Learning Outcomes

After studying this Chapter, you shall be able to:

 Know the Generally Accepted Accounting Principles
 Learn the different Accounting Concepts and their interpretation
 Identify fundamental Accounting Assumptions
 Evaluate the need of Accounting Policies
 Analyze the effects of Accounting Concepts and Conventions

3.1 Introduction

There are various users of accounting information. Each category of user is interested, directly or
indirectly, in financial performance of the entity. Their purpose is served if and only if the accounts
are reliable and comparable. These should be prepared on the basis of consistent accounting
concepts, conventions and policies. If the financial information fulfills all of the above features
then the information becomes comparable. This comparison may be inter-firm or even intra-firm.
The theory base of accounting consists of different principles, concepts, conventions, fundamental
accounting assumptions, accounting policies, rules, guidelines, etc. In this module all these
parameters have been discussed in detail.
3.2 Generally Accepted Accounting Principles [GAAP}

Meaning

Financial Statements are prepared by the accountants certainly on the basis of some principles.
There are rules to be adhered by these professionals in this accounting process. The standard
framework is required to be followed so as to maintain reliability and relevance. Generally
Accepted Accounting Principles (GAAP) include all those regulatory provisions which are available in
the form of principles, concepts, conventions, guidance notes, standards, rules, act, laws, etc.
Although it is inevitable for this noble profession to follow standardized rules, but GAAP are not
uniform globally. For example in India companies are preparing financial statements as per Indian
GAAP. But multinational companies (like Infosys) operating in India are preparing their statements
on the basis of both Indian and US GAAP.

Definition

As per statement No. 4 of the Accounting Principles Board (USA), “ Generally Accepted Accounting
Principles incorporate the consensus at a particular time as to which economic resources and

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obligations should be recorded as assets and liabilities by financial accounting, which changes in
assets and liabilities should be recorded, when these changes are to be recorded, how the assets
and liabilities and changes in them should be measured, what information should be disclosed and
which financial statements should be prepared.”

3.3 Accounting Concepts

Meaning

The Financial Statements are prepared on the basis of certain assumptions and basic principles.
These are defined by accounting concepts. Accounting concepts lay down the foundation for
accounting principles. The accounting concepts are broad working rules for all accounting
activities, from recording to interpretation, and have been developed by accounting profession.
There are specific accounting concepts which are relevant at the time of recording like dual aspect
concept, money measurement concept, entity concept, etc. Some of the concepts are concerned
with the recognition of revenue like realization concept whereas accounting period concept,
matching concept, going concern concept, etc. are related with income measurement and
determination of financial position. These concepts lay the foundation for sound structure of
accounting and are the foundation of systematic and proper accounting.

1 Business Entity Concept

This concept recognizes that business and owner are two separate and distinct entities. It means
when proprietor introduces money in the business, the accountant records it as a liability (capital).
Similarly when proprietor withdraws any amount from firm for his personal purposes, then it is
treated as drawings. This concept requires recording the transactions from the firm’s point of view
and not of proprietor. The owner is treated as a creditor for his investment in the business. For
example if Shyam has started his business Rs. 5,00,000 in cash. He purchased goods for Rs. 25,000,
Machinery for Rs. 1,00,000 and Furniture Rs. 40,000. Now, the net effect of these transactions may
be disclosed in a statement called as Balance Sheet in the following manner:

Balance Sheet As At ………

Liabilities Amount Assets Amount
Capital 5,00,000 Machinery 1,00,000
Furniture 40,000
Stock 25,000
Cash in Hand 3,35,000
5,00,000 5,00,000
This means that enterprise owns Rs. 5,00,000 to Mr. Shyam. This concept is required to determine
business profit and its state of affairs correctly. That is why it is applicable to all types of entities
including sole proprietorship.

2 Dual Aspect Concept

It is the basic principle of accounting. This concept recognizes that there are two aspects of each
and every transaction. For example if machinery is purchased by the business on cash basis, then on

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Chapter 3 3 Theory base of Accounting

the one hand machinery is coming into the business but on the other hand cash is going out of
business. This dual effect may be:
a) Increase in asset and decrease in asset
b) Increase or decrease in both
c) Increase in liability and decrease in liability

This concept is the core principle of accounting and is called as double entry system of
bookkeeping.

3 Cost Concept

The cost concept indicates measurement base that is used in accounting particularly for fixed
assets. According to this concept, an asset purchased is recorded in the books of accounts at the
price paid to acquire it i.e. at its cost of acquisition and not at its market price. The cost refers to
the amount of cash or cash equivalent paid or payable for purchase of such asset. The cost concept
is highly objective because it is derived from an independent transaction between two parties.
However, this concept has many drawbacks like assumption of stable purchasing power, lack of
comparability, etc.

