CHAPTER

Generally Accepted Accounting

Principles (GAAP) and Basic
Accounting Concepts
LEARNING OBJECTIVES
Thestudy of this Chapter would enable students to understand:
a Meaning and Nature of Generally Accepted Accounting Principles (GAAP)
a Accounting Principles or Concepts:
1. Going Concern Concept 2. Accounting (Business) Entity Concept
3. Money Measurement Concept 4. Accounting Period or Periodicity Concept
5. Complete or Full Disclosure Concept 6. Revenue Recognition or Realisation Concept
7. Verifiable Objective Concept 8. Matching Concept
9. Historical Cost Concept 10. Accrual Concept
ll. Dual Aspect Concept 12. MaterialityConcept
13. Consistency Concept 14. Conservatism or Prudence Concept
15. Timeliness 16. Industry Practice
17. Substance Over Legal Form

GENERALLY ACCEPTED ACCOUNTINGPRINCIPLES (GAAP)

Meaning and Nature
GAAP are a set of rules, concepts and guidelinesfor preparingfinancial statements.
Business communicates through its financial statements, which are prepared following Generally
manner by
Accepted Accounting Principles (GAAP) so that they are understood in uniform
all the users.
practices for recording
GAAP are a combination of accounting standards and commonly accepted
supported and implemented
Oftransactions and reporting of accounting information. GAAP are
of India (ICAI).
by the accounting bodies such as the Institute of Chartered Accountants
the transaction over legal
Financial reporting is not merely guided by legal form. Substance of
reporting.
form has an important bearing on recording of transactions and their
applying these principles.
GAAP include not only accounting principles but also procedures for
economic events are reported
They are, therefore, ground rules of accounting so that similar
by all in a similar manner.
 3.2 Double Entry Book Keeping—ISq

Meaning and Nature of Accounting Principles

"Principles of Accounting are the general law or rule adopted or proposed as a guide to action, a settledground
or basis ofconduct or practice." —American Institute of Certified Public Accountants
Accounting principles may be defined as those rules of action or conduct which are adopted by
universally for recording accounting transactions. They are the norms or rules which are followedin
accounting for treating various items of assets, liabilities, expenses, incomes, etc. For example, Inventory
(stock) should be recorded at lower of its cost or net realisable value and fixed assets should be depreciated
over their useful life, etc.
Features of Accounting Principles:
1. Accounting principles are man-made.
2. Accounting principles are flexible.
3. The general acceptance of accounting principles usually depends on how they meet the criteriaof
relevance, objectivity and feasibility.
(i) Relevance. Accounting principles are relevant, if they result in information that is usefulto the
users of accounting information.
(ii) Objective. Accounting principles are objective, if they are not influenced by the personal bias
of the persons preparing the accounting information.
(iii) Feasible. Accounting principles are feasible, if they can be applied without undue complexity
and cost.

ACCOUNTING PRINCIPLES OR CONCEPTS

Accounting principles or concepts are the assumptions or propositions based on which financial
transactionsare recorded and financial statements are prepared. Stating differently, theyare
principles or rules of accounting. These principles or rules are followed so that the financial
statementsare prepared on same basis and uniformly understood by the user.
The accounting principles or concepts are:
1. Going Concern Concept
2. Accounting (Business) Entity Concept
3. Money Measurement Concept
4. Accounting Period (or Periodicity) Concept
5. Complete or Full Disclosure Concept
6. Revenue Recognition or Realisation Concept
7. Verifiable Objective (Evidence) Concept
8. Matching Concept or Matching Principle
9. Historical Cost Concept
10. Accrual Concept
11. Dual Aspect Concept
12. Materiality Concept
13. Consistency Concept
14. Conservatism or Prudence
Concept
15. Timeliness
16. Industry Practice
17. Substance
Over Legal Form
Generally Accepted Accounting Principles (GAAP) and Basic Accounting Concepts 3.3

Going Concern Concept, Accrual Concept and Consistency Concept are fundamental accounting concepts
recognised by the Accounting Standard (AS- 1). Fundamental accounting concepts, are presumed to have been
followed by the enterprises in preparing their financial statements.

Let us discuss these concepts in detail.

