UNIT-2

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES:

Accounting principles may be defined as those rules of action or conduct, which are adopted by
the accountants, universally, while recording the transactions. Generally Accepted Accounting
Principles (GAAP) may be defined as those rules of action or conduct, which are derived from
experience and practice, and when they prove useful, they are accepted as principles of
accounting. They are, however, not rigid. They are subject to change. They have evolved in order
to deal with practical problems experienced by a preparer and a user rather than to reflect some
theoretical ideal. Generally Accepted Accounting Principles (GAAP) is a term used to describe,
broadly, the body of principles that governs the accounting for financial transactions underlying
the preparation of a set of financial statements.
Generally accepted accounting principles (GAAP) refer to a common set of accepted accounting
principles, standards, and procedures that companies and their accountants must follow when
they compile their financial statements. GAAP is a combination of authoritative standards (set by
policy boards) and the commonly accepted ways of recording and reporting accounting
information. GAAP improves the clarity of the communication of financial information.

BREAKING DOWN 'Generally Accepted Accounting Principles - GAAP':

GAAP is meant to ensure a minimum level of consistency in a company's financial statements,

which makes it easier for investors to analyze and extract useful information. GAAP also
facilitates the cross comparison of financial information across different companies.

These 10 general principles can help you remember the main mission and direction of the GAAP
system.
1.) Principle of Regularity
The accountant has adhered to GAAP rules and regulations as a standard.
2.) Principle of Consistency
Professionals commit to applying the same standards throughout the reporting process to prevent
errors or discrepancies. Accountants are expected to fully disclose and explain the reasons
behind any changed or updated standards.
3.) Principle of Sincerity
The accountant strives to provide an accurate depiction of a company‟s financial situation.
4.) Principle of Permanence of Methods
The procedures used in financial reporting should be consistent.
5.) Principle of Non-Compensation
Both negatives and positives should be fully reported with transparency and without the
expectation of debt compensation.
6.) Principle of Prudence
Emphasizing fact-based financial data representation that is not clouded by speculation.
7.) Principle of Continuity
While valuing assets, it should be assumed the business will continue to operate.
8.) Principle of Periodicity
Entries should be distributed across the appropriate periods of time. For example, revenue should
be divided by its relevant periods.
9.) Principle of Materiality / Good Faith
Accountants must strive for full disclosure in financial reports.
10.) Principle of Utmost Good Faith
Derived from the Latin phrase “uberrimae fidei” used within the insurance industry. It
presupposes that parties remain honest in transactions.

CHARACTERISTICS OF ACCOUNTING PRINCIPLES:

1. Objectivity:-Objectivity connotes reliability and trustworthiness. A principle is objective to
the extent when the accounting information is not influenced by personal bias or judgment of
those who provide it. This implies that accounting information is prepared and reported in a
“neutral” way. In other words, it is not biased towards a particular user group or vested interest.
It also implies verifiability, which means that there is some way of ascertaining the correctness
of the information reported.
2. Application:-Application of the principle must be possible. In case, the principle is only
theoretical and has no practical utility or application, then the principle has no value.
3. Reliability:-This implies that the accounting information that is presented is truthful, accurate,
complete (nothing significant missed out) and capable of being verified (e.g. by a potential
investor).
4. Feasibility:-A principle is feasible to the extent it can be implemented without much
complexity or cost.
5. Understand ability:-The accounting principle should be simple and easily understandable by
all. This implies that the accounting information should be in such a way that it is easily
understandable to users — who are generally assumed to have a reasonable knowledge of
business and economic activities.

ACCOUNTING CONCEPTS:
Separate Entity Concept:-According to this concept, business is considered as aseparate entity,
distinct from the persons who own it.

Money Measurement Concept:- Accounting records only those transactions that can be
expressed, in terms of money, though quantitative records are kept, additionally.

Dual Aspect Concept:- As per this concept, for every debit, there is a corresponding credit. In
other words, when a transaction is recorded, debit amount has to be equal to the credit amount.

Going Concern Concept:- The underlying idea of this concept is that the business would
continue for a fairly long period to come. Accounting transactions are recorded from this point of
view.

