Accounting is the craft of recording, classifying, and summarizing the financial information and statements of an entity. Accounting encompasses not only the work of recording business transactions but also analytical skills and the ability to explain financial uncertainties in business, thereby creating a clear picture of the entity’s financial stability.
In a business climate where there are disclosures of financial statements to external interested parties such as stock markets, investors, finance departments, banks, and tax authorities or government, it is imperative to devise an accounting framework by virtue of which there can be a recording of financial operations so as to facilitate a standardized comparison of financial statements and the application of similar accounting principles across different companies. This need led to the development of Generally Accepted Accounting Principles, or GAAP.
Knowing GAAP
Generally Accepted Accounting Principles (GAAP) comprise the fundamental principles of accounting, which represent the rules and guidelines for the presentation, formulation, and reporting of accounting statements. GAAP serves as a common language for fiscal reporting, ensuring that financial statements and figures are well understood and accurate. For instance, the Financial Accounting Standards Board (FASB) operates on these principles as a foundational base to set its accounting practices.
GAAP covers:
- Fundamental accounting principles/regulations
- Accounting standards that are generally established by the principal accounting body
- Industry-established protocols
Across India, the compilation of financial reports is conducted in accordance with the accounting standards established by the Institute of Chartered Accountants of India (ICAI) and the legal provisions outlined in relevant laws, such as Schedule III of the Companies Act, 2013, which every company is required to follow. On their part, the ICAI also issues guidance notes on various topics to assist with accounting procedures and promote precision and transparency on these standards.
Core Principles Elemental to GAAP
These are the generally accepted accounting principles that cover the primary aspects of accounting and aid in the reporting and recording of financial transactions.
1. Concept of Business Entity
It affirms that every organization should be recognized as a distinct entity from its owners. This concept should be followed while capturing all relevant financial information of a sole proprietorship. When the whole business, including its assets and debts, is the property of the proprietor, a distinction needs to be made between the financial operations of the company and those belonging to the proprietor individually.
2. Expression in Monetary Units
All business dealings and accounting transactions of a venture should be effectively represented in a monetary unit (for example, Indian Rupees). If it is unworkable, then there is no need to enter it in the record book or books of accounts of the venture.
3. Accounting Year
This principle implies that a business entity’s accounting process should be completed within a specified time frame, typically a financial year, tax year, or calendar year. Therefore, every transaction that pertains to a given accounting period or fiscal year will constitute the financial statements compiled for that particular period.
4. Historical Cost Rule
This principle records business transactions at their historical costs, which are their purchase prices or original costs. According to this theory, a firm or business must account for and document its assets and liabilities at their initial cost or purchase price in its balance sheet. An example is the acquisition of an office complex valued at $ 7 million. The purchase was made 12 years ago; although in the present market, the building is valued at more than $10,000,000.
5. Going Concern Premise
This accounting concept assumes a business will keep running in the near future for at least a year, without having to sell its assets because of bankruptcy or closing down. This idea covers different parts of how we value assets and report finances. It has an impact on how we look at income, assets, and debts, as well as money put into business strategies. Even the depreciation concept and amortization are derived on the assumption that a business will sustain its operation for the next 12 months following the financial year.
6. Complete Disclosure Principle
This principle prioritizes transparency and accountability in financial reporting and the disclosure of both financial and non-financial material information, as the omission of which can affect the economic decisions of investors and creditors. A company is required to reveal information on any change in accounting standards, outstanding legal suits, the quantities of stocks, and other facts and figures in its accounts.
7. Concept of Matching
This concept of accounting controls the reporting of expenses and revenues. It requires that a firm account for its expenses and revenues in tandem. Matching of revenues and costs is performed on the income statement over a specified period, such as a quarter, month, or year.
Suppose a company pays its workers an annual bonus based on their performance during the financial year. The plan is to pay 5% of the profits realized during the year, which will be paid off or disbursed in February of the following year.
In 2019, the company earned $120 million and will, therefore, pay its workers a bonus of $ 6 million in February 2020.
Although the bonus will not be paid until the following year, the matching principle dictates that the expenditure should be recorded in the 2019 Income statement as $6 million.
In the balance sheet during the culmination of 2019, a bonus payable balance of $6 million will be credited, and a deduction in retained earnings of the same amount in the balance sheet will be balanced.
During February 2020, when the bonus is disbursed, it will not be reflected in the income statement. The cash balance on the balance sheet will be credited by $6 million, and the bonuses payable balance will be simultaneously debited by $6 million, ensuring the balance sheet remains balanced.
8. Accrual Accounting Principle
This concept requires the recording of all revenue and expenses in the period in which they occur rather than when cash or short-term liquid investments are received or spent. What is of significance is the revenue or income earned and the cost incurred, regardless of the associated cash flow or exchange of cash. This implies that there is a recording of the transaction at the moment the economic activity occurs, not at the time when the money is spent or received. This type of accounting provides an accurate representation of the company’s financial health and standing by matching expenditures and revenues, which is helpful for tax planning and efficiency purposes.
9. Consistency in Accounting
A company may choose to adopt a specific accounting method for a series of business transactions. Such accounting practices must be consistently observed over future accounting periods to facilitate a comparison of the results between the intervals. Consistency helps in the comparison of financial statements from different durations and allows stakeholders to assess the performance trends and changes more adeptly.
10. Materiality Principle
The materiality concept in accounting states that financial details important enough to affect investment and financial reporting choices should be reported. This idea helps draw a line between crucial and unimportant information, thus steering clear of information overload. If an omission or misrepresentation of information can influence a user’s decision, that information is regarded as material and warrants disclosure. For instance, if an entity has a significant revenue stream, a minor mistake regarding a negligible expense may be considered immaterial. On the other hand, the same error for a small enterprise can be material.
11. Conservative Approach
The aim of the conservatism principle in accounting is to understate or undervalue the revenue or the value of an asset. It is one of the key rules that accords maximum importance to exercising prudence in financial accounting, keeping the financial statements true to the actual financial stability of the company. It stipulates that accountants should immediately foresee and record the likely losses and expenditures, but postpone and delay assessing prospective gains till they are actualized. This principle works as a safeguard against misleading investors with unrealistic financial information.
Conservatism is applied in asset valuation, particularly for inventory items using the lower cost or market rule. This serves the purpose of avoiding overestimation of assets in the balance sheet. This principle is also used while estimating bad debt provisions, inventory costing, and asset depreciation.
Final Words
GAAP serves as the conceptual framework for financial reporting and accounting, providing the transparency, comparability, and consistency of financial statements. By offering a standardized procedure for recording and disclosing financial data, GAAP enhances the soundness and credibility of financial reports, promotes informed strategic decision-making, and helps entities maintain accountability. With the changing financial climate, GAAP continues to evolve to attend to the increasing demands to stay relevant and maintain its integrity in guiding the presentation of accounts and the financial records.
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