CHAPTER-2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES & ACCOUNTING EQUATION (GAAP)

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) The application of GAAP provides standards for sound accounting practices & procedures. These principles are the guidelines to make the financial statements true & fair. “The principles, which constitute the ground rule for financial reporting are termed as generally accepted accounting principles”. Walter, Meigs & Johnson These principles are developed by professional accounting bodies like ICAI,ICAEW, AICPA.

PRINCIPLES A general law or rule, adopted or professed as a guide to action, a settled ground or basis of conduct or practice. FEATURES OF ACCOUNTING PRINCIPLES MAN MADE- These are not tested in laboratory, only man made. OBJECTIVITY- Based on facts and free from personal bias USEFULNESS/RELEVANCE- Relevant & useful to the person who is using financial statements FEASIBILITY- Practicable or feasible & valuable

POSTULATES- Mean to assume without proof, to take for granted or positive consent, a position assumed as self-evident. These are generally recognized assumptions which reflects the judgment of facts or tend or events. DOCTRINES- Mean principles of belief, it refers to an established principle propagated by a teacher which is followed in strict faith. AXIOM- Denotes a statement of truth which cannot be questioned by anyone.

ACCOUNTING CONCEPTS CONCEPTS DENOTES LOGICAL CONSIDERATION & A NOTION WHICH IS GENERALLY & WIDELY ACCEPTED. SR.NO. TERMS DETAILS 1 BUSINESS ENTITY CONCEPT OWNER & BUSINESS ARE treated as two different and distinct entities & we record the transaction from view point of business 2 MONEY MEASUREMENT CONCEPT All the business transaction are measured & settled in monetary terms. Money is a common denominator. Money is a medium to value the quantities. 3 GOING CONCERN CONCEPT Business will continue to exist & carry on its operations for an indefinite period in future. 4 ACCOUNTING PERIOD CONCEPT Life of the business is perpetual but still it has to report the result of the activity undertaken in specified period normally one year. In most it is financial year 1st April to 31st March.

ACCOUNTING CONCEPTS SR.NO. TERMS DETAILS 5 COST CONCEPT Transaction should be recorded at cost rather than at a subjective or arbitrary value. Actual cost of acquisition should be considered. 6 DUAL CONCEPT For every debit , there is a credit. ASSETS – LIABILITIES = PROPERIETOR’S CLAIM OR A – L = P 7 REVENUE RECOGNITION CONCEPT Profit should be Considered only when realized. No anticipated profit should be taken credit of. 8 MATCHING CONCEPT Information can be ascertained relating to the profit of any entity only if the revenues of the same accounting period are matched against the expenses of the same year. 9 ACCURAL CONCEPT Recognize noncash events & circumstances as they occur. Accrual is concerned with expected future cash receipts & payments. 10 SATBLE MONETORY UNIT CONCEPT Purchasing power of monetary unit remain same throughout, thus ignoring b the effect of raising or falling purchasing power of monetary unit due to inflation or deflation.

ACCOUNTING CONVENTIONS principles Or accepted practice which apply generally to transactions. They have an influence in determining: ---which assets and liabilities are recorded on a balances sheet ---how assets and liabilities are valued ---what income and expenditure is recorded in the income statements ---at what amount income and expenditure is recorded.

THE NATURE AND PURPOSE OF ACCOUNTING CONVENTIONS ---Financial statements should be ‘fair presented’ ---Compliance with IASs goes a long way towards achieving this. ---Additional disclosures, beyond those required by IASs, should be made when necessary to achieve a fair presentation. ---In areas where no IAS exists, the financial statements should be presented in accordance with the stated accounting policies of the enterprise, in a manner which provides relevant, reliable, comparable and understandable information.

1. Going concern ---Going concern: assumption that an enterprise will continue in operational existence for the foreseeable future. ---Management must review the going concern status to confirm it is appropriate for the financial statements. They should consider all available information for the foreseeable future covering, but not limited to, twelve months from the reporting date. 2. Accruals (matching) ---Accruals (or matching ) basis of accounting: assets, liabilities, income and expenses are recognized when they occur and not when cash or its equivalent is received or paid ----Cost should be set off against the revenues they have contributed to.

