GAAP CONCEPTS AND CONVENTIONS

By Dr. Githaiga Stephen

 Objectives of the Topic
At the end of this topic, the students should be able to:-
Explain the importance of a GAAP.
Explain meaning and application of GAAP; Balance sheet
Understand meaning and application of GAAP; Income statement
 Introduction to GAAP
The term ‘Concept’ is used to connote the accounting postulates, i.e., necessary
assumptions and ideas which are fundamental to accounting practice.
In other words, fundamental accounting concepts are broad general assumptions which
underline the periodic financial statements of business enterprises.
The reason why some of these terms should be called concepts is that they are basic
assumptions and have a direct bearing on the quality of financial accounting
information.
The term ‘convention’ is used to signify customs or tradition as a guide to the
preparation of accounting statements.
Introduction to GAAP
Accounting Concepts Accounting Conventions
♦ Separate Business Entity Concept ♦ Convention of Materiality
♦ Money Measurement Concept ♦ Convention of Conservatism
♦ Dual Aspect Concept ♦ Convention of consistency
♦ Going Concern Concept
♦ Accounting Period Concept
♦ Cost Concept
♦ The Matching Concept
♦ Accrual Concept
♦ Realisation Concept
 GAAP: Balance Sheet;
Separate Business Entity Concept.
In accounting we make a distinction between business and the owner.
All the books of accounts records day to day financial transactions from the viewpoint of the business
rather than from that of the owner.
The proprietor is considered as a creditor to the extent of the capital brought in business by him. For
instance, when a person invests 10,000 US Dollars into a business, it will be treated that the business
has borrowed that much money from the owner, and it will be shown as a ‘liability’ in the books of
accounts of business.
Similarly, if the owner of a shop were to take cash from the cash box for meeting certain personal
expenditure, the accounts would show that cash had been reduced even though it does not make any
difference to the owner himself.
Thus, in recording a transaction the important question is how does it affects the business? For
example, if the owner puts cash into the business, he has a claim against the business for capital
brought in.
 GAAP: Balance Sheet;
Separate Business Entity Concept.
In so far as a limited company is concerned, this distinction can be easily maintained because a
company has a legal entity of its own.
 Like a natural person it can engage itself in economic activities of buying, selling, producing,
lending, borrowing and consuming of goods and services.
However, it is difficult to show this distinction in the case of sole proprietorship and partnership.
Nevertheless, accounting still maintains separation of business and owner.
It may be noted that it is only for accounting purpose that partnerships and sole proprietorship are
treated as separate from the owner (s), though law does not make such distinction.
Infact, the business entity concept is applied to make it possible for the owners to assess the
performance of their business and performance of those whose manage the enterprise.
The managers are responsible for the proper use of funds supplied by owners, banks and others.
 GAAP: Balance Sheet;
Money Measurement Concept.
In accounting, only those business transactions are recorded which can be expressed in terms of
money. In other words, a fact or transaction or happening which cannot be expressed in terms of money
is not recorded in the accounting books. As money is accepted not only as a medium of exchange but
also as a store of value, it has a very important advantage since a number of assets and equities, which
are otherwise different, can be measured and expressed in terms of a common denominator.
We must realise that this concept imposes two limitations.
Firstly, there are several facts which though very important to the business, cannot be
recorded in the books of accounts because they cannot be expressed in money terms.
 Secondly, use of money implies that we assume stable or constant value of US dollars.
Taking this assumption means that the changes in the money value in future dates are
conveniently ignored.
 GAAP: Balance Sheet;
Dual Aspect Concept.
Financial accounting records all the transactions and events involving financial element. Each of such
transactions requires two aspects to be recorded. The recognition of these two aspects of every transaction
is known as a dual aspect analysis. According to this concept every business transactions has dual effect.
It follows from ‘dual aspect concept’ that at any point in time owners’ equity and liabilities for any
accounting entity will be equal to assets owned by that entity. This idea is fundamental to accounting and
could be expressed as the following equalities:
Assets = Liabilities + Owners Equity ...............(1)
Owners Equity = Assets - Liabilities ...............(2)
The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’ denotes the
resources supplied by the owners of the entity while the term ‘liabilities’ denotes the claim of outside
parties such as creditors, debenture-holders, bank against the assets of the business. Assets are the
resources owned by a business. The total of assets will be equal to total of liabilities plus owners capital
because all assets of the business are claimed by either owners or outsiders.
