Financial Accounting & Analysis Accounting principles, its concepts and Conventions. (Financial Accounting & Analysis) (Accounting principles) Accounting is the process of recording financial transactions pertaining to a business. Learning Objectives At the end of this topic, you will be able to: Understand what are accounting principles. Develop an understanding of the importance of accounting principles Identify the need for accounting principles (Financial Accounting & Analysis) (Accounting principles) Accounting Principles The term principle has been defined by AICPA as “A general law or rule adopted or professed as a guide to action, a settled ground or basis of conduct or practice”. So, Generally Accepted Accounting Principles (GAAP) refers to the rules or guidelines adopted for recording or reporting of business transactions, in order to bring uniformity in the preparation and presentation of financial statements. GAAP are basic accounting principles and guidelines which provide the basis for more elaborate and extensive accounting rules and standards. The Financial Accounting Standards Board (FASB) uses these principles as the basis to frame accounting methods and practices. 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, we have to prepare the financial statements on the basis of standards issued by the Institute of Chartered Accountants of India (ICAI) and the law which would be applicable as per the respective acts (For example, Schedule III to Companies Act, 2013 should be compulsorily followed by all companies). (Financial Accounting & Analysis) (Accounting principles) Accounting Principles Also, at regular intervals, the ICAI releases Guidance Notes on various topics to clarify the issues faced while accounting. These basic accounting principles may not be a part of the accounting standards, but they are expected to be followed every time. They are the pillars of accountancy. Features of accounting principles: 1. Accounting principles are man-made: Accounting principles are man-made and therefore they are based on practical usages and are the best source to refer to in case of any doubt. For bringing uniformity in the accounting records, it is necessary to follow them. 2. Accounting principles bring flexibility: The accounting principles are very flexible in nature. They are not cast in stone. So, if need be, with the passage of time, they can be changed. 3. Accounting principles are generally acceptable: Accounting principles are generally accepted all across. They from the base for Accounting. (Financial Accounting & Analysis) (Accounting principles) Accounting Principles Accounting principles are generally classified in two categories: 1. Accounting Concepts: Accounting concepts are the basic accounting assumptions. While recording business transactions and preparing the books of accounts, they are the rules of accounting which have to be followed compulsorily. It beings standardization in the books of accounts across different entities. Also, it helps the end users to understand the books better. 2. Accounting Conventions: Accounting Conventions are a result of firms following accounting practices or principles for a long period of time. They can be considered as customs or traditions which are followed in the preparation of accounting standards. In the next few slides, we would be discussing about the needs and importance of accounting principles. We will also be studying about the concepts & conventions in detail (Financial Accounting & Analysis) (Accounting principles) Need for Accounting Principles For a language to make sense, we ensure that it has the same meaning to all. Similarly, accounting is the language through which we understand financial records. And through the accounting principles, we ensure that the accounts speak similar sense to anyone who reads them. There are few general norms which the principles should follow to be acceptable: (a) Usefulness (b) Objectivity, and (c) Feasibility The first criteria of accounting principle is that they should be useful. Because of these principles, the financial records will become more relevant and functional to the user of the records. If there is an accounting rule which does not increase the usefulness of the financial records to its end users, then it can not be accepted as an accounting principle. The second criteria of accounting principle is that they should be objective in nature. It will be considered objective when it is supported by actual facts rather than just conjecture and assumptions. It should be free from the personal bias and fancy of the reader (Financial Accounting & Analysis) (Accounting principles) Need for Accounting Principles The third criteria should be that the accounting principles are practicable. For example, in the books of accounts, we record assets at cost less depreciation and not at market rate. This principle is practical and feasible because we do not have to check the market price continuously. Because of this principle, we do not have to track the changes in the price of the asset and record the same in our books. The three features above are generally found in all accounting principles. However, sometimes to adopt a particular rule as an accounting principle, we have to strike a balance between the three. Sometimes, we may even need to sacrifice one rule in favor of another rule. For example, if we take the reporting of assets in the books, we report them at cost at which it was purchased, which may not be of much use to the end user, as the current market price could be very different from the historical figure; but it is used because it is much more feasible than using the market price. Similarly, we make provision for bad and doubtful debts on debtors. This provision is based on certain percentages and is not based on any facts, per se. There is no hard evidence to support this provision. These provisions are the outcome of a subjective approach. (Financial Accounting & Analysis) (Accounting principles) Importance of Accounting Principles If we take the accounting system as a whole, the accounting principles play a very fundamental and central role. They guide as to how do the accounting at the present and at the future level. The principles give a semblance of balance and stability to the books. They help approach the books in a normative and practical manner. However, this all is only possible if the principles have been used properly in an objective manner. If we compare accounts with the laws of science, the rules of science rarely, if ever, change. However, accounting principles are ever evolving. The accounting principles are based on the practical usefulness over the years. The company’s policies and strategies, external factors play a big role in how the books of accounts are maintained. The GAAP give a framework to ensure that the books of accounts are maintained in a honest and transparent way. The principles are a guiding light for the accountants to prepare the books. The principles make sure that when the books are prepared, the economic events which have taken place are recognized, recorded and presented in a standardized manner. (Financial Accounting & Analysis) (Accounting Principles) Summary In this topic, you learnt: Understood what are the accounting principles. Developed an understanding of the importance of accounting principles Identified the need for accounting principles
