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Accounting Principles and Assumptions

Accounting Principles and Assumptions - Success Roar Classes

What is Accounting Principles?

  • Accounting principles refer to those set of rules which provide the basic idea, parameters, limitations for implementing the accounting process in a well-defined manner. These rules are also called Generally Accepted Accounting Principles or GAAPs. (Accounting Principles and Assumptions)

Principles of Accounting are the general law or rule adopted or proposed as a guide to action, a settled ground, or basis of conduct or practice.

American Institute of Certified Public Accountants

  • Accounting principles are the norms or rules which are adopted by accountants universally while recording accounting transactions.
    • They are followed in the accounting of various items of assets, liabilities, expenses, income, etc.
    • For example- The depreciation over Fixed Assets should be charged using a constant method. This rule makes the financial information comparable. (Accounting Principles and Assumptions)
  • Accounting principles can be divided into two further parts-
    • Accounting Assumptions or concepts
    • Accounting Conventions
  • Characteristics of Accounting Principles
    1. Accounting principles are a uniform set of rules developed to ensure the uniformity, understandability, comparability, and other qualitative characteristics of accounting.
    2. These are accepted worldwide.
    3. These rules are not static in nature. These rules changes over the period of time due to change in a business environment.
    4. These rules are based on the experiences of some persons.
    5. The acceptability of accounting principles depends on
      1. How much relevant information can be provided to the users through it?
      2. How much reliable and authenticated accounting information can be prepared by applying this.
      3. Is it easy to apply the accounting principle in terms of cost and effort?

What are the types of Accounting assumptions or concepts?

  1. The accounting concepts are the foundation or basis of accounting work. These provide a guideline on how transactions should be recorded and the financial information to be communicated to the users. These are followed by every type of business entity all over the world.
  2. Accounting principles are divided into two categories-
  3. Further, these accounting concepts can be divided into two parts-
    • Defined by Accounting Standard-1, Disclosure of Accounting Policies- These are provided under the Accounting Standard-1, Disclosure of Accounting Policies issued by the Institute of Chartered Accountants of India.
      1. Going Concern Concept
      2. Consistency Concept
      3. Accrual Concept
    • Other concepts/assumptions-
      1. Business Entity Concept
      2. Money Measurement Concept
      3. Accounting Period Concept
      4. Historical Cost Concept
      5. Matching Concept
      6. Dual Aspect Concept
      7. Revenue Recognition Concept
      8. Verifiable Objective Concept

Accounting assumptions as per AS-1 Disclosure of Accounting Policies

  1. Going Concern Concept: –
    1. As per the going concern concept, it is assumed that the business will continue to exist for a long period in the future. Therefore, the transactions of the business are recorded in such a manner that the business entity will work for a long period.
    2. For example, making long-term business policies, taking a long-term loan from a bank, recording the assets at historical cost instead of its market value, classification of assets into current and noncurrent, etc.
  2. Consistency Assumption-
    1. This accounting provides that the methods or principles used in making books of accounts should be followed consistently over a long period until the change will justify the better presentation of the financial statement.
    2. Such types of changes should be shown in the footnote of the financial statement.
    3. The consistency maintains the comparability and usefulness of accounting information for users.
    4. In other words, the policies, methods, principles used in accounting should not be change from one year to another.
    5. For example, if the stock of the business is valued through the FIFO method for one year and in the next year the LIFO method is used, then the financial statement will be misleading and not useful for users. Other examples change in the depreciation method of accounting.
  3. Accrual Assumption-
    1. In accounting, the accrual basis is a method for recording transactions in the books of accounts. Does it guide when to record a transaction in the books? It helps in providing more appropriate and useful information about the business activities in comparison to a cash basis.
    2. For revenues- The revenues are to be recorded when it is earned. For example, the sale is to be recorded when the transaction is completed in terms of transfer of ownership. Same the revenue on services is to be recorded when services rendered. This assumption does not consider the receipt of cash for determining the time when the revenue is received.
    3. For expenses-the transaction related to expenses is to be recorded when it is incurred. Expenses will be considered to be incurred when the obligation to pay for it has been created.
    4. This helps to show the correct picture of the financial position of a business entity.
    5. For example, rent expenses for the year 2020-21 were 24,000 out of which only 22,000 is paid. Here rent for the march is not paid but the obligation has been created due to the use of the rented property. Hence this will be recorded at the end of March and will be included in the year 2020-21. (Accounting Principles and Assumptions)

