Generally Accepted Accounting Principles

The term Accounting Principles refers to the rule of action or conduct to be applied in accounting. Accounting
principles may be defined as "those rules of conduct or procedure which are adopted by the accountants
universally, while recording the accounting transactions." There are a number of accounting principles based on
which we prepare our accounts. These generally accepted accounting principles lay down accepted assumptions
and guidelines and are commonly referred to as accounting concepts and conventions.

The accounting principles can be classified into two categories:

I. Accounting Concepts.
II. Accounting Conventions.

I. Accounting Concepts
Accounting concepts mean and include necessary assumptions or postulates or ideas which are used to
accounting practice and preparation of financial statements. The following are the important accounting
concepts:

(1) Entity Concept

(2) Dual Aspect Concept
(3) Accounting Period Concept
(4) Going Concern Concept (Continuity of Activity)
(5) Cost Concept (Objectivity Concept)
(6) Money Measurement Concept
(7) Matching Concept
(8) Realization Concept
(9) Accrual Concept
(10) Other misc. concepts
● Rupee Value Concept
● Cost-Attach Concept
● Verifiable Objective Evidence Concept
● Uniformity
● Relevance

II. Accounting Conventions

Accounting Convention implies that those customs, methods and practices to be followed as a guideline for
preparation of accounting statements. The important accounting conventions are as follows:

(1) Convention of Disclosure.

(2) Convention of Conservatism.
(3) Convention of Consistency.
(4) Convention of Materiality.

The classification of accounting concepts and conventions can be explained in the following pages.

I. Accounting Concepts
(1) Entity Concept:
The business and its owner(s) are two separate entities (persons). Any private and personal incomes and
expenses of the owner(s) should not be treated as the incomes and expenses of the business. For accounting
purpose the “business” is treated as a separate entity from the proprietor(s).This concept helps in keeping
private affairs of the proprietor away from the business affairs. For example
● If the proprietor of the business invests Rs.50,000 in his business, it is deemed that the proprietor
has given that much amount to the business as loan which will be shown as a liability for the business.
● On withdrawal of any amount by the proprietor it will be credited in cash account and debited in
proprietor's capital account.
● Insurance premiums for the owner’s house should be excluded from the expense of the business.
● The owner’s property should not be included in the premises account of the business.
● Any payments for the owner’s personal expenses by the business will be treated as drawings and
reduced the owner’s capital contribution in the business
Separate entity concept implies that business unit or a company is a body corporate and having a separate
legal entity distinct from its proprietors. The proprietors or members are not liable for the acts of the
company. But in the case of the partnership business or sole trader business there is no separate legal entity
from its proprietors. Here proprietors or members are liable for the acts of the firm. As per the separate
entity concept of accounting it applies to all forms of business to determine the scope of what is to be
 recorded or what is to be excluded from the business books. In conclusion, this separate entity concept
applies much larger in body corporate sectors than sole traders and partnership firms.
(2) Dual Aspect Concept:
According to this concept, every business transaction involves two aspects, namely, for every receiving of
benefit there is a corresponding giving of benefit. The dual aspect concept is the basis of the double entry
book keeping. Accordingly for every debit there is an equal and corresponding credit. The accounting equation
of the dual aspect concept is:
Capital + Liabilities = Assets
(Or)
Assets = Equities (Capital)
The term Capital refers to funds provide by the proprietor of the business concern. On the other hand, the
term liability denotes the funds provided by the creditors and debenture holders against the assets of the
business. The term assets represent the resources owned by the business. For example, Mr. Amit starts
business with cash of Rs. l, 00,000 and building of Rs.5, 00,000, and then this fact is recorded at two
places; Assets Accounts and Capital Account. In other words, the business acquires assets of Rs.6, 00,000
which is equal to the proprietor's capital in the form of cash of Rs. l, 00,000 and building worth of Rs.5,
00,000. The above relationship can be shown in the form of accounting equation:
Capital + Liabilities = Assets
Capital (Rs. l, 00,000 + Rs.5, 00,000) + Liabilities (Nil) = Assets Rs.6, 00,000

(3) Accounting Period Concept:

According to this concept, performance of a business can be analyzed and determined on the basis of suitable
accounting period instead of waiting for a long period, i.e. until it is liquidated (shut down). Being a business is
continuous affairs for an indefinite period of time, the proprietors, the shareholders and outsiders want to
know the financial position of the concern, periodically. Thus, the accounting period is normally adopted for
one year. At the end of the each accounting period an income statement and balance sheet are prepared. This
concept is simply intended for a periodical ascertainment and reporting the true and fair financial position of
the concern as a whole.

