2.1 Generally Accepted Accounting Principles (GAAP)
- Need for Theory Base: Accounting aims to provide information about a firm’s financial performance to various users (owners, managers, investors, creditors, etc.) to help them make important decisions. For this information to be meaningful, it must be reliable and comparable, both for inter-firm and inter-period comparisons. This requires consistency in accounting policies, principles, and practices, which necessitates a proper theory base of accounting. No discipline can develop without a sound theoretical base.
- Composition of Theory Base: The theory base of accounting consists of principles, concepts, rules, and guidelines developed over time to bring uniformity and consistency to accounting processes and enhance utility for users.
- Definition of GAAP: To maintain uniformity and consistency, certain rules or principles, generally accepted by the accounting profession, have been developed. These are called Generally Accepted Accounting Principles (GAAP). GAAP refers to the rules or guidelines adopted for recording and reporting business transactions to ensure uniformity in financial statement preparation and presentation.
- Evolution and Nature: GAAP has evolved over a long period based on past experiences, customs, statements by professional bodies, and government regulations, gaining general acceptability among accounting professionals. However, these principles are not static and are influenced by changes in legal, social, and economic environments, as well as user needs.
- Interchangeability of Terms: Terms like principles, concepts, conventions, postulates, assumptions, and modifying principles are used interchangeably. In this context, they are referred to as Basic Accounting Concepts.
2.2 Basic Accounting Concepts
These are the fundamental ideas or basic assumptions underlying financial accounting theory and practice, serving as broad working rules for all accounting activities.
Business Entity Concept:
- Assumes that a business has a distinct and separate entity from its owners.
- For accounting purposes, the business and its owners are treated as two separate entities.
- Owner’s capital is treated as a liability of the business to the owner.
- Owner’s drawings reduce capital and business liabilities.
- Accounting records are made from the business’s viewpoint, not the owner’s.
- Personal assets and liabilities of the owner are not considered in business records, nor are personal transactions unless they involve business funds.
Money Measurement Concept:
- States that only transactions and happenings expressible in monetary terms (e.g., sale of goods, payment of expenses) are recorded.
- Qualitative aspects (e.g., manager’s appointment, human resource capabilities, organization’s image) are not recorded.
- Records are kept in monetary units, not physical units.
- Limitation: This concept does not account for changes in the value of money due to price changes, leading to the addition of heterogeneous values in financial statements (e.g., assets bought at different times) and potentially not reflecting a true and fair view of affairs.
Going Concern Concept:
- Assumes a business firm will continue operations indefinitely, not being liquidated in the foreseeable future.
- This assumption provides the basis for valuing assets in the balance sheet.
- It allows for charging only the consumed part of an asset as an expense from current revenue, carrying forward the remaining amount to future periods over the asset’s estimated life. Without this, the entire cost would be expensed in the purchase year.
Accounting Period Concept:
- Refers to the time span at the end of which financial statements are prepared to ascertain profits/losses and the position of assets/liabilities.
- Information is required regularly for decision-making.
- Financial statements are normally prepared annually, though interim statements may be necessary in certain situations (e.g., partner retirement, quarterly results for listed companies).
Cost Concept:
- Requires all assets to be recorded at their purchase price, including acquisition cost, transportation, installation, and making the asset ready for use.
- This concept is historical, meaning the recorded cost remains constant despite market value changes.
- Advantage: Brings objectivity to recording as cost is verifiable from purchase documents. Market value is unreliable due to fluctuations.
- Limitation: Does not show the true worth of the business and may lead to “hidden profits” during rising prices, where market value exceeds recorded cost.
Dual Aspect Concept (or Duality):
- This is the foundation of accounting.
- States that every transaction has a dual or two-fold effect and should be recorded at two places, involving at least two accounts.
- Examples: Investment of capital increases cash (asset) and capital (owner’s equity). Purchasing goods for cash increases stock (asset) and reduces cash (asset). Purchasing machinery on credit increases machinery (asset) and liabilities (creditor).
- Expressed by the fundamental Accounting Equation: Assets = Liabilities + Capital.
- This concept forms the core of the Double Entry System.