1. Going Concern Concept
Business will be carried for a foreseeable period with no intention to close or scale down its operations
significantly.
Going Concern Concept prescribes that transactions be recorded in the books of account presuming
that business will be carried for a foreseeableperiod and without any intention to close the business or
bringing down significantly the level of its operations.
Therefore, distinction is made between capital expenditure, i.e., expenditure that will give
benefit of enduring nature, i.e., for a long period and revenue expenditure, i.e., one whose
benefit will be exhausted within the year.
It is on the basis of this concept that fixed assets are recorded at their cost and depreciatedin
a systematic manner over their estimatedusefullife without reference to their market value.
For example, a machine purchased for 1,10,000(residual value being 10,000)and having
estimated useful life of 10 years. is written off in the next 10 years in a systematic
manner to determine profit or loss for each year.
2. Accounting Entity Concept or Business Entity Concept
Business is an accounting entity and transactions are recorded in the booksof accountfrom the view
point of business.
According to this Concept, business is separate and distinct from its owners. Transactions are
recorded in the books of account from the business point of view. Owners being separate and
distinct from the business, amount due to them is shown as a liability (capitalor loan) of the
business. Their Capital Accounts with the business are credited with the capital introduced,
profit earned during the year, etc., and debited by the amount of drawings.
The financial position and financial performance (profit or loss for the year) of a business cannot
be known in the absence of this concept.
This concept applies to all forms of business organisations, i.e.,sole proprietorship, partnership
or a company.
3. Money Measurement Concept
Transactions and events are recorded in the booksof account in money terms.
According to this Concept, transactions and events which can be measured and expressed
in terms of money are recorded in the books of account because,money is the common
measuring unit for recording and reporting the transactions. This concept makes accounting
information more meaningful. However, the concept suffers from two major limitations:
(i) Transactionsand events that cannot be measured in terms of money are not recorded,
howsoever important they may be to the enterprise. For example, quality of staff is not
shown in the financial statements because the quality cannot be measured in terms of money.
(ii) Money is considered to have static value as the transactions are recorded at the value on
the transaction date and the subsequent changes in the money value are ignored.
 3.4 Double Entry Book Keeping—ISC

4. Accounting Period (Periodicity) Concept

Life of the business is broken into smaller periods usually a period of 12 months.
According to the Accounting Period Concept or Periodicity Concept, life of an enterp
is broken into smaller periods so that its performanceis measured at regular intervals.
information provided by the financial statements at regular intervals is more useful for the use
of accounting information than the information available at the end of the life of the business
Financial Statements prepared every year (accounting period) are helpful in meeting the needs
of the users. Many of the users especially the management and bankers, require the information
from the accounts at regular intervals so that decisions can be taken at the appropriate time.
Management requires information at regular intervals to assess the performance,funds
requirement (short-term as well as long-term), bankers require accountinginformation
periodically. Similarly, the Government has to assess the tax dues from the enterprise.

5. Complete or Full Disclosure Concept

Financial statements should give completeandfull disclosure of all material items in an understandable
manner.
The Concept of Complete Disclosure or Full Disclosure, holds that "thereshouldbe complete
and understandable reporting on thefinancial statements of all significant informationrelating to the
economicaffairsof the entity." Apart from legal requirements, good accounting practice requires
all material and significant information be disclosed. Such information is disclosed by way of
notes to the financial statements. For example, it would be appropriate to show interest receive
and interest paid separately as income and expense instead of showing them at net amount.
The practice of appending notes to the financial statements (such as about Contingent Liabilities
or market value of investments) is because of the concept of full disclosure.

6. Revenue Recognition or Realisation Concept

Revenue is recognised when it is earned, whether receivedor not.
According to the Revenue Recognition Concept or Realisation Concept, revenue is recognised
when it is earned and the obligation to receive the amount is established. It is to be noted that
recognising revenue and receipt of an amount are two separate aspects. Let us take an example
to understand it.
An enterprise sells goods in February, 2021 and receives the amount in April, 2021. Sale, i.e.,
revenue shall be recognised, i.e., recorded in the books of account in February, 2021,i.e., when
the goods are sold. It is so because the legal obligation is established (on sale) in February, 2021 }
On the other hand, receipt of amount against the revenue shall be recorded in April, 2021.Let
us take another example. Suppose, an enterprise has received an advance in February, 2021
for the sale to be made in May, 2021;revenue shall be recognised, i.e., recorded in the books Of'
account in May, 2021,on sale having been made because the legal right to receive the amount
has been established in May, 2021.
Generally Accepted Accounting Principles (GAAP) and Basic Accounting Concepts 3.5

7. Verifiable Objective (Evidence) Concept

Transactions are recorded in the booksofaccount on the basis ofevidences. Thus, free from personal bias.
Objectivity means reliability and verifiability, which means that there is some evidence in
ascertaining the correctness of the information reported.
"Ihe Verifiable Objective Concept holds that accounting should be free from personal bias.
Measurements that are based on verifiable evidences are regarded as objective. It means all
accounting transactions should be evidenced and supported by business documents. These
supporting documents are cash memo, invoices, sales bills, etc., and provide the basis for
accountingand audit.