(4) Going Concern Concept (Continuity of Activity):

It is otherwise known as Continuity of Activity Concept. This concept assumes that business concern will
continue for a long period to exist. In other words, under this assumption, the enterprise is normally viewed as
a going concern and it is not likely to be liquidated in the near future. This assumption implies that while
valuing the assets of the business, the basis is productivity and not the basis of their realizable value or the
present market value. Fixed assets are valued at cost less depreciation till date for the purpose of balance
sheet. This concept is useful in valuation of assets and liabilities, depreciation of fixed assets and treatment
of prepaid expenses. Due to application of this concept,
● Possible losses from the closure of business will not be anticipated in the accounts.
● Prepayments, depreciation provisions may be carried forward in the expectation of proper matching
against the revenues of future periods.
● Fixed assets are recorded at historical cost.

(5) Cost Concept (Objectivity Concept):

This concept is based on "Going Concern Concept." Cost Concept implies that assets acquired are recorded in
the accounting books at the cost or price paid to acquire it. And this cost is the basis for subsequent
accounting for the asset. This concept does not recognize the realizable value, the replacement value or the
real worth of an asset. For accounting purpose the market value of assets are not taken into account either
for valuation or charging depreciation of such assets. Cost Concept has the advantage of bringing objectivity in
the preparation and presentation of financial statements. In the absence of cost concept, figures shown in
accounting records would be subjective and questionable. But due to inflationary tendencies, the preparation of
financial statements on the basis of cost concept has become irrelevant for judging the true financial position
of the business.

(6) Money Measurement Concept:

According to this concept, accounting transactions are measured, expressed and recorded in terms of money.
This concept excludes those transactions or events which cannot be expressed in terms of money, even if they
are very important or useful for the business. For example, factors such as
● the death of an executive
● resignation of a manager
● the skill of the supervisor,
● market conditions & technological changes,
● the efficiency of management
● employer-employee relationship
cannot be recorded in accounts in spite of their importance to the business. This makes the financial statements
incomplete.
 (7) Matching Concept:
Matching Concept is closely related to accounting period concept. The chief aim of the business concern is to
ascertain the profit periodically. To ascertain the profit made during a period, it is necessary to match
“revenues” of the period with the “expenses” of that period. Income (profit) earned by the business during a
period is compared with the expenditure incurred to earn the revenue. Thus, matching of costs and revenues
related to a particular period is called as Matching Concept. Due to application of this concept,
● Expenses incurred but not yet paid in current period should be treated as accrual/accrued expenses
under current liabilities
● Expenses incurred in the following period but paid for in advance should be treated as prepayment
expenses under current asset
● Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use

(8) Realization Concept (Revenue Recognition Concept):

Realization Concept is otherwise known as Revenue Recognition Concept. As per AS 9, Revenue is the gross
inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an
enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise
resources yielding interest, royalties and dividends.
According to this concept profit should be accounted for only when it is actually realized. Revenue is
recognized only when sale is affected or the services are rendered. However, in order to recognize revenue,
receipt of cash is not essential. Even credit sale results in realization as it creates a definite asset called
“Account Receivable”. However there are certain exception to the concept like in case of contract accounts,
hire purchase etc. Similarly incomes like commission interest rent etc. are shown in Profit and Loss A/c on
accrual basis though they may not be realized in cash on the date of preparing accounts.

(9) Accrual Concept:

Accrual Concept is closely related to Matching Concept. According to this concept, revenue recognition depends
on its realization and not on its actual receipt. Likewise costs are recognized when they are incurred and not
when paid. The accrual concept ensures that the profit or loss shown is on the basis of full fact relating to all
expenses and incomes. Under the accrual system, revenue and expenses are identified with specific periods of
time like a month, half year or a year. It implies recording of revenues and expenses of a particular
accounting period, whether they are received/paid in cash or not.

