GAAP

Generally Accepted Accounting Principles:-

A widely accepted set of rules, conventions, standards, and procedures for reporting financial information as established by the Financial Accounting standards Board are called Generally Accepted Accounting principles ( GAAP).  These are the common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information.

GAAP is to be followed by companies so that investors have a optimum level of consistency in the financial statements they use when analyzing companies for investment purposes.  GAAP cover such aspects like revenue recognition, balance sheet item classification and outstanding share measurements.

Accounting concepts and Conventions:

As seen earlier, the accounting information is published in the form of financial statements.  The three basic financial statements are

i.                     The profit & Loss Account that shows net business result i.e. profit or loss for a certain periods.

ii.                   The balance sheet that exhibits the financial strength of the business as on a particular dates

iii.                  The cash flow statement that describes the movement of cash from one date to the other.

As these statements are meant to be used by different stakeholders, it is necessary that the information contained therein is based on definite principles, concrete concepts and well accepted convention.

Accounting principles are basic guidelines that provide standards for scientific accounting practices and procedures.  They guide as to how the transaction are to be recorded and reported.  They assure uniformity and understandability.  Accounting concepts lay down the foundation for accounting principles.  They are ideas essentially at mental level and are self-evident.  These concepts ensure recording of financial facts on sound bases and logical considerations.  Accounting conventions are methods or procedures that are widely accepted. 

Professional Accounting Bodies have published statement of these concepts.  Over years, many of these concepts are being challenged as outlived.  Yet, no major deviations have been made as yet.  Path breaking ideas have emerged and the accounting standards of modern days do require companies to record and report transaction which may not be necessarily based on concepts that are in vogue for long.

It is essential to study accounting from the basic levels and understand these concepts in entirely.

A.      BASIC ASSUMPTIONS

1.       Business entity concept:-  As per this concept, the business is treated as distinct and separate from the individuals who own or manage it.  For example, if the owner pays his personal expenses from business cash, this transaction can be recorded in the books of business entity.  This transaction will take the cash out of business and also reduce the obligation of the business towards the owners.

The entity concept requires that all the transactions are to be viewed, interpreted and recorded from ‘business entity’ point of view.  An accountant steps into the shoes of the business entity and decides to account for the transactions.  The owner’s capital is the obligation of business and it has to be paid back to the owner in the event of business closure.  Also, the profit earned by the business will belong to the owner and hence is treated as owner’s equity.

2.       Going concern Concept:- The basic principles of this concept is that business is assumed to exist for an indefinite period and is not established with the objective of closing it down.  So unless there is good evidence to the contrary, the accountant assumes that a business entity is a ‘going concern’- that it will continue to operate as usual for a longer period of time.  It will keep getting money from its customers, pay its creditors, buy and sell goods, use assets to earn profits in future.  If this assumption is not considered, one will have to constantly value the worth of the assets and resource.  This is not practicable.  This concept enables the accountant to carry forward the values of assets and liabilities from one accounting period to the other without asking the question about usefulness and worth of the assets and recoverability of the receivables.

The going concern concept forms a sound basis for preparation of a balance sheet.

3.       Money measurement concept:- A business transaction will always be recoded if it can be expressed in terms of money.  The advantage of this concept is that different types of transactions could be recorded as homogenous entries with money as common denominator.  A business may own Rs.3 laks cash, 1500kgs of raw material,10 vehicles, 3 computers etc.  Unless each of these is expressed in terms of money, we cannot find out the assets owned by the business.  When expressed in the common measure of money, transaction could be added or subtracted to find out the combined effect.  In the above example, we could add values of different assets to find the total assets owned.

The application of this concept has a limitation.  When transactions are recorded in terms of money, we only consider the absolute value of the money.  The real value of the money may fluctuate from time to time due to inflation, exchange rate changes, etc.  This fact is not considered when recording the transaction.

4.       The accounting period concept: This period is usually one year, which could be a calendar year i.e. 1^st January to 31^st December or it could be a fiscal year in India as 1^st April to 31^st march.  The business organizations have the freedom to choose their own accounting year.  For certain organizations, reporting of financial information in public domain are compulsory.  In India, listed companies must report their quarterly unaudited financial results and year audited financial statements.  For internal control purpose, many organizations prepare monthly financial statements.  The modern computerized accounting systems enable the companies to prepare real-time online financials at the click of button.

Businesses are living, continuous organisms.  The splitting of the continuous stream of business events into time period is thus somewhat arbitrary.  There is no significant change just because one accounting period ends and a new one begins.  This results into the most difficult problem of accounting of how to measure the net income for an accounting period.  One has to be careful in recognizing revenue and expenses for a particular accounting period.  Subsequent section on accounting procedures will explain how one goes about it in practice.

