Classification of Accounting Principles
Accounting principles are broadly classified into three categories, these are:
- Basic Assumptions
- Basic Principles (Concepts)
- Modifying Principles (Conventions)
Basic Accounting Assumptions
The owner and business are treated as two distinct entities, and we record that viewpoint of business.
1. Separate Business Entity: As per this assumption, a business is considered separate from its owner(s). This assumption helps keep the business transactions strictly free from the effect of the owner's personal affairs. For instance, when a person starts the business with cash of 2,00,000, then this amount increases the balance of cash from the point of business and on the other hand, the owner is treated as a liability, and this is shown in the liability side of the balance sheet as owner's capital. For this transaction, this journal entry is passed:
Cash A/c Dr. 2,00,000
To Owner's Capital A/c 2,00,000
This concept is becoming more popular because in one sense capital itself may be regarded as a liability—the amount due from the business to the owner. This concept is applicable to the all forms of business organizations whether it is a limited company, partnership firm or a sole trader.
2. Going Concern Concept: As per International Accounting Standards, it is a fundamental accounting assumption underlying the preparation of financial statements. Under this assumption, "the enterprise is normally viewed as a going concern, that is, continuing operation for the foreseeable future. Under this all assets are shown at cost price and not at market price and depreciation is provided on cost price in order to calculate true profit.
It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the sale of its operations". Under this assumption, the assets of the business are valued by the accountants on the basis of the going concern concept, historical cost and expected life of the assets.
3. Money Measurement Concept: Money is medium to value quantities. As per this assumption, only those business transactions that can be measured in money are recorded in the accounting. Those transactions/activities of the business that cannot be measured in Notes money are not recorded in accounting.
4. Accounting Period Assumption: As per the going concern concept, the business's income can be measured at the time of the liquidation of the business or at the time when the business is sold. But practically, it is very difficult to wait such a long period that is also not definite. Therefore, it is agreed among the accountants that the economic life of the business is divided into different segments to prepare the financial statements and determine profits. Generally, this time segment is one year, either a calendar year or a financial year. Sometimes it may be less than twelve months i.e., quarterly, half-yearly, etc. Reports made for less than twelve months are called interim reports and are less reliable than annual reports. At the end of each segment (period), profit and loss accounts and balance sheets are prepared.
Basic Accounting Principles (Concepts)
These basic accounting principles are commonly accepted/agreed principles by the accountants to record the business financial transactions. These are as follows:
Money Measurement Concept
This is the concept tunes the system of accounting as fruitful in recording the transactions and events of the enterprise only in terms of money. The money is used as well as expressed as a denominator of the business events and transactions. The transactions which are not in the expression of monetary terms cannot be registered in the book of accounts as transactions.
Business Entity Concept
This concept treats the owner as a totally different entity from the business. To put it in a nutshell, "Owner is different, and Business is different". The capital that is brought into the firm by the owner at the commencement of the firm is known as capital. The amount of the initially invested capital should be returned to the owner, considered due to the owner, who was nothing but the contributor of the capital.
Going Concern Concept
The concept deals with the quality of long lasting status of the business enterprise irrespective of the owners' status, whether he is alive or not. This concept is known as concept of long term assets. The fixed assets are bought in the intention to earn profits during the season of the business. The assets which are idle during the slack season of the business retained for future usage, in spite of that those assets are frequently sold out by the firm immediately after the utility leads to mean that those assets are not fixed assets but tradable assets. The fixed assets are retained by the firm even after the usage is only due to the principle of long lastingness of the business enterprise.
If the business disposes the assets immediately after the current usage by not considering the future utility of the assets in the firm which will not distinguish in between the long-term assets and short-term assets known as tradable in categories.
Revenue Recognition Principle
It is also called revenue realization principle, meaning profit should be considered only when realised. As per this principle the revenue is recorded in accounting when the sales have taken place. If there is expectation that will be a particular transaction there in future, that is not recorded in accounting. Revenue/sales is considered to be made when title of ownership of Notes goods passes from the seller to buyer and the buyer become legally liable to pay.
However, this principle has some exemptions which are as follows:
1. In the case of sales made on the basis of hire purchase system where ownership is not transferred at the time of sales while it is transferred at time of final payment. Herewith, sales are presumed to the extent of installment received.
2. In the case of contract accounts, if the contract is for long period revenue cannot be realized until the contract is not completed. Here, only a part of total revenue is treated as realized.
Cost Principle
This principle is closely related to the going concern concept. As per this principle, every business transaction should be recorded at its historical cost and not at its market price. At the time of recording of the transactions, their market price is not considered. Sometimes its market price may be less than or more than its actual cost but its actual cost is recorded in accounts because of cost principle. Under this principle the historical cost of a transaction becomes the base cost for the subsequent years. On the basis of this cost, the depreciation is charged on the assets and the balance is shown in the balance sheet. All the fixed assets and current assets are recorded at historical cost. Thus, we observe that the balance sheet prepared on the basis of historical cost does not give us actual results for those applicable of fixed assets and current assets. Due to the changing in the price level changes, the financial statements become irrelevant for the users. This led to the inflation accounting to came into existence.
Dual Aspect Principle
This is the basic principle of accounting. As per this principle every financial transaction of the business has dual effect and recorded at two places. Therefore, it is called double entry system.
