is recognized when a sale is made. A sale is considered to be made at the point when the property in goods passes to the buyer, and he becomes legally liable to pay. This implies that revenue is generally realized when goods are delivered, or services are rendered. The rationale is that delivery validates a claim against the customer. However, in the case of long-run construction contracts, revenue is often recognized based on a proportionate or partial completion method. Similarly, in the case of long-run installment sales contracts, revenue is regarded as realized only in proportion to the actual cash collection. Both these cases are the exceptions to the notion that an exchange is needed to justify the realization of revenue.
The convention is an agreement, principle or statement expressed or implied to solve a given type of problem. Conventions allow a standardized approach to problem-solving and behavior in certain situations. Accounting conventions are guidelines that arise from applying accounting principles practically. These are based on customs and designed to overcome practical problems in accounting. The critical accounting conventions are mentioned below.
Convention of Materiality:
The materiality concept states that items of minor significance need not be given the strict, theoretically correct treatment. For example, there are many events in business that are insignificant. The cost of recording and showing in a financial statement such events may not be well justified by the utility derived from that information. For example, an ordinary calculator costing Rs. 100 may last for ten years. However, the effort involved in allocating its cost over the ten years is not worth the benefit that can be derived from this operation. Therefore, the cost incurred on the calculator may be treated as the expense of the period in which it is purchased. Similarly, when a statement of outstanding debtors is prepared for sending to top management, figures may be rounded to the nearest ten or hundred.
Convention of Consistency
The convention of consistency requires that once a firm decided on specific accounting policies and methods and has used these for some time, it should continue to follow the same methods or procedures for all subsequent similar events and transactions unless it has a sound reason to do otherwise. In other words, accounting practices should remain unchanged from one period to another. For example, if depreciation is charged on fixed assets according to the straight-line method, this method should be followed yearly. Analogously, if stock is valued at 'cost or market price, whichever is less, this principle should be applied in each subsequent year.
However, this principle does not forbid the introduction of improved accounting techniques. If for valid reasons, the company makes any departure from the method so far in use, then the effect of the change must be clearly stated in the financial statements in the year of change. The application of the principle of consistency is necessary for comparison. One could draw valid conclusions by comparing data from one year's financial statements with that of the other. However, the inconsistency in the application of accounting methods might significantly affect the reported data.
Convention of Conservatism
This concept requires that the accountants follow the policy of "playing safe" while recording business transactions and events. That is why the accountant follows the rule of anticipating no profit but providing for all possible losses while recording the business events. This rule means that an accountant should record the lowest possible value for assets and revenues and the highest possible value for liabilities and expenses. According to this concept, revenues or gains should be recognized only when they are realized in the form of cash or assets (i.e., debts), the ultimate cash realization of which can be assessed with reasonable certainty. Further, provisions must be made for all known liabilities, expenses, and losses. Probable losses regarding all contingencies should also be provided for. 'Valuing the stock in trade at market price or cost price whichever is less, 'making the provision for doubtful debts on debtors in anticipation of actual bad debts,' 'adopting written down value method of depreciation as against straight-line method,' not providing for a discount on creditors but providing for a discount on debtors', are some of the examples of the application of the convention of conservatism.
The principle of conservatism may also invite criticism if not applied cautiously. For example, the accountant creates private reserves by creating excess provisions for bad and doubtful debts, depreciation, etc. As a result, the financial statements do not present an accurate and fair view of the state of affairs. American Institute of Certified Public Accountants has also indicated that this concept needs to be applied with much more caution and care as over-conservatism may result in misrepresentation.
The accounting concepts and conventions discussed in the preceding pages are the core elements of accounting theory. These principles, however, permit a variety of alternative practices to co-exist. On account of this, the financial results of different companies can not be compared and evaluated unless complete information is available about the accounting methods used. The lack of uniformity among accounting practices has made it difficult to compare the financial results of different companies. It means that companies and their accountants should not be too discretion when presenting financial information how they like. In other words, the information contained in financial statements should conform to carefully considered standards. Accounting standards are needed to:
- provide a basic framework for preparing financial statements to be uniformly followed by all business enterprises.
- make the financial statements of one firm comparable with the other firm and the financial statements of one period with the financial statements of another period of the same firm
- make the financial statements credible and reliable, and
- create general confidence among the outside users of financial statements.