Theory Base of Accounting: GAAP, Basic Concepts, and Systems

The Need for a Theory Base in Accounting

• Definition: The theory base of accounting consists of principles, concepts, rules, and guidelines developed over time to bring uniformity and consistency to the process of accounting and enhance its utility to different users of accounting information.

• Core Purpose: Accounting is concerned with the recording, classifying, and summarising of financial transactions and events and interpreting their results. It aims to provide information about the financial performance of a firm to various users, including:

  • Owners and managers.

  • Employees.

  • Investors (interested in profit/loss and performance comparisons).

  • Creditors and bankers (interested in liquidity position).

  • Suppliers of goods and services.

  • Tax authorities.

• Reliability and Comparability: For information to be meaningful, it must be:

  • Reliable: Accurate and trustworthy.

  • Comparable: Necessary for inter-firm comparison (comparing performance between different firms) and inter-period comparison (comparing a firm's current performance with its own previous years).

• Consistency: Consistency is required throughout identifying, measuring, communicating, and reporting transactions. This is achieved through adhering to consistent accounting policies, principles, and practices.

• Regulatory Body: The Institute of Chartered Accountants of India (ICAI) is the regulatory body for the standardisation of accounting policies in India. They issue Accounting Standards to be uniformly followed.

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Generally Accepted Accounting Principles (GAAP)

• Definition: GAAP refers to the rules or guidelines adopted for recording and reporting business transactions to bring uniformity in the preparation and presentation of financial statements.

• Synonymous Terms: These rules are also known as principles, concepts, conventions, postulates, assumptions, and modifying principles.

• AICPA Definition: The American Institute of Certified Public Accountants (AICPA) defines a principle as: "A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice."

• Characteristics of GAAP:

  • General Acceptability: The word "generally" implies pertaining to many persons, cases, or occasions.

  • Evolutionary: These principles have evolved over a long period based on past experiences, usages, customs, professional body statements, and government regulations.

  • Non-static: Principles are influenced by changes in legal, social, and economic environments, as well as user needs.

  • Objectivity: For example, recording transactions at historical cost provides objectivity because it is verifiable through documents like cash receipts.

• Concepts vs. Conventions:

  • Concepts: Fundamental ideas and necessary assumptions underlying accounting practice.

  • Conventions: Customs or traditions used as a guide to preparing accounting statements.

  • Practical Usage: In practice, these terms are used interchangeably and are referred to as Basic Accounting Concepts.

Basic Accounting Concepts

2.2.1 Business Entity Concept

• Assumption: A business has a distinct and separate entity from its owners.

• Accounting Treatment: Business and owners are treated as two separate entities.

• Capital as a Liability: When an owner invests money (Capital), it is recorded as a liability of the business to the owner.

• Drawings: When an owner withdraws money for personal use, it is treated as a reduction of the owner's capital and a reduction in the business's liabilities.

• Point of View: Records are made from the perspective of the business unit, not the owner. Personal assets, liabilities, and transactions of the owner are not recorded unless they involve the inflow or outflow of business funds.

2.2.2 Money Measurement Concept

• Core Rule: Only transactions and happenings that can be expressed in terms of money (e.g., sale of goods, payment of expenses) are recorded.

• Non-Monetary Exclusions: Facts like the appointment of a manager, human resource capabilities, creativity, or organizational image are not recorded.

• Monetary Unit over Physical Units: Assets are recorded in currency ($rupees$ and $paise$) rather than physical units.

  • Example: If a firm has $2\,acres$ of land, $10\,rooms$, $30\,computers$, and $20\,tons$ of raw material, these cannot be added meaningfully. Instead, they are valued: Land ($2\,crore$), Building ($1\,crore$), Computers ($15\,lakh$), Furniture ($2\,lakh$), Raw Material ($33\,lakh$), and Finished Goods ($4\,lakh$), totaling $3\,crore\,59\,lakh$.

• Limitation: The value of money is not stable due to price changes. Adding a building bought in 1995 for $2\,crore$ and a plant bought in 2005 for $1\,crore$ involves heterogeneous values, as the purchasing power of the rupee has changed.

2.2.3 Going Concern Concept

• Assumption: A business will continue its operations indefinitely and will not be liquidated in the foreseeable future.

• Basis for Asset Valuation: This allows for assets to be valued based on their service life rather than immediate market value.

  • Example: A computer purchased for $50,000$ with a $5\,year$ life is not charged as a single expense. Instead, the cost is spread. If $10,000$ is charged annually for $5\,years$, the remaining value is carried forward as an asset. Without this assumption, the full $50,000$ would be charged in the year of purchase.

