2. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES – Financial Accounting

2 CHAPTER

Generally Accepted Accounting Principles

MEANING OF ‘GENERALLY ACCEPTED ACCOUNTING PRINCIPLES’ (GAAP)

Generally Accepted Accounting Principles may be defined as 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 principles.

The general acceptance of the accounting principles or practices depends upon how well they meet the following three criteria:

  1. Relevance A principle is relevant to the extent it results in information that is meaningful and useful to the user of the accounting information.
  2. Objectivity Objectivity connotes reliability and trustworthiness. A principle is objective to the extent the accounting information is not influenced by personal bias or judgement of those who provide it. It also implies verifiability which means that there is some way of ascertaining the correctness of the information reported.
  3. Feasibility A principle is feasible to the extent it can be implemented without much complexity or cost.

These criteria often conflict each other, for instance, information about the value of a new product to the inventor is indeed relevant but the best estimate of the value of a new product made by the management is highly subjective. Accounting, therefore does not attempt to record such values. It sacrifices relevance in the interest of objectivity. In developing new principles, the essential problem is to achieve a trade-off between relevance on one hand and objectivity and feasibility on the other.

BASIC ASSUMPTIONS OF ACCOUNTING

The basis assumptions of accounting are like foundation pillars on which the structure of accounting is based. The four basic assumptions are as follows:

Let us discuss these basic assumptions of accounting one by one:

  1. Accounting Entity Assumption According to this assumption, a business is treated as a separate entity that is distinct from its owner(s), and all other economic proprietors. For example, in case of a proprietary concern, though the legal entity of the business and its proprietor is the same, for the purpose of accounting, they are to be treated as separate from each other. If this assumption is not followed, the financial position and operating results of a business entity cannot be ascertained. In other words, this assumption requires that for accounting purposes, a distinction should be made between (i) personal transactions and business transactions, and (ii) transactions of one business entity and those of another business entity. For example, if the household expenses (Rs 10,000) of a proprietor are shown as business expenses, the profits of a business will be understated to the extent of Rs 10,000.
  2. Money Measurement Assumption According to this assumption, only those transactions which are capable of being expressed in term of money are included in the accounting records. In other words, the information which cannot be expressed in terms of money is not included in accounting records. For example, if the sales director is not on speaking terms with the production director, the enterprise is bound to suffer. Since, monetary measurement of this information is not possible, this fact is not recorded in accounting records. By expressing all transactions in terms of money, the different transactions expressed in different units are brought to a common unit of measurement (i.e., money). Besides ignoring the non-monetary facts or attributes, this assumption also ignores the changes in the purchasing power of the monetary unit. In other words, this assumption treats all rupees alike, whether it is a rupee of 1950 or 1999. Hence, now a days, it is considered to provide additional data showing the effect of price level changes on the reported income, assets and liabilities of the business.
  3. Accounting Period Assumption It is also known as periodicity assumption or time period assumption. According to this assumption, the economic life of an enterprise is artificially split into periodic intervals which are known as accounting periods, at the end of which an income statement and position statement are prepared to show the performance and financial position. The use of this assumption further requires the allocation of expenses between capital and revenue. That portion of capital expenditure which is consumed during the current period is charged as an expense to income statement and the unconsumed portion is shown in the balance sheet as an asset for future consumption. Truly speaking, measuring the income following the concept of accounting period is more an estimate that factual since, actual income can be determined only on the liquidation of the enterprise. It may be noted that the custom of using twelve month period applied only for external reporting. For internal reporting, accounts can be prepared even for shorter periods, say monthly, quarterly or half yearly.
  4. Going Concern Assumption It is also known as continuity assumption. According to this assumption, the enterprise is normally viewed as a going concern, that is, continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations. It is because of the going concern assumptions:
    1. that the assets are classified as current assets and fixed assets.
    2. the liabilities are classified as short-term liabilities and long-term liabilities.
    3. the unused resources are shown as unutilised costs (or unexpired costs) as against the break-up values as in case of liquidating enterprise. Accordingly, the earning power and not the break-up value evaluates the continuing enterprise.

According to Accounting Standard (1) issued by the Institute of Chartered Accountants of India, if this concept is followed, this fact need not be disclosed in the financial statements since its acceptance and use are assumed. In case this concept is not followed, the fact should be disclosed in the financial statement together with reasons.

