Accounting Principles
It refers to the rules and actions adopted by the accountants globally for recording accounting transaction.
Are the rules of action or conduct adopted by accountants universally while recording accounting transaction. They are the norms or rules which are followed in giving accounting treatment to various items of assets, liabilities, expenses, income etc.
According to American institute of certified public accountants “Principles of the accounting are general law or rule adopted or proposed as a guide to action. A settled ground or basis of conduct or practice.”
Accounting Principle divided into two categories
- Accounting concepts - Accounting concepts have been established by professional organizational and are standard principles that must be followed when preparing financial accounts. It defines the assumptions on the basis of which financial statements of business entity are prepared. Concept means idea or motion which has universal application. It mainly helps in the recording of business transaction and preparing final account. Business entity concept. Cost concept, going concern concept, dual aspect concept, matching concept etc.
- Accounting convention - Accounting conventions are generally accepted practices that can change and are updated over time, depending upon the requirement in financial reporting. It emerges out of accounting practices adopted by various organization over period of time. Focus on the preparation and presentation of financial statements. If need not have universal application. Convention denotes customs or tradition or usages which are in use since long. Accounting convention are consistency, disclosure, conservatism and materiality.
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Accounting
Concepts |
Accounting
convention |
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Are the basic assumption within which accounting operates. They are generally accepted accounting rules based on which
transactions are recorded and financial statements are prepared. |
Are the outcome of accounting practices pr principle being followed
by enterprise over a period of time. Convention may undergo a change with time to bring about improvement
in quality of accounting information. |
- GAAP = Accounting principles, concepts & conventions
- GAAP = Generally accepted accounting principles
Entity Concept
It states that business enterprise is a separate entity, identity apart from its owner. Business transactions are recorded in the books of accounts and owner’s transactions in the personal books of accounts.
- Entity Concept means that enterprise is liable to its owner for capital investment made by the owner. Since the owner invested capital, he has a claim on the profit of the enterprise.
- The portion of profit which is apportioned to the owner and is immediately payable becomes current liability in the case of a corporate entity.
Example of applicability of this concept –
- Due to Entity Concept, capital shows in the liability side.
- Person expense of owner shows as drawing which deduct from the capital.
In simple terminology, it also known as business entity concept, the transaction associated with a business must be separately recorded from those of its owner’s.
Money Measurement Concept
As per this concept, only those transactions which can be measured in terms of money are recorded. Transactions, even if they affect the results of the business materially, are not recorded if they are not convertible in monetary terms.
- Entity and money measurement are viewed as the basic concepts on which other procedural concepts hinge.
Example of applicability of concept:
- Strike of employees – Not recorded in books of accounts, because while it hampers the business, it cannot be measured in financial terms and thus is not recorded.
- Employees of organization
In simple terminology, it is a concept only those accounting transactions to be recorded that can be expressed in terms of money.
Periodicity Concept
According to this concept, accounts should be prepared after every period and not at the end of the life of the entity. Usually, this period is one calendar year. We generally follow from 1st April of a year to 31st March of the immediately following year, which is called the accounting period.
Example:
- Accrued Expenses and Accrued Revenue
- Due to definite accounting period, there is accrued or prepaid income/expense.
If there is no definite period, then there is no concept of accrual. According to this concept, an organization can report its financial statements within certain selected periods of time. We generally follow from 1st April to 31st March.
There are two types of years:
- Calendar year: 1st January to 31st December
- Financial year: 1st April to 31st March
Accrual Concept
Accrual means recognition of revenue and costs as they are earned or incurred and not as money is received or paid. The effect of transactions and other events are recognized on mercantile basis i.e., when they occur.
- Accrual Concept: Revenue - Expenses = Profit
- Example - Sales recorded whether they are credit sale or cash.
In simple transaction, accrual concept transactions must be recorded when they occur even if the payment is not yet made or received. For e.g. goods purchased on credit will be recorded on the date of purchase rather than the date of payment done.
Matching Concept
In this concept, all expenses matched with the revenue of that period should only be taken into consideration.
This concept is based on the accrual concept as it considers the occurrence of expenses and income and does not concentrate on actual inflow or outflow of cash.
Example:
- Prepaid expenses, outstanding expenses
- Selling expenses related to sales
According to this concept, Expenses = Revenue
All expenses matched with the revenue of that period should only be taken into consideration.
Going Concern Concept
The financial statements are prepared on the assumption that an enterprise is a going concern and will continue its operations for the foreseeable future.
Examples:
- Preliminary expenses – “Written off too many periods due to going concern.”
- Depreciation
- Inclusion of loan
- Non-current liabilities
In simple terminology, going concern concept is an entity is expected to continue to operate for an indefinitely long period in the future owners may change but business continues to operate.
Cost Concept
The value of the assets is to be determined on the basis of historical cost, in other words, acquisition cost.
Example:
Machinery purchased whose market value is ₹6,00,000 but we purchased it at ₹5,70,000. So, in the books, the value of the machinery is recorded as ₹5,70,000 i.e., acquisition cost.