Cost Concept:- Cost is the basis for all accounting in respect of fixed assets.

Accounting Period Concept:- According to the „Going Concern Concept‟, every business
would exist for a longer duration. That longer duration is divided into appropriate segments or
periods for studying the results shown by the business for each period

Matching Concept:- Hence, every one tries to find out the cost and revenue during a particular
accounting period and compare the financial results with preceding year to find out whether the
business is progressing or going down.

Realisation Concept:- According to this concept, profit is recognised as and when realised.
Now, the important issue is, what the actual point of sale is and when profit is deemed to have
been accrued? Sale is deemed to have taken place, when the title to the property or goods passes
from the seller to the buyer.

ACCOUNTING CONVENTIONS:

Conservatism: “anticipate no profit and provide for all possible losses”. For example, closing
stock is valued at cost price or market price, whichever is lower.

Consistency: It is presumed, unless otherwise stated, Accounting Practices are unchanged, year
after year. If the accounting practices are changed, the fact is to be mentioned and its impact is to
be quantified.

Materiality: This convention emphasises that all material facts should be recorded in
accounting. Accountant should attach importance to material details and ignore insignificant
details.

Full Disclosure: The Convention of „Disclosure‟ means that all material facts must be disclosed
in the financial statements. For example, in case of sundry debtors not only the total amount of
sundry debtors should be disclosed, but also the amount of good and secured debtors, the amount
of good, but unsecured debtors and amount of doubtful debts should be stated.

Share Capital: This is divided into two types: equity capital and preference capital. The first
represents the contribution of equity shareholders who are the owners to the firm. Equity capital,
being risk capital, carries no fixed rate of dividend. Preference capital represents the contribution
of preference shareholders and the dividend rate payable on it is fixed.

Reserves and Surplus: Reserves and surplus are profits, which have been retained in the firm.
There are two types of reserves: revenue reserves and capital reserves. Revenue reserves
represent accumulated retained earning from the profits of normal business operations. These are
held in various forms: general reserve, investment allowance reserve, capital redemption
reserves, dividend equalization reserve, and so on. Capital reserves arise out gains, which are not
related to normal business operations. Examples of such gains are the premium on issue of shares
or gain on revaluation of assets.

Secured Loans: These are the borrowings of the firm against which specific collateral have been
provided. The important components of secured loans are: debentures, loans from financial
institutions, and loans from commercial banks.

Current liabilities and Provisions: Current liabilities and provisions, as per the classification
under the companies Act, consist of the amounts due to the suppliers of goods and services
bought on credit, advance payments received, accrued expenses, unclaimed dividend, provisions
for taxes, dividends, and so on. Current liabilities for managerial purposes (as distinct from their
definition in the Companies Act) are obligations, which are expected to mature in the next twelve
months.