It may be noted that if there are good reasons to believe that the business, or some part of it, is going to be liquidated or that it will cease to operate (say within a year or two), then the resources could be reported at their current values (or liquidation values).

BASIC PRINCIPLES OF ACCOUNTING

Basic principles of accounting are essentially, the general decision rules which govern the development of accounting techniques. These principles guide how transactions should be recorded and reported. On the basis of the four basic assumptions of accounting, the following basic principles of accounting have been developed:

Let us discuss these basic principles of accounting one by one.

  1. Duality Principle Two fold aspect of a transaction is called dual aspect or duality of a transaction. This duality is the basis of double entry records. As the name implies, the entry made for each transaction is composed of two parts—one for debit and another for credit. The double entry system may be compared with the Newton’s law of motion, viz. to every action there is always an equal and contrary reaction. Every debit has equal amount of credit. So the total of all debits must be equal to the total of all credits.

    Example 1 Mr X sold goods for cash Rs 1,000 to Mr Y. In this case the dual aspects of this transaction for Mr X and Mr Y are as follows:

    Example 2 Mr X sold goods for Rs 1,000 to Mr Y on credit. In this case the dual aspects of this transaction for Mr X and Mr Y are as follows:

  2. Revenue Recognition Principle This principle is mainly concerned with the revenue being recognised in the Income Statement of an enterprise. Revenue is the gross inflow of cash, receivables or other considerations arising in the course of ordinary activities of an enterprise from the sale of goods, rendering of services and use of enterprise resources by others yielding interests, royalties and dividends. It excludes the amount collected on behalf of third parties such as certain taxes. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other considerations. Revenue is recognised in the period in which it is earned irrespective of the fact whether it is received or not during that period.
  3. Historical Cost Principle According to this principle, an asset is ordinarily recorded in the accounting records at the price paid to acquire it at the time of its acquisition and the cost becomes the basis for the accounts during the period of acquisition and subsequent accounting periods. Accordingly, if nothing is paid to acquire an asset; the same will not be usually recorded as an asset, e.g., a favourable location and increasing reputation of the concern will remain unrecorded though these are valuable assets. The justification for the use of the cost concepts lies in the fact that it is objectively verifiable. This does not mean that the asset will always be shown at cost. The cost of an asset is systematically reduced from year to year by charging depreciation and the asset is shown in the balance sheet at book value (i.e., cost less depreciation). It may be noted that the purpose of depreciation is to allocate the cost of an asset over its useful life and not to adjust its cost so as to bring it close to the market value.
  4. Matching Principle According to this principle, the expenses incurred in an accounting period should be matched with the revenues recognised in that period, that is, if revenue is recognised on all goods sold during a period, cost of those goods sold should also be charged to that period. It is wrong to recognise revenue on all sales, but charge expenses only on such sales as are collected in cash till that period.

    This concept is basically an accrual concept since, it disregards the timing and the amount of actual cash inflow or cash outflow and concentrates on the occurrence (i.e., accrual) of revenue and expenses. This concept calls for adjustment to be made in respect of prepaid expenses, outstanding expenses, accrued revenue and unaccrued revenues.

    Matching does not mean that expenses must be identifiable with revenues. Expenses charged to a period may or may not be related to the revenue recognised in that period, for example, cost of goods sold and commission to salesmen are directly related to sales whereas rent, interest, depreciation accruing with the passage of time and stock lost by fire are not directly related to sales revenue, yet they are charged to the accounting period to which they relate. Thus, appropriate costs have to be matched against the appropriate revenues for the accounting period.

  5. Full Disclosure Principle According to this principle, the financial statements should act as means of conveying and not concealing. The financial statements must disclose all the relevant and reliable information which they purport to represent, so that the information may be useful for the users. For this, it is necessary that the information is accounted for and presented in accordance with its substance and economic reality and not merely with its legal form. The practice of appending notes to the financial statements has developed as a result of the principle of full disclosure. The disclosure should be full, fair and adequate so that the users of the financial statements can make correct assessment about the financial performance and position of the enterprise.
  6. Objectivity Principle According to this principle, the accounting data should be definite, verifiable and free from personal bias of the accountant. In other words, this principle requires that each recorded transaction/event in the books of accounts should have an adequate evidence to support it. In historical cost accounting, the accounting data are verifiable since, the transactions are recorded on the basis of source documents such as vouchers, receipts, cash memos, invoices, and the like. These supporting documents form the basis for their verification by auditors afterwards. For items like depreciation and the provisions for doubtful debts where no documentary evidence is available, the policy statements made by management are treated as the necessary evidence. At the same time the accounting data is ‘bias free’ since the accounting data are neither subject to the bias of the management nor the accountant who prepares the accounts. On the other hand, in value-based accounting (e.g., current cost accounting) accounting data is not bias-free because value may mean different things for different persons.
MODIFYING PRINCIPLES OF ACCOUNTING

