GAAP

The document discusses Generally Accepted Accounting Principles (GAAP). It defines GAAP and explains that GAAP provides the framework for detailed accounting rules and standards. It then lists and describes the key principles of GAAP, including business entity assumption, monetary unit assumption, accounting period, historical cost concept, going concern assumption, full disclosure principle, matching concept, accrual basis of accounting, consistency, materiality, and conservatism.

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GAAP

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GAAP ( Generally Accepted

Accounting Principles )
Updated on: Mar 27th, 2021 - 1:36:26 PM
7 min read

Accountancy is often referred to as an art – the art of recording, classifying

and summarizing financial information. As is the case with any form of art,
accountancy also involves the use of one’s creative skills, to maintain a record
of financial transactions. However, if free rein is given on the system of
accountancy to be followed, there will be no limit on the scope of manipulation
of accounts.

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.