ACCOUNTING PRINCIPLES/STANDARDS

What Are Generally Accepted Accounting Principles (GAAP)?

Generally accepted accounting principles (GAAP) refer to a common set of accounting

principles, standards, and procedures issued by the Financial Accounting Standards Board
(FASB). Companies must follow GAAP when their accountants compile their financial
statements.

Key Takeaways

 GAAP is the set of accounting principles set forth by the FASB that companies must
follow when putting together financial statements.
 GAAP aims to improve the clarity, consistency, and comparability of the communication
of financial information.
 GAAP may be contrasted with pro forma accounting, which is a non-GAAP financial
reporting method.
 The ultimate goal of GAAP is to ensure a company's financial statements are complete,
consistent, and comparable.
 There are key concepts that guide the principles of GAAP.

What are the Basic Accounting Principles?

Accounting principles are the rules that an organization follows when reporting financial
information. A number of basic accounting principles have been developed through common
usage. They form the basis upon which the complete suite of accounting standards have been
built. The best-known of these principles are as follows:

 Accrual principle. Financial statements are prepared under the Accruals Concept of
accounting which requires that income and expense must be recognized in the accounting
periods to which they relate rather than on cash basis. An exception to this general rule is
the cash flow statement whose main purpose is to present the cash flow effects of
transaction during an accounting period.

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 Under Accruals basis of accounting, income must be recorded in the accounting period in
which it is earned. Therefore, accrued income must be recognized in the accounting
period in which it arises rather than in the subsequent period in which it will be received.
Conversely, prepaid income must be not be shown as income in the accounting period in
which it is received but instead it must be presented as such in the subsequent accounting
periods in which the services or obligations in respect of the prepaid income have been
performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are
incurred.

Therefore, accrued expense must be recognized in the accounting period in which it

occurs rather than in the following period in which it will be paid. Conversely, prepaid
expense must not be shown as expense in the accounting period in which it is paid but
instead it must be presented as such in the subsequent accounting periods in which the
services in respect of the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue
earned in an accounting period. Accruals concept is therefore very similar to the
matching principle.

 Conservatism principle. This is the concept that you should record expenses and
liabilities as soon as possible, but to record revenues and assets only when you are sure
that they will occur. This introduces a conservative slant to the financial statements that
may yield lower reported profits, since revenue and asset recognition may be delayed for
some time. Conversely, this principle tends to encourage the recordation of losses earlier,
rather than later. This concept can be taken too far, where a business persistently
misstates its results to be worse than is realistically the case.

 Consistency principle. This is the concept that, once you adopt an accounting principle
or method, you should continue to use it until a demonstrably better principle or method
comes along. Not following the consistency principle means that a business could
continually jump between different accounting treatments of its transactions that makes
its long-term financial results extremely difficult to discern.

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 Cost principle. This is the concept that a business should only record its assets,
liabilities, and equity investments at their original purchase costs. This principle is
becoming less valid, as a host of accounting standards are heading in the direction of
adjusting assets and liabilities to their fair values.

 Economic entity principle. This is the concept that the transactions of a business should
be kept separate from those of its owners and other businesses. This prevents
intermingling of assets and liabilities among multiple entities, which can cause
considerable difficulties when the financial statements of a fledgling business are first
audited.

 Full disclosure principle. This is the concept that you should include in or alongside the
financial statements of a business all of the information that may impact a reader's
understanding of those statements. The accounting standards have greatly amplified upon
this concept in specifying an enormous number of informational disclosures.

 Going concern principle. This is the concept that a business will remain in operation for
the foreseeable future. This means that you would be justified in deferring the recognition
of some expenses, such as depreciation, until later periods. Otherwise, you would have to
recognize all expenses at once and not defer any of them.

 Matching principle. This is the concept that, when you record revenue, you should
record all related expenses at the same time. Thus, you charge inventory to the cost of
goods sold at the same time that you record revenue from the sale of those inventory
items. This is a cornerstone of the accrual basis of accounting. The cash basis of
accounting does not use the matching the principle.

 Materiality principle. Information is material if its omission or misstatement could

influence the economic decisions of users taken on the basis of the financial statements
(IASB Framework). Materiality therefore relates to the significance of transactions,
balances and errors contained in the financial statements. Materiality defines the
threshold or cutoff point after which financial information becomes relevant to the
decision making needs of the users. Information contained in the financial statements

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 must therefore be complete in all material respects in order for them to present a true and
fair view of the affairs of the entity.

Materiality is relative to the size and particular circumstances of individual companies.

Example - Size

A default by a customer who owes only $1000 to a company having net assets of worth
$10 million is immaterial to the financial statements of the company.

