2. concepts and conventions of accounting mba 1st tri semester

Generally Accepted
Accounting Principles

To provide information useful
for making investment and
lending decisions
Generally Accepted
Accounting Principles
What is the primary objective of
financial Accounting and Reporting?

Generally Accepted Accounting
Principles and Basic Concepts
• If every accountant used his or her own rules for
recording transactions, the financial statements would
be useless in making comparisons.
• Therefore, accountants have agreed to apply a common
set of measurement principles (a common language) to
record information for financial statements.

The rules that govern accounting are called GAAP
(generally accepted accounting principles).
• GAAP - a term that applies to the broad
concepts or guidelines and detailed practices in
accounting, including all the conventions,
rules, and procedures that make up accepted
accounting practice at a given time
Generally Accepted Accounting
Principles

ACCOUNTING PRINCIPLES
“Accounting principles are the rules of action or the
methods and procedures of accounting commonly
adopted while recording business transactions.”
Accounting principles are general decision rules,
derived from objectives and concepts of
accounting which govern the development of
accounting techniques.

Accounting principles are classified into
two parts.
(A) Accounting concepts.
(B) Accounting conventions.

Accounting
concepts
Accounting
conventions

(A)ACCOUNTING CONCEPTS
These are basic assumptions or fundamental
proposition concerning the economic,
political and sociological environment in
which accounting must operate.

1. Business entity concept
2. Going concern concept
3. Money measurement concept
4. Double entry concept
5. Accounting period concept
6. Cost concept
7. Realization concept
8. Matching of cost & Revenue
concept
9. Accrual concept
10. The Reliability Concept
(A)ACCOUNTING CONCEPTS

B) ACCOUNTING CONVENTIONS
Accounting conventions are traditions and
customs which guide the accountant while
preparing the accounting statements.

1. Convention of Full disclosure
2. Convention of conservatism
3. Convention of consistency
4. Convention of Materiality
B) ACCOUNTING CONVENTIONS

(separate entity concept)
In accounting, the business is
considered to be a separate entity from
the proprietor(s)/owner(s).

It is helpful in keeping business affairs strictly free
from the effect of private affairs of the proprietor(s).
Consequently :
Amount invested by proprietor is shown as a
“liability” in the books of the business.
Amount paid for personal expenses of proprietor
are shown as drawings from capital of the
proprietor.
It is applicable to all forms of business
organisations

•Assume that John decides to open up a gas
station and coffee shop.
•The gas station made Rs 250,000 in profits,
while the coffee shop lost Rs 50,000.
•How much money did John make?

According to this concept it is assumed that the
business will continue for a fairly long time to
come.
There is neither the intention nor the necessity
to liquidate the particular business venture in
the foreseeable future.
The entity will continue to operate in the forseeable
future.

Accordingly:
•Fixed assets are recorded at cost not liquidation value.
•Depreciation on fixed assets is charged over the
expected lives.
•Deferred costs are amortized over appropriate period
•Prepaid expenses as treated as assets.
•NOTE: This concept does not imply permanent
continuance of the enterprise.

•If the continuity of an entity is in doubt, a
liquidation approach to the balance sheet
is taken, and the assets and liabilities are
valued as if the entity were to be liquidated
in the near future.

Money is the common denominator for
quantifying the effects of transactions.
Accounting records only monetary transactions.

Events or transactions which cannot be
expressed in money do not find place in the
books of account though they may be very
useful for the business.
This concept helps in understanding the state
of affairs of the business in a much better way.

Each transaction has two aspects:
a) Receiving of a benefit
b) The giving of that benefit
The recognition of the two aspects to every
transaction is known as a dual aspect
analysis.
(Dual Aspect Concept)

There must be a double entry to have a complete
record of each business transaction.
An entry being made in the receiving account (debit)
and an entry of the same amount in the giving account
(credit).
Thus every debit must have a equal and
corresponding credit and vice-versa and upon this
dual aspect has been based the double entry system
of accounting.

