In an environment where financial statements are presented to external stakeholders such as investors, banks, stock exchanges, revenue departments, government, etc., there arises a need for an accounting framework on the basis of which the financial transactions should be recorded so as to make the resulting financial statements comparable. This need led to the framing of the Generally Accepted Accounting Principles (GAAP).
What is GAAP?
Generally Accepted Accounting Principles (GAAP) are basic accounting principles and guidelines which provide the framework for more detailed and comprehensive accounting rules, standards and other industry-specific accounting practices. For example, the Financial Accounting Standards Board (FASB) uses these principles as a base to frame their own accounting standards. Thus GAAP encompasses:
- Basic accounting principles/guidelines
- Accounting Standards usually issued by the premier accounting body of the country
- Industry-specific accounting practices to cover unusual scenarios
In India, financial statements are prepared on the basis of accounting standards issued by the Institute of Chartered Accountants of India (ICAI) and the law laid down in the respective applicable acts (for example, Schedule III to Companies Act, 2013 should be compulsorily followed by all companies). The ICAI also releases guidance notes from time to time on various topics to help in the accounting process and provide clarity. While the basic accounting principles may not directly form part of the accounting standards and the related laws, they are assumed and expected to be universally followed.
Generally Accepted Accounting Principles
The following are the general accounting principles as mentioned earlier:
- Business Entity Assumption: It states that every business entity should be treated as an entity that is separate from its owners. Therefore, all financial transactions should also be distinguished in such a manner. This concept is especially important while recording financial transactions of a sole proprietor. When the entire business with its assets and liabilities belong to the proprietor, the financial transactions need to be distinguished between those related to the business and those related to the proprietor personally.
- Monetary Unit Assumption: All the financial transactions of a business should be capable of being expressed in a monetary unit (Indian Rupees, for example) and if it is not possible to do so, then it should not be recorded in the books of accounts of the business.
- Accounting Period: This principle entails that the accounting process of a business should be completed within a certain time period which is usually a financial year or a calendar year. Thus, every transaction which relates to a particular accounting period will form a part of the financial statements prepared for that period.
- Historical Cost Concept: As a general rule, when certain economic resources or assets are acquired by an enterprise, they are recorded as per the cash or cash equivalent actually spent to acquire that resource or asset on the transaction date – even if the transaction happened the previous day or ten years ago. This would result in the value of the remaining asset constant irrespective of the accounting period. The market value of the asset is not taken into account unless specifically required by law or an accounting standard.
- Going Concern Assumption: The business entity is assumed to be a going concern, i.e., it will continue to operate for an indefinite amount of time. This assumption is important because if the business entity were to liquidate in the near future, it would have to restate its assets and liabilities in the accordance with the actual amount that could be realised or payable as the case may be so as to reflect the true financial position of the entity.
- Full Disclosure Principle: An accounting entry may not independently be able to provide all the relevant information relating to the transaction. Hence the full disclosure principle requires the entity to disclose all the financial information relevant to the investor/user to assist him in decision making. At the transactional level, this is done by recording an adequate narration with every transaction and at the financial statement level, this is implemented by providing notes to the accounts.
- Matching Concept: This concept requires the revenue for a particular period to be matched with its corresponding expenditure so as to show the true profit for the period.
- Accrual Basis of Accounting: This principle requires all revenue and expenditure to be recorded in the period it is actually incurred and not when cash or cash equivalent has been received/spent. The earning of the income and the incurring of the expenditure is important, irrespective of the corresponding cash flow.
- Consistency: An entity may decide to follow a particular accounting procedure in relation to a series of transactions. Such accounting procedures need to be followed consistently over the following accounting periods so as to facilitate comparison of the results between two periods. For example, an entity might choose to adopt the straight-line method of depreciation of its tangible fixed assets. This method needs to be consistently followed even in the coming years.
- Materiality: This accounting principle allows an entity to disregard another accounting principle if the result of the same does not affect the decision making of the user of the financial statements. Certain errors or omissions may also be ignored if their effect is immaterial to the financial statements. For example, when a fixed asset is purchased, the matching concept requires the entity to recognise the expenditure over the useful life of the asset. If an entity purchases a keyboard for Rs. 300 and the turnover of such an entity is in crores of rupees, it would be immaterial to the user of financial statements whether such an asset is recognised as an asset or expense. Thus, even if the computer keyboard is considered as an expense in the year of purchase, it would not be violating the basic accounting principles since the amount involved and the impact of the same is immaterial.
- Conservatism: In the process of accounting, one might come across various situations where there are two equally acceptable ways of accounting for a particular transaction. One might even have to choose between recording a transaction or not recording the same. In such a situation, a conservative approach should be followed. This means that while accounting for a particular transaction, all anticipated expenses or losses will need to be accounted for but all potential income or gains should not be recorded until actually earned/received. This is why a provision for expenses like bad debts is made but there is no corresponding record provided for an increase in the realisable value of an asset.