On the basis of this principle it is said that every debit must have an equivalent credit and every credit must have an equivalent debit because every transaction of the business has two aspects. For instance, if Mr. Aditya Raj started a business for cash 2,00,000 there will be two aspects of this transaction. In one aspect cash is coming into business while in the other aspect the business has to pay this amount to Mr. Aditya Raj. Because Mr. Aditya Raj has given the amount to the business.
Full Disclosure Principle
As per this principal, the financial statements should disclose true and fair view so that these may provide accurate and sufficient information to the users of financial statements. Disclosure principle means to give all the information relating to the economic activities of the business to the owner, creditors and investors. Nowadays this principle is getting more importance as big business houses are being run in the form of limited companies. As per Companies Act 1956, the profit and loss account and the company's balance sheet must show true and fair view of the company. Therefore, companies are giving the foot notes regarding some items as investments, contingent liabilities, etc., along with the balance sheet.
Matching of Cost and Revenue Principle
As per the going concern concept, the accurate profit/loss of the business can be determined at the time of liquidation of the business or sale of the business. But it will generate a lot of problems. Therefore, the economic life of the business is divided into different segments in order to determine the profit/loss of the business. Generally a segment of the economic life of the business becomes of a year. To compute the operational profits/loss of the business in a year, it is necessary to find the expenses and revenues relating to the period. Then all the revenues of that period are matched with all the expenses/costs incurred to earn that revenue.
Objectivity Principle
It is also known as objective evidence concept. As per this principle the transactions which are recorded in accounting must be on the objective and factual basis. There should be a voucher or documentary evidence behind each entry in the accounting. The entry must be free from personal bias and based on the rational approach. If the entries are made without evidence, it will lose the confidence of the several users of the financial statements about their reliability. For the auditing of the financial statements, there is also a need of objective evidence.
The Modifying Accounting Principles (Conventions)
Basic accounting assumptions and principles provide us the various rules to prepare the financial statements. If these financial statements are relevant and reliable, they will give much useful information to the various users of the financial statements. In order to prepare the true and fair financial statements, there is a need to modify the accounting assumptions and principles. These modified accounting principles are as follows:
1. Conservation (Prudence): As per the law of conservatism, when preparing the financial statements, all the possible losses must be kept in mind and all anticipated profits/gains should be left out. In other words the accounts must follow the policy of playing safe. Likewise stock-in-trade is valued at 'market price or cost whichever is least', provision for bad and doubtful debt, provision for depreciation on fixed assets, etc., are maintained. This principle is being criticized nowadays on the ground that it goes against the principle of disclosure. The accountants create a secrete reserve by providing bad and doubtful debts, depreciation and stock valuation. The financial statements loose their true and fair view. Profit and loss account depicts the lower income and the balance sheet understates the assets and the liabilities of the business.
Today the law of conservatism has been replaced by prudence. It means that conservatism is adopted only in the inevitable uncertainties and doubts. The accountants should also give the reasons for adopting particular accounting techniques, method and policies without undue conservatism.
2. Consistency: In order to enable the management to compare the results of several years of the business, whatever accounting policy is adopted in a year must be adopted in the coming years. There should be uniformity in the accounting process, rules & methods. As a result biasness of accountant is removed.
According to Kohlar there are three forms of consistency:
(a) Vertical Consistency is used in the different financial statements of the business on the same date. For instance, depreciation on fixed assets is used in the income statement and the balance sheet on the same date.
(b) Horizontal Consistency enables the comparison of the profit or performance of a business in a year with the performance of another year for example the depreciation methods.
(c) Third Dimensional Consistency refers to the same principles or practices of accounting adopted by the different firms in an industry.
3. Timeliness: Accounting information given in the financial statements must be reliable and relevant. In order to be relevant, this information must be supplied in time. If late and obsolete information is provided, it will hamper the management and the users of the financial statements to take appropriate, timely and rational decision.
4. Materiality: Herewith, the materiality means that only that information should be disclosed and attached with financial statements which influence the decisions of shareholders, investors and creditors, etc. and the other insignificant details must be ignored. Moreover, an item of information may be material for one purpose while that may be immaterial for other. This is a subjective matter. For example, the component's cost may be very significant for small businessman while it may be insignificant for a large businessman. In one more example, the Companies Act permits to ignore the paise at the time of preparation of financial statements while for the income tax purpose the income is rounded off to the nearest ten.
5. Cost-Benefit Principle: As per this principle the cost of using an accounting principle should not exceed its benefits. It does not mean that to curtail the costs, no information or a little information should be given to the users of the financial statements.
6. Industry Practice: Different accounting principle/practice is adopted in the different industries. When preparing the financial reports and presenting the accounting information the prevailing accounting practices in a particular industry should be kept in mind. For example, disclosing of investments and stock at the cost or market price whichever is lower. Thus we see that the prevailing accounting practices in an industry play an important role in adopting the accounting practices.
Generally Accepted Accounting Principles
Accounting principles are those rules of actions on the basis of which the transactions of the business are recorded, classified and summarized. If the financial statements are not prepared on the basis of these principles, there will be low acceptability and difficulty to understand them, and the comparison will be impossible and unreliable. Therefore, the accountants recommend that there should be common concepts and conventions of accounting so that the above difficulties and problems may not occur. These common concepts and conventions of accounting have become the basic accounting concepts and conventions as these are commonly accepted by the body of the professional accountants all over the world to prepare the financial statements, Therefore, they are termed as Generally Accepted Accounting Principles (GAAP).