Assets:-Broadly speaking, assets represent resources, which are of some value to the firm. They
have been acquired at a specific monetary cost by the firm for the conduct of its operations.
Assets are classified under the Companies Act as fixed assets, investments, current assets, loans
and advances, miscellaneous expenditure and losses.
Fixed Assets:-These assets have two characteristics: they are acquired for use over relatively
long periods for carrying on the operations of the firm and they are ordinarily not meant for
resale.
Investments:-These are financial securities owned by the firm. Some investments represent
long-term commitment of funds (usually these are the equity shares of other firms held for
income and control purposes). Other investments are likely to be short term in nature such as
holdings of units in mutual fund schemes and may rightly be classified under current assets for
managerial purposes.
Current Assets, Loans and Advances:-This category consists of cash and other assets, which
get converted into cash during the operating cycle of the fir. Current assets are held for a short
period of time as against fixed assets, which are held for relatively longer periods.
Miscellaneous Expenditures and Losses:-This category consists of two
Items: (i) miscellaneous expenditures and (ii) losses .Miscellaneous expenditures represent
certain outlays such as preliminary expenses and
Developmental expenses, which have not been written off.
PROFIT AND LOSS ACCOUNT:
Definition:
The account through which annual net profit or loss of a business is ascertained, is called profit
and loss account. Gross profit or loss of a business is ascertained through trading account and
net profit is determined by deducting all indirect expenses (business operating expenses) from
the gross profit through profit and loss account. Thus profit and loss account starts with the result
provided by trading account.
Every business wants to know the incomes earned and expenses incurred during a particular
period, usually at the end of the year. Profit & Loss Statement/Account shows the profits/losses
earned/incurred by a business for a month or a year. Companies use Profit & Loss Statement and
others use “T Account” for these below mentioned reasons.
Profit & Loss Statement/Account is prepared for two main reasons.
i. To know the profits/losses earned/incurred by a business,
ii. Statutory requirements (Companies Act, Partnership Act or any other law)
Traditionally, there were two steps to know the profit/loss. It meant, the preparation of :
a. Trading Account
b. Profit & Loss Account
Trading account reflects the gross profit or loss of the business. Profit & Loss Account shows the
net profit or loss earned by the company.
Sequence of Expenses in Profit and Loss Account:
There is no hard and fast rule as to the order in which the items of expenses are shown in profit
and loss account. Generally, the items of expenses are shown in the following sequence:
Office and Administration Expenses:
These are the expenses with the management of the business e.g. salaries of manager, accountant
and office clerks, office rent, office stationary, office electric charges, office telephone etc.
Selling and Distribution Expenses:
These are the expenses which are directly or indirectly connected with the sale of goods. These
expenses vary with the sales i.e. they increase or decrease with the increase or decrease of sale of
goods. Examples are advertisements, carriage outward, salesmen's salaries and commission,
discount allowed, traveling expenses, bad debts, packaging expenses, warehouse rent etc.
Financial and Other Expenses:
All other expenses excepting those mentioned above are considered under this class.
Features of Profit and Loss Account:
1. This account is prepared on the last day of an account year in order to determine the net
result of the business.
2. It is second stage of the final accounts.
3. Only indirect expenses and indirect revenues are shown in this account.
4. It starts with the closing balance of the trading account i.e. gross profit or gross loss.
5. All items of revenue concerning current year - whether received in cash or not - and all
items of expenses - whether paid in cash or not - are considered in this account. But no
item relating to past or next year is included in it.
6. he following is a specimen of profit and loss account
7. Name of Business
Profit and Loss Account for the year ended .....

$ $
Trading A/C Trading A/C
Gross profit (transferred) ----- Gross profit (transferred) -----
Office and Administration Expenses: ----- Interest received -----
Salaries ----- Rent received -----
Rent, rates, taxes ----- Discount received -----
Postage & telegrams ----- Dividend received -----
Office electric charges ----- Bad debts recovered -----
Telephone charges ----- Provision for discount on creditors -----
Printing and stationary ----- Miscellaneous revenue -----
Selling and Distribution Expenses: Net loss - transferred to capital A/C -----
Carriage outward -----
Advertisement -----
Salesmen's salaries -----
Commission -----
Insurance -----
Traveling expenses -----
Bad debts -----
Packing expenses -----
Financial and Other Expenses:
Depreciation -----
Repair -----
Audit fee -----
Interest paid -----
Commission paid -----
Bank charges -----
Legal charges -----
Net profit - transferred to capital A/C -----

If credit side exceeds the debit side = Net profit

If debit side exceeds the credit side = Net loss

Example:
The following is the trial balance of XYZ company on 31st December 2005.

Dr. Cr.
$ $
1 Opening stock 64,000
2 Purchases 460,000
3 Returns inwards 50,000
4 Carriage inwards 16,000
5 Salaries 96,000
6 Carriage outwards 10,000
7 Rent 72,000
8 Discount allowed 8,000
9 Sundry debtors 240,000
10 Plant and Machinery 360,000
11 Furniture 60,000
12 Drawings 18,000
13 Sundry creditors 350,000
14 Returns outwards 36,000
15 Sales 740,000
16 Capital 328,000

1,454,000 1,454,000

The closing stock is valued at $126,000.

Required:

Prepare a profit and loss account for the year ended 31st December 2005.

