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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
POSTULATESMean 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.
DOCTRINESMean principles of belief, it refers to an established principle propagated
by a teacher which is followed in strict faith.
AXIOMDenotes a statement of truth which cannot be questioned by anyone.
ACCOUNTING CONCEPTS
CONCEPTS DENOTES LOGICAL CONSIDERATION & A
NOTION WHICH IS GENERALLY & WIDELY ACCEPTED.
SR. TERMS
NO.
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.
SR.NO.
ACCOUNTING
CONCEPTS
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
ACCOUNTING CONVENTIONS
 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
 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
15
Assets = Liabilities + Owners’ Equity
Debit
Assets
Current assets
Long-term assets
Credit
Liabilities
Current liabilities
Long-term liabilities
Credit
Direct investment
Capital stock
Indirect investment
Dividends (debit)
Retained earnings
Revenue (credit)
Expense (debit)
16
Journal Entries
 Going back to the Fundamental Accounting Equation:
Assets = Liabilities + Owners’ Equity
Debit
Assets
Current assets
Long-term assets
Credit
Liabilities
Current liabilities
Long-term liabilities
Introduction to Accounting
Credit
Direct investment
Capital stock
Indirect investment
Dividends (debit)
Retained earnings
Revenue (credit)
Expense (debit)
17
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
1. Transactional
•
The recording of an exchange with another entity
2. 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
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
21
Assets
Current assets
Long-term assets
Buildings
Vehicles
FURNITURE
EQUIPMENTS
LONG TERM LOAN
Element structures
Owners’ equity
Liabilities
Current liabilities
Accounts payable
Accrued liabilities
Long-term liabilities
Bank loans
Notes payable
Bonds payable
Introduction to Accounting
22
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.
Sources of GAAP
Committee on Accounting Procedures
Accounting Principles Board
Financial Accounting Principles Board
Committee on Accounting Procedure
1939 - 1959
First private body concerned with writing
accounting rules
Issued 51 Accounting Research Bulletins
Members were practicing CPAs
An “ad hoc” approach
(CAP)
Accounting Principles Board
1959 - 1973
(APB)
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
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.
o The recording is done by means of a “debitcredit” 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.”
33
NORMAL BALANCES — ASSETS
AND LIABILITIES
Assets
Increase
Debit
Decrease
Credit
Normal
Balance
Liabilities
Decrease Increase
Debit
Credit
Normal
Balance
NORMAL BALANCE — OWNER’S
CAPITAL
Owner’s Capital
Decrease
Debit
Increase
Credit
Normal
Balance
Summarizing the
Rules of Debits and Credits
Increase Decrease
Assets
DR
CR
Liabilities
CR
DR
Owners’ equity
CR
DR
Revenues
CR
DR
Expenses
DR
CR
Normal
Balance
DR
CR
CR
CR
DR
DOUBLE-ENTRY SYSTEM
 total debits always equal the total
credits
 accounting equation always stays in
balance
Assets
Liabilities
Equity
EXPANDED BASIC EQUATION
AND DEBIT/CREDIT RULES AND
EFFECTS
Asset
s
= Liabilities +
Assets
Liabilities
Dr.
+
Cr.
-
=
Dr.
-
+
Cr.
+
Owner’s Equity
Owner’s
Capital
Dr.
-
+
Cr.
+
Revenues
Dr.
-
-
Cr.
+
-
Owner’s
Dividend
s
Dr. Cr.
+
-
Expense
s
Dr. Cr.
+
-
The Debit-Credit Convention
Balance increases
• 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
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
 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.
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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