To make the information useful, the basic assumptions and principles discussed earlier, have to be modified. These modifying principles are as follows:

Let us discuss these Modifying Principles of Accounting one by one:

  1. Cost-benefit principle According to this principle, the cost of applying an accounting principle should not be more than its benefits. If the cost is more, this principle should be modified.

    Balance between benefit and cost The balance between benefit and cost is pervasive constraint rather than a qualitative characteristic. The benefits derived from information should exceed the cost of providing it. In India often it is stated that many investors are not using the information contained in the annual report of a company. So there is a provision for giving abridged accounts to the shareholders. However, those who are interested in full information, can get full annual reports by requesting the company. In this process the company saves the expenditure relating to publication of annual reports to some extent.

  2. Materiality principle This principle is basically an exception to the Full Disclosure Principle. The full disclosure principle requires that all facts necessary to ensure that the financial statements are not misleading, must be disclosed, whereas the materiality principle requires that the items or events having an insignificant economic effect or not being relevant to the user’s need not be disclosed. According to the materiality principle, all relatively relevant items, the knowledge of which might influence the decision of the users of the financial statements, should be disclosed in the financial statements. Which information is more relevant than others is largely a matter of judgement. For instance, accounting and recording of a small calculator as an asset in the balance sheet may not be justified due to the excess of cost of recording over the benefits in terms of usefulness of recording and the accounting of calculators as assets. The materiality depends not only upon the amount of item but also upon the size of business, level and nature of information, level of the person/department who makes the judgement about materiality, for instance a worker reporting to his foreman about the production in grams (e.g., part of kilogram), a foreman to his supervisor in kilograms, a supervisor to his production manager in quintals and the production manager to the top management in tonnes, may be justified with regard to the circumstances. It hardly makes any difference if the production manager reports to the top management that the production is 1,99,000.90 kilograms or simply 200 tonnes (nearly). It is desirable to establish and follow uniform policies governing material or non-material items so that while measuring income for an accounting period, the non-material items can be ignored on uniform basis. This principle of materiality is to be applied even if the cost of its application exceeds its benefits.
  3. Consistency principle According to this principle, whatever accounting practices (whether logical or not) are selected for a given category of transactions, they should be followed on a horizontal basis from one accounting period to another to achieve compatibility, for instance, if the inventory is valued on LIFO basis, should be followed year after year and if a particular asset is depreciated according to WDV method, this method should be followed year after year. If this principle of consistency is not followed, the intra-firm comparison (i.e., comparison of actual figures of one period with those of another period for the same firm), Inter-firm comparison (i.e., comparison of actual figures of one firm with those of another firm belonging to the same industry) and Pattern comparison (i.e., comparison of actual figures of one firm with those of industry to which the firm belongs) cannot be made.

    The consistency should not be confused with mere uniformity or inflexibility and should not be allowed to become an impediment to the introduction of improved accounting standards. It is not appropriate for an enterprise to leave its accounting policies unchanged when more relevant and reliable alternatives exist.

    The users should be informed of the accounting policies employed in the preparation of the financial statements, any change in these policies and the effects of such changes.

    Comparability User must be able to compare the financial statements of an enterprise through time to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position, performance and changes in financial position. Hence the measurement and display of the financial effect of such like transactions and other events must be carried out in a consistent way throughout an enterprise and over time for that enterprise and in a consistent way for different enterprises. An important implication of this qualitative characteristic is that users be informed of the accounting policies employed in the preparation of financial statements, any changes in those policies and the effects of such changes so that users would be able to identify difference between the accounting policies for like transactions and other various events used by the same enterprise from period to period and by different enterprises. This qualitative characteristic requires pursuance of consistency in choosing accounting policies. Lack of consistency may disturb the comparability quality of the financial statement information. Mere disclosure of accounting policies and changes therein may not be sufficient. Accordingly, accounting standard on disclosure of accounting policies consider consistency as a fundamental accounting assumption alongwith accrual and going concern.