4 Going Concern Concept

According to Kohler “A going concern is defined as any enterprise which is expected to continue
operating indefinitely in the future”. Indefinite existence means that the business enterprise will
not be wound up within the foreseeable future and therefore would be able to meet its contractual
obligations and use its resources according to the plans and predetermined goals. According to
Accounting Standard 1 issued by ICAI, “Going concern implies that the enterprise has neither the
intention nor the necessity of liquidation or curtailing materially the scale of the operations.”
Going concern is one of the fundamental accounting assumptions. Because of application of this
concept, fixed and current assets are categorized.

5 Money Measurement Concept

As per this concept, only those transactions and events are recorded which can be measured in
terms of money. Money is the medium of exchange. Most of the business transactions and events
are settled in money terms. There may be some important transactions which are incapable of
being converted into monetary terms. For example: managing ability of managers, retirement of
key personnel, etc.

6 Accounting Period Concept

This concept is also called as periodicity concept. The going concern concept assumes an indefinite
life of the entity. But we cannot wait up to the end of the life of the business in order to calculate
the net result of business operations. That is why; a small but workable fraction of time is selected
out of the infinite life cycle of the business entity. This period is called as accounting period
concept. Usually a period of 12 months is considered which again may be calendar year or financial
year or any other.

7 Accrual Concept

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This concept requires to recognize the revenues if they belong to the relevant accounting period
irrespective of whether cash or cash equivalent has been received or not. Expenses are recognized
initially as per matching concept i.e. if they are related to the revenues earned. The accrual
concept advocates including such expenses which have been recognized as per matching concept,
whether they have been paid or not. It may be noted that the alternative approach is cash basis of
accounting in which the revenues and expenses are recognized in the period in which they are
received or paid, irrespective of the period to which they belong.

8 Realization Concept

It deals with the timing of recognition of revenue. For example: a business transaction includes
many activities at different points of time, like:
Time Activity
1 Receipt of proposal of order
2 Acceptance of order
3 Issue of material, exp. incurred towards processing for completion of order
4 Completion of order and ready for delivery
5 Dispatch of order and invoice raised
6 Receipt by the customer
7 Receipt of cash or cash equivalent
Now a question arises about the point of time at which revenues may be recognized. The answer is
given by realization concept. As per this concept, revenue is recognized when goods or services are
transferred and a consideration or promise of consideration is received. Obviously in above context,
the revenue recognition time is time 6. It is important to note that time 5 is not the correct time
because unless goods are delivered to the customer and accepted by him, the promise is not
obtained and sale cannot be recognized.

9 Matching Concept

In accounting, profit is always calculated for a particular accounting year. The profit is the excess
of Revenue over Expense. This profit is always calculated in respect of a specific period. In order to
determine the profit or losses accrued in an accounting period, the expenses must relate to the
goods or services sold during the period. At very first step, the accounting period is decided
followed by recognition of revenues related with that period. The matching concept requires that
the expenses for an accounting period are to be matched against related revenues rather than cash
received or cash paid. This concept leads to adjustment of certain items like prepaid and
outstanding expenses, unearned or accrued incomes.

3.4 Accounting Conventions

1. Convention of Conservatism

It is quite logical not to be optimistic about the possible inflow of revenues. Infact, the revenues
are to be recognized only when they are reasonably certain. If we identify the expected profits in
the books of account, then we may be recognizing an amount which may never be realized. But
losses are to be recognized as soon as they are reasonably possible. So this convention takes into
consideration all prospective losses but not the prospective profits.

2. Convention of Consistency
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According to the convention of consistency, same accounting policies should be adopted over
different accounting periods. It helps in better understanding of accounting information and make
accounts more comparable. For example if straight line method has been adopted for providing
depreciation in first two years, followed by written down value in next two years and again another
method in following year, then profits revealed by these accounts will not be comparable. So the
accounting policy once adopted should not be changed. But it does not mean that practice once
adopted cannot be changed because consistency is not an excuse to continue with inappropriate
accounting policies.

3. Convention of Full Disclosure

According to this convention, all the economic activities of a business entity should be completely
and understandably reported in the financial statements. Most of the material information is legally
required to be disclosed yet, there could be some information which, though not legally required to
be disclosed, but is required to serve this basic purpose. Therefore this information should also be
disclosed.-

4. Convention of Materiality

The financial health of the enterprise is generally viewed through their financial statements. But, it
is possible if and only if these statements fulfill the criteria of true and fair. This criterion also
depends upon the concept of materiality. Any information is said to be material if its knowledge
might influence the economic decision of the users. It is a subjective and relative term. Information
may be material for one but not for other. Due to application of this convention, paise may be
rounded off to rupee while recording a transaction. Similarly it is useless to record each item of
stationery separately like pens, pencils, stapler pins, etc. Materiality should be considered both
individually as well as in aggregate.