 GAAP: Balance Sheet;
Going Concern Concept.
Accounting assumes that the business entity will continue to operate for a long time in the future unless
there is good evidence to the contrary. The enterprise is viewed as a going concern, that is, as continuing
in operations, at least in the foreseeable future. In other words, there is neither the intention nor the
necessity to liquidate the particular business venture in the predictable future. Because of this assumption,
the accountant while valuing the assets do not take into account forced sale value of them. Infact, the
assumption that the business is not expected to be liquidated in the foreseeable future establishes the basis
for many of the valuations and allocations in accounting. For example, the accountant charges
depreciation of fixed assets values. It is this assumption which underlies the decision of investors to
commit capital to enterprise.
Only on the basis of this assumption can the accounting process remain stable and achieve the objective
of correctly reporting and recording on the capital invested, the efficiency of management, and the
position of the enterprise as a going concern. However, if the accountant has good reasons to believe that
the business, or some part of it is going to be liquidated or that it will cease to operate (say within six-
month or a year), then the resources could be reported at their current values. If this concept is not
followed, International Accounting Standard requires the disclosure of the fact in the financial statements
together with reasons.
 GAAP: Balance Sheet;
Cost Concept.
The term ‘assets’ denotes the resources land building, machinery etc. owned by a business. The money
values that are assigned to assets are derived from the cost concept. According to this concept an asset is
ordinarily entered on the accounting records at the price paid to acquire it. For example, if a business buys a
plant for $5,000 the asset would be recorded in the books at $5,000 even if its market value at that time
happens to be $6,000. Thus, assets are recorded at their original purchase price and this cost is the basis for
all subsequent accounting for the business. The assets shown in the financial statements do not necessarily
indicate their present market values. The term ‘book value’ is used for amount shown in the accounting
records.
The cost concept does not mean that all assets remain on the accounting records at their original cost for
all times to come. The asset may systematically be reduced in its value by charging ‘depreciation’, which
will be discussed in detail in a subsequent lesson. Depreciation have the effect of reducing profit of each
period. The prime purpose of depreciation is to allocate the cost of an asset over its useful life and not to
adjust its cost.
However, a balance sheet based on this concept can be very misleading as it shows assets at cost even
when there are wide difference between their costs and market values. Despite this limitation you will find
that the cost concept meets all the three basic norms of relevance, objectivity and feasibility.
 GAAP: Income Statement
Accounting Period Concept.
This concept requires that the life of the business should be divided into appropriate segments for studying
the financial results shown by the enterprise after each segment. Although the results of operations of a specific
enterprise can be known precisely only after the business has ceased to operate, its assets have been sold off
and liabilities paid off, the knowledge of the results periodically is also necessary. Those who are interested in
the operating results of business obviously cannot wait till the end.
The requirements of these parties force the businessman ‘to stop’ and ‘see back’ how things are going on.
Thus, the accountant must report for the changes in the wealth of a firm for short time periods. A year is the
most common interval on account of prevailing practice, tradition and government requirements. Some firms
adopt financial year of the government, some other calendar year. Although a twelve-month period is adopted
for external reporting, a shorter span of interval, say one month or three month is applied for internal reporting
purposes.
This concept poses difficulty for the process of allocation of long-term costs. All the revenues and all the cost
relating to the year in operation have to be taken into account while matching the earnings and the cost of those
earnings for the any accounting period. This holds good irrespective of whether or not they have been received
in cash or paid in cash. Despite the difficulties which stem from this concept, short term reports are of vital
importance to owners, management, creditors and other interested parties. Hence, the accountants have no
option but to resolve such difficulties.
 GAAP: Income Statement
The Matching concept.
This concept is based on the accounting period concept. In reality we match revenues and expenses during
the accounting periods.
Matching is the entire process of periodic earnings measurement, often described as a process of matching
expenses with revenues.
In other words, income made by the enterprise during a period can be measured only when the revenue
earned during a period is compared with the expenditure incurred for earning that revenue.
 Broadly speaking revenue is the total amount realised from the sale of goods or provision of services
together with earnings from interest, dividend, and other items of income.
Expenses are cost incurred in connection with the earnings of revenues. Costs incurred do not become
expenses until the goods or services in question are exchanged.
Cost is not synonymous with expense since expense is sacrifice made, resource consumed in relation to
revenues earned during an accounting period.