3. Consistency ---Consistency: presentation and classification of items in the financial statements should be retained from one period to the next unless a significant change in the nature of the operations of the enterprise or a review of its financial statement presentation demonstrates that more relevant information is provided by presenting items in a different way, or a change is required by a new IAS. 4. Materiality and aggregation ---Similar items should be aggregated together ,but information that is material should not be aggregated with other items ---Information is material if its non-disclosure could influence the economic decisions of users.

5. Accounting period convention ---Accounting period convention :the lifetime of the business is divided into arbitrary periods of a fixed length. usually one year. At the end of each arbitrary period, usually referred to as the accounting period, two financial statements are prepared: The balance sheet, showing the position of the business as at the end of the accounting period The income statement for the accounting period.

OTHER CONVENTIONS Reliability A basic requirement. To be reliable, financial information must be free from bias and error. Some contingent items may by their nature be bound to be unreliable .Subsidiary qualities that make information reliable are. Faithful representation Information must faithful represent the effects of transactions and other events. Substance over form Some transactions have a real nature (substance) that differs from their legal form. Whenever it is legally possible, the real substance prevails over the legal form.

Neutrality Judgments are made without bias in arriving at items in the financial statements. Prudence The right degree of caution must be exercised in preparing financial statements and in estimating the outcome of uncertain events. Completeness Information presented in financial statements should be complete, subject to the constraints of materiality and cost.

Comparability Financial statements should be comparable with the financial statements of other companies and with the financial statements of the same company for earlier periods. To achieve comparability we need consistency disclosure of accounting policies. Accounting standards contribute to comparability by reducing the options available to enterprises in their treatment of transactions. Understandardablity Dependent upon users’ abilities. The framework suggest that a reasonable knowledge of business and accounting has to be assumed here.

Accounting Equation Assets = Liabilities + Owners’ Equity Fundamental Accounting Equation: Assets = Liabilities + Owners’ Equity This equation is always in balance In order for this equation to remain in balance, double-entry bookkeeping is employed. That is, the recording of every transaction or event must have at least two parts Either an equal impact (increase or decrease) to both sides of the equation or equal and opposite impact to one side. The recording of every transaction must keep this equation in balance Introduction to Accounting

Assets = Liabilities + Owners’ Equity Debit Credit Assets Current assets Long-term assets Liabilities Current liabilities Long-term liabilities Direct investment Capital stock Indirect investment Dividends (debit) Retained earnings Revenue (credit) Expense (debit)

Assets = Liabilities + Owners’ Equity Debit Credit Journal Entries Going back to the Fundamental Accounting Equation: Assets = Liabilities + Owners’ Equity Debit Credit Assets Current assets Long-term assets Liabilities Current liabilities Long-term liabilities Direct investment Capital stock Indirect investment Dividends (debit) Retained earnings Revenue (credit) Expense (debit) Introduction to Accounting

ACCOUNTING METHODS Cash Accounting Revenue is recorded when cash is received. Expense is recorded when cash is disbursed. Very straightforward. Facts determine the timing of entries. Less room for judgment. Accrual Accounting Revenue is recorded (recognized) when the revenue has been earned. When the product or service has been provided to the customer, regardless of when payment is received. Expenses are matched to the revenue that they helped to earn, regardless of when payment is made.

CASH ACCOUNTING METHODS It is possible for cash receipt to coincide with revenue recognition and cash payment to coincide with expense recognition. However, in business in North America (and, indeed globally), it is the norm for the exchange of cash to either precede or follow the actual “economic event”. Except in the simplest of entities (e.g. an individual person) or in unique circumstances, cash accounting will not yield useful information. Accrual accounting is the standard method.

ACCRUAL ACCOUNTING Transactional Adjusting The recording of an exchange with another entity Adjusting Required only when financial statements are prepared to “adjust” accounts to where they should be Always include at least one Balance Sheet account and one Income Statement account. e.g. Depreciation of capital assets, earning of interest revenue.

