At the end of the chapter, you will be able to understand
Need and Meaning of Accounting Principles
Meaning and Characteristic Features of Generally Accepted Accounting Principles (GAPP)
Basic Accounting Concepts – Entity Concept, Money Measurement Concept, Going Concern Concept – Accounting Standard (AS)–1, Periodicity Concept, Cost Concept – Special Features, Realisation Concept, Matching Concept.
Basic Accounting Conventions – Convention of Conservatism (Prudence), Convention of Consistency, Convention of Materiality and Convention of Disclosure
Distinction Between Concepts and Conventions
A uniform set of rules and guidelines must be necessary for any accountant to prepare the financial statements of an enterprise. If there are no standardised set of rules, then each accountant for each enterprise will prepare the financial statements in their own way which will result in unreliable, inconsistent and biased accounting information. Keeping in view of this, the accountants have developed certain rules and guidelines to be followed by each enterprise. These rules and guidelines are the outcome of constant hard work of accounting professionals over the years. Generally, such set of rules and guidelines are known as accounting principles.
GAPP 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.” GAPP is a technical accounting term, which describes the basic rules, concepts, conventions and procedures that represent the accepted accounting principles at a particular time. According to the American Institute of Central Public Accountants (AICPA), the principles which have substantial authoritative support become a part of the generally accepted accounting principles. It further stated that, “generally accepted accounting principles incorporate the consensus at any time as to which economic resources and obligations should be recorded as assets and liabilities, which changes in them should be recorded, how the recorded assets and liabilities and changes in them should be measured, what information should be disclosed and how it should be disclosed and which financial statements should be prepared.” GAPP include accounting principles as well as procedures for applying these principles.
As GAPP are ground rules for accounting, the salient characteristic features of accounting principles are highlighted as:
Generally, all the above three features are found in accounting principles. In some cases, sacrifice of one principle in favour of other principle may become necessary. In some cases, an optimum balance of all the three is struck for adopting a particular rule as an accounting principle. These features often contradict with each other. In applying new principles, it is essential to achieve a trade-off between relevance on one hand and objectivity and feasibility on the other.
Basically, an accounting concept is an opinion. Accounting concept is the base for evolving a set of rules and guidelines to record business transactions. It is a recognised presumption that business in an accounting entity, separate from its owners, is a sole proprietorship, or partnership firm or limited companies (private as well as public). Accounting concept is not subject to any proof because it is only an opinion based on the assumption. Despite the fact that accounting concept is not a fact, its role in the preparation of financial statements or any accounting process is well recognised by the accountants.
The factors that determine the evolution of accounting concepts are:
In general, while recording business transactions, business entity concept and historical cost concept have been taken as basic concepts. There are some more basic accounting concepts that are being observed while preparing the financial statements. They are:
For accounting purposes, the business is treated as a unit or entity, apart from its owners. The proprietor of a business enterprise is always considered to be separate and distinct from the business. According to this concept (i.e., business as an entity), all the transactions of the business are recorded in the books of the business. Each business entity is treated as a separate distinct unit and accounting process is carried on and as such all personal transactions affecting the proprietors are not to be taken into account. As per the business as an entity concept, even the proprietor (owner) of business enterprise is observed as a creditor to the extent of his capital contributions. Thus, capital is a liability like any other liability and the amount is due to proprietor, that is, the enterprise owes to the proprietor. This concept, as a separate legal entity, is specifically applicable to joint stock companies.