It follows from the dual aspect concept that at any time:
This relationship is called “accounting equation.”
Assets = Equity + Liability

It requires that accounting information be reported
at regular intervals (accounting periods).
The life of the business is divided into
appropriate segments (accounting periods) for
studying the results shown by the business
after each segment.
(periodicity concept)

Accounting period is a period to measure business
performance.

at the end of which financial statements are prepared
Accounting period is the span of time
to throw light on
the results of operation during the relevant period and
the financial position at the end of the relevant
period.

Importance: Though the life of the business is
considered to be indefinite (according to going
concern concept), the measurement of income and
studying of the financial position of the business
after a very long period would not be helpful in
taking proper corrective steps at the appropriate
time.

6. Cost concept
Assets and liabilities should be recorded at
historical cost i.e. costs as on acquisition.

6. Cost concept
This does not mean the the assets will always be
shown at cost. It may be systematically reduced in
its values by charging depreciation.
This cost is the basis for all subsequent accounting
for the assets.

Advantage: This concept brings objectivity in the
preparation and presentation of financial statements.
Limitation:
•It distorts the true worth of an asset by sticking to its
original cost.
•Financial statements become irrelevant in case of inflation
•Removes cost of fixed assets by writing off their cost while
asset may be in good condition
•Assets for which no payment has been made are not shown
e.g knowledge ,skill of Human Resources.
6. Cost concept

The revenue principle governs two things:
When to record revenue and…
the amount of revenue to record.
.

It deals with the determination of the point of time
when revenues are earned

Situation 2
The client has taken a trip arranged by
Air & Sea Travel. – Record Revenue
Air & Sea
Travel, Inc.
April 2
Air & Sea
Travel, Inc.
Situation 1
No transaction has occurred.
– Do Not Record Revenue
March 12
I plan to have you
make my travel
arrangements.

•To be recognized, revenue must be:
–Earned - goods are delivered or a service is
performed
–Realized - cash or a claim to cash (credit) is
received in exchange for goods or services
•Revenue does not have to be received in cash.

When is revenue recognized?
Revenue from sales transaction
Revenue from services
 When the seller of goods has transferred to the
buyer property (ownership ) in the goods, for a price
and the buyer becomes legally liable to pay.
When service has been rendered.

 When no uncertainty exists as to its measurability
and collectability.
When is revenue recognized?
Revenue arising from the use by others of
enterprise resources yielding interest, royalties
and dividends

8. Matching Principle
Revenues earned during an accounting
period is compared with the
expenditure incurred during the same
period for earning that revenue.

The Matching Principle
It is the basis for recording
expenses and includes two steps:
•Identify all the expenses incurred during the
accounting period.
•Measure the expenses and match expenses
against revenues earned.

Revenue – Expense = Net income

Revenue – Expense = (Net loss)

The determination of profit of a particular
accounting period is essentially a process
of matching the revenue recognized during
the period and the expenses incurred
during the same period to obtain the
revenue.

Revenue is total amount realised from
sale of goods or
provision of services
earnings from interest, dividend and other
items of income.
Expenses are costs incurred in connection
with the earning of revenues.

Matching concept is based on accounting
period concept.
On account of matching concept,
adjustments are made for all prepaid expenses
outstanding expenses, accrued incomes while
preparing financial statements.

9. Accrual concept
Incomes and expenses should be recognised as
and when they are earned and incurred,
irrespective of whether the money is received or
paid for it.

9. Accrual concept
Revenue is recognised when it is realised, i.e. when sale
is complete or services are given irrespective of whether
cash is received or not.
Similarly expenses are recognised when assets or
benefits are used rather than when they are paid for and
in the accounting period in which they help in earning
the revenue whether cash is paid or not.

9. Accrual concept
TWO METHODS
Reporting Revenue and Expense
Cash Basis of Accounting
Accrual Basis of Accounting

Cash Basis of Accounting
 Revenue reported when cash is received
 Expense reported when cash is paid
 Does not properly match revenues and
expenses

Accrual Basis of Accounting
 Revenue reported when earned
 Expense reported when incurred
 Properly matches revenues and expenses
in determining net income
 Requires adjusting entries at end of period
for outstanding expenses and incomes
while preparing final accounts

This concept is used by all businesses that disclose their
financial statements to various interestsed parties.
The Companies Act, 1956 provides that accrual concept
has to be maintained for practically all accounting
purposes.
The law in India provides that in cases where accrual
concept cannot be followed under any circumstances, cash
basis may be followed.
9. Accrual concept

The Reliability Concept
(Objective Evidence)
RELIABILITY-The quality of information that
assures decision makers that the information
captures the conditions or events it purports to
represent.

