FINANCIAL ACCOUNTING

UNIT 1

Accounting Principles
(GAAP)
-by Prof. Priyanka Pradhan
 Generally Accepted Accounting
Principles (GAAP)
■ Accounting principles may be defined as
those rules of action or conduct which are
adopted by the accountants universally
while recording accounting transactions.
■ Accounting Principles are classified as:
Accounting Concepts
Accounting Conventions
Accounting Concepts
■Rules of accounting that should be followed
in preparation of all accounts and financial
statements.
Accounting Conventions
■Are guidelines used to help companies
determine how to record certain business
transactions that have not yet been fully
addressed by accounting standards.
The key difference
■Between Accounting Concept and
Convention lies in the fact that
accounting concepts refer to the rules and
regulations of accounting, while
accounting convention refers to the set of
practices discussed by the accounting
bodies before preparing final accounts.
 Important criteria for
GAAP :
■(a) Relevance : The principle is relevant to
the extent it results in information that is
meaningful and useful to the user of the
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.
(c) Feasibility : A Principle is feasible to
the extent it can be implemented without
much complexity or cost.
Accounting Concepts
■Accounting Concepts refers to those basic
assumptions or postulates or conditions
upon which the science of accounting is
based.

■Balance Sheet - related concepts

■Profit & Loss - related concepts
Balance Sheet – Basic Concepts
■The Business Entity Concept
■Going Concern Concept
■Monetary Unit Concept
■Cost Concept
■Conservatism Concept
■Accounting Equivalence Concept
The Profit & Loss Account and
Related Concept
■The Accounting Period Concept
■Realization Concept
■Accrual Concept
■Matching Expenses with Revenue
concept
The Business entity concept
■This concept implies that the affairs of a
business are to be treated as being quite
separate from the non-business activities of
its owners
■Personal transactions of the owner should
not be included.
■In short as business has its own existence
and therefore business and owners both
should be consider as different persons.
■For e.g. A director’s private car should not
be included in the fixed assets of the
company.
Going Concern Concept
■Accountant has to assume that business
will continue to operate in future for
indefinite period of time until it is
liquidated in the immediate future.
■Continuing activity and not liquidation.
■For example: In case of basis for depreciation
the cost of a fixed assets is allocated over its
useful life and it will not be considered as the
current year only.
■Thus it does not imply permanent
continuance of an enterprise but it presumes
that the enterprise will continue in operations
long enough to charge against income.
■SLM
■D = C-S
N
D = Rs.10,00,000 – Rs.2,00,000