But, in some form of organisations, accounting entity is not necessarily a separate legal entity. Take the case of sole proprietorship, where a sole trader cannot separate his business assets and liabilities from those of his personal assets and liabilities. Legally speaking, a sole trader’s liability is “unlimited,” which means his business liability can be met with his personal assets. Law allows to recover debts occur in business from his personal resources. The same is the case of partnership firms. A partnership firm is not a legal entity. As per the Partnership Act, all the partners are jointly and severally liable for firm’s debts. But in companies registered under the Companies Act (public limited companies), this legal entity concept is recognised because the shareholders (real owners of the company) are not liable for the company’s debt. Liability is limited to the extent of their amount they invested in shares of their particular company. But, it is important to be noted at this juncture, that is, for accounting purposes, the principle of business entity is observed. Even though the legal provisions stipulate and treat the sole trader and his business as one unit, the accounting principles treat them as two different units as business and personal. Hence, in business enterprises, whichever type it belongs to, that is, sole proprietorship, partnership firms or joint stock companies, the separate entity concept is taken into consideration. Even the separate entity is not recognised by law in some form of organisations, as explained above, for accounting purpose the separate entity concept is always to be taken as base. One should understand in this context that the concepts of legal and business activities are not compatible with each other.
The “entity concept” reveals:
The money measurement concept highlights the fact that in accounting, all transactions of any type of enterprise are recorded in terms of money. According to this concept, transactions, which cannot be expressed in terms of money, are not recorded in the books of account. They assume that money is a stable unit of measurement which means same value of money for all times is taken into consideration.
This concept suffers from a serious limitation. According to this concept, a transaction is recorded at its money value on the date of the transaction. It fails to recognise the frequent changes in the money value. For example, a land (measuring 1,000 sq. mtrs.) was purchased for Rs 1,00,000 in 1990 and another transaction of purchase of a land (same extent, same location) for Rs 2,00,000 in 2000 were recorded at Rs 1,00,000 and Rs 2,00,000 respectively. But, the worth of land purchased in 1990 is more in real terms than the one that was purchased in 2000, though it is recorded as Rs 2,00,000.
Both these transactions are shown in today’s Balance Sheet, that is, 2010 at the rate on which they were purchased. Its worth will be several times higher today. This is due to the fact of rising prices and change in the value of money. Money as a unit of measurement is not stable or constant forever. In accounting this important factor, that is, change in the value of money is ignored.
Another drawback in the usage of this concept is that it does not take into consideration of non-monetary transactions. It ignores all the other facts and events that affect the enterprises. For example, quality of the products marketed, working conditions of employees, sales policy and such facts and events, which cannot be recorded in terms of money, are ignored. Under such circumstances, this concept affects the true usefulness of accounting records. Consequently, this affects the management decisions and overall efficiency of the management
Despite the above illustrated limitations, the importance of the usage of money measurement concept cannot be underestimated. The financial statements prepared at the end of the accounting period show the operating results (after all necessary adjustments – additions and deductions) in a summarised form. To make necessary adjustments, that is, for addition or subtraction a common unit of measurement is needed. Here, it is in terms of money. In the absence of a common measurement unit, that is, in terms of money, any information will be valueless.
Example: A business has a land of 1000 sq. mtrs., building with 10 rooms and one conference hall, 100 chairs, 150 fans, 5 tonnes of raw materials, 10 air conditioners and so on. If they are expressed like this without any common measurement unit their value as exist cannot be assessed and if any purchase or sale from these items also cannot be quantified.
Suppose, if the same is expressed in terms of money, that is, a land of Rs 1,00,000 (1000 sq. mtrs.); building worth Rs 50,00,000 (with 10 rooms and a conference hall); 100 chairs each at Rs 250; 10 air conditioners each at Rs 20,000, then the total value as exist is easily ascertained. At the time of any addition by way of purchase or deduction by way of sale can be adjusted with the existing items.
Hence, this concept increases the value of the state of affairs of a business enterprise in its true sense. The use of money measurement concept has become inevitable and indispensable.
