What is GAAP?
Generally Accepted Accounting Principles (GAAP) are rules, concepts and conventions that are widely accepted for preparing accounts. They come from practice, professional bodies (in India, the Institute of Chartered Accountants of India) and law. GAAP makes accounts uniform, reliable and comparable. Principles must be relevant, objective (based on facts) and feasible (practical to apply).
Fundamental accounting assumptions: going concern, consistency, accrual
Going concern
The business is assumed to continue for a long time and not close soon. That is why fixed assets are shown at cost less depreciation, and prepaid expenses are shown as assets.
Consistency
The same accounting methods (for example, depreciation or stock valuation) are used year after year. A change is allowed only for a good reason and must be disclosed.
Accrual
Revenue is recorded when earned and expenses when incurred, whether cash is received or paid or not. So outstanding expenses and accrued income are included in the year they belong to.
Basic accounting principles
- Business entity: the business is separate from its owner. Owner's capital is a liability of the business; personal expenses are drawings.
- Money measurement: only events that can be expressed in money are recorded, in one currency (₹).
- Accounting period: life of the business is split into equal periods (in India usually 1 April–31 March) to find profit and position regularly.
- Historical cost: assets are recorded at the price paid to get them, including costs to make them ready. Market value changes are ignored.
- Dual aspect: every transaction has two equal effects. This gives the accounting equation Assets = Liabilities + Capital.
- Revenue recognition (realisation): revenue is counted when it is earned — for goods, when ownership passes to the buyer — not when cash comes.
- Matching: expenses of a period are set against the revenue of the same period to find true profit.
- Full disclosure: all material facts are shown in the statements or their notes (for example, a pending court case).
- Conservatism (prudence): anticipate no profit, but provide for all possible losses. Stock is valued at cost or net realisable value, whichever is lower; provision for doubtful debts is made.
- Materiality: an item is shown separately only if it could affect a user's decision. Very small items (a ₹150 stapler) are simply treated as expense.
- Objectivity: entries must be backed by verifiable evidence like bills and receipts, free from personal bias.
How the principles work together
Going concern allows depreciation; accrual and matching together decide which year an item belongs to; dual aspect keeps the books balanced; conservatism and objectivity keep figures on the safe and checkable side. Note: conservatism sometimes clashes with consistency — if a firm keeps switching valuation methods to be "safe", comparability suffers.
Board exam focus
Common questions: "Name the principle" from a situation (1 mark), "Explain matching/conservatism with an example" (3 marks), and difference between two concepts. Always add a short example.
Key formulas and definitions
- Dual aspect → Assets = Liabilities + Capital
- Matching → Profit = Revenue of period − Expenses of the same period
- Conservatism → Closing stock = lower of cost and net realisable value
- Accounting period in India: 1 April to 31 March
Worked examples
1. Name the principle: a firm shows its land at ₹20 lakh (purchase price) though its market price is now ₹35 lakh.
Historical cost principle.
2. Name the principle: goods sold on credit on 28 March are counted as sales of that year though payment comes in May.
Revenue recognition (and accrual).
3. Stock cost ₹80,000; its market value is ₹72,000. At what value is it shown and why?
₹72,000, the lower of cost and market value — conservatism (prudence): provide for the possible loss of ₹8,000.
4. The owner pays his daughter's school fees from the business. How is it treated?
Business entity principle: it is not a business expense; it is drawings and reduces capital.
5. A firm changed its depreciation method from SLM to WDV every alternate year. Which assumption is broken?
Consistency — results of different years cannot be compared.
Common mistakes
- Confusing accrual with cash: accrual records when earned or incurred, not when cash moves.
- Thinking conservatism means recording expected profits too. It records expected losses only.
- Mixing up matching and accrual: accrual is about timing of recording; matching pairs expenses with the related revenue of the same period.
- Treating materiality as only size in rupees. It also depends on the nature of the item and whether it could change a decision.