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CHAPTER 2
Accounting Concepts, Conventions & Principles
NEED AND MEANING OF ACCOUNTING PRINCIPLES
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 standardized 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. The AICPA (American Institute of
Certified Public Accountants) defines principles as “Principles of accounting are the
general laws or rules adopted or proposed as a guide to action, a settled ground or
basis of conduct or practice.” Accounting principles are adopted based on their general
acceptability rather than universal acceptability and thus are popularly known as
“Generally Accepted Accounting Principles” (GAAP).
MEANING AND CHARACTERISTIC FEATURES OF GAAP
Meaning of GAAP
GAAP 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.” GAAP 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.” GAAP include
accounting principles as well as procedures for applying these principles.
Salient Features of GAAP
GAAP are ground rules for accounting, the salient characteristic features of these
accounting principles are as below:
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(i) Ensure uniformity: Accounting principles have been formulated to ensure
uniformity and easy understanding of the accounting information.
(ii) Flexible: Accounting principles are general rules and not final statements.
They are not static. Any change in government regulation or introduction of
statutory legislation may affect the existing accounting principles. Hence,
accounting principles will have to be modified in conformity with those
changes.
(iii) Simple guidelines: Accounting principles are not laboratory tested
principles. They are not discovered. They are man-made. They are derived
from experience. They are simple guidelines.
(iv) GAAP depends on the following attributes:
(a)
Relevance
: A principle is relevant to the extent it results in information that is
meaningful and useful to the user of accounting information.
(b)
Objectivity
: 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 or checking the
correctness of the information reported.
(c)
Feasibility
: A principle is feasible to the extent it can be implemented without much
complexity or cost.
Generally, all the above three features are found in accounting principles. In some
cases, sacrifice of one principle in favor 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.
BASIC ACCOUNTING CONCEPTS
An accounting concept is a basic assumption on which the accounting system functions.
Accounting concept is the base for evolving a set of rules and guidelines to record
business transactions. For example, it is a recognized 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 recognized by the accountants.
The factors that determine the evolution of accounting concepts are:
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(i) New inventions, improvement in technology, increasing business activities,
proliferation of multinational companies as an impact of globalization – all necessitate
new kind of varied transactions. Hence, new accounting concepts have to be developed
to combat with such innovations in technology. Accounting concepts are ever changing
in nature.
(ii) New accounting concepts have to be devised keeping pace with the changes in
legal, socioeconomic environments.
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 as
follows.
(i) Entity or business entity or accounting entity concept
(ii) Money measurement concept
(iii) Going concern concept
(iv) Accounting period concept
(v) Cost concept
(vi) Realization concept
(vii) Accrual concept & Matching concept
(viii) Dual aspect concept
Entity Concept
For accounting purposes, the business is treated as a unit or entity, apart
from its owners.
The owner 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 owner, that is, the enterprise owes to the owner.
It is important to note that, in some form of organizations, 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 occurring 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
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Partnership Act, all the partners are jointly and severally liable for firm’s debts.
However, in companies registered under the Companies Act (public limited companies
or share companies), this legal entity concept is recognized 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.
Whatever type of legal entity it may be, 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. One should understand in this
context that the concepts of legal and business activities are not compatible with each
other.
Thus, the “entity concept” implies that
(i) Personal transactions of the owners are not at all recorded. Only business
transactions are to be recorded.
(ii) Net result (profit/loss) is related to the business.
(iii)The capital is treated as a liability of the business, which it has to owe to its owners.
(iv)This concept may be applied to the whole enterprise as one single unit or to
different departments of the enterprise.
Money Measurement Concept
The money measurement concept highlights the fact that in accounting, all transactions
of any type of enterprise are recorded in terms of money. Money is a stable unit of
measurement which makes comparison possible and helps in understanding the state of
affairs of the business in a much better way.
According to this concept, transactions, which cannot be expressed in terms
of money, are not recorded in the books of account.
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 `1,00,000 in 1990 and another transaction of purchase of a land
(same extent, same location) for `2,00,000 in 2000 were recorded at `1,00,000 and
`2,00,000 respectively. However, purchasing power of birr is not same in both these
years. Therefore, money measurement concept ignores time value of money.
Another drawback in the usage of this concept is that it does not take into consideration
of nonmonetary 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 summarized 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 tons 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 `1,00,000 (1000
sq. mtrs.); building worth `50,00,000 (with 10 rooms and a conference hall); 100 chairs