2.2.4 Accounting Period Concept

• Definition: The span of time (usually one year) at the end of which financial statements are prepared to ascertain profit/loss and financial position.

• Frequency: Users require timely information for decision-making.

• Legal Requirements: The Companies Act 2013 and the Income Tax Act require annual statements.

• Interim Reports:

  • Quarterly Results: Companies listed on stock exchanges must publish results every $3\,months$.

  • Specific Situations: The accounting period may be shorter than $12\,months$, such as upon the retirement of a partner.

2.2.5 Cost Concept

• Rule: Assets are recorded at their purchase price, including cost of acquisition, transportation, installation, and making the asset ready for use.

• Historical Nature: The cost is historical and does not change with market fluctuations.

  • Illustration: Shiva Enterprise (June 2005) buys a plant for $50\,lakh$, spends $10,000$ on transport, $15,000$ on repairs, and $25,000$ on installation. Total recorded cost = $50,50,000$.

• Merit: It brings objectivity as costs are verifiable from documents.

• Demerit: It may not reflect the true worth or replacement cost, leading to "hidden profits" during periods of rising prices.

2.2.6 Dual Aspect Concept

• Foundation: Every transaction has a two-fold effect and must be recorded in at least two accounts.

• Examples:

  • Investing $50,00,000$ capital: Increases Cash (Asset) and increases Capital.

  • Purchasing goods for $10,00,000$ cash: Increases Stock (Asset) and decreases Cash (Asset).

  • Purchasing machinery for $30,00,000$ on credit: Increases Machinery (Asset) and increases Creditor (Liability).

• Accounting Equation:     $\text{Assets} = \text{Liabilities} + \text{Capital}$

• This concept is the core of the Double Entry System.

2.2.7 Revenue Recognition (Realisation) Concept

• Rule: Revenue is included in records only when it is realized.

• Definition of Revenue: Gross inflow of cash/receivables from sales, services, interest, royalties, and dividends.

• Timing of Realisation: Revenue is realized when a legal right to receive it arises (point of sale/service), not necessarily when cash is received.

  • Example: Rent for March 2017 received in April 2017 is recorded in the 2016-17 fiscal year. Interest for April 2017 received in March 2017 is recorded in the 2017-18 fiscal year.

• Exceptions:

  • Construction Contacts: Revenue is recognized proportionately based on the part of work completed over $2-3\,years$.

  • Hire Purchase: Revenue is treated as realized when installments are collected.

2.2.8 Matching Concept

• Rule: Expenses incurred in an accounting period must be matched with the revenues earned during that same period.

• Application:

  • Expenses like salaries and insurance are recognized based on the period they relate to, not when paid.

  • Depreciation of fixed assets is divided over the periods the asset is used.

  • Cost of Goods Sold: Only the cost of goods actually sold during the year is deducted from revenue, not the total cost of all goods produced/purchased. Unsold stock is carried forward.

2.2.9 Full Disclosure Concept

• Rule: All material and relevant facts must be completely disclosed in financial statements or accompanying footnotes.

• Legal Compliance: The Indian Companies Act 1956 provides a mandatory format for profit and loss accounts and balance sheets. Regulatory bodies like SEBI also mandate disclosures to ensure a "true and fair" view.

2.2.10 Consistency Concept

• Rule: Accounting policies and practices should remain uniform from one period to another to allow for valid comparisons.

• Example: If the method of depreciation or stock valuation changes every year, net profit figures become non-comparable.

• Flexibility: Change is not prohibited, but any change in policy and its financial effect must be disclosed.

2.2.11 Conservatism (Prudence) Concept

• Rule: Take a "play safe" approach. Do not anticipate profits, but provide for all possible losses.

• Examples:

  • Valuing closing stock at cost or market value, whichever is lower.

  • Creating provisions for doubtful debts.

  • Writing off intangible assets like goodwill or patents.

• Warning: Deliberate underestimation of assets leads to secret reserves, which should be discouraged.

2.2.12 Materiality Concept

• Rule: Accounting should focus on material facts that would influence the decision of an informed user.

• Definition of Materiality: Depends on the nature and amount involved.

• Example: Revenue vs. Capital expenditure. Small items like pencils or erasers are treated as expenses in the year of purchase rather than assets, even if they aren't fully consumed.