5.       The accrual concept:  The accrual concept is based on recognition of both cash and credit transactions.  In case of a cash transaction, owner’s equity is instantly affected as cash either is received or paid.  In a credit transaction, however, a mere obligation towards or by the business is created.  When credit transactions exist (which is generally the case), revenues are not the same as cash receipts and expenses are not same as cash paid during the period.

When goods are sold on credit as per normally accepted trade practices, the business gets the legal right to claim the money from the customer.  Acquiring such right to claim the consideration for sale of goods or services is called accrual of revenue.  The actual collection of money from customer could be at a later date.

Similarly, when the business procures goods or services with the agreement that the payment will be made at a future date, it does not mean that the expense effect should not be recognized.  Because an obligation to pay for goods or services is created upon the procurement thereof, the expense effect also must be recognized.

Today’s accounting systems based on accrual concept are called as Accrual System or Mercantile system of Accounting.

A.      BASIC PRINCIPLES

a.       The revenue realization Concept:

It says amount should be recognized only to the tune of which it is certainly realizable.  Thus, mere getting an order from the customer won’t make it eligible to recognize as revenue.  The reasonable certainty of realizing the money will come only when the goods ordered are actually supplied to the customer and he is billed.  This concept ensures that income unearned or unrealized will not be considered as revenue and the firms will not inflate profits.

Consider that a store sales goods for Rs.25 lacs during a month on credit.  The experience and past data shows that generally 2% of the amount is not realized.  The revenue to be recognized will be Rs.24.5lacs.  Although conceptually the revenue to be recognized at this value, in practice the doubtful amount of Rs.50 thousand (2% of Rs.25 lacs) is often considered as expense.

b.      The matching concept:

As we have seen the sale of goods has two effects: (i) a revenue effect, which results in increase in owner’s equity by the sales value of the transaction and (ii) an expense affect, which reduces owner’s equity by the cost of goods sold, as the goods go out of the business.  The net effect of these two effects will reflect either profit or loss.  In order to correctly arrive at the net result, both these aspects must be recognized during the same accounting period.  One cannot recognize only the revenue effect thereby inflating the profit or only the expense effect which will deflate the profit.  Both the effects must be recognized in the same accounting period.  This is the principle of matching concept.

To generalize, when a given event has two effects – one on revenue and the other on expense, both must be recognized in the same accounting period.

c.       Full disclosure Concept:

As per this concept, all significant information must be disclosed.  Accounting data should properly be clarified, summarized, aggregated and explained for the purpose of presenting the financial statement which are useful for the user of accounting information.  Practically, this principle emphasized on the materiality, objectivity and consistency of accounting data which should disclose the true and fair view of the state of affairs of a firm.  This principle is going to be popular day by day as per companies act, 1956 major provisions for disclosure of essential information about accounting data and as such, concealment of material information, at present, is not very easy.  Thus, full disclosure must be made for such material information which are useful to the users of accounting information.

d.      Dual Aspect Concept:

The assets represent economic resources of the business, whereas the claims of various parties on business are called obligations.  The obligations could be towards owners (called as owner’s equity) and towards parties other than the owners (called as liabilities)

When a business transaction happens, it will involve use of one or the other resource of the business to create or settle one or more obligations.  E.g. consider Mr.Ramesh starts a business with the investment of Rs.20 lacs.  Here, the business has got a resource of cash worth Rs.20 lacs (which is its asset), but at the same time it has created an obligation of business towards Mr.Ramesh that in the event of business closure, the money will be paid back to hime.  This could be shown as:

        Assets = Liabilities + Capital

This is the fundamental accounting equation shown as formal expression of the dual aspect concept.  This powerful concept recognizes that every business transaction has dual impact on the financial posting.  Accounting systems are set up to simultaneously record both these aspects of every transaction; that is why it is called as Double-entry system of accounting.  In its as present form the double entry system of accounting owes its existence to an Italian expert Mr.Luca Pacioli in the year 1495.

Continuing with our example Mr.Ramesh, now let us consider he borrows Rs.10 lacs from bank.  The dual aspect of this transaction  - on one hand the business cash will increase by Rs.10 lacs and a liability towards the bank will be created for Rs.10lacs.

The student must note that the dual aspect concept entails recognition of the two effect of each transaction.  These effects are of equal amount and reverse in nature.  How to decide these two aspects? After recording both aspects of the transaction, the basic accounting equation will always balance or be equal.

e.      Verifiable Objective Evidence Concept:-

Under this principle, accounting data must be verified.  In other words, documentary evidence of transaction must be made which are capable of verification by an independent respect.  In the absence of such verification, the data which will be available will neither be reliable nor dependable, i.e., these should be biased data.  Verifiability and objectivity express dependability, reliability and trustworthiness that are very useful for the purpose of displaying the accounting data and information to the users.

f.        Historical Cost Concept:

Business transactions are always recorded at the actual cost at which they are actually undertaken. The basic advantage is that it avoids an arbitrary value being attached to the transactions. Whenever an asset is bought, it is recorded at its actual cost and the same is used as the basis for all subsequent accounting purposes such as charging depreciation on the use of asset, e.g. if a production equipment is bought for Rs.1.25 crores, the asset will be shown at the same value in all future periods when disclosing the original cost.  It will obviously be reduced by the amount of depreciation, which will be calculated with reference to the actual cost.  The actual value of the equipment may rise or fall subsequent to the purchase, but that is considered irrelevant for account purpose as per historical cost concept.

g.       Balance Sheet Equation Concept:

Under this principle, all which has been received by us must be equal to that has been given by us and needless to say that receipts are clarified as debits and giving is clarified as credits.  The basic equation appears as below

Debit = Credit

Naturally every debit must have a corresponding credit and vice-e-versa.  So, we can write the above in the following form

Expenses + Losses + Assets = Revenues + Gains + Liabilities

 And if expenses and losses, and incomes and gains are set off, the equation take the following form

Assets = Liabilities

Or Assets = Equity + External Liabilities

i.e., the Accounting Equation.

B.      MODIFYING PRINCIPLES

a.       The concept of Materiality:

This is more of a convention than a concept.  It proposes that while accounting for various transactions, only those which may have material effect on profitability or financial status of the business should have special consideration for reporting.  This does not mean that the accountant should exclude transactions from recording. E.g. even Rs.10 worth conveyance paid must be recorded as expense.  The concept of materiality is subjective and accountant will have to decide on merit of each case.  Generally, the effect is said to be material, if the knowledge of an event would influence the decision of an informed stakeholder.

The materiality could be related to information, amount, procedure and nature.  Error in description of an asset or wrong classification between capital and revenue would lead to materiality of information.  Some transactions are by nature material irrespective of the amount involved. E.g. audit fees, loan to directors.

b.      The concept of Consistency

This concept advocates that once an organization decides to adopt a particular method of revenue or expense recognition in line with the other concepts, the same should be consistently applied year after year, unless there is a valid reason for change in the method.  Lack of consistency would result in the financial information becoming non-comparable between the different accounting periods.  The insistence of this concept would result in avoidance of window dressing the results by choosing the accounting method by convenience and thereby either inflating or understating net income.

Consider an example.  An asset of Rs.15 lacs is purchased by a business.  It is estimated to have useful life of 3 years.  It will follow that the asset will be depreciated over a period of 3 years at the rate of Rs.5 lacs every year.  The estimate of useful life and the rate of depreciation cannot be changed from period to other without a valid reason.

However, it may be difficult to be consistent if the business entities have two factories in different countries which have different statutory requirement for accounting treatment.

c.       The conservatism concept:

Accountants who prepare financial statements of business, like other human being, would like to give a favourable report on how well the business has performed during an accounting period.  However, prudent reporting based on skepticism builds confidence in the results and in the long run best serves all the divergent interest of users of financial statements this philosophy of prudence leads to the conservatism concept.

This concept underlines the prudence of under-stating than over-stating the net income of an entity for a period and the net assets as on particular date. For years, this concept was meant to “anticipate no profits but recognize all losses” this can be stated as

1.       Delay in recognizing income unless one is reasonably sure.

2.       Immediately recognize expenses when reasonably sure.

     This, of course, does not mean to overdo and create window dressing in reporting.  E.g. if the business has sold Rs.15 lacs worth goods on the last day of accounting period and also received a cheque for the same, one cannot argue that the revenue should not be recognized as it is not certain whether the cheque will be cleared by the bank.  One cannot stretch the conservatism concept too much.  But at the same time, if the business has to receive Rs. 3 lacs from a customer to whom goods were sold quite some time ago and no payments are forthcoming, then while determining the net income for the period, the accountant must judge the likelihood of the recoverability of this money and the prudence will prevail to make a provision for this amount as doubtful debtors.

d.      Timeliness Concept:

Under this principle, every transaction must be recorded in proper time.  Normally, when the transaction is made, the same must be recorded in the proper books of accounts.  In short, transaction should be recorded date-wise in the books.  Delay in recording such transaction may lead to manipulation, misplacement of vouchers, misappropriation etc. of cash and goods.  Principle of timeliness is followed by banks, i.e. every bank verifies the cash balance with their cash book and within the day, the same must be completed.

e.      Industry practice:

As there are different types of industries, each industry has its own characteristics and features.  There may be seasonal industries also.  Every industry follows the principles and assumption of accounting to perform their own activities.   Some of them follow the principles, concepts and conventions in a modified way. e.g. electric supply companies, insurance companies maintain their accounts in a specific manner.  Insurance companies prepare revenue account just to ascertain the profit/loss of the company and not profit and loss account.  Similarly, non trading organizations prepare income and expenditure account to find out surplus or Deficit.