Solution:

As we have already discussed that profit and loss account starts with the gross profit or
gross loss figure produced by trading account, we have to determine the gross profit or
gross loss by preparing trading account of XYZ company first.
 XYZ co.
Trading Account for the year ended 31.12.2005

$ $
Stock 1.1.2005 64,000 Sales 740,000
Purchases 4,60,000 Less returns 50,000 470000
Less returns 36,000 424,000
Stock
126,000
(closing)
Carriage inward 16,000
Gross profit (transf.
312,000
to P&L A/C)

816,000 816,000

XYZ co.
Profit and Loss Account for the year ended 31.12.2005

$ $
Office and Administration
Gross profit (transferred from 312,000
Expenses:
Salaries 96,000
Rent, rates, taxes 72,000
Selling and Distribution
Expenses:
Carriage outwards 10,000
Discount allowed 8,000
Net profit - transferred to capital
126,000
A/C

312,000 312,000

ACCOUNTING STANDRADS:
The Institute of Chartered Accountants of India (ICAI), being a premier accounting body in the
country, took upon itself the leadership role by constituting the Accounting Standards Board
(ASB) in 1977. The ICAI has taken significant initiatives in the setting and issuing procedure of
Accounting Standards to ensure that the standard-setting process is fully consultative and
transparent. The ASB considers the International Accounting Standards (IASs)/International
Financial Reporting Standards (IFRSs) while framing Indian Accounting Standards (ASs) and
try to integrate them, in the light of the applicable laws, customs, usages and business
environment in the country. The composition of ASB includes, representatives of industries
(namely, ASSOCHAM, CII, FICC
I), regulators, academicians, government departments etc.
Although ASB is a body constituted by the Council of the ICAI, it (ASB) is independent in the
formulation of accounting standards and Council
of the ICAI is not empowered to make any modifications in the draft accounting standards
formulated by ASB without consulting with the
ASB
The standard-setting procedure of Accounting Standards Board (ASB) can be briefly outlined as
follows:
♦Identification of broad areas byASB for formulation of AS.
♦Constitution of study groups by ASB to consider specific projects and toprepare preliminary
drafts of the proposed accounting standards. The draft normally includes objective and scope of
the standard, definitions of the terms used in the standard, recognition and measurement
principles wherever applicable and presentation and disclosure requirements.
♦Consideration of the preliminary draft prepared by the study group of ASB and revision, if any,
of the draft on the basis of deliberations.
♦Circulation of draft of accounting standard (after revision by ASB) to the Council members of
the ICAI and specified outside bodies such as Department of Company Affairs (DCA), Securities
and Exchange Board of India (SEBI), Comptroller and Auditor General of India (C&AG),
Central Board of Direct Taxes (CBDT), Standing Conference of Public Enterprises (SCOPE),
etc. for comments.
♦Meeting with the representatives of the specified outside bodies to ascertain their views on the
draft of the proposed accounting standard.
♦Finalisation of the exposure draft of the proposed accounting standard and its issuance inviting
public comments.

Benefits and Limitations:

Standardisation of alternative accounting treatments:-Standards reduce to a

reasonable extent or eliminate altogether confusing variations in the accounting treatments used
to prepare financial statements.
(ii) Requirements for additional disclosures:-There are certain areas where important information
are not statutorily required to be disclosed. Standards may call for disclosure beyond that
required by law.
(iii) Comparability of financial statements:The application of accounting standards would, to a
limited extent, facilitate comparison of financial statements of companies situated in different
parts of the world and also of different companies situated in the same country. However, it
should be noted in this respect that differences in the institutions, traditions and legal systems
from one country to anothergive rise to differences in accounting standards adopted in different
countries.
However, there are some limitations of setting of accounting standards:
(i) Difficulties in making choice between different treatments:
Alternative solutions to certain accounting problems may each have arguments to recommend
them. Therefore, the choice between different alternative accounting treatments may become
difficult.
(ii) Lack of flexibilities:There may be a trend towards rigidity and away from flexibility in
applying the accounting standards.
(iii) Restricted scope
:Accounting standards cannot override the statute. The standards are
required to be framed within the ambit of prevailing statutes.
Balance Sheet:
The balance sheet is one of the three fundamental financial statements and is key to
both financial modeling and accounting. The balance sheet displays the company‟s total assets,
and how these assets are financed, through either debt or equity. It can also sometimes be
referred to as a statement of net worth, or a statement of financial position.
The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity.

