The basic purpose of accounting is to ensure that the financials that are prepared by the company give a true and fair picture of the organization. But the word 'true and fair' brings in a lot of ambiguity along with. What one company lies down as its fair practices might be unethical for another organization. Moreover, each organization is established with a different set of assumptions and these assumptions cannot be equated to each other. It is because of these assumptions that the rules provided under accounting framework become difficult to be applied to each organization.
To remove this problem, whenever accounting is done for an organization, it is assumed that the following things hold true for it. Until the following assumptions (conventions of accounting) hold true, GAAP i.e. Generally Accepted Accounting Principles cannot be applied to it.
Consistency Basis - The underlying aspect of Consistency Principle is that an accounting principle once adopted should be followed consistently from one period to another. Although this principle prefers usage of consistent accounting policies over a period it does not restrict the company from changing the policies. The principle says that in case the company decides to change any policy, there should be a complete disclosure of the change and its effects on the financial statement items must be shown in the footnotes.
For eg: Let us suppose that Reliance Power has been following straight line method of depreciation for 6 years on a machinery worth Rs. 10,00,000 with an expected life of 10 years. The present value of the machinery is Rs. 4,00,000 and in the 7th year the company decides to adopt reducing balance method at 20% rate of depreciation. Due to this shift, the depreciation for the 7th year will be Rs. 80,000 while it would have been Rs. 1,00,000 if straight line method would have been followed.
Convention of Full Disclosure - This convention states that each and every piece of information relating to relevant facts should be disclosed by the company i.e. detailed information about the line items should be known by the parties using financial statements. The word "FULL" includes two aspects:
Adequate: This means sufficient information should be disclosed.
Fair: All the users should be treated fairly.
Combining these two aspects full disclosure means that sufficient information should be given to all the users irrespective of what position they hold in the company.
For eg: If the net sales of the company are Rs. 9,50,000, then the company should disclose how the 'net' figure was reached after the working. Therefore, it should mention Gross Sales as Rs. 10,00,000 and Sales return as Rs. 50,000.
Principle of Materiality - According to the principle of materiality, a piece of information is considered as material (important) only if the misstatement of it will influence the decision of the investors. In other words, if information is omitted from the balance sheet and it doesn't affect any related party's outlook of the company, then it is not material from accounting view point. The materiality of a fact depends on its nature and amount involved. The dealing of immaterial fact, as per this convention, should be done by clubbing all such transactions under one head while the material transactions should be transferred to their respective heads.
For eg: If APIL buys a dustbin for $8 with an expected life of 8 years and it has to be depreciated over its lifetime. In such a case, the convention of materiality suggests that the entire $8 should be recorded as expense in the year in which it is purchased rather than charging $1 as depreciation every year for 8 years.
Convention of Conservatism - This convention is based on the principle "Anticipate no profits but provide for all possible losses". The reason behind such an assumption is to ensure that the profits are not overstated because it might lead to over distribution of dividends and that would mean distribution out of capital. On the one hand, the company cannot state the profits on the basis of the expected market but on the other hand, the company has to make a provision for anticipated losses.
For eg: The inventory should be valued at the market price or the cost, whichever is lower because cost price is the most conservative valuation of the company and the company is expected to make the sale at least at this price. Other examples are writing off intangible assets like goodwill and creating a provision for bad and doubtful debts.
Once it is assured that the above mentioned conventions are followed by the organization, the framework has to be set up to ensure that the accounting does not go hay-wire i.e. to ensure that the accounting records are uniform and consistent. To make sure that the structured manner is followed for preparation of financial statements, GAAP has laid down the following concepts.
Going Concern - An enterprise is usually seen as a GOING CONCERN i.e. not started with an aim to shut down in foreseeable future. In simple terms, whenever an organization is started, it is viewed as something that will continue for a reasonable period of time. A start up with the timeline decided in advance (apart from certain exceptions where the time is of the essence and there is no point of continuing it beyond the stipulated time) defies the basic assumption of accounting. This concept gives an assurance to the investors that they'll get the returns for a longer period of time as the firm won't be dissolved in the near future.
Historical Cost Convention - The most widely used principle under GAAP is that of historical costing i.e. the asset is recorded at the cost at which it was required and not on the present market value. This leads to a discrepancy in the balance sheet because the market value of assets is either depreciated or appreciated over a period of time but the value in the financial statements is not this revised value, instead it is the value at the time of acquiring. Therefore it must be realized that the assets can be disposed at a much higher or lower value than the one presented by the company. Another aspect attached to this concept is that the cost recorded in the books of accounts does not include only the purchase price but includes the cost of transportation, cost of installation and miscellaneous costs as well.