8. Matching Concept or Matching Principle

If revenue is recognised, all related expenses should also be accounted, whether paid or not.
According to the Matching Concept, revenue recognised and cost incurred to earn that revenue
should be matched. It means revenue and related costs should be recognised in the same
accounting period. Since the accounts are usually prepared on accrual basis, the expenses
incurred in an accounting period are matched with the revenues recognised in that period.
In brief, Matching Principle requires that all revenues earned during an accounting year, whether
received or not, and all related costs incurred, whether paid or not, have to be taken into account while
preparing Profit and Loss Accountfor that year. Similarly,all amounts receivedor paid during the
current year but relating to the next year, should be excludedfrom the current year's revenues and costs.

9. Historical Cost Concept

Transactions are recorded at the cost incurred.
According to the Historical Cost Concept, transactions are recorded in the books of account at
their cost to the business. For example, an asset is recorded in the books of account at the price
paid to acquire it and the cost is the basis for all subsequent accounting of the asset.Asset
is recorded at the cost at the time of its purchase but its value is systematicallyreduced by
charging depreciation. The market value of an asset may change with passage of time, but
for accounting purposes it continues to be shown in the books of account at its book value
(i.e.,cost at which it was purchased less depreciation provided till date). For example, an
asset is purchased for 5,00,000and if at the time of preparing the final accounts, even if its
market value is say, 4,00,000or 7,00,000,yet the asset shall be recorded at its purchase price

The cost principle has the advantage of bringing objectivity into accounts. Information given
in the financial statements is not influenced by the personal bias or judgments.
10. Accrual Concept
An expense is recognised when incurred, whether paid or not. Similarly, revenue is recognisedwhen
earned, whether received or not.
According to the Concept, a transaction is recorded at the time when it is entered into and
not when the settlement takes place. The concept is important because it recognises assets,
 Double Entry Book Keeping--ISC*
3.6
expenses as and when transactions relating to them are entered .
liabilities, revenues and Recognition Concept, revenue is recognised as
along with Revenue
Under this concept are rendered, who, in turn, undertakes the obligationk
or services
when the goods are sold regarded as incurred when the expense has been in
expense is
pay for them. Similarly,
is assumed.
and an obligation to pay for outstanding expenses, ac
that adjustments are made
It is because of this concept unearned income, etc., while preparing the final accounG
incomes,prepaid expenses and
the end of the accounting period.
Exarnple:
1st January, 2021 amounting to to
& Co. purchased computers on
M/S RSM by the enterprise and ha!
on 15th April, 2021. Since the asset has been purchased
paid 2021, it must record the transactionin
incurred a liability of 5,00,000 on 1st January,
books of account on 1st January, 2021. The transaction on recording shall reflectthat
its
5,00,000and also owes an equal amountto
the enterprise owns assets (computers) of
the supplier.
VS & Co. on 27th February, 2021 for 15,000on
Similarly, if M/S RSM & Co. sells goods to M/S the amount
on 27th February, 2021 although
credit of two months, the sale should be recorded
is recorded because the revenue has been
will be received on 27th April, 2021.The transaction
& Co. should also recordthe
earned, although the amount has not been received. M/S VS
goods have been purchased
purchase in its books of account on 27th February, 2021because
although the amount has not been paid.