3.5 Fundamental Accounting Assumptions

Meaning

The financial statements are prepared and presented with some assumptions called as fundamental
accounting assumptions. According to Accounting Standard 1, these assumptions are usually not
specifically stated because their acceptance and use are assumed. But disclosure is necessary if
there is any departure in this regard. It means so long as fundamental accounting assumptions are
followed in preparation of financial statements, no disclosure of such adherence is necessary.

Components

As per Accounting Standard 1, Disclosure of Accounting Policies, there are three Fundamental
accounting assumptions which are as follows:

1 Going concern: A business entity is assumed to carry on its business operations forever. This is
because it is difficult to envisage any economic activity on the part of a business entity if its
liquidation were shortly expected. According to AS 1, the enterprise is normally viewed as a going
concern and continuing in operation for the foreseeable future. It is assumed that the enterprise
has neither the intention nor the necessity of closing the operations.

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2 Consistency: The principle of consistency refers to the practice of using same accounting
policies for similar transactions in all accounting periods. The consistency improves comparability
of financial statements through time. An accounting policy can be changed if the change is required
(i) by a statute (ii) by an accounting standard (iii) for more appropriate presentation of
financial statements.
3 Accrual: As already discussed in Para 4.8, the accrual basis of accounting, transactions are
recognised as soon as they occur, whether or not cash or cash equivalent is actually received or
paid. Accrual basis ensures better matching between revenue and cost and profit/loss obtained
on this basis reflects activities of the enterprise during an accounting period, rather than cash
flows generated by it.
The accrual basis can overstate the divisible profits as there is a risk of recognising an income
before actual receipt. The dividend decisions based on such overstated profit may lead to erosion
of capital. For this reason, accounting standards require that no revenue should be recognised
unless the amount of consideration and actual realisation of the consideration is reasonably certain.
3.6 Accounting Policies

Meaning

As per Para 11 of Accounting Standard 1, “The accounting policies refer to the specific accounting
principles and the methods of applying those principles adopted by the enterprise in the
preparation and presentation of financial statements.” For example depreciation policy will
comprise of rules for recognition of depreciation, the measurement and treatment of depreciation,
etc. Since each and every entity has its own operating environment, no single list can be prepared
about the policies which are equally and uniformly applicable to all entities. The following are
some of the areas wherein different accounting policies are available:

i) Method of depreciation (straight line or Written down value);

ii) Valuation of Inventories (Weighted average, FIFO, etc.);
iii) Valuation of investments and fixed assets (Cost, Market Value, Replacement Value);
iv) Treatment of contingent liabilities;
v) Treatment of goodwill;
vi) Recognition of profit on long term contracts;
vii) Treatment of expenditure during construction period;
viii) Treatment of retirement benefits etc.

The choice of the appropriate accounting principles and the methods of applying those principles to
an enterprise depend on the circumstances in which the enterprise operates.

Factors Affecting Selection of Accounting Policies

The major considerations in the selection of Accounting Policies are:

a) Primary Consideration: The true and fair view of financial statements is one of the most
important factors to be considered in the selection of accounting policies.

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b) Other consideration: In addition to primary consideration, three factors are also considered
in such selection, which are as follows:
1. Prudence: Prudence means conservatism. It requires not to anticipate profits but to
recognize the expenses. The profits are not anticipated in view of uncertainty associated
with future events. Provision should be created for all known liabilities and losses even
though the amount cannot be determined with certainty and represents only a best
estimate in the light of available information. Due to prudence,
 Profits are not overstated
 losses are not understated
 Assets are not overstated and
 Liabilities are not understated.
It may be noted that, prudence does not permit creation of hidden reserve.
2. Substance over Form: It means that the transaction and events relating to business
should be accounted for as per their economic reality with reference to actual happening
in true sense and not in accordance with its legal sense. The Accounting treatment and
presentation should be governed by their substance and not merely by legal form.
For example : In the hire purchase transaction if the assets are purchased, then the
assets are shown in the books of hire – purchase in spite of the fact that the hire purchase
is not the legal owner of the assets purchased. In fact, the purchase becomes owner only
on payment of last installment. Therefore we ignore the legal form of the transaction and
account the transaction as per its substance.
3. Materiality: All material, substantial and important items should be disclosed. The items
is said to be material if the knowledge of it might influence the decisions of user of
financial statements. Materiality is not always a matter of relative size.