  4. Prudence principle (or conservatism principle) According to this principle, the principle of ‘anticipate no profit but provide for all probable losses’ should be applied. The valuation of stock-in-trade at a lower of cost or net realisable value and making the provisions for doubtful debts and discount on debtors are the applications of this principle. In other words, the principle of conservatism requires that in the situation of uncertainty and doubt, the business transactions should be recorded in such a manner that the profits and assets are not overstated and the losses and liabilities are not understated.

    When the stock is valued at cost in one accounting period and at a lower of cost or net realisable value in another accounting period, this principle conflicts with the principle of consistency.

    When excessive provisions for doubtful debts and depreciation are charged, it leads to the creation of secret reserves, and thus, this principle conflicts with the principle of full disclosure.

    The estimation of probable losses is a subjective judgement and thus, this principle conflicts with the principle of objectivity. The practice of making provisions for doubtful debts and the like implies lesser charges in the following accounting periods. In other words, it reduces the current income and raise the future income and thus it conflicts with the matching principle. Nowadays, the conservatism principle is being replaced by the prudence principle which requires that the conservation principle should be applied rationally only in circumstances in which great uncertainty and doubt exists as the over-conservatism may result in misrepresentation.

    Uncertainties inevitably surround many transactions. This should be recognized by exercising prudence in preparing financial statements. Prudence does not, however, justify the creation of secret or hidden reserves.

    The preparers of financial statements have to contend with uncertainties that inevitably surround many events and circumstances. Such uncertainties are recognized by the disclosure of their nature and extent and by exercise of prudence in the financial statements. Prudence is the inclusion of a degree of caution. In the exercise of judgement needed in making the estimate required under conditions of uncertainties so that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income or deliberate over statement of liabilities or expenses.

  5. Timeliness principle According to this principle, timely information (though less reliable) should be made available to the decision makers. If the quarterly reports are made available on half-yearly basis, the information contained in the quarterly report would not be very useful to the decision makers since, the information has lost its capacity to influence the decision during the period of half-year, after the expiry of which the quarterly report had been submitted.

    If there is undue delay in reporting the information, it may lose its relevance. To provide information on a timely basis, it may often be necessary to report before all aspects of a transaction or other events are known. In India there is a provision for publishing half-yearly financial report of the listed companies (listed in the stock exchanges). This provides timely information to investors and potential investors to make their investment decisions. Conversely, if reporting is delayed until all aspects are known, the information may be highly reliable but of little use to the users who have had to make decisions in the interim period.

  6. Substance over form Transactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form.
  7. Industry practice The peculiar characteristics of an industry may require departure from the accounting guidelines discussed above. For example, in case of the agricultural industry, it is a common practice to disclose the crops at market value rather than at a cost since it is costly to obtain accurate cost figures of individual crops.
THEORETICAL QUESTIONS

Multiple Choice Questions

  1. During the life-time of an entity, accountants produce financial statements at arbitrary points in time in accordance with which basic accounting principles?
    1. Cost-benefit
    2. Periodicity
    3. Conservatism
    4. Matching
    5. None of the above
  2. The accounting principles that conforms to the tendency of accountants to resolve uncertainty and doubt in favour of understating assets and revenues and overstating liabilities and expenses, is known as:
    1. conservatism
    2. materiality
    3. industry practice
    4. consistency
    5. None of the above.
  3. Revenue is generally recognised at the point of sale. Which principle is applied herein?
    1. Consistency
    2. Matching
    3. Revenue recognition
    4. Cost principle
    5. None of the above.
  4. When information about two different enterprises has been prepared and presented in a similar manner, the information exhibits the characteristics of:
    1. relevance
    2. reliability
    3. consistency
    4. verifiability
    5. None of the above.
  5. The assumption that a business enterprise will not be sold or liquidated in the near future is known as the:
    1. economic entity
    2. monetary unit
    3. conservatism
    4. periodicity
    5. None of the above.
  6. The primary qualities that make accounting information useful for decision-making are:
    1. comparability and consistency
    2. materiality and timeliness
    3. relevance and freedom from bias
    4. reliability and comparability
    5. None of the above.