This going concern concept assumes that the enterprise will continue to exist for a number of years (indefinite) in future. As Accounting Standards (AS)–1, going concern concept is a fundamental accounting assumption underlying the preparation of financial statements. While dealing with the disclosure of accounting policies, AS–1 stipulates “the enterprise is normally viewed as a going concern, that is, as 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.” Construction activities is a typical example. Once the construction of the specified project is completed, the business comes to an end. On the other hand, certain business enterprises that are engaged in automobile, consumable goods exist for over a century. It will continue its operations in the foreseeable future. This going concern concept is followed in the valuation of assets. If this is not followed, AS–1 requires the disclosure of fact with reason.
Advantages
Disadvantages
The net income of the business, really speaking, can be measured correctly by computing the assets of the business existing at the time of its commencement with those existing at the time of its liquidation (wind up). As per the going concern concept, the life of the business is indefinite. In that case, one has to wait for a very long period to know the results of his business. The preparing and reporting of the net results of the business at the end of the life is not at all useful to its users. Not even corrective measures can be taken by the owners after liquidation takes place. Each and every user of financial statements are much interested to know “how things are going” at frequent intervals. Hence, the accounting professionals have developed this concept – the periodicity concept.
A shorter and convenient time is chosen for the measurement of income and reporting the same at specified intervals. Usually, twelve months period is followed for the purpose of preparing and reporting financial statements. This time interval is known as accounting period and that is the reason for calling this as “Accounting Period Concept.” The generally adopted accounting period is calendar year, that is, from Jan 1 to Dec 31 or it may be a financial year, which starts from Apr 1 and ends on Mar 31, of the following year. Now-a-days, financial accounts are prepared and reported at shorter intervals of half yearly, quarterly or even a month. Such accounts are termed as interim accounts. Interim accounts, which are less than half yearly are mainly intended for internal use. Half yearly accounts are reported in papers as part of listing requirements. In general, such interim accounts are not subject to audit.
Periodicity concept also depends on the type of business. There are some kinds of businesses, which are called “continuing profit seeking enterprises.” These type of business enterprises continue indefinitely. In such cases, accounting and reporting has to be carried out periodically.
Advantages
Disadvantages
According to the cost concept, the asset is recorded at the price paid to acquire it, that is, at cost (not market value) and this cost is the basis for all subsequent accounting for the asset. This is also called as historical cost because the acquisition cost, which is taken as a basis, relates to the past.
In case, if nothing is paid for acquiring the asset as per this concept, it will not be recorded in the books of accounts as an asset. In this context, it is appropriate to quote, “thus the knowledge and skill, that is built up as the business, operates a team work that grows up within the organisation, a favourable location that becomes of increasing importance as time goes by, a good reputation with its customers, none of these appears as an asset in the accounts of the company.”
Features
The essence of realisation concept is the timing of the revenue recognition. This concept of “revenue recognition” is explained in Chapter 9 – “Revenue Recognitions and Revenue Expenses” in Objective–8 – “Accounting Standards AS–9 Relating to Revenue Recognition.” Hence, instead of repeating once again, only salient features of this concept are explained as below. (Students have to refer these two chapters for detailed explanation on this concept.)
Realisation occurs when the following conditions are met with:
In accrual system of accounting, revenue is recognised when it is realised, that means when sale is complete or services are rendered, whether cash is received or not is immaterial. Similarly, costs (expenses) are recognised when they are incurred and not when paid. The date of transaction (sale/service/cost) is taken for accounting process and not the date of actual receipt of revenue or the date of actual payment for cost.
This system of accounting necessitates certain adjustments in the preparation of income statement. Regarding revenue, amount relating to other than the current accounting period is to be excluded and provision for revenue recognised but not received in cash is to be included. Similarly, regarding costs, provision is to be made for the costs incurred but not paid and the costs for the period other than the accounting period is to be excluded.