However, if the amount of default was, say, $2 million, the information would have been
material to the financial statements omission of which could cause users to make
incorrect business decisions.

 Monetary unit principle. This is the concept that a business should only record
transactions that can be stated in terms of a unit of currency. Thus, it is easy enough to
record the purchase of a fixed asset, since it was bought for a specific price, whereas the
value of the quality control system of a business is not recorded. This concept keeps a
business from engaging in an excessive level of estimation in deriving the value of its
assets and liabilities.

 Reliability principle. This is the concept that only those transactions that can be proven
should be recorded. For example, a supplier invoice is solid evidence that an expense has
been recorded. This concept is of prime interest to auditors, who are constantly in search
of the evidence supporting transactions.

 Revenue recognition principle. This is the concept that you should only recognize
revenue when the business has substantially completed the earnings process. So many
people have skirted around the fringes of this concept to commit reporting fraud that a
variety of standard-setting bodies have developed a massive amount of information about
what constitutes proper revenue recognition.

 Time period principle. This is the concept that a business should report the results of its
operations over a standard period of time. This may qualify as the most glaringly obvious

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 of all accounting principles, but is intended to create a standard set of comparable
periods, which is useful for trend analysis.

 Dual Aspect Concept | Duality Principle in Accounting

Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of

accounting that necessitates the recognition of all aspects of an accounting transaction.
Dual aspect concept is the underlying basis for double entry accounting system.

Explanation

In a single entry system, only one aspect of a transaction is recognized. For instance, if a
sale is made to a customer, only sales revenue will be recorded. However, the other side
of the transaction relating to the receipt of cash or the grant of credit to the customer is
not recognized.

Single entry accounting system has been superseded by double entry accounting. You
may still find limited use of single entry accounting system by individuals and small
organizations that keep an informal record of receipts and payments.

Double entry accounting system is based on the duality principle and was devised to
account for all aspects of a transaction. Under the system, aspects of transactions are
classified under two main types:

1. Debit (Dr)

2. Credit (Cr)

Debit is the portion of transaction that accounts for the increase in assets and expenses,
and the decrease in liabilities, equity and income.

Credit is the portion of transaction that accounts for the increase in income, liabilities and
equity, and the decrease in assets and expenses.

The classification of debit and credit effects is structured in such a way that for each debit
there is a corresponding credit and vice versa. Hence, every transaction will have 'dual'
effects (i.e. debit effects and credit effects).

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The application of duality principle therefore ensures that all aspects of a transaction are
accounted for in the financial statements.

Exercise

Mr ABC started business in the month of January

Jan 1 Started business with 500 cash

Jan 4 Bought goods for cash 85

Jan 10 Bought goods on credit 116 from E morgan

Jan 15 Sold goods for cash 42

Jan 19 Returned goods to Homes 18

Jan 20 Sold goods to James 55 on credit

Amounts are in dollars

Required: Prepare a double entry for the above transactions.

Limitations of accounting principles.

1. Recording only monetary items

As per accounting principal, only the events measurable in terms of money are recorded
in the books of accounts. But events of great importance, if not measurable in terms of
money, are not accounted for.

For that reason, recorded accounting information fails to exhibit the exact financial
position of a business concern.

2. Time

Value of Money

Under the accounting system money value is treated constantly.

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But the value of money always changes due to inflation. Under existing accounting
systems, accounts are maintained considering historical cost ignoring current changed
value.

As a result, the accounts maintained fail to exhibit the exact financial position of a
business concern.

3. Recommendation of alternative methods

There exists an application of alternative methods in determining depreciation of assets

and valuation of stock etc. Information regarding the activities of the business is
expressed in a misleading way if an alternative method is used to achieve a particular
object.

4. Restrain of Accounting Principles

Exhibited accounting information cannot always exhibit a true and fair picture of a
business concern owing to limitations of the accounting principles used.

For example, Fixed assets are shown after deducting depreciation. In the case of inflation,
the value of fixed assets shown in the accounts does not correspond to the real position.

5. Recording of past events

Accounting past events are accounted for. But naturally, there is no system of recording
events that may occur in the future.

6. Allocation of problem

The allocation process is an important problem in the accounting system. The value of
fixed assets is exhausted, charging depreciation for the allocated period.

The useful life of fixed assets is fixed up hypothetically, which does not stand accurately
in most cases.

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7. Maintaining secrecy

Secrecy cannot be ensured for the involvement of many employees in accounting work,
although maintaining secrecy is very important.

8. The tendency for secret reserves

Often management creates secret reserves intentionally by increasing or decreasing assets

and liabilities for which the total financial picture of an organization is not reflected.