10 years
= Rs. 80,000 per year
Monetary Unit Concept
■Transactions or events which can not be
expressed in terms of money, do not find a
place in the books of accounts even though
they may be very useful for the business.
■This concept introduces many difficulties in
accounting in the sense that those assets
which cannot be accurately expressed in
terms of monetary units reflected in
business accounts.
■For e.g. It is hardly possible to add
thousands of square feet of buildings space
with tons of coal and numbers of bank
notes, effective sales policy because of
physical nature of their measurement units.
Cost Concept
■Concept deals that purpose of accounting
all transaction are recorded at their
monetary cost of acquisition.
■Assets are normally shown at their original
costs of acquisition.
Cost Concept
■Any changes in the market value after the
purchase are ignored.
■Historical cost is the most objective
measure of the value of an asset. However,
it cannot reflect the current value of an
asset.
Cost Concept
■E.g. A fixed asset acquired at a cost of
$100,000 would be recorded at this amount
in the books. Even if its market value may
have gone up or down in future, it should be
recorded at its original cost $100,000.
Conservatism Concept
■ The accountant should always be on the side of safety.
■ The Conservatism concept means that normally he will
take the figure which will understate rather than overstate
the profit.
■ Provision is made for all known liabilities.
■ “Anticipate no profits and provide for all possible
losses and if in doubt write off.”
 Accounting Equivalence
Concept
■Assets = Owners Equity + Liabilities
■For e.g. Mr. X had provided Rs10,00000 as
the capital to start a business, the assets
owned by that company at that stage would
be a cash balance of Rs10,00000 .
 Accounting Equivalence
Concept
■Corresponding to this amount would be the
equity; i.e. an amount which could be
claimed by Mr. X this relationship is
expressed as:
Assets = Equities (Claims)
In accounting terms:
Assets Equities
Cash Rs.10,00000 = Mr. X’s
Equity (Capital) Rs.10,00000
The Profit & Loss Account and
Related Concept
The Accounting Period
Concept
■The life of business is divided into
appropriate segments for studying the
results shown by the business after each
segment.
 The Accounting Period
Concept
■The measurement of income & studying
financial position of the business after a
very long period would not be helpful in
taking corrective steps at the appropriate
time of business with losses. Thus it
requires to know at frequent intervals ‘Stop
and, see back’.
Realization Concept
■This concept holds to the view that profit can only
be taken into account when realization has
occurred.
■When goods produced are transferred or required
services are rendered to a customer either for cash
or for some other assets or for a promise to pay
cash in future.
■Generally, sales revenue arising from the sale of
goods is recognized when the goods are delivered
to the customers.
■For e.g. Profit is earned when goods or
services are provided to customers. Thus it
is incorrect to record profit when order is
received, or when the customer pays for the
goods.
Accrual concept
■The accrual concept says that net profit is
the difference between revenues and
expenses.
■Income and costs are recognized as they are
earned and incurred but not as they are
received or paid.
■For e.g. Income due but not received,
outstanding expenses, Prepaid expenses etc.
 Matching Expenses with
Revenue concept
■To ascertain the actual profit or loss of a given
period, total revenue of the given accounting
period is compared (matched) with total expenses
for that period.
■If the income or revenue is more than the expenses
than the difference is known as profits & vice a
versa.
■In matching process, adjustments are to be made
for all outstanding expenses, and unearned
incomes etc.
Accounting Conventions
■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
■Conservatism/Prudence
■Consistency
■Materiality
■Full Disclosure
Conservatism/Prudence
It is a policy of “Playing safe.”
Prudence also means early recognition of
unfavorable events.
Working rule relating to the conservatism is –
“Anticipate no profits and provide for all
possible losses and if in doubt write off.”
■ Examples:
■ Making provisions for doubtful debts in anticipation of
actual Bad debts.
■ Creating Investment Fluctuation Reserve
■ Applying Written Down Value (WDV) Method of
depreciation as against Straight line method.
■ Providing for the loss on issue of debenture, when the
same are issued at par but redeemable at premium.
Consistency
■ The consistency convention principle implies
that accounting practices and methods remain
unchanged from on accounting period to
another accounting period.
■ For example, using only one method for
valuation in accountancy for longer duration of
time.
Types of Consistency
■ Vertical Consistency: is maintained within the interrelated
financial statement of the same date.
■ Horizontal Consistency: is maintained between financial
statements from one year to another year and subsequent
years.
■ Third Dimensional 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.
Materiality
■ The 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.”
■ It is observed that 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 year.
Full Disclosure
■ Disclosure may be defined as “the communication of
financial information about the activities of a business
enterprise to the interested parties for facilitation their
economic decisions.”
■ Sacher Committee Report on this aspect emphasises that –
“Openness in company affairs is the best way to secure
responsible behavior.”
Basis for measurement
The basis for measuring the items in the financial
statement should be
■Reliability
■Relevance
■Consistency
■Comparability
■Understandability and
■Standardization
Short Questions - True/False
■The “Entity concept of accounting” is not
applicable to sole trading concerns and partnership
concerns.
■The Accounting equivalence concept results in the
accounting equation = Capital + Liabilities =
Assets
■The conservatism has usually the effect of
“anticipate no losses & provide for possible
profits.”
■“Monetary Unit Concept” takes into account
monetary as well as non monetary units.
 Composition of financial statements

Financial Statements

Summary of Financial transactions which can be classified into

Capital Nature Revenue Nature

Classification

Items of capital Items of revenue

nature are reflected nature are reflected
in the in the
Balance Sheet Profit & Loss account

The impact on Cash Balances due to the operations and

financing activities during the period.

Cash Flow Statement