The term ‘accounting’ refers to (i) recording, (ii) classifying and (iii) summarizing the financial transactions and events of a business. In addition to this, accounting includes interpreting the results obtained as a consequence of financial transactions and events.
Now, the objective to maintain books of accounts is to ascertain the financial performance of a business. Various stakeholders use this information in order to make certain decisions. Now, these stakeholders can be owners, managers, investors, creditors, employees etc. Therefore a business needs to prepare financial statements in order to help stakeholders in taking important financial and investment decisions.
But, this accounting information needs to be reliable and comparable. This is because such information can be compared over a period of time while making decisions. Hence, a business needs to prepare financial statements that are consistent and follow basic accounting principles. The basic accounting principles are typically referred to as Generally Accepted Accounting Principles (GAAP). These principles are developed to bring uniformity in the financial statements.
Generally Accepted Accounting Principles (GAAP) are the guidelines adopted for recording and reporting of business transactions. These rules bring uniformity in the preparation and the presentation of financial statements.
So, following are the basic accounting principles that you must know:
1. Accounting Period Concept
A business needs to prepare financial statements at the end of a specific period. These statements reflect the financial performance of a business at the end of a specific period. Hence, the period for which these financial statements are maintained is termed as ‘accounting period’.
Now, these statements reflect financial information that is useful for various stakeholders. These stakeholders use this information to take investing, financing and managing decisions at regular intervals. This means that stakeholders are unable to take important decisions in case proper financial statements are not prepared at regular intervals. Suppose, a business follows a different inventory policy for two different periods. In this case, the business is unable to compare the statements of two periods in question. This is because the accounting records do not follow consistent policy for stock.
Furthermore, a business is required to prepare financial statements annually as per the Income Tax Act and Companies Act 2013. However, there are certain scenarios where a business has to prepare interim financial statements. For example, companies listed on stock exchanges need to maintain quarterly statements. These statements provide information about the profitability and financial position of a business at the end of three months.
2. Conservatism Concept
The conservatism concept is based on an old saying “Anticipate No Profits But Anticipate Losses”. This means that you should preferably understate rather than overstate your business’s net income.
Hence, profits should not be recorded until they are realized as per this concept. However, all losses should be recorded in the books of accounts. These losses also include those losses that have less chances of occurring.
Thus, this policy is a firm approach towards recording transactions. Furthermore, it helps in dealing with business uncertainties and protecting the interests of its creditors. This means overestimating profits may lead to unwanted distribution of business assets.
Suppose, the profit in your books of accounts is more than the actual profit. This means that certain items in your financial statements are overestimated. Hence, you need to check for those items in order to ascertain profit or loss correctly. This does not not mean that you should intentionally underestimate the value of your business assets. It is because doing so can lead to some hidden profits.
3. Realization Concept
This concept states that revenues arising on account of sale of goods or services are recorded only when they are realized. Here, revenues refer to the cash flow arising from:
- sale of goods and services and
- use of business resources by other entities or individuals resulting in interest, royalties and dividends
Typically, your business realizes revenues at the time of selling goods or offering services. This means revenues are realized when the legal right to receive such revenues arise.
Suppose, you made sales on credit to your customers. Now, these sales are shown as revenue (also accounts receivable) in your books on a day when such sales are made. This means that such sales are not shown as revenues at a time when money is received from the buyer.
However, certain types of income are recognized on the basis of time and not when they arise. These include income such as rent, commission, interest etc .
Say you receive rent for March 2018 in the month of April 2018. This rent is shown in the income statement for March 2018 even if such a rent is received in April 2018.
4. Matching Concept
This concept states that expenses incurred should match with the revenues generated during a particular accounting period. This means expenses incurred during a particular period are deducted from revenues earned during the same period.
As we know, revenues are recognized on sale of goods or services. And not when cash is received for such sales . Similarly, expenses are recognized the moment you use an asset or a service to generate revenue. And not when cash is paid for such expenses.
For example, expenses such as salaries, rent etc are realized on the basis of the period to which they relate. And not when they are actually paid.
5. Consistency Concept
The financial statements help in evaluating the performance of a business. But such statements should be consistent in order to compare results over a period of time. Thus, you need to follow uniform and consistent accounting policies to compare results over a period of time.
This is because different accounting policies for different periods makes inter – firm and inter period comparison difficult. For example, you cannot compare profits for two different periods if the policy of depreciation differs for both the periods.
Therefore, it is important to follow consistency concept while preparing financial statements. This is because consistency helps you to do away with personal bias and makes results comparable.
6. Materiality Concept
Materiality concept states that trivial events and events having an insignificant impact on the books of accounts can be ignored. Now, materiality of a fact depends upon the nature and amount of money involved. There are facts that reasonably influence the decisions of stakeholders using financial statements of your business. Such facts are considered ‘material facts’. For example, change in the method of inventory valuation in the near future would significantly impact financial results of your business.
Therefore, information regarding material facts should be disclosed in the footnotes of the financial statements. Such an information would thereby help stakeholders in making informed decisions.
However, there are cases where the facts are trivial in nature and the amount involved is too small. In such cases, materiality concept does not apply.
7. Historical Cost Concept
This concept states that all assets need to be recorded at historical cost. This means assets should be recorded at purchase price in books of accounts. Such a price includes the cost of:
- installation and
- making the asset ready to use
Thus, the cost concept is historical in nature. This means that assets are recorded at a price paid at the time of their acquisition. This price remains the same over the years.
For instance, a business purchases machinery for Rs. 2.50 crores on a particular date. Now, the purchase price remains the same over the years, though its market value may fluctuate.
Thus, recording assets at historical cost lends objectivity to the recorded transactions. This is because it is easy to verify assets from their purchase documents. On the other hand, recording assets at market value is not reliable. This is because the value of assets may change over the period. The change in value of assets makes comparing financial statements challenging.
8. Money Measurement Concept
This concept states that only transactions that can be expressed in terms of money are recorded in the books of accounts. Transactions or happenings that cannot be expressed in monetary terms are not recorded in accounting statements. For instance, the appointment of a manager or skill sets of human resources are non – monetary in nature. These transactions are not recorded in the books of accounts.
Furthermore, transactions are recorded in terms of monetary units and not in terms of units of physical quantity. This is because assets expressed in different units cannot be used to calculate the worth of business. Suppose, a business has fixed assets including a building built on two hectares of land and sixty personal computers. Now, these figures alone cannot be added together to give a meaningful insight. However, a building priced at Rs. 2.50 crores and sixty computers worth Rs. 10 lakhs helps in calculating the total assets of an enterprise.
But, the major drawback of this concept is that the value of money does not remain the same over a period of time. As a result, the accounting statements do not give a true and fair view of a business.
9. Dual Aspect Concept
This concept states that every transaction has a dual affect and should be recorded in two separate accounts. The dual accounting concept is the foundation for recording transactions in books of accounts. This concept is based on the double entry system of accounting. Following accounting equation is used to express this concept:
Assets = Liabilities + Capital
As per this equation, the assets of a business are always equal to the claims of owners and outsiders. The claim of owners is termed as capital (owner’s equity). Whereas, the claims of outsiders are called liabilities (creditors equity). Now, the dual effect of every transaction impact this equation in such a way that both sides are equal at all times.
Say, you get money amounting to Rs. 10 lakhs to start a business. Now, such a transaction will have a dual affect. That is to say, it will increase cash and at the same time capital account by Rs. 10 lakhs.
10. Going Concern Concept
This accounting principle assumes that a business will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future.