Chapter 3: Accounting Principles
Topic 01: Introduction to Accounting Principles
Accounting principles are a set of rules and guidelines that govern how financial transactions are recorded, classified, summarized, and presented. These principles ensure uniformity, consistency, and comparability in financial reporting. They are essential for understanding a business’s financial health and performance. These rules are usually called ‘Generally accepted accounting principles’ (GAAP).
Topic 02: Nature or Characteristics (Features) of Accounting Principles:
- Accounting Principles are Uniform set of Rules:
Accounting principles are uniform set of rules or guidelines developed to ensure uniformity and easy understanding of the accounting information.
- Accounting Principles are Man-made:
Accounting principles are not natural laws but rather developed by humans based on experience, logic, and the needs of various stakeholders.
- Accounting Principles are Flexible:
Accounting Principles are not rigid but flexible. They are not static they evolve over time to adapt to changes in the business environment, economic conditions, technological advancements, and the demands of users of financial information.
- Accounting Principles are Generally Accepted:
For accounting principles to be effective, they must be widely accepted and followed by the accounting profession and businesses. This general acceptance gives them authority and legitimacy.
For the acceptance of an accounting principles depends upon how well it satisfies the following three criteria:
- Relevance: A principle is relevant if it results in information that is useful to the user of the accounting information.
- Objectivity: They guide accountants to record transactions based on objective evidence (like invoices, receipts), reducing personal bias and estimations. This adherence to objectivity makes financial information more reliable and trustworthy for users.
- Feasibility: A principle is feasible if it can be applied without undue complexity or cost.
Topic 03: Need of Accounting Principles
Accounting principles are not just theoretical concepts; they are the practical bedrock that ensures financial information is understandable, reliable, and useful for everyone who needs it. They bring order and meaning to financial data, which is essential for the smooth functioning of economies and the confidence of market participants.
Kinds of Accounting Principle:
- Accounting Concepts or Assumptions:
These are the fundamental assumptions and ideas that are basic to accounting practice. They provide the theoretical framework for accounting.
As per Accounting Standard (AS-1), issued by Institute of Chartered Accountants of India,there are three fundamental accounting concepts:
(1)Going Concern Concept:
This assumption states that a business enterprise will continue its operations for an indefinite period (a long time) and will not be liquidated in the near future. This concept justifies valuing assets at their historical cost rather than their liquidation value. It also differentiates between capital expenditure and revenue expenditure.
Example: A factory building purchased for ₹1 crore is recorded at that cost, assuming it will be used for many years, not at what it would fetch if sold immediately.
(2)Consistency Concept:
Accounting policies and practices followed by an enterprise should be uniform and consistent from one accounting period to another. This allows for comparability of financial statements over time. If a change in policy is necessary, it must be disclosed and its effect explained.
Example: If a company chooses the Straight Line Method of depreciation, it should continue using it consistently unless a change is justified and disclosed.
(3)Accrual Concept:
Transactions are recorded when they occur, irrespective of whether cash has been paid or received. Both revenues and expenses are recognized when earned or incurred, not when cash changes hands. This is crucial for matching concept and provides a more accurate picture of a business’s financial performance than the cash basis of accounting.
Example: Outstanding salaries are recorded as an expense in the period they relate to, even if paid later.
Other Accounting Concept:
(4) Business Entity Concept:
This concept treats the business and its owners as separate and distinct entities. Transactions are recorded from the business’s perspective, not the owner’s personal perspective. The owner’s capital is treated as a liability of the business to the owner.
Example: If the owner withdraws cash for personal use, it’s recorded as “drawings” reducing the owner’s capital, not as a business expense.
(5) Money Measurement Concept:
Only those transactions and events that can be expressed in monetary terms are recorded in the books of accounts. Non-monetary events, however important,are not recorded. This limits the scope of accounting.
Example: A dispute with a key supplier, while significant, won’t be recorded until it has a measurable financial impact.
(6) Accounting Period Concept:
The entire life of a business is divided into shorter, regular time intervals for the purpose of preparing financial statements. This allows for periodic assessment of profitability and financial position. It ensures timely information for decision-making.
Example: A company prepares its Profit & Loss Account and Balance Sheet annually, typically from April 1st to March 31st.
