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Accounting Principles, Concepts & Conventions

Accounting is the language of business, and like any language, it needs rules to be understood. These rules are called GAAP (Generally Accepted Accounting Principles). They ensure that financial statements are consistent, reliable, and comparable across different companies.

In this lesson, we will break down the three pillars of GAAP: Principles, Concepts, and Conventions.

1. Accounting Concepts (The "Assumptions")

These are the fundamental assumptions on which accounting is based. Without these, financial statements would be meaningless.

A. Business Entity Concept

"The business and the owner are two separate persons."

This is the most fundamental concept. It treats the business as a distinct legal entity separate from its owners.

Why it matters: If an owner buys a car for personal use using business money, it is recorded as Drawings (reducing capital), not as a Business Asset.
Example: If Mr. Sharma starts a textile shop with ₹10 Lakhs, the business "owes" this ₹10 Lakhs back to Mr. Sharma. That is why Capital is shown on the Liabilities side of the Balance Sheet.

B. Money Measurement Concept

"Only what can be measured in money is recorded."

Accounting only records transactions that have a monetary value.

Recorded: Sale of goods for ₹50,000, Salary paid ₹20,000.
Not Recorded: The skill level of the manager, the loyalty of employees, or the quality of customer service (unless it translates to sales).
Limitation: It fails to account for inflation. A building bought in 1990 for ₹5 Lakhs is still shown at ₹5 Lakhs (minus depreciation) today, even if it's worth ₹5 Crores.

C. Going Concern Concept

"The business will continue forever."

We assume the business will not close down in the near future.

Impact: This is why we charge Depreciation. If we thought the business would close next year, we would sell all assets at their current market value (Liquidation Value) instead of depreciating them over 10 years.
Example: Tata Motors builds a factory assuming it will produce cars for decades, not just for one year.

D. Accounting Period Concept

"Life of business is divided into small time intervals."

Since a business lives forever (Going Concern), we can't wait until it closes to calculate profit. We divide its life into periods—usually 1 year (April 1 to March 31 in India)—to measure performance.

E. Cost Concept (Historical Cost)

"Assets are recorded at the price paid to acquire them."

An asset is recorded at its purchase price, not its current market value.

Example: If Reliance purchased land for ₹1 Crore in 2010, it will still appear at ₹1 Crore in the 2024 Balance Sheet, even if the market value is ₹10 Crores today.
Why? Market values fluctuate daily and are subjective. Purchase price is a verified fact (you have the bill).

F. Dual Aspect Concept

"For every debit, there is an equal and opposite credit."

This is the heart of Double Entry Bookkeeping.

Formula: Assets = Liabilities + Capital
Example: If you buy Furniture for ₹50,000 for Cash:
1. Furniture (Asset) increases by ₹50,000.
2. Cash (Asset) decreases by ₹50,000.
- The total Assets remain unchanged. The equation stays balanced.

G. Revenue Recognition (Realization) Concept

"Revenue is earned when the sale is made, not when cash is received."

Example: You sold goods on credit to a customer on March 25th. The customer pays on April 5th.
Question: Which year does the revenue belong to?
Answer: The current year (ending March 31st), because the legal transfer of ownership happened on March 25th.

H. Matching Concept

"Match expenses to the revenue they helped generate."

To find the true profit for a year, you must deduct the expenses incurred in that year, regardless of whether cash was paid.

Impact: This concept gives birth to Outstanding Expenses and Prepaid Expenses.
Example: If you pay sales commissions in April for sales made in March, that expense belongs to March, because that's when the revenue was earned.

2. Accounting Conventions (The "Traditions")

These are customs or traditions followed by accountants to improve the quality of financial statements.

A. Convention of Conservatism (Prudence)

"Anticipate no profit, but provide for all possible losses."

This is the rule of "playing it safe." Accounts should never overstate the financial position.

Rule: If you have two values for an asset, choose the lower one.
Example: Closing Stock is valued at Cost Price or Market Price, whichever is lower. If you bought pens for ₹10 and market price drops to ₹8, value them at ₹8. If market price rises to ₹12, keep them at ₹10 (do not book unrealized profit).

B. Convention of Consistency

"Stick to one method."

You should use the same accounting methods year after year so that financial statements are comparable.

Example: If you use Straight Line Declaration (SLM) method for depreciation in 2023, don't switch to Written Down Value (WDV) in 2024 just to show higher profits.
Note: You can change methods if the law requires it or if it gives a fairer view, but you must declare the change.

C. Convention of Materiality

"Don't sweat the small stuff."

Focus on facts that are important (material) to decision-makers. Insignificant details can be ignored or grouped together.

Example: A calculator bought for office use technically has a life of 5 years (it's an Asset). But because it costs only ₹500, we treat it as an Expense (Stationery) immediately, rather than depreciating ₹100 every year. It’s not "material" enough to clutter the Balance Sheet.

D. Convention of Full Disclosure

"Hide nothing."

Financial statements must disclose all significant information honestly.

Example: If there is a big lawsuit pending against the company that could wipe out its profits, it must be mentioned in the Footnotes (Contingent Liability), even if the court hasn't decided yet.

Summary Table

Concept	The "Golden Rule"	Practical Example
Business Entity	Owner ≠ Business	Capital is a Liability.
Money Measurement	Only ₹ transactions	Employee skill is not an Asset.
Going Concern	Business runs forever	Depreciation is charged.
Dual Aspect	Assets = Liab + Cap	Buying machinery also reduces Cash.
Matching	Profit = Rev - Expenses (same period)	Outstanding Salary is a Liability.
Prudence	Play it safe	Closing Stock at Cost or Market (Lower).
Consistency	Don't flip-flop	Use same depreciation method annually.
Materiality	Ignore trivial items	₹100 stapler