Reliable data are supported by convincing
evidence that can be verified by independent
parties.
The impact of events should be measured in
a systematic, reliable manner.

Information must
be reasonably
accurate.
Information must
be free from bias.
Information must
report what
actually
happened.
Individuals would
arrive at similar
conclusions using
same data.
The Reliability (Objectivity) concept

Entries in accounting records and data reported
in financial statements must be based on
objectively determined evidence so as to be
reliable.

Objectively determined evidence includes:
•invoices and vouchers for purchase and sale,
•bank statement for amount of cash at bank,
•physical checking of stock in hand.

Sometimes judgement is used, for
example provision for doubtful debts
but estimation should be made based
on objective factors, such as past
experience in collecting debts and
reliable forecasts of future business
activities.

Without this concept users of financial
statements would not have confidence in them.

Accounting reports should disclose fully and
fairly the information they purport to represent.
Significant information should be disclosed in financial
statements.
Such disclosures can also be made through
footnotes.eg.about
•contingent liabilities
•Market value of investmetns
•The basis of valution of fixed assets, investments
and stock.

Financial statements should be honestly prepared
and sufficiently disclose information which is of
material interest to proprietors, present and
potential creditors and investors.

2. Convention of Conservatism
(Prudence)
“ Anticipate no profits but provide for all
possible losses”

Prudence is the “inclusion of a degree of
caution in the exercise of judgement needed
in making the estimates required under
conditions of uncertainty, such that assets or
income are not overstated and liabilities or
expenses are not under stated.”
(Prudence)

•Policy of ‘caution’ & ‘playing safe’
•Policy of safeguarding against possible losses in
world of uncertainty
•Assets or income are not overstated and
liabilities or expenses are not under stated.
•Anticipated losses are shown in the form of
provisions.
(Prudence)

As a result of this convention :
Revenues and gains are recognized only when
realized in form of cash or assets the ultimate
cash realization of which can be assessed with
reasonable certainty.
Provisions must be made for all known
liabilities, expenses and actual and probable
losses.eg. Provision for doubtful debts is made
Closing stock is valued at lower of cost and
market price.
(Prudence)

3. Convention of Consistency
Accounting practices should remain
unchanged from one accounting period
to another.

This convention requires that once a firm has
decided on certain accounting policies and
methods and has used these for some time, it
should continue to follow the same methods or
procedures for all subsequent similar events
and transactions unless it has a sound reason to
do otherwise.

•The comparison of one accounting period with
that in the past is possible.
•Eliminates personal bias.

Consistency does not forbid introduction of
improved accounting technique.
The effect of the change (inflating or
deflating the figures of profit as compared
to the previous period) must be clearly
stated in the financial statements by way of
a note.

Consistency also implies external consistency i.e.
the financial statements of one enterprise should
be comparable with another
Every enterprise should follow same accounting
methods and procedures of recording and
reporting business transactions.

The accountant should attach importance to
material details and ignore insignificant
details.

A financial statement item is material:
•if there is reason to believe that knowledge
of it would influence the decision of the
informed investor.(AAA)
•if its omission or misstatement would tend
to mislead the reader of the financial
statements under consideration.

Deciding what constitutes a material detail is left to the
discretion of the accountant.
Materiality often depends on:
•The size of the organization – what is material to one
company might not be material to another company.
•Purpose - An item may be material for one purpose
while immaterial for another.
•Amount involved - Materiality may or may not
depend upon amount.
•Customs – only round figures may be shown in
financial statements to make figures manageable
without affecting accuracy.

2. concepts and conventions of accounting mba 1st tri semester

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2. concepts and conventions of accounting mba 1st tri semester