THEORY BASE OF ACCOUNTING

Accounting principles, concepts and conventions are known as Generally Accepted Accounting Principles (GAAP). These principles are the base of Accounting.
Generally Accepted Accounting Principles (GAAP) refers to the rules or guidelines adopted for recording and reporting of business transactions, in order to bring uniformity and consistency in the preparation and the presentation of financial statements.

FUNDAMENTAL ACCOUNTING ASSUMPTIONS :

This concept assumes that an enterprise has an indefinite life or existence. It means that the intentions of the business are to continue for sufficiently longer period of time. It will not be dissolved or liquidated in the immediate future. If a machinery purchased is expected to last (to be used for) next 10 year, then the cost of machinery will be spread over the next 10 year for calculating net profit or loss of each year (Dep. Charged.)

The full cost of the machine would not be treated as expense in the year of purchase itself. Market value of the asset is irrelevant and is not recorded in the balance sheet, as these assets are not going to be sold in the near future.

Relevance :

(a) Distinction is made between a capital expenditure and revenue expenditure.
(b) Classification of assets and liabilities into short term and long term respectively.
(c) Depreciation charged on fixed assets or fixed assets appears in the balance Sheet at book value, without having reference to their market value.

1. It implies that accounting practices once selected and adopted, should be applied consistently year after year.


2. Same Accounting practices will be followed for similar items year after year. This will ensure a meaningful study of the performance of the business for a number of years.


3. When the accounting principles and practices are uniformly/consistently followed from year to year that the result obtained will be comparable.

Consistency assumption does not mean that particular practices once adopted cannot be changed. The only requirement is that when a change is desirable, it should be fully disclosed in the financial statements along with its effect on income statement and financial position (Balance Sheet) of the year in which that change is made.

This assumption is important when alternative accounting practices are equally acceptable. E.g. two methods of charging depreciation, written down value method and Straight line method are equally acceptable. If a firm adopts one method in the previous year and the other method in next year, the result will not be comparable.

3. Accrual Assumption :

Accrual concept applies equally to revenue and expenses. As per this assumption, revenue is recognized when it is accrued/ earned, that is, when sale is complete or services are rendered. It is immaterial, whether the cash is received or not. E.g. if a credit sale for ϕ 15,000 of two month is made on 15th Feb. 2011, then the revenue earned is to be recorded on 15th Feb. 2011 not on the date of cash realized, i.e, after two months. Similarly, expenses are recognized in the accounting period in which they facilitate in earning the revenues, whether the cash is paid for them or not. E.g. if at the end of year the two month salary is due but not paid. Then the expenses of salary will be recorded in the current year in which salary is due, not in the next year in which it will be paid.

Relevance :

Earning of a revenue and consumption of a resource (expenses) can be accurately matched to a particular accounting period Accounting Principles

4. Accounting Entity. / Business Entity :

An entity has a separate existence from its owner. According to this principle, business is treated as an entity, which is separate and distinct from its owner. Therefore business transactions are recorded; analyzed and financial  statements are prepared from the business point of view and not of the owner.

1. The owner is treated as a creditor (liability) for his investment in the business, as if the firm has borrowed from its owner instead of the outside parties.


2. Interest on capital is treated as expense like any other business expense.


3. His private expenses are treated as drawings leadings to reduction in capital.


4. This concept is applicable to all forms of business organizations – sole proprietorship, partnership or a company.

5. Money Measurement Principle:

According to this principle, only those transactions that are measured in money or can be translated in term of money are recorded in the books of accounts of the enterprises.

1. Money means the currency of a country.
2. Money is a common measuring unit for recording and reporting business transactions.

Example : purchases cost ϕ 15,000 will be recorded in the books of accounts but the good human relationship within organization will not be recorded.

Limitations :

1. it ignores qualitative aspects e.g. efficient human resources (Assets), satisfied customers (Assets) and dishonest employee (liabilities)
2. Self-generated goodwill not recorded.
3. Value of money (currency) is not stable.
4. The facts which cannot be expressed in money cannot be recorded.
5. To make accounting records simple, relevant, understandable and homogeneous, facts are expressed in a common unit of measurement - money.

6. Accounting Period Principle :

According to this principle, the whole indefinite life of an enterprise is divided into part, known as accounting period.

Accounting period is defined as interval of time, at the end of which the profit and loss account and balance sheet are  prepared. So the performance is measured at regular intervals and decision can be taken at the appropriate time. This interval may be quarterly, half-yearly and one year. Accounting period is usually a period of one year and that year may be financial year or calendar year.

Relevance :

1. As per SEBI and Companies Act Annual reports are to be prepared and submitted to registrar annually.
2. As per income tax law, tax on income is calculated on annual basis from 1st April to 31st March (Financial Year)
3. Accounting period concept is responsible for the preparation of income statement on accrual basis as distinguished from cash basis of accounting.

7. Full Disclosure Principle:

According to this principle, apart from legal requirements all significant and material information relating to the economic affairs of the entity should be completely disclosed in its financial statement and accompanying footnotes.

Disclosure of material information will result in better understanding of users, so, they take good and sound decision from the information. E.g. footnotes such as :

1. Contingent liabilities in respect to a claim of a very big amount against the business are pending in a court of law.
2. Change in the method of providing depreciation.
3. Market value of investment.

Disclosure of all material facts is compulsory but is does not imply that even those figures which are irrelevant are to be included in financial statements

8. Materiality Principle :

According to this principle, only those items or information should be disclosed that have material effect and relevant to the users. So, item having an insignificant effect or being irrelevant to user need not be disclosed separately, these may be merged with other item.

If the knowledge of any information may effect the decision of a user of account, is termed as material information.
It should be noted that an item material for one enterprise may not be material for another enterprise. E.g. an item of expenses ϕ 50,000 is material for an enterprise having turnover of ϕ 1,50,000 but it is not material for an enterprise having turnover of ϕ 100 crore.
The nature of transaction should be taken into consideration for materiality of information. E.g. a difference of ϕ 200 in the valuation of stock may be immaterial but the difference of ϕ 50 in cash could be termed as material.

9. Prudence/ conservatism Principle :

According to this principle, profit in anticipation should not be recorded but loss in anticipation should immediately be recorded. The objective of this principle is profit of the enterprise in no case overstated.

When there are different equally acceptable alternative methods are available, the method which having least favourable immediate effect on profit should be adopted. e.g.

1. Valuation of stock at cost or realizable values whichever is lower.
2. Provision for doubtful debts and Provision for discount on debtor is made.
3. Ignore provision for discount on creditors.

CBSE Accountancy Class XI ( By Mr. Kailash Gururani )
Email Id : [email protected]