The salient features of this concept are explained as under:
After revenue recognition, all costs (expenses) that were incurred to earn the revenue of the period will be charged against that revenue earning during that accounting period to determine the net income of the business enterprises. This is the main principle involved in this concept. To put it in simple terms, matching revenues against the related expenses is termed as matching concept. The revenues and expenses shown in a Profit and Loss Account must belong to the accounting period for which it is prepared. Because of this, sometimes the accrual concept is also called the matching concept. The revenue earned during an accounting period and costs incurred during the same accounting period is computed and the following standard equation is applied to determine the net income of a business enterprise.
where | π = Profit |
ΣR = Sum of Revenues | |
ΣE = Sum of Expenses (Costs Incurred) |
Important aspects to be considered while applying the matching concept are:
Example: Association of sales revenue with the cost of goods sold. Mr Shekar buys 50 computers at Rs 30,000 each. He pays Rs 6,000 as carriage inward and Rs 9,000 for special package. He sells them for Rs 17,00,000
Cost of Goods Sold is (50 × Rs 30,000) + Rs 6,000 + Rs 9,000 = Rs 15,15,000
Sales: Rs 17,00,000 Profit: Rs 17,00,000 − Rs 15,15,000 = Rs 1,85,000
Cost of Goods Sold: Rs 15,15,000 is directly associated with Rs 17,00,000 (sale)
Hence, matching is adopted on accrual basis. Hence, the payments of cash for purchases and receipts of cash for sales is ignored. Thus, matching concept is possible only when the association is direct as shown in the example.
Net loss decreases owner’s equity (as illustrated in the above example) where net income will increase owner’s equity.
Features
Definition: An accounting convention is defined as, “a rule of practice, which has been sanctioned by general custom or usage. They are lamp posts to procedures employed in the collection, measurement and reporting of financial data.”
Accounting conventions has come into existence by common accounting practises. They are adopted by common consents. It may also be said that an accounting convention is a common procedure which is adopted by common agreement. It acts like a guide to select and apply the procedure.
Some accounting conventions are:
It is a policy of “playing safe.” Prudence also means early recognition of unfavourable events. Working rule relating to the convention of conservatism is – “Anticipate no gains but provide for all losses and if in doubt, write it off.” That means the accountant should not anticipate profit but he should make provision for all losses. In case of doubt, it should be written off or at least he should not indulge in over estimation. Unless the gain is actually realised, he should not record it. This accounting convention is recognised in AS–1, which strongly supports the observation of prudence in the framing of accounting policies. “Uncertainties, inevitably, surround many transactions. This should be recognised by exercising prudence in financial statements. Prudence does not, however, justify the creation of secret or hidden reserves.” In general, convention of conservatism affects the assets that are held for short term.
Following are some of the examples of the application of the convention of conservatism:
Circumstances
The principle of prudence is applied in the following circumstances:
Its net impact on financial statements:
Criticism of convention of conservatism
It may be stated that any principle adopted in a moderate and optimum level, the results will be true and fair.
The consistency convention principle implies that accounting practises and methods remain unchanged from one accounting period to another accounting period. To put it in other way, the same accounting methods will be followed for every year. This convention facilitates easy comparison of different financial statements. As per AS–1, consistency is a fundamental assumption and it is assumed that accounting policies are consistent from one period to another. Where this assumption is not followed, such fact should be disclosed with specific reason for not complying with this.
This consistency convention is the forerunner in choosing a particular method of accounting, when a number of alternative methods are available.
For example, there are several methods of valuation of inventories like First-In-First-Out (FIFO) Method, Last-In-First-Out (LIFO) Method, Weighted Average Method and so on. If one method is followed in one accounting year, say FIFO, in subsequent years also the same FIFO Method has to be followed for valuing the inventories. If there is any change in the method, it will affect the financial statements to a great extent. A change in the method of providing depreciation, making provision for doubtful debts, change from cash basis to accrual or mercantile basis are some of the examples where switching over from one method to other method is possible. It is to be noted that once a method is chosen, it has to be followed in the subsequent years also. Any change will result in unreliable financial statements to its users. No comparison is possible from such financial statements. Hence, consistency convention gains a high degree of significance in such contexts, as explained above.