Revenue Recognition (Realisation) Concept:
- Requires revenue to be included in accounting records only when it is realized.
- Revenue Definition: Gross inflow of cash from (i) sale of goods/services, and (ii) use of enterprise’s resources yielding interest, royalties, dividends.
- When Realized: Revenue is realized when a legal right to receive it arises (i.e., goods sold or service rendered). Credit sales are revenue when made, not when cash is received.
- Income like rent, commission, interest is recognized on a time basis (e.g., March rent for the March financial year, even if received in April).
- Exceptions: Proportionate revenue recognition for long-term contracts (e.g., construction work) and for installments collected on hire purchase sales.
Matching Concept:
- Emphasizes that expenses incurred in an accounting period should be matched with revenues earned during that same period.
- Revenue is recognized when sales are complete or service rendered, not when cash is received.
- Expenses are recognized when an asset or service is used to generate revenue, not when cash is paid (e.g., salaries, rent, insurance, depreciation are recognized based on the period they relate to or are used).
- When calculating profit/loss, only the cost of goods sold during the period should be matched against sales revenue, not the cost of all goods produced/purchased.
- Implies that all revenues earned and all costs incurred in an accounting year, regardless of cash receipt or payment, should be considered for profit/loss ascertainment.
Full Disclosure Concept:
- Financial statements are the primary means of communicating financial information to interested parties.
- Requires full, fair, and adequate disclosure of all material and relevant facts concerning an enterprise’s financial performance in the financial statements and accompanying footnotes.
- This enables users to make correct assessments of profitability and financial soundness, aiding informed decisions.
- Regulatory bodies like the Indian Companies Act 1956 and SEBI mandate comprehensive disclosures to ensure a true and fair view.
Consistency Concept:
- Accounting information is useful for comparisons (inter-firm and inter-period) only if accounting policies and practices are uniform and consistent over time.
- Inconsistent policies (e.g., different depreciation methods) make profit figures incomparable.
- Consistency eliminates personal bias and aids comparability of results across accounting periods and between enterprises.
- Consistency does not prohibit changes in accounting policies, but required changes must be fully disclosed with their probable effects on financial results.
Conservatism Concept (Prudence):
- Provides guidance for recording transactions based on a “playing safe” policy.
- Requires a conscious approach to avoid overstating profits, which could lead to dividend distribution out of capital.
- States that profits should not be recorded until realized, but all losses, even those with remote possibilities, must be provided for.
- Examples: Valuing closing stock at cost or market value, whichever is lower; creating provisions for doubtful debts; writing off intangible assets.
- If market value of stock falls, it’s shown at cost; if it rises, the gain isn’t recorded until sale.
- This approach reflects a generally pessimist attitude but helps manage uncertainty and protects creditors.
- Deliberate underestimation of assets leading to “secret reserves” should be discouraged.
Materiality Concept:
- Requires accounting to focus on material facts; efforts should not be wasted on immaterial facts for income determination.
- Material Fact Definition: A fact is material if its knowledge would reasonably influence the decision of an informed user of financial statements.
- Examples of material facts: Money spent on increasing theatre capacity (increases future earning capacity), change in depreciation method, likely future liabilities.
- When amounts are very small, strict adherence to accounting principles is not required (e.g., stationery treated as expense, not asset).
Objectivity Concept:
- Requires accounting transactions to be recorded objectively, free from bias of accountants and others.
- This is achieved when transactions are supported by verifiable documents or vouchers (e.g., cash receipts, invoices, delivery challans).
- Adoption of ‘Historical Cost’ is partly due to its enabling objectivity, as actual cost is verifiable, unlike fluctuating market values.
2.3 Systems of Accounting
The two main systems for recording transactions:
Double Entry System:
- Based on the “Dual Aspect” principle, where every transaction has two effects: receiving a benefit and giving a benefit.
- Each transaction involves two or more accounts and is recorded in different places.
- Basic principle: every debit must have a corresponding credit.
- A complete, accurate, and reliable system, minimizing frauds and mis-appropriations, and allowing arithmetic inaccuracies to be checked by trial balance.