Other Accounting Assumptions

  1. Business Entity Concept: –
    1. According to this concept, a business and its owner both are treated as separate from each other.
    2. Due to this concept, the capital introduced by the owner in the business is treated as a liability and the amount withdrew by the owner from the business is called drawings.
    3. The separate books of accounts are prepared by the owner and business from their own point of view.
    4. For example, interest on capital is treated as expenses in the books of business whereas this is recorded as income in the books of the owner.
    5. This concept is applicable while making accounts of every type of transaction like company, partnership, sole proprietorship, etc.
  2. Money Measurement Concept-
    1. In accounting, only those transactions and events are recorded in the books of accounts which can be expressed in terms of money.
    2. Due to this assumption sometimes any event which is crucial or important for business will not be recorded in the books of the business.
    3. For example, honesty of employees, the efficiency of management, introduction, etc.
    4. Further transactions which can be measured in money will also be recorded in terms of money in the books.
    5. For example, if a business purchased ₹ 1,000 Fans for 10,000 then 10,000 will be recorded in books instead of recording the number of fans.
    6. In other words, all financial transactions are to be expressed and recorded in a common unit of measurement, i.e., money.
  3. Accounting Period Concept-
    1. As the business is intended to work for a long period, the actual results of the business operations can be ascertained at the closing of the business.
    2. But is not feasible to wait and calculate profit after such a long time. This will also make confusion regarding the outstanding dues of outside creditors.
    3. Hence, the whole life of the business entity is divided into equal time periods so that the profit can be calculated on regular basis.
    4. This time period is generally adopted of the twelve-month period.
    5. This period is called the accounting year or Financial year beginning on 1st April and ending on 31st March.
    6. In the case of a new business entity, an accounting year can be less than 1 year. (Accounting Principles and Assumptions)
  4. Historical Cost Concept-
    1. Historical cost means the cost incurred in past for the acquisition of any asset or other useful resources.
    2. According to this concept an asset is recorded at its historical cost in the financial statement and all transactions related to assets in the future will be done on the basis of its historical cost.
    3. For example, machinery purchased by a business entity on 1.4. 2019 for ₹ 50 lakhs. The machinery will be recorded at ₹ 50 lakhs and will be depreciated on the basis of this cost. Further, if in the year 2020-21 the market value of this machinery decreased by ₹ 5, in this case, this reduction will have no impact on the book value of the machinery. 
    4. Hence, we can say that this method ignores the market value of the asset.
    5. How we can say that it is justified to use historical cost-
      • Market value has its own limitations, for example, it changes frequently, it can be valued by valuation officers and valuation may differ from person to person, hence it is justified to consider the historical cost to record the asset.
      • The historical cost represents the cost actually paid to acquire the asset and it is also complying with the going concern assumption. 
    6. Limitations of historical cost concept
      • This method ignores the recording of the items for which no money has been paid. For example, self-generated goodwill, experience or knowledge of management/employees, etc.
      • This method represents the asset on its past cost may not be suitable for future decisions by the users.
      • This method ignores the current market value of the asset in the current market situation which may represent the incorrect financial position of the business.
  5. Matching Concept
    1. This concept helps in identifying the correct profit or loss for the accounting year.
    2. According to this concept, any income of the current year and all expenses incurred on earning such income shall be included in the accounts of the current year.
    3. It says about matching the expenses with relevant income. For example, a sale of ₹ 50,000 has made during the year. For earning this 50,000, expenses of ₹ 40,000 have been incurred. In this case, the full amount of ₹ 40,000 will be recorded in the books whether paid or not.
    4. Impact of the concept in accounting-
      • Due to this concept, all expenses which are unpaid but related to the current year are added to the expenses paid and all expenses which are paid but related to the next year are deducted from the total paid expenses amount.
      • Expenses paid during the year Less: expenses paid but related to the subsequent year Add: expenses not paid but related to the current year = Expenses incurred during the year
  6. Dual Aspect Concept-
    1. In every transaction, two aspects can be seen. First giving something and second receiving something. This means every transaction will have impact on at least two accounts For example, in the case of cash sales, a business entity gives goods to the customer and receives cash for the sale of goods. Here both cash and sale accounts are affected.
    2. As per this concept, both aspects of every business transaction must be recorded in the books of accounts.  The system based on this concept is called the Double entry system.
    3. Due to this concept, both sides of the Balance sheet are always equal in amount. And on the basis of this, an equation can be set up in books i.e. Assets = Capital + Liabilities
    4. If the accounting is done correctly the above equation will always remain balanced with each and every transaction in the business.
    5. For example, in the above transaction of sale, there was a decrease in one asset named stock but at the same time, another asset named cash get increased. (Accounting Principles and Assumptions)
  7. Revenue Recognition Concept
    1. According to this concept, revenue is recognized when the amount is earned by the business entity or the purchased becomes actually liable for the payment of the amount. The cash receipt is not considered in this concept.
    2. This concept guides that when to recognize revenues.
    3. For example, in the case of sale revenue will be recognized when the ownership is transferred to the purchaser whether the amount is paid or not.
    4. There are many cases which are the exception of revenue recognition concept, for example, a transaction of contract where the amount recognized on the basis of completion of some % of work, in mining business recording of revenue at the time of production instead of a sale, etc.
  8. Verifiable Objective Concept –
    1. According to this concept, the accounting information must be objective i.e., free from any errors or frauds, or personal bias.
    2. Further, the accounting information must be based on some verified evidence for example sale invoices, payment vouchers, etc. This means the verification of the accounting information must be possible through supporting evidence. (Accounting Principles and Assumptions)

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