CHAPTER-2GENERALLY 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.
PRINCIPLESA 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 CONCEPTSCONCEPTS DENOTES LOGICAL CONSIDERATION & A NOTION WHICH IS GENERALLY & WIDELY ACCEPTED.
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
Journal Entries • Going back to the Fundamental Accounting Equation: 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 • 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 • 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 • 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. • Liabilities • Current liabilities • Accounts payable • Accrued liabilities • Long-term liabilities • Bank loans • Notes payable • Bonds payable 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
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 MECHANISM1. 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.”
Assets Increase Decrease Debit Credit Liabilities Decrease Increase Debit Credit NORMAL BALANCES — ASSETS AND LIABILITIES • Normal Balance Normal Balance
NORMAL BALANCE — OWNER’S CAPITAL Owner’s Capital Normal Balance Decrease Increase Debit Credit
Summarizing theRules of Debits and Credits Normal IncreaseDecreaseBalance 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 Assets Liabilities Equity
EXPANDED BASIC EQUATION AND DEBIT/CREDIT RULES AND EFFECTS Liabilities Assets Owner’s Equity Owner’s Capital Owner’s Dividends Assets Liabilities Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. + - - + - + + - Revenues Expenses Dr. Cr. Dr. Cr. - + + - = + = + - + -
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.