- Can be implemented by both large and small organizations.
Single Entry System:
- An incomplete system of financial record maintenance.
- Does not record the two-fold effect of every transaction.
- Only personal accounts and cash book are typically maintained.
- Lacks uniformity in recording transactions; for some, only one aspect is recorded, for others, both.
- Accounts are incomplete, unsystematic, and therefore not reliable.
- Followed by small businesses due to its simplicity and flexibility.
2.4 Basis of Accounting
Two broad approaches to accounting based on timing of revenue and cost recognition:
Cash Basis:
- Entries are made when cash is received or paid, not when due.
- Example: December rent paid in January is recorded in January. Credit sales are recorded when payment is received, not at the time of sale.
- Incompatible with the matching principle.
- Profit is calculated as the difference between receipts and disbursements, rather than on the occurrence of transactions.
- Though simple, it’s inappropriate for most organizations.
Accrual Basis:
- Revenues and costs are recognized in the period they occur, rather than when cash is paid or received.
- Distinguishes between receipt/payment of cash and the right to receive/obligation to pay cash.
- More appropriate for profit calculation as expenses are matched against related revenue.
2.5 Accounting Standards
- Definition: Written policy documents covering recognition, measurement, treatment, presentation, and disclosure of accounting transactions in financial statements.
- Issuing Body: Authoritative statements issued by the Institute of Chartered Accountants of India (ICAI).
- Objective: To bring uniformity in accounting policies, eliminate non-comparability of financial statements, and enhance their reliability. They provide standard accounting policies, valuation norms, and disclosure requirements.
- Benefits:
- Eliminates variations in accounting treatment for financial statement preparation.
- May require disclosures not mandated by law but useful for the public, investors, and creditors.
- Facilitates comparability of financial statements both within the same company over different periods (intra-company) and between different companies (inter-company).
- Limitations:
- Makes choosing between alternative accounting treatments difficult.
- Can be rigid, limiting flexibility in applying standards.
- Cannot override statutes; must be framed within the ambit of prevailing laws.
Goods and Services Tax (GST)
- Nature: A destination-based tax on the consumption of goods and services.
- Levy: Proposed to be levied at all stages from manufacture to final consumption, with credit for taxes paid at previous stages (set-off). Only value addition is taxed, with the burden borne by the final consumer.
- Destination-based Tax: Tax accrues to the taxing authority with jurisdiction over the place of consumption (place of supply).
- Dual Aspect: Both Central and State governments simultaneously levy GST on a common tax base.
- Components:
- CGST (Central Goods and Services Tax): Revenues go to the Central Government. Subsumes central excise duty, additional excise duty, special excise duty, central sales tax, etc..
- SGST (State Goods and Services Tax): Revenues go to the State Government. Merges state taxes like VAT, entertainment tax, luxury tax, entry tax, etc..
- IGST (Integrated Goods and Services Tax): Levied on inter-state transfer of goods and services, and on import of goods and services. Revenue is divided between Central and State Governments as per specified rates.
- Fiscal Federalism: India’s Constitution allows both Centre and States to levy taxes. Dual GST aligns with this, with Centre administering CGST & IGST, and States administering SGST.
- Characteristics:
- Common law and procedure under a single administration nationwide.
- Destination-based, levied at consumption point.
- Comprehensive levy on both goods and services at the same rate with input tax credit.
- Minimum number of rates (not exceeding two).
- No scope for cess, resale tax, additional tax, turnover tax, multiple levies (sales tax, entry tax, octroi, entertainment tax, luxury tax).
- Advantages:
- Abolition of multiple taxes on goods and services.
- Widens tax base, increases revenue for Centre and State, reduces administrative costs.
- Reduced compliance cost and increased voluntary compliance.
- Affected rates of tax to a maximum of two floor rates.
- Removed the cascading effect of taxation.
- Enhances manufacturing and distribution, affecting production costs, leading to increased demand and production.
- Promotes economic efficiency and sustainable long-term economic growth as it is neutral to business processes, models, structure, and location.
- Helps extend competitive edge in international markets, leading to increased exports.