Eric. L Kohler describes three types of consistencies:
Vertical Consistency: This consistency is maintained within the interrelated financial statement of the same date. “Interrelation” refers to the binding relationship among the constituents of the financial statements namely, Profit and Loss Account (Income Statement) and Balance Sheet. For example, vertical inconsistency will happen where an asset has been depreciated in one basis, say, Straight Line Method for Income Statement and on another basis, say, Written-Down-Value Method for the Balance Sheet.
Horizontal Consistency: This type of consistency is maintained between financial statements from one year to another year and subsequent years. This enables the comparison of performance of a business enterprise in one year with its performance in the next year.
Third Dimensional Consistency: This type of consistency enables the comparison of the performance of a business enterprise with the performance of another business enterprise in the same type of industry, and preferably on the same date.
One may think that in the context of ever changing social-economic environment that the convention follows a rigid and morbid approach without giving room for any flexibility and changes. However, a change is allowed but it has to be applied not frequently. Once a change in the accounting policy is adopted, as already stated, as AS–1, it should be disclosed in the final reports. Reason for such change is to be shown in such statements. Any effect on the financial provision of the enterprise, on account of a change in accounting procedure, has to be disclosed.
Proliferation of financial information makes the task of accountants more difficult in deciding what information could be provided in the financial statements. His position is so delicate that he is not able to distinguish between material and immaterial information. Many definitions on this aspect leave it to the hands of accountants to decide themselves what should be included and what should not be included in the financial statements.
The American Accounting Association (AAA) defines the term materiality as – “An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor.”
Eric. L. Kohler has defined materiality as – “The characteristic attachment to a statement, fact, or item whereby its disclosure or the method of giving it expression would be likely to influence the judgement of a reasonable person.”
The convention of materiality emphasises “the relative importance of the information” to judge what is material and what is immaterial. Materiality acts as a guide for accounting professionals in deciding what should be disclosed in the financial statements of an enterprise.
Increase in the salary bill, loss of markets, fall in the value of stock are some of the examples of material financial information that should be disclosed in the financial statements. Now, any important material information has come to the notice (surfaced) after the date of the final statements, should also be disclosed.
It has to be observed that an item, material for one enterprise may be immaterial for another enterprise. For example, an item, raw material is an important item for manufacturing enterprises, whereas the same item may not be important for trading enterprises, which are interested in finished products only. Hence, the convention of materiality signifies the relative information.
Similarly, an item, material in one year may not be material in the next year. For example, an item, Bad Debts shown in the previous accounting periods, the same amount may not become important in the subsequent years.
Further, any insignificant amount is usually not recognised as an important item and treated as immaterial. But, if the aggregate value of such items and expenses exceed 1% of the total revenues of the company, a separate disclosure of items and expenses must be made according to the statutory provisions of the Companies Act.
As per AS–1, convention of materiality should govern the selection and application of accounting policies. Financial statements should disclose all items, which are material enough to affect evaluations or decisions. AS–5, in conformity with AS–1, stipulates as “all material information should be disclosed that is necessary to make the financial statements clear and understandable.”
The accounting convention of disclosure necessitates to prepare and present financial statements fairly by disclosing all material information therein. Disclosure may be defined as, “the communication of financial information about the activities of a business enterprise to the interested parties for facilitating their economic decisions.” It is a system of communication between the management and users of financial statements.
The convention of full disclosure that every financial statement should fully disclose “all pertinent information that has a bearing on the figures in the statements and that will make possible a reasonable interpretation of their meaning.” It should be important to note that no information of substance or interest to users especially investors will be concealed in presenting financial statements. Take for example, if the Balance Sheet shows Debtors at Rs 1,00,000, it is important to know how much Bad Debts are there and what percentage of provision is made for the Doubtful Debts and the like. If the same has been disclosed as Debtors 1,25,000, Provisions at Rs 25,000, then such disclosure leads the management to think why a provision @ 20% has been provided. Only prompt disclosures, without suppressing or omitting any item, facilitate proper decision making at the level of management and the other users also can know the true financial position of the entities.