(7) Cost Concept or Historical Cost Concept:
All assets are recorded in the books of accounts at their acquisition cost, which includes all expenses incurred to make the asset ready for use. This provides objective and verifiable data. However, it doesn’t reflect the current market value of assets.
Example: Land purchased for ₹50 lakh is recorded at ₹50 lakh, even if its market value increases to ₹80 lakh later.
(8) Dual Aspect Concept:
Every business transaction has two-fold effects and should be recorded in at least two accounts. This is the basis of the double-entry system of bookkeeping. This leads to the fundamental accounting equation:
Assets = Liabilities + Capital
Example: When cash is introduced into the business, Cash increases and Capital also increases by the same amount.
(9) Revenue Recognition(Realisation)Concept:
Revenue is recognized when it is earned, regardless of when the cash is received. Revenue is considered earned when goods are delivered or services are rendered, and the legal right to receive payment arises. This ensures that revenue is recognized in the period it relates to.
Example: If goods are sold on credit in March, the revenue is recognized in March, even if payment is received in April.
(10) Matching Concept:
Expenses incurred to earn revenue in a particular accounting period should be matched against that revenue. This helps in determining the true profit or loss for a period. Expenses are recorded in the same period as the revenues they helped generate.
Example: The cost of goods sold in a particular year is matched against the sales revenue of that same year. Depreciation is matched over the useful life of an asset to the revenue generated by its use.
(11) Objectivity Concept:
Accounting transactions should be recorded in a manner that is free from personal bias of the accountants or others. The information should be verifiable from source documents. This enhances the reliability of financial statements.
Example: Purchase of an asset is recorded based on the invoice rather than an arbitrary estimate.
- Accounting Conventions:
These are customs or traditions that guide the preparation of accounting statements, often based on practical experience rather than strict theoretical foundations.
Following are the main Accounting Conventions:
1. Convention of full disclosure:
All material and relevant facts concerning the financial performance and position of an enterprise must be fully and completely disclosed in the financial statements and their accompanying footnotes. Users of financial statements should have all necessary information to make informed decisions.
Example: Disclosure of contingent liabilities, significant accounting policies, changes in accounting methods, etc.
2. Convention of Materiality:
Accounting should focus on material facts. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Immaterial items can be ignored or merged with other items. This avoids cluttering financial statements with insignificant details. What is material depends on the nature of the item and the amount involved.
Example: A small expenditure like a stapler might be expensed directly rather than capitalized as an asset, as its value is immaterial.
3. Convention of Conservatism or Prudence:
All anticipated losses should be recorded in the books of accounts,but all unrealized gains should be ignored. It advocates “playing safe.” This leads to an understatement of profits and assets, and an overstatement of liabilities, creating a cautious approach. It prevents over-optimism in financial reporting.
Example:Closing stock is valued at cost price or net realizable value, whichever is lower. Provision for doubtful debts is created even if actual bad debts haven’t occurred.
Difference between Accounting Concepts & Conventions:
| Basis of Difference | Accounting Concepts | Accounting Conventions |
| Legal Position | Generally mandatory and form the fundamental assumptions underlying accounting standards. They are often legally binding, especially for publicly traded companies. | Generally accepted practices or guidelines that are not strictly legally binding but are widely followed due to their practical utility and common acceptance. They fill gaps where concepts are not fully prescriptive. |
| Recording vs. Financial Statements | Primarily concerned with how transactions are recorded and recognized in the books of accounts. They form the basis of journal entries and ledger postings. | Primarily concerned with the presentation and disclosure of information in financial statements. They guide how to interpret and apply concepts to ensure a true and fair view of the financial position and performance. |
| Significance | Are fundamental theoretical assumptions that provide the backbone of the accounting system. They are the “what” and “why” of accounting. Essential for the very existence and reliability of accounting. | Are practical guidelines or customs that facilitate the application of concepts and help overcome practical challenges in preparing financial statements. They are the “how” of accounting application in specific scenarios. |
| Role of Personal Judgment | Generally less scope for personal judgment as they are fundamental principles that must be adhered to. They aim for objectivity and verifiability. | Often involve more scope for personal judgment due to their practical nature. However, this judgment must be reasonable and justifiable. |
| Uniform Adoption | Tend to be more universally adopted across different countries and industries, forming the core of major accounting frameworks. | May show some variations in their application across different entities, industries, or even countries, although the underlying principle remains. |