Example Balance Sheet:

Below is an example of Amazon‟s 2017 balance sheet. As you will see, it starts with current
assets, then non-current assets and total assets. Below that is liabilities and stockholders‟ equity
which includes current liabilities, non-current liabilities, and finally shareholders‟ equity.
Current Assets:
Cash and Equivalents:
The most liquid of all assets, cash, appears on the first line of the balance sheet. Cash
Equivalents are also lumped under this line item and include assets that have short-term
maturities under three months or assets that the company can liquidate on short notice, such
as marketable securities. Companies will generally disclose what equivalents it includes in the
footnotes to the balance sheet.
Accounts Receivable:
This account includes the balance of all sales revenue still on credit, net of any allowances for
doubtful accounts (which generates a bad debt expense). As companies recover accounts
receivables, this account decreases and cash increases by the same amount.

Inventory:
Inventory includes amounts for raw materials, work-in-progress goods and finished goods. The
company uses this account when it reports sales of goods, generally under cost of goods sold in
the income statement.

Non-Current Assets:

Plant, Property and Equipment (PP&E:)

Property, Plant and Equipment (also known as PP&E) capture the company‟s tangible fixed
assets. This line item is noted net of depreciation. Some companies will class out their PP&E by
the different types of assets, such as Land, Building, and various types of Equipment. All PP&E
is depreciable except for Land.

Intangible Assets:
This line item will include all of the companies intangible fixed assets, which may or may not be
identifiable. Identifiable intangible assets include patents, licenses, and secret formulas.
Unidentifiable intangible assets include brand and goodwill.

Current Liabilities:

Accounts Payable:
Accounts Payables, or AP, is the amount a company owes suppliers for items or services
purchased on credit. As the company pays off their AP, it decreases along with an equal amount
decrease to the cash account.

Current Debt/Notes Payable:

Includes non-AP obligations that are due within one year time or within one operating cycle for
the company (whichever is longest). Notes payable may also have a long-term version, which
includes notes with a maturity of more than one year.

Current Portion of Long-Term Debt:

This account may or may not be lumped together with the above account, Current Debt. While
they may seem similar, the current portion of long-term debt is specifically the portion due
within this year of a piece of debt that has a maturity of more than one year. For example, if a
company takes on a bank loan to be paid off in 5-years, this account will include the portion of
that loan due in the next year.

Non-Current Liabilities:
Bonds Payable:
This account includes the amortized amount of any bonds the company has issued.
Long-Term Debt:
This account includes the total amount of long-term debt (Excluding the current portion, if that
account is present under current liabilities). This account is derived from the debt schedule,
which outlines all the companies outstanding debt, the interest expense and the principal
repayment for every period.

Shareholders’ Equity:

Share Capital:
This is the value of funds that shareholders have invested in the company. When a company is
first formed, shareholders will typically put in cash. For example, an investor starts a company
and seeds it with $10M. Cash (an asset) rises by $10M, and Share Capital (an equity account)
rises by $10M, balancing out the balance sheet.

Retained Earnings:
This is the total amount of net income the company decides to keep. Every period, a company
may pay out dividends from its net income. Any amount remaining (or exceeding) is added to
(deducted from) retained earnings.

How is the Balance Sheet used in Financial Modeling:

This statement is a great way to analyze a company‟s financial position. An analyst can generally
use the balance sheet to calculate a lot of financial ratios that can determine how well a company
is performing, how liquid or solvent a company is, and how efficient it is.

Changes in balance sheet accounts are also used to calculate cash flow in the cash flow
statement. For example, a positive change in plant, property, and equipment is equal to capital
expenditure minus depreciation expense. If depreciation expense is known, capital expenditure
can be calculated and included as a cash outflow under cash flow from investing in the cash flow
statement.