There should be a sufficient disclosure of information, which is of material interest to various users of financial statements. In limited company form of enterprise there is divorce between Capital (contributed by shareholders who are the real owners) and the management. As the entire activities of such enterprises are entrusted with the management and with whom entire resources were entrusted, they owe to make a full disclosure to the shareholders (owners who have contributed the capital) and all the users of financial information. Sacher Committee Report on this aspect emphasises that – “Openness in company affairs is the best way to secure responsible behaviour.” Accounting Standards also require the disclosure of all significant accounting policies in the final reports. AS–1 exclusively deals this concept “disclosure.” Besides this, AS–5 deals with the information to be disclosed in financial statements. The concept of “disclosure” also covers the events occur after the Balance Sheet date and the date on which the financial statements are authorised for issue. The procedure of appending notes relating to items which are not shown in financial statements is followed now. In addition to these accounting standards, the Companies Act also enforces through its statutory provision to comply with. The requirements of Schedule VI affecting Balance Sheet and profit and loss of the company make available comprehensive information for various users. Thus, the convention of full disclosures has attained much significance in the accounting policies of business enterprises.
We have discussed so far, conventions and concepts as the important aspects influencing the nature of the financial accounting policies. Both the aspects differ from each other.
Differences Between Concepts and Conventions
Basis of Differences | Concepts | Conventions |
---|---|---|
1. Basis |
A concept is based on the assumptions, which forms the foundation of accounting principles. |
A convention is based on the general agreement. |
2. Precedence |
Accounting concept is preceded by the accounting conventions. |
Accounting conventions are not followed by the accounting concepts. |
3. Personal judgement |
Personal judgement has no role in following the accounting concepts. |
Personal judgement plays a major role in following the accounting conventions. |
4. Internal inconsistency |
Accounting concepts are not internally inconsistent. |
Accounting conventions are internally inconsistent. |
5. Uniformity in application |
There is uniform application of accounting concepts in different organisations. |
It is not so in accounting convention. |
6. Legal status |
Accounting concepts are generally established by the law. |
Accounting conventions are established by the common accounting practises. |
Accounting concept: Necessary assumptions on conditions upon which accounting system functions.
Accounting convention: It is a rule or an accepted method of accounting practise based on general consent or agreement.
Consistency: Conformity from period to period with unchanging policies and procedures.
Generally Accepted Accounting Principles (GAPP): A term which applies to the broad concepts or guidelines and detailed practises in accounting, including all the conventions, rules and procedures that make up accepted accounting practise, in general.
Entity Concept: The business establishment is regarded as a separate entity. It has a separate existence. The business is treated separately from that of the owner.
Going Concern Concept: Accounting is based on the assumption that the business firm has an indefinite period of existence.
Historical Cost: It is an accounting concept under which an asset (resource or service) is recorded at cost (price actually paid for it). It is the acquisition cost. It is not the market price. Realisable values are ignored
Matching Concept: An attempt to match revenues against the appropriate expenses is referred to as the matching concept.
Prudence (Conservatism): As per this accounting convention, “anticipate no gains; but provide for all losses and if in doubt, write off.”
Periodicity Concept: According to this concept, financial statements are to be prepared periodically at regular intervals and to be reported about the progress of the business.
Anthony R.N. and J.S. Reece, “Accounting Principles,” Richard D. Irwin Inc.
I. State whether the following statements are True or False
Answers
1. True |
2. False |
3. True |
4. False |
5. True |
6. False |
7. False |
8. True |
9. False |
10. True |
11. False |
12. True |
13. True |
14. True |
15. False |
16. True |
17. False |
18. True |
19. False |
20. False |
II. Fill in the blanks with suitable words
Answers
18.191.162.21