Only costs that have expired during an accounting period are considered as expenses.
 GAAP: Income Statement
Conservatism Concept.
This concept requires that the accountants must follow the policy of ‘’playing safe” while recording
business transactions and events. That is why, the accountant follow the rule anticipate no profit but provide
for all possible losses, while recording the business events. This rule means that an accountant should record
lowest possible value for assets and revenues, and the highest possible value for liabilities and expenses.
According to this concept, revenues or gains should be recognised only when they are realised in the form of
cash or assets (i.e. debts) the ultimate cash realisation of which can be assessed with reasonable certainty.
Further, provision must be made for all known liabilities, expenses and losses, Probable losses regarding all
contingencies should also be provided for. ‘Valuing the stock in trade at market price or cost price which
ever is less’, ‘making the provision for doubtful debts on debtors in anticipation of actual bad debts’,
‘adopting written down value method of depreciation as against straight line method’, not providing for
discount on creditors but providing for discount on debtors’, are some of the examples of the application of
the convention of conservatism.
The principle of conservatism may also invite criticism if not applied cautiously. For example, when the
accountant create secret reserves, by creating excess provision for bad and doubtful debts, depreciation, etc.
The financial statements do not present a true and fair view of state of affairs.
 GAAP: Income Statement
Realizations Concept.
Realisation is technically understood as the process of converting non-cash resources and rights into
money. As accounting principle, it is used to identify precisely the amount of revenue to be recognised and
the amount of expense to be matched to such revenue for the purpose of income measurement. According to
realisation concept revenue is recognised when sale is made. Sale is considered to be made at the point when
the property in goods passes to the buyer and he becomes legally liable to pay. This implies that revenue is
generally realised when goods are delivered or services are rendered. The rationale is that delivery validates
a claim against the customer. However, in case of long run construction contracts revenue is often recognised
on the basis of a proportionate or partial completion method. Similarly, in case of long run installment sales
contracts, revenue is regarded as realized only in proportion to the actual cash collection. In fact, both these
cases are the exceptions to the notion that an exchange is needed to justify the realisation of revenue.
 GAAP: Income Statement
Consistency Concept.
The convention of consistency requires that once a firm decided on certain accounting policies and
methods and has used these for some time, it should continue to follow the same methods or procedures for
all subsequent similar events and transactions.
Materiality Concept
Materiality concept states that items of small significance need not be given strict theoretically correct
treatment. Infact, there are many events in business which are insignificant in nature. The cost of recording
and showing in financial statement such events may not be well justified by the utility derived from that
information.
This convention will unnecessarily overburden an accountant with more details in case he is unable to find
an objective distinction between material and immaterial events. It should be noted that an item material for
one party may be immaterial for another. Actually, there are no hard and fast rule to draw the line between
material and immaterial events and hence, It is a matter of judgement and common sense. Despite this
limitation, It is necessary to disclose all material information to make the financial statements clear and
understandable. This is required as per IAS-1 and also reiterated in IAS-5. As per IAS-1, materiality should
govern the selection and application of accounting policies.
 GAAP: Income Statement
Accrual Concept.
It is generally accepted in accounting that the basis of reporting income is accrual.
Accrual concept makes a distinction between the receipt of cash and the right to receive it, and the
payment of cash and the legal obligation to pay it.
This concept provides a guideline to the accountant as to how he should treat the cash receipts and the
right related thereto.
Accrual principle tries to evaluate every transaction in terms of its impact on the owner’s equity.
The essence of the accrual concept is that net income arises from events that change the owner’s equity in
a specified period and that these are not necessarily the same as change in the cash position of the business.
Thus it helps in proper measurement of income.
Further Readings
• Donald E. Kieso, Jerry J. Weygandt & Terry, D.
Warfield (2010), Intermediate Accounting
International Student Version, 13th Edition. Wiley
• Garrison /Noreen/Brewer, Managerial Accounting
11th Edition (McGraw Hill, 2005)
• Peter Atrill (2018) Accounting and Finance for
Non-Specialists 11th edition, Pearson Canada;
ISBN-10: 1292244011,ISBN-13: 978-1292244013
• Padberg Thomas (2017) How to Analyse Bank
Financial Statements: A concise practical guide for
analysts and investors Kindle Edition.
Hampshire,GU314AD.Great Britain.
• Wood F.F & Sangster, A. (2008) Business
Accounting 1 11th edition Pearson
THANK YOU