11. Dual Aspect Concept

debit and credit of equal amount.
A transactionhas two aspects,i.e.,
'
According to the Dual Aspect Concept, every transaction has two aspects, a debit and a credit
of equal amount. Simply stated, for every debit there is a credit of equal amount and vice
versa. For example, Atul starts a business with a capital of 1,00,000.There are two aspectsof
the transaction.
On one hand, the business has an asset of 1,00,000(Cash) while on the other hand, the business
has a liability towards the proprietor (Atul) of which is taken as proprieto€s capital
The expression can be shown in the form of an equation as follows:
Capital (Equities) = Cash (Assets)

The term 'assets' denotes the resources owned by a business whereas the term 'equities' denots
the claims against the assets. Equities are of two types, i.e., "owners' equity" and "outsider'
'
equity". Owners' equity (or capital) is the claim of owners against the assets while outsiders
equity (or liabilities) is the claim of outsiders such as creditors, debentureholders against the
assetsof the business. Since all assets of the business are claimed by someone (either ownersor
outsiders), the total of assets is equal to total of liabilities. Therefore, the relationship between
assets, liabilities and capital can be expressed in the form of accounting equation as folloWS
Assets = Equities
or Assets = Capital + Liabilities
or Capital = Assets —Liabilities
 Generally Accepted Accounting Principles (GAAP) and Basic Accounting Concepts 3.7

In the above example, if the business purchases furniture of 20,000out of amount invested
by the proprietor, the situation will be as follows:
Equities = Assets
Capital 1,00,000 = Cash 80,000 + Furniture 20,000
Subsequently,if the business borrows 50,000from a bank, the new position would be
as follows:
Capital + Liabilities = Assets
Capital + Bank loan 50,000 = cash + Furniture 20,000.

12. Materiality Concept

An item is material if it can influence the decision of the user. Accordingly, it is accounted in books

of account. Items that are material should be disclosed.

According to the American Accounting Association, "an item should be regardedas material if there
is a reason to believe that knowledgeof it would influence the decision of an informed investor." Thus,
whether an item is material or not shall depend on its nature and/or amount and therefore, is
a matter of exercising judgment. An item, material for one enterprise, may not be material for
another enterprise.
Examples:
Amount spent on repairs of building say 2,50,000is material for an enterprise having a
turnover of say but it is not material for an enterprise having a turnover of say
15 crore.
• Cost of loose tools may be material for a small repair workshop but may not be material for
Maruti Udyog.
A departure from generally accepted accounting principles is always material.
In keeping with the principle of materiality, material items are disclosed whereas items that
81. are not material, are not shown separately.

13. Consistency Concept

Policiesand practices once adopted should be applied consistently year after year to meet the qualitative
characteristics.
According to the concept, accounting practices once selected and adopted should be applied
consistently year after year. The concept helps in better understanding of accounting information
and makes it comparable with that of previous years. Consistencyis particularly important
when alternative accounting practices are equally acceptable.For example, two methods of
charging depreciation, Written Down Value Method and Straight Line Method, are equally
acceptable. The method once chosen and applied should be applied consistently year after year.
It, however, does not mean that a practice once adopted cannot be changed. An enterprise may
change the accounting policy if the law or accounting standard requires it or it will result in
better presentation. For example, if an enterprise has been charging depreciation on Straight
Line Method (SLM),it may change the method to Written Down Value (WDV)Method.
 3.8 Double Entry Book Keeping—ISC

The rationale of the Consistency Concept can be better understood with the following exampl
A companypurchases a fixed asset for and charges depreciation @20%on
Straight Line Method. At the end of the second year, the book value of the asset will be:

Cost of the Fixed Asset 10,00

Less:Depreciation @20% for 1st year (20% of 10,00,000) 2,00,

Less:Depreciation @20% for 2nd year (20% of 10,00,000)

Book Value of the Fixed Asset
Now, if the method is changed to the Written Down Value Method in the second year,ÄiÄGi
value of the asset at the end of the 2nd year will be:

Cost of the Fixed Asset 10,000m

Less: Depreciation @20% for 1st year (20% of 10,00,000)

Less: Depreciation @20% for 2nd year (20% of 8,00,000)

Book Value of the Fixed Asset
The effect of change will be that the depreciation in 2nd year will be less by 40,000and its
effect on profit will be that Profit will be more by 40,000and also the book value of the asset
will be more by 40,000in the BalanceSheet.
14. Conservatism or Prudence Concept
Account all expectedexpenses and losses but do not account expected gains and incomes.
Prudence (or Conservatism)Concept is many a time described using the phrase "Do not
anticipate a profit, but provide for all possible losses." In other words, prospective losses are accounted
whileprospectiveincomesare not accounted.The application of this concept ensures that the
financialstatements do not paint a better picture than what actually is.
Closingstock valued at lower of cost or net realisable value or Provision for Doubtful Debts
or Providing for Discount on Debtors is because of Prudence Concept.
15. Timeliness
Preparing and presentingfinancial statements within reasonable time is important.
Timelinessmeans that the financial statements or information should be provided to users
within a reasonabletime. The information not provided on time loses its importance and
relevance. For example, if financial statements for the year ended 31st March, 2021 are furnished
in January, 2022,they do not remain useful because considerable time has elapsed and corrective
action may not be possible in proper time.
16. Industry Practice
An accounting practice
followed in that industry.
The practiceprevalent in particular
industry should
be kept in mind while recording and
presentingaccountinginformation. This
two or more enterprises will make inter-firm comparison, i.e.,comparision Of
relevant besides increasing the reliability of the accounting information
providedby the enterprise
amongst the users of such information.
 Generally Accepted Accounting Principles (GAAP) and Basic Accounting Concepts 3.9