2.2.13 Objectivity Concept

• Rule: Transactions must be recorded in an objective manner, free from bias, supported by verifiable documents (vouchers, cash receipts, invoices, delivery challans).

• Basis for Historical Cost: Historical cost is preferred because it is objectively verifiable, unlike market value which varies by person and place.

Systems and Basis of Accounting

Systems of Accounting

1. Double Entry System:

   • Based on "Dual Aspect."

   • Records both aspects (receiving and giving a benefit).

   • Rule: Every debit has a corresponding credit.

   • Complete, accurate, and minimizes fraud. Arithmetical accuracy is checked via Trial Balance.

2. Single Entry System:

   • Incomplete and unsystematic; does not record the two-fold effect of every transaction.

   • Only personal accounts and cash books are typically maintained.

   • Used by small firms due to simplicity/flexibility.

Basis of Accounting

1. Cash Basis: Entries are made only when cash is received or paid.

   • Problem: Incompatible with the Matching Principle.

2. Accrual Basis: Revenues and costs are recognized when they occur, regardless of when cash is exchanged.

   • Advantage: Provides a more appropriate calculation of profit by matching expenses against related revenue.

Accounting Standards

• Definition: Written policy documents covering recognition, measurement, treatment, presentation, and disclosure, issued by an authoritative body (ICAI in India).

• Objectives:

  • Eliminate non-comparability.

  • Enhance reliability and credibility of accounting data.

  • Provide standard valuation norms and disclosure requirements.

• Benefits:

  • Eliminates variations in treatment.

  • Calls for disclosures beyond legal requirements.

  • Facilitates inter-firm and intra-firm comparisons.

• Limitations:

  • Reduces choice and flexibility.

  • Standards cannot override the law (statute).

Goods and Services Tax (GST)

• Definition: GST is a destination-based tax on the consumption of goods and services. It is levied at all stages from manufacture to final consumption.

• Key Principle: Only value addition is taxed; the burden falls on the final consumer.

• Fiscal Federalism: A dual GST system where both Centre and States levy tax on a common base.

• Components:

  • CGST (Central GST): Revenue for the Central Government. Subsumes excise duty, service tax, etc.

  • SGST (State GST): Revenue for the State Government. Subsumes VAT, luxury tax, entertainment tax, etc.

  • IGST (Integrated GST): Charged on inter-state transfers and imports. Revenue is divided between Centre and States.

• Examples:

  • Intra-state: Sale within Punjab ($10,000$) at 18% GST ($9\%$ CGST + $9\%$ SGST). Total tax = $1,800$ ($900$ to Centre, $900$ to Punjab).

  • Inter-state: Sale from MP to Rajasthan ($1,000,000$) at 18%. Total tax = $18,000$ as IGST to the Central Government.

• Characteristics:

  • Common law and procedure nationwide.

  • Comprehensive levy on both goods and services.

  • Input Tax Credit (ITC) allows for subtraction of taxes paid at previous stages.

• Advantages:

  • Abolition of multiple taxes.

  • Removes cascading effects (tax on tax).

  • Reduced compliance costs and increased voluntary compliance.

  • Promotes economic efficiency and international competitiveness.

Questions & Discussion

Test Your Understanding - I (Answers)

1. Question: During the life-time of an entity accounting produce financial statements in accordance with which basic accounting concept?

   • Answer: (c) Accounting period

2. Question: When information about two different enterprises have been prepared and presented in a similar manner, the information exhibits the characteristic of?

   • Answer: (d) None of the above (Contextually: Comparability)

3. Question: A concept that a business enterprise will not be sold or liquidated in the near future?

   • Answer: (a) Going concern

4. Question: The primary qualities that make accounting information useful for decision-making?

   • Answer: (b) Reliability and comparability

Practical Scenarios (Activity 1)

• Scenario: Ruchica prepares statements for her father's firm 'Friends Gifts'.

• Mistakes Identified:

  • Building valuation: Recorded at market value ($20\,lakh$) instead of historical cost ($7\,lakh$). Violates Cost Concept.

  • Stock valuation: Changed method to increase value by 15%. Violates Consistency Concept.

  • Computer purchase: Full amount ($70,000$) charged to one year despite a $5\,year$ life. Violates Going Concern and Matching Concepts.

Legal Damages (Activity 2)

• Scenario: Trader faces a lawsuit for poor quality goods. Court judgment is likely against him, but the amount is uncertain. The accountant suggests ignoring it.

• Critique: The accountant is wrong. Under the Conservatism (Prudence) Concept, all possible losses should be provided for, even if the amount is an estimate.