(10)Other misc. concepts:

● Rupee Value Concept:
This concept assumes that the value of rupee is constant. In fact, due to inflationary pressures, the value of
rupee will be declining. Under this situation financial statements are prepared on the basis of historical costs
not considering the declining value of rupee. Similarly depreciations also charged on the basis of cost price.
Thus, this concept results in underestimation of depreciation and overestimation of assets in the balance sheet
and hence will not reflect the true position of the business.

● Cost-Attach Concept:
This concept is also known as “cost-merge” concept. When a finished good is produced from the raw material there
are certain process and costs which are involved like labor cost, power and other overhead expenses. These
costs have a capacity to “merge” or “attach” when they are brought together.

● Verifiable Objective Evidence Concept:

According to this concept the accounting information should be free from bias and capable of independent verification.
All accounting transactions should be evidenced and supported by objective documents. The information should
be based upon verifiable evidence such as invoices, contracts, correspondence, vouchers, bills, passbooks,
cheque etc.

● Uniformity:
Different companies within the same industry should adopt the same accounting methods and treatments for like
transactions. The practice enables inter-company comparisons of their financial positions.

● Relevance:
Financial statements should be prepared to meet the objectives of the users. Relevant information which can satisfy
the needs of most users is selected and recorded in the financial statement
 II. Accounting Conventions
(1) Convention of Disclosure:
The disclosure of all material information is one of the important accounting conventions. According to this
convention all accounting statements should be honestly prepared and all facts and figures must be disclosed
therein. The disclosure of financial information is required for different parties who are interested in the
welfare of that enterprise. The Companies Act lays down the forms of Profit and Loss Account and Balance
Sheet. The convention of disclosure is required to be followed as per the requirement of the Companies Act
and Income Tax Act. Thus as per application of this convention
● Financial statements should be prepared to reflect a true and fair view of the financial position and
performance of the enterprise
● All material and relevant information must be disclosed in the financial statements

(2) Convention of Conservatism (prudence):

This convention is closely related to the policy of playing safe. This principle is often described as "anticipate
no profit, and provide for all possible losses." Thus, this convention emphasizes that uncertainties and risks
inherent in business transactions should be given proper consideration. Under this convention revenues and
profits are not anticipated. Only realized profits with reasonable certainty are recognized in the profit and
loss account. However, provision is made for all known expenses and losses whether the amount is known for
certain or just estimation, For example,
● Inventory is valued at cost price or net realizable value whichever is lower.
● Provision for bad and doubtful debts is made in the books before ascertaining the profit.
● Fixed assets are depreciated over their useful economic lives
This treatment minimizes the reported profits and the valuation of assets

(3) Convention of Consistency:

The Convention of Consistency implies that accounting policies, procedures and methods should remain
unchanged for preparation of financial statements from one period to another. Under this convention
alternative improved accounting policies are also equally acceptable. Companies should choose the most suitable
accounting methods and treatments, and consistently apply them in every period. Changes are permitted only
when the new method is considered better and can reflect the true and fair view of the financial position of
the company. The change and its effect on profits should be disclosed in the financial statements. In order to
measure the operational efficiency of a concern, this convention allows a meaningful comparison in the
performance of different period. Thus as per application of this convention
● If a company adopts straight line method, it should not be changed to adopt reducing balance method
in other period
● If a company adopts weight-average method as stock valuation, it should not be changed to other
method e.g. first-in-first-out method

(4) Convention of Materiality:

According to Kohler's Dictionary of Accountants Materiality may be defined as "the characteristic attaching to
a statement, fact, or item whereby its disclosure or method of giving it expression would be likely to influence
the judgment of a reasonable person." According to this convention consideration is given to all material
events, insignificant details are ignored while preparing the profit and loss account and balance sheet.
Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be
presented separately. The evaluation and decision of material or immaterial depends upon on the size and
nature of the item, the circumstances and lies at the discretion of the Accountant. For example
● Small payments such as postage, stationery and cleaning expenses should not be disclosed separately.
They should be grouped together as sundry expenses
● The cost of small-valued assets such as calculators, pencil sharpeners and paper clips should be written
off to the profit and loss account as revenue expenditures, although they can last for more than one
accounting period