3.7 Disclosure of Accounting Policies

The different accounting policies are followed by different entities in the preparation of financial
statements. The results of financial statements are significantly influenced by the accounting
policies which have been followed by the enterprise. For example: if an entity has acquired a
machinery at Rs. 80,000 and they provide depreciation @ 10% p.a. then depreciation would be Rs.
8,000 followed by Rs. 7,200 in second year. Alternatively, if the rate is increased to 20%, then these
figures would become Rs. 16,000 and Rs. 14,400. It is clear that in order to understand and
comprehend the views presented in financial statements requires adequate disclosure of significant
accounting policies. As per Para 18 of Accounting Standard 1 on Disclosure of accounting Policies,
issued by ICAI, “To ensure proper understanding of financial statements, it is necessary that all
significant accounting policies adopted in the preparation and presentation of financial statement
should be disclosed.”
In accordance with the main principles given in Para 24 to 27 of Accounting Standard 1, the
following are the disclosure requirements:
1. An enterprise should disclose
a. All those accounting policies which are significant and
b. At one place and as a part of financial statements

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2. The enterprise should not give any specific disclosure if fundamental accounting assumptions
are followed. For example if an enterprise has prepared their accounts following going
concern concept, then no specific disclosure is required. But, negative disclosure is required if
not followed.
3. In respect of change in accounting policies disclosure is required:
a. If it has a material effect in the current period. Infact, the amount by which any
item is affected, is also disclosed.
b. If it is reasonably expected to have material effect in a later period
c. Where the quantum of effect is not ascertainable, the fact should be disclosed.

Miscellaneous Problems for Practice

Illustration 3.1
State with reasons whether the following statements are true or false:
(i) Expenses represent inflow of resources.
(ii) The first step in measurement of business income is to decide accounting period.
(iii) The revenues must be matched with expenses.
(iv) The matching concept recognizes that business operations will continue for an unlimited
period of time.
(v) Inflation leads to overstatement of Income as historical cost is considered.

Solution
(i) False: The expenses represent the outflow of assets which are incurred or used or
consumed in the process of generating or earning revenues.
(ii) True: The business income reflects the income for a given period. It is not the income
earned during the whole life of business.
(iii) False: The expenses and cost must be matched with periodical revenue. It means the
revenues must be identified before identification of cost and expenses in the process of
measurement of business income.
(iv) False: The Doctrine of Continuity states that business will continue operations for the
foreseeable future.
(v) True: Because the current revenues are matched with the historical costs.

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Chapter 3 9 Theory base of Accounting

Illustration 3.2
State the Accounting Concept or Convention followed in each of the following situations:
(a) Advance received from customer is not treated as sales or income.
(b) The transaction, sale of goods for cash, is recorded by debiting cash and crediting sales
A/c.
(c) Purchase of negligible item like pencils and eraser, is treated as expense.
(d) The amount of capital introduced by the owner is credited to Capital A/c.

Solution
(a) Revenue Recognition concept
(b) Dual Aspect Concept
(c) Materiality Concept
(d) Business Entity Concept

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Chapter 3 10 Theory base of Accounting

TEST YOUR KNOWLEDGE

Objective Type questions

State whether the following statements are True (T) of False (F).
(1) As per Business Entity Concept, the transactions between the business and its owners are
not recorded.
(2) According to Cost Concept, assets are recorded at the value paid or payable for acquiring
them.
(3) Accrual implies following same method of depreciation year after year.
(4) The Money measurement Concept does not allow to record caliber and quality of the
management team as it cannot be measured in monetary terms.
(5) Revenue Recognition concept requires to value the stock at lower of cost and net realizable
value.
[Answers: True:- 2,4 False:- 1,3,5]
Theoretical Questions
1. What do you understand by Accounting Concepts?
2. What are Fundamental Accounting Assumptions? Briefly explain all of them.
3. “Only financial transactions are recorded in accounting.” Explain this statement.
4. Explain the various accounting conventions.
5. A business transaction includes many activities at different points of time. The Realization
Concept states the point of time at which revenues may be recognized. Explain.
6. Briefly explain IFRA and Ind-AS.
7. What are the objectives of Accounting Standards issued by ICAI?
8. Write short notes on the following:
(i) Accounting Period Concept
(ii) Going Concern Concept
(iii) Dual Aspect Concept
(iv) Matching Concept

Basic Accounting for Non-Commerce students(GMC) CA. (Dr.) K. M. Bansal & Dr. Ritu Gupta