Genrally Accepted Accounting principles--Part 1

                        Generally Accepted Accounting Principles

Now after learning about the book keeping our first task is to do the work of journal—that is, to record transaction in the books of account but there are certain rules and principle of recording transaction these rules and principle is known as Generally Accepted Accounting Principles (GAAP). Let’s learn them in detail:
In every sphere we see certain rules which are applicable for all like in India there is a driving rule that we should drive on the left side of the road, if we want to overtake any vehicles we need to do that from its right side, these are the basic rule that everyone must follow if they want to drive on the road, they are generally accepted principle or rules.

Similarly, to record transaction one must follow the universally accepted general rule. These principle are developed by the Accounting body over time after lots of experiments

GAAP may be defined as “Those rules or actions, which are derived from experience and practice, and when they prove useful, they are accepted as principles of accounting.

 Now this GAAP has two main categories:

·        Accounting concepts.

·        Accounting conventions.

Part 1-Accounting concepts:

Accounting concepts are the necessary assumption and condition on which the accounting is based. The following are the accounting concepts:

Separate entity concepts:

According to this concept business is treated as separate entity like separate person distinct from the owner of the business. The reason behind this assumption is that the true value and the work of the business can never be determined unless we are treating business affairs separately than the proprietor. This concept says that if an owner is introducing certain amount in the business as capital, business will treat that amount as a liability in the sense that it has to pay that amount to the owner, similarly if any stock/cash is being drawn from the business by the owner, business deduct that cash or stock from the capital to decrease the liability. It is to be noted that for the joint stock company this assumption is legally compulsory-that is, company and shareholders are two different and separate entity and they do the transaction accordingly. In sole proprietor and partnership this concept exists but not legally. It is recommended for them to record transaction by assuming this concept.

Money measurement concept—

Accounting records only those transactions that can be expressed in terms of money or money value. If the events or transaction can’t expressed in money however, much important they are, they will not recorded in the books of account. The work of the manager of the company is very useful, without him company can made loss but the company can’t record that value in the books of account because that value can’t be expressed in the terms of money.

The money measurement concept increases the true understanding of the state of affairs of the business.

For example- if a business has a cash balance of Rs 50000, plot of land 000 sq. meters, two air conditioners, 1 kg of raw material. There is an absence of money measurement concept. These different types of assets can’t be added to give true value of the business. Thus they can’t be considered as a transaction.

Dual concept of Accounting—

This is the basic concept of accounting. As per this concept for every debit there is a corresponding credit. In other words, when a transaction is recorded debit amount must be equal with credit amount. This is known as “Double Entry Principle”.

Suppose 1 lakh rupees have been introduced into the business as capital. Here

The journal entry of this transaction will be:

Cash a/c…………………….dr 1 lakh

 To capital a/c                                 1 lakh.

Here cash is debited with 1 lakh where as capital is credited with 1 lakh thus both credit and debit get equalized and asset and liability also get equalized. For every transaction we have to consider this rule or principle.

So this is called the double entry concept where every transaction must equalize debit and credit amount.  We will learn this concept in detail while doing journal entries. Till then we should remember that every transaction has dual aspect; every transaction must affect debit and credit side equally.

Going concern concept:

The main idea of this concept is that the business would continue for a fairly long period of time. All the accounting transactions are recorded from this point of view. On account of this concept, accountant doesn’t take in to account the market value of fixed asset (forced value of the asset, as if the business is liquidated) for preparing balance sheet. Depreciation is charged on the original cost of the fixed asset on the basis of expected lives, considering that the business would continue at least for a reasonable period, at least sufficient to the life of the asset. At the time of preparation of final account we take into consideration outstanding expenses and prepaid expenses because of this assumption that business will continue for long period in the future.

It is to be noted that going concern concept doesn’t mean permanent continuation of business indefinitely.

It rather presumes that the business will continue the operation long enough that the cost of fixed asset would be charged over the useful life of the asset.

Historical Cost concept:

This concept is related with Going Concern concept. Historical cost concept says that fixed asset should be recognized in the balance sheet at original cost- that is, at a price on which that fixed asset was acquired. Suppose we have purchased fixed asset costing 1 lakh, now this 1 lakh will be shown in the balance sheet every year until that asset is disposed off.

The main idea of this concept is that the market price changes very frequently and it would be very difficult for the accountant to record the amount in the balance sheet and compare the performances of a company in different years. 

AS 10- Accounting for fixed Assets, also says that historical cost can only be changed if there is revaluation of fixed assets, otherwise it will be constant in the balance sheet throughout the life of the asset. Land cannot be revalued and it will be shown only on the cost incurred during acquisition.

It follows from this concept that if nothing is paid for acquiring an asset, it will not be recorded at all in the Balance sheet.

This original cost concept is applied only to the fixed assets; current assets are not affected by this concept.

Accounting period concept—

According to the ‘Going concern concept’ every business would exists for a longer duration. The longer duration is divided into the appropriate periods for studying the results shown by the business in each period.

The main idea of this concept is we should stop somewhere while doing business and look back to see how the business has performed so far, so that we can compare the performance of that period with the previous period.

Thus this concept helps us to compare and analyze the performance of our business. What we need to keep in mind that this Accounting period should be similar- that is, of 12 months.

Accrual or Matching concept—

This concept is the result of the Accounting Period Concept. The matching concept says that the revenue and cost in the same accounting period should be matched to get true financial results and position of the business.

Suppose, during an accounting period, we have purchased goods on credit for Rs 5lakh and sold those goods on cash for Rs 7 lakh, this concept says that the Revenue (7 lakh) during an accounting period should be matched with all the costs (here 5 lakh) incurred in that accounting period to get revenue whether we have paid for that expenses during an accounting period or remained due as outstanding.

Thus, this concept denies the cash basis of accounting and gives the proper method to determine true profit and loss of the business. It is because of this concept that an outstanding expense, prepaid expenses, accrued income has come in existence.

Take another example suppose, an expenditure Rs 5000 has been incurred and the benefit of it will be last not only for current year but for future period also (say for next 3 year), then that expenditure of that amount will be deferred in the proportion of 3 years like this—

Total validity of that expenditure =4 years. (Current year+ next 3 year), then we have to divide that expenditure by 4 equal year that is, 5000/4=1250. Therefore, in current year expenditure recognized would be 1250(in debit side of p/l a/c) and 3750 would be deferred (asset side of balance sheet)-that is, postponed in current year for charging against future year Income. If we charged that whole expenditure in current year it would be an unfair treatment because expenditure is going to give benefit to the future years also and that must be matched with future year income. The best example of this type of expenditure is “Research and Development”, advertisements expense, etc.

Realization concept:

Realization concept is all about sales, to be specific; it is about the timing of sales. It gives an answer to the question what is the actual point of sales? And when the profit to be recognized in the books?—It says that sales is deemed to have been taken place when the title to the goods passes from seller to the buyer and at that point of time only profit  is to be recognized.

For example, a company X received an order of shirts from company Y. X purchased garments and manufacture shirts to complete an order then manufacturing required amount of shirts X transfer them to Y. Here when X should recognize its sales? At the time of taking the order or at the time shirts were ready or at the time of transferring of shirts to Y? Is an important question—the answer is sales should be recognized when the shirts are delivered from X to Y.

Here there are two exceptions first- at the time of hire purchase agreement sale should be recognized until the last payment has been made.

Second-In the contract accounting sales should be recognized by the contractor at the end of the contract or as per contract agreement.

Thus, we have come to an end of the part 1 of the GAAP; soon I'm coming with the part 2 of this GAAP concept so that student can have the full understanding of this concept.