Element structures Assets Current assets Assets Current assets Long-term assets Buildings Vehicles FURNITURE EQUIPMENTS LONG TERM LOAN Assets Current assets Cash Cash on hand Bank accounts Accounts receivable Accounts receivable – customer 1 Accounts receivable – customer 2 Inventory Raw materials Work in process Finished goods Product 1 Product 2 Introduction to Accounting

Element structures Owners’ equity Liabilities Current liabilities Accounts payable Accrued liabilities Long-term liabilities Bank loans Notes payable Bonds payable Owners’ equity Capital stock (direct investment) Retained earnings (indirect investment) Revenue Expenses (Dividends) Although revenue and expenses are not sub-pieces of Retained earnings the way Current assets are a sub-piece of Total assets, for the purposes of understanding how they fit in to the equation, this representation is helpful. Introduction to Accounting

Sources of GAAP Committee on Accounting Procedures Accounting Principles Board Financial Accounting Principles Board

Committee on Accounting Procedure (CAP) 1939 - 1959 First private body concerned with writing accounting rules Issued 51 Accounting Research Bulletins Members were practicing CPAs An “ad hoc” approach

Accounting Principles Board (APB) 1959 - 1973 Appointed by the AICPA Primarily from public accounting Issued 31 APB Opinions Criticized for failing to deal with problems on a timely basis Many saw a need for independence

Financial Accounting Foundation (FAF) Established 1973 Appoints members of Financial Accounting Standards Board (FASB) Appoints members of Financial Accounting Standards Advisory Committee (FASAC) Provides financial support to FASB Contributions from industry & CPA firms Wheat committee

Financial Accounting Standards Board (FASB) Established 1973 7 members Members are full time, well paid Responsible only to FAF Passage of standards requires 5 out of 7 votes

ACCOUNTING MECHANISM 1. Single entry system- under this merely personal aspects of a transaction recorded . 2. Indian( desi nama) system- books are written in regional languages such as muriya, sarafi etc. And books are called bahis. 3. Double entry system- only method fulfilling all the objectives of systematic accounting. It recognize the two fold aspects of every business transaction.

DOUBLE-ENTRY An account is an individual accounting record of increases and decreases labeled as debits and credits. There are separate accounts for each classification type such as cash, salaries expense, accounts payable, etc.

FATHER OF ACCOUNTING According to Pacioli, “ Double-entry accounting is based on a simple concept: each party in a business transaction will receive something and give something in return. In accounting terms, what is received is a debit and what is given is a credit. The T account is a representation of a scale or balance.” Scale or Balance Luca Pacioli Developer of Double-Entry Accounting, (1445-1517) Receive DEBIT Give CREDIT

The Double Entry System RULES Accounting information is based on the double entry system. An account is an arrangement of transactions affecting a given asset, liability or other element. Under this system, the two-sided effect of a transaction is recorded in the appropriate accounts. The recording is done by means of a “debit-credit” convention (set of rules) applying to all accounts.

DEBITS AND CREDITS Recording on the left side of an account is debiting the account Recording on the right side is crediting the account For individual accounts: If the total of debit amounts is bigger than credits, the account has a debit balance If the total of credit amounts is bigger than debits, the account has a credit balance

Debits and Credits Two of the most familiar accounting terms are “debits and credits.” In the double-entry system, debits must always equal credits for the accounting equation. Debit (from the Latin word debere) means “left.” It is often abbreviated as “dr.” Credit (from the Latin word credere) means “right.” It is often abbreviated as “cr.”