17. Substance Over Legal Form

Recordingof transactions should be guided by its substance and not by its legalform.
substance Over Legal Form means that transaction is to be recorded in the books of account on
the basis of its substance and not by its legal form. For example, Pawan sold land to Samir for
Pawan has received the amount and has given possession of land to Samir. However,
registration papers of land are yet to be executed. In brief, the substance of the transaction is that
land has been sold and sale consideration has been received. A legal formality, i.e., execution
of registration deed is pending. Thus, land should be shown as sold in the books of account
and not as an asset of the entity.
Illustration.
As a Chief Accountant, while preparing the accounts of your company, you face a number of
problems. These are:
(i) Production Manager of the company is interested to show the good industrial relations
in the accounts.
(ii) The long-term future success of the company is doubtful due to market competition.
(iii) Customers of the company have placed orders from which the company is expected to
earn large profits.
(iv) One of the shareholders of the company has invested his saving in some shares of another
company.
(v) At the end of the accounting period, factory rent of the company is outstanding fore 10,000.
(vi) Market value of the fixed assets is very high as compared to their book value and the
directors are interested to show the fixed assets at their current market price.
(vii) During the year a company purchased pencils of 50. These remained unused.
(viii) A debtor who owes a large amount to the company is declared insolvent.
(ix) Balance Sheet of the last year shows that company owns shares in a quoted company
and they are quoted at substantially lower value. The value is not likely to increase.
(x) Hari sold goods to Jasmin of 10,000.Jasmine has not taken the delivery yet.
each
You are required to (i) state which accounting concept would be followed in dealing with
of the above problems and (ii) explain briefly what each concept means.
Answer:
(i) MoneyMeasurementConcept.Transactions and events that can be expressed in money or in
money terms are recorded in the books of account. Since good industrial relations cannot
be measured and expressed in money terms, they will not be shown in the accounts.
is
(ii) GoingConcernConcept.The business will continue for an indefinite future and there no
intention to close the business or reduce size of its operations significantly. The doubt
of success does not lead to the inference that business will not continue for an indefinite
period and also the intention that the business will be downsized significantly.
(iii) RealisationConcept.Revenue is recognised when sale is made or service is rendered.
Therefore, profit will be recognised when the transaction takes place and not when the
order is placed.
3.10 Double Entry nook

(iv) BusiltcssEntityConcx•pt.
Business is t@ated as a separate entity distinct from it.%owners,
investment in another company's share is by a shareholder who is distinct from the bug;
(v) AccrualConcept.This concept recognises revenues and expenses as they have been ea
or incurred respectively,ignoring the date of receipt or payment. Since the factory
of the companyis outstanding, it will be recorded in the books of account.
(vi) HistoricalCostConcept.According to the Historical Cost Concept, the fixed assets shoukF
be shown at their cost price, which is the cost of acquisition less depreciation.
(vii) MaterialityConcept.An item is recorded on the basis of it being material. The purchaseQ
pencilsof 50 is not a material item. Therefore, it will be debited to Stationery Account
(Profit and Loss Account).
(viii) Prudenceor ConservatismConcept.When more than one measurement alternative
permissiblefor a transaction, that alternative which has the least favourable
effecton net profit or capital should be selected. In simple words, the concept is ofte
stated, "Anticipaten6 profit, but provide for all possible losses". Thus, Provisionfq
DoubtfulDebtsshould be made against the amount of debtors.
(ix) Cost/Conservatism Concept.Shares in a company should be valued at the lower of Cost
or Net Realisable(market) value. Both these values are objective.
(x) SubstanceOverLegalForm.Goods on being sold to Jasmine means ownership in the goods
have been transferred by Hari to Jasmine. It should be recorded in the books as sale of goods