    [Answer: 1. (b), 2. (a), 3. (c), 4. (e) Comparatively,
    5.(e) (Going concern), 6. (e) (Relevance and reliability)]

Fill in the Blanks

  • 7. Companies must prepare financial statements at least yearly due to the ............... assumption.
  • 8. ................ and ............... are the two primary qualities that make accounting information useful for decision-making.
  • 9. The ............... principle requires that the same accounting methods should be used from one accounting period to the next.
  • 10. Recognition of expenses in the same period as a associated revenues is known as the .............. principle.

    [Answer: 7. Periodicity, 8. Relevance and Reliability, 8. Consistency, 10. Matching]

True or False Questions

  • 11. State whether each of the following statements is True or False:
    1. Principles which have substantial authoritative support become a part of the generally accepted accounting principles.
    2. Personal transactions are distinguished from business transactions in accordance with the accounting entity assumption.
    3. Monetary facts or attributes and the changes in the purchasing power of the monetary unit are ignored in accordance with the monetary unit assumption.
    4. The economic life of an enterprise is artificially split into periodic intervals in accordance with the going concern assumption.
    5. The assets are classified as current assets and fixed assets in accordance with the accounting period assumption.
    6. Revenues are matched with expenses in accordance with the matching principle.
    7. The financial statements must disclose all the relevant and the reliable information in accordance with the objective principle.
    8. The accounting data should be definite, verifiable and free from personal bias in accordance with the full disclosure principle.
    9. The materiality principle is an exception to the full disclosure principle.
    10. Accounting practices should be followed on a horizontal basis from one accounting period to another period in accordance with the consistency principle.
    11. When stock is valued at cost in one accounting period and at lower of net realisable value in another accounting period, the conservatism principle conflicts with the consistency principle.

    [Answer: True: (a), (b), (i),(j),(k), False: (c), (d), (e), (f), (g), (h)]

  • 12. Following are the applications of some accounting assumptions or principles. State the name of the relevant accounting assumption or principle applied herein.
    1. Classification of assets as current assets and fixed assets.
    2. Appending notes to the financial statements.
    3. Accounting of a small calculator as an expense and not as an asset.
    4. Following the WDV method of depreciating a particular asset year after year.
    5. Valuation of stock at lower of cost or net realisable value.
    6. Making provision for doubtful debts.
    7. Valuation of the crops at market value.

    [Answer: (a) Going Concern Assumption, (b) Full Disclosure Principle,
    (c) Materiality Principle, (d) Consistency Principle, (e) Conservatism Principle,
    (f) Conservation Principle, (g) Industry Practice]

Short Answer Type Questions

  • 13. What is meant by Generally Accepted Accounting Principles (GAAP)?
  • 14. What is meant by ‘Basic Assumptions of Accounting’? Enumerate the four basic assumptions that underline the financial accounting structure.
  • 15. What is the Accounting Entity Assumption?
  • 16. What is the ‘Monetary Unit Assumption’? Does it hold good when the prices are not stable. Give reasons for your answer.
  • 17. What is the ‘Accounting Period Assumption’ ? Why is it necessary for preparing the financial statements?
  • 18. What is the ‘Going Concern Assumption’? Why is it necessary to assume that an economic entity will remain a going concern?
  • 19. What is meant by the ‘Basic Principle of accounting’ ? Enumerate the five basic principles of accounting.
  • 20. What is the ‘Revenue Recognition Principle’ ? When should revenue be recognised? Are there exceptions to the general rule?
  • 21. What is the ‘Cost Principle’?
  • 22. What is the ‘Matching Principle’? Why should a business concern follow this principle?
  • 23. What is the ‘Full Disclosure Principle’? Name the exception to this principle.
  • 24. What is the ‘Objective Principle’?
  • 25. Enumerate the six modifying principles.
  • 26. What is the ‘Materiality Principle’?
  • 27. What is the ‘Consistency Principle’? Why should a business concern follow this principle? Name the exception to this principle.
  • 28. What is the ‘Conservatism Principle’? Give two areas of application of this principle.
  • 29. What is meant by Timeliness Principle’ and ‘Industry Practice’?
  • 30. What is ‘Basic Accounting Equation’?
  • 31. Enumerate the two primary qualities of useful accounting information.

Essay Type Questions

  • 32. Describe the basic assumptions of accounting.
  • 33. Explain the basic accounting principles.
  • 34. Identify and explain the modifying principles.