NORMAL BALANCES — ASSETS AND LIABILITIES Increase Decrease Debit Credit Decrease Increase Debit Credit Liabilities Normal Balance Normal Balance

NORMAL BALANCE — OWNER’S CAPITAL Decrease Increase Debit Credit Normal Balance

Summarizing the Rules of Debits and Credits Normal Increase Decrease Balance Assets DR CR DR Liabilities CR DR CR Owners’ equity CR DR CR Revenues CR DR CR Expenses DR CR DR

DOUBLE-ENTRY SYSTEM total debits always equal the total credits accounting equation always stays in balance Fix the Equation Assets = Liabilities + Equity. Assets Liabilities Equity

EXPANDED BASIC EQUATION AND DEBIT/CREDIT RULES AND EFFECTS Assets Liabilities Owner’s Equity = + Assets Dr. Cr. + - Liabilities Dr. Cr. - + Dr. Cr. Owner’s Capital - + Dr. Cr. Owner’s Dividends + - = + - Dr. Cr. Revenues - + Dr. Cr. Expenses + - + -

The Debit-Credit Convention Balance increases Balance decreases Credit entries in an asset account Credit entries in an expense account Debit entries in a liability account Debit entries in equity account Debit entries in a revenue account Debit entries in an asset account Debit entries in an expense account Credit entries in a liability account Credit entries in equity account Credit entries in a revenue account

Disclosure requirements of IAS 18: ---Accounting policies for revenue recognition, including the methods used to determine the stage of completion of transaction involving services. ---Amount of revenue recognized for each of the five categories (sale of goods, rending of service, interest, royalties and dividends), where material. ---The amount, if material, in each category arising from exchanges of goods or services.

Other matters dealt with in IAS 18 Selection and disclosure of accounting policies ---where there are no IASs, the policies should be selected and applied so that the financial statements are: 1 relevant to the decision-making needs of users 2 reliable: i.e. they ○Represent faithfully the results and financial position ○Reflect the substance rather than the form of transactions ○Are neutral ○Exercise prudence without impairing neutrality ○Are complete. ---The accounting policies must be disclosed by note to the financial statements.

FEATURES OF DOUBLE ENTRY SYSTEM 1.Two parties-one receiving the benefits & other giving the benefits 2. Each party is affected in opposite direction but with the same amount. 3. Each transaction affects at least two items 4. Changes are recognised from the angle of the party in whose books recording is done 5. Changes are recorded in two related accounts. Account receiving the benefit is debited & Account rendering the benefit credited. 6. Each account has two sides –left(debit) & right (credit). 7. For each transaction , debit amount is equal to the credit Amount.

ADVANTAGES DISADVANTAGES COMPLETE RECORD OF BUSINESS TRANSACTIONS ARITHMATICAL ACCURACY INFORMATION ABOUT FINANCIAL STATEMENT COMPARISON REDUCTION IN THE CHANCES OF ERRORS DETAILS OF ACCOUNT ASCERTAINMENT OF COST OF PRODUCTION INFORMATION OF PROFITS EFFECTIVE CONTROL SYSTEM DETERMINING THE TAX LIABLITY CALCULATION OF ABNORMAL LOSSES REQUIREMENT OF EXPERT KNOWLEDGE LENGTHY CUMBERSOME PROCESS EXPENSIVE

BASIS OF ACCOUNTING SYSTEM CASH SYSTEM- Recording of transaction on actual receipts & actual payments basis only. ACCURAL SYSTEM- Recording of transaction on the basis of the period in which they accrue. BASIS OF DIFFERENCE CASH SYSTEM ACCRUAL SYSTEM 1. GENUINENESS OF RESULTS NO INFORMATION OF ACCURATE PICTURE OF PROFIT OR LOSS CORRECT INFORMATION OF ACTUAL PROFIT &LOSS 2. PERIOD RECEPITS & PAYMENTS DURING THE YEAR, WETHER CURRENT, PAST ,FUTURE. RECEPITS & PAYMENTS DURING THE YEAR CURRENT YEAR ONLY ,WETHER PAID IN THE CURRENT, PAST ,FUTURE. 3. USERS OF SYSTEM FOLLOWED BY PROFEESSIONALS FOLLOWED BY BUSINESS HOUSES 4. SIMPLICITY SIMPLE TO UNDERSTAND & IN PRACTISE BASED ON TECHNICALITIES 5. TRUE & FAIR VIEW CAN NOT ASCERTAINED CAN BE ASCERTAINED

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