Simple terminology, all transaction to be recorded with assets the price at which they were bought not at market value.
Realisation Concept
It closely relates to the Cost Concept. Any change in the value of assets is to be recorded only when the business realizes it.
Example:
When an asset is recorded at its historical cost, i.e., ₹5,00,000, and even if its current cost is ₹15,00,000, such change is not counted unless there is certainty that such change will materialize.
Note: "Going Concern, Cost Concept, and Realisation Concept give the basis for valuation (situation)."
It is also known as Revenue Recognition Concept. This concept indicates how much revenue should be recognized from a given sale (reported when the sale is done).
Example: If there is a sale of goods at a discount, then the revenue to be recorded should be the lower amount and not the normal price.
Dual Aspect Concept
This concept is the core of double-entry bookkeeping.
Every transaction or event has two aspects.
Examples:
- Increase one asset and decrease another asset
- Purchase machinery ₹50,000 from Mohan (cash)
- Increases asset (machinery) by ₹50,000 but at the same time decreases another asset (cash) by ₹50,000.
- Increase one asset and simultaneously increase liability
- Purchase machinery from Mohan (on credit)
- Increases asset (machinery) by ₹50,000 and at the same time increases liability (Mohan – creditor) by ₹50,000.
Dual Aspect gives Accounting Equation
Equation:
- Equity (E) + Liabilities (L) = Assets (A)
- Equity = Assets (A) – Liabilities (L)
- Equity + Long-term Liabilities + Current Liabilities = Fixed Assets + Current Assets
In simple words, an entry of a transaction has a dual effect (Debit = Credit} per double entry system.
Conservatism Concept
Conservatism states that the accountant should not anticipate income and should provide for all possible losses. When many alternative values of assets exist, the accountant should choose the method which leads to the lesser value.
Examples:
- Provisioning is the express result of conservatism, e.g.
- Provision for Tax
- Provision for Doubtful Debts, etc.
- Stock is valued at Cost or Net Realisable Value (NRV), whichever is lower.
In simple term conservation concept is Recognize and record expenses and liabilities as soon as possible, and recognize revenues only when they are assured to be received.
Prudence: It refers to judgment about the possible future losses which are to be guarded, as well as gains which are uncertain.
Consistency Concept
Uniformity means being consistent with the same accounting policies. In order to achieve comparability of the financial statements of an enterprise through time, the accounting policies are followed consistently from one period to another.
A change in an accounting policy is made only in certain exceptional circumstances, and such changes need to be disclosed.
Example: Selecting one method of depreciation, either WDV (Written Down Value) or SLM (Straight Line Method), or in the valuation of inventory.
In simple word consistency concept, A business should maintain the same accounting method for all subsequent events of the same character unless there is a sound reason to change it.
Materiality Concept
According to this principle, all the items having a significant economic effect on the business of the enterprise should be disclosed in the financial statements.
Any insignificant item which will only increase the work of the accountant but will not be relevant to the users’ needs should not be disclosed in financial statements.
The Materiality Concept permits other concepts to be ignored if their effect is not considered material. According to this concept, trivial matters may not be considered.
Only material items should be reported those whose inclusion or exclusion results in significant changes in the decision-making for the users of business information.
Three fundamental assumptions of Accounting
- Going Concern Assumption - According to this assumption, a business shall continue for a foreseeable period. There is no intention to close or significantly reduce operations. Because of this concept, a distinction is made between Capital Expenditure and Revenue Expenditure. Example: Machinery purchased for ₹10 lakh, life 10 years (Jan 2021). The total cost is not charged fully in the year of purchase — only depreciation is charged each year.
- Consistency Assumption - Accounting methods once selected should be applied consistently year after year. Ensures comparability with previous years. It Eliminates personal bias. Example: Two methods of charging depreciation (e.g., straight-line or written-down value) — once a method is chosen, it should be used consistently.
- Accrual Assumption - Transactions are recorded when they occur, not when cash is received or paid. Profit is recorded when goods/services are sold, and ownership passes to the customer. Expenses are recognized when goods/services are received or availed, even if payment is pending.
Accounting Conventions
- Convention of Conservatism - According to this convention, accountants must follow the rule: anticipate no profit, but provide for all possible losses while recording business transactions to meet uncertainties efficiently. Because of this convention, provision for bad and doubtful debts is created.
- Convention of Full Disclosure - According to this convention, there should be adequate disclosure of all material information in the financial statements prepared for stakeholders such as investors, creditors, and the government. According to this concept, all important information about the financial condition and activities of the entity must be disclosed in the reports.
- Convention of Consistency - According to this convention, it is essential that accounting procedures and methods remain unchanged from one accounting period to another to facilitate comparison. For example, if material issued is priced on the basis of the FIFO method, the same method should be followed thereafter.
- Convention of Materiality - According to this convention, accountants should attach importance to material details and ignore insignificant ones. Without this distinction, accounting would become unnecessarily complex and burdened with minor details. Examples include changes in competition or demand patterns.
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