For eg: Let us suppose that APIL brought a piece of land for Rs. 50,00,000 in 2008 and recorded the same in the books of accounts. Now, in 2011, the value appreciated to Rs. 80,00,000 and since the land is still an asset of APIL, it will be recorded in the books of accounts but the value at which it will be recorded will be Rs. 50,00,000 and not the appreciated value.
Separate Entity - This convention holds a special importance because it has to be kept in mind at all times that the business is different from its owners. In other words, the transactions of the owners are segregated from those of the business and vice-versa. This is the reason that when an owner puts the money in the business, that amount is treated as the liability of the business and when he withdraws the money, that amount is not the expense of the business but is treated as personal drawings. This convention ensures that the business is not affected by the personal dealings of the owners. The accounts that are prepared are thus the accounts of the business and not that of those who own it. This is a very important concept from the legal perspective as well to ensure limited liability of the owners otherwise there would be a charge against all the personal assets of the owners in the case of liquidation.
For eg: Let us suppose that B owes Rs. 10,000 to its creditors but he is declared insolvent before making the payment. In such a case, the creditors of B cannot sue the business for recovering the money.
Money Measurement - This concept underlines the fact that only the transactions that can be recorded in the monetary terms are actually recorded in the books. In other words, the transactions that cannot be quantified are not recorded. Monetary value is of the essence in accounting. This concept is very important because the records of the transactions are to be kept in the monetary terms and not in the physical terms. It helps in reducing the ambiguity about what is to be recorded and what not. Although there are companies like Infosys that attach a value to each of their employees, views them as assets and mentions this in the annual statement.
For eg: The skills of an employee, quality of management and brand recognition are some of the qualitative aspects of business that are never found in the financials of the company although they play a vital role in success of the business.
Accounting Period Concept - According to this concept, the financials of the company are prepared for a particular period of time i.e. the balance sheet and profit & loss accounts are prepared up to a particular date and this period is known as Accounting Period. This period can be 1 month (monthly), 3 month (quarterly), 6 months (semi-annually) and 1 year (annually) but they are usually prepared for one year.
Accrual Basis - The word 'accrual' means an amount of money that becomes due i.e. it is either to be received by the company or to be paid by the company. The company becomes the legal claimant of money when the company has earned it whether it has received it or not is a separate matter. In other words, the income and expense is recognized when the transaction is completed rather than when the money is received or paid respectively. This is the reason that the recording of a transaction is done when the transaction occurs and not when it is completed. The reason behind this principle is that there is a difference between receivables and cash receipts and similarly there is a difference between expenses and cash payments.
For eg: APIL purchases boiler worth Rs. 10,00,000 on March 15th,2011 but the payment is not made till April 20th, 2011. In spite of transaction not being completed on March 15th, 2011, there will an increase in the liabilities (Creditors) and increase in the assets (Fixed assets) of APIL and the same will be recorded in the books.
Dual Aspect - The fundamental logic in accountancy is that every transaction has a dual effect i.e. for each penny that company earns there is some cost attached to it and vice-versa. It is this nature of the transactions that beings in the concept of 'Dual Aspect'. Therefore, while preparing the books of accounts it should be ensured that the entry is made on both the sides. The fundamental equation of accounting also stems from this concept:
Assets = Liabilities + Capital
The above equation reflects the fact that all the owners and the outsiders have a claim on all the assets of the company.
For eg: If a company purchases machinery and its payment is made by cheque. In this case, the company's assets will rise as additional machinery is included but the bank account will come down by the amount equivalent to the amount paid for acquiring machinery. This reduction in the bank account and an increase in assets is a DUAL ASPECT.
Realization - According to this concept, the profits from any transaction should be included in the books of accounts only when they are realized i.e. only when the company has a legal right to get them. Therefore, even when the cash has not been received, it can be put as sales in the books of accounts when the company gets the right to receive the amount.
For eg: Tata Motors sells a car worth Rs. 6,00,000 on 29th March, 2010 but receives the payment on 7th May, 2010. Assuming that the financial year of the company is from April to March, the revenues for the FY 09-10 will be Rs. 6,00,000 as the amount became due in this period although it was received in the FY.
Matching Concept - This concept says that the revenues earned by the company and the expenses that the company incurs to earn these revenues must be of the period under consideration. This is to make sure that the company does not show inflated profits by postponing the expenses to the next period and showing the profits in this period.
For eg: A company makes a sale of Rs. 25000 on cash, pays Rs. 15000 for purchasing the semi-finished goods, Rs. 5000 as salary, Rs. 800 as commission and Rs. 1200 as transportation charges. Now, after deducting all the charges, the company should record Rs. 3000 as net profit.
The above mentioned bodies influence Indian GAAP. The two bodies marked with red and blue are the international organizations while the rest are Indian bodies that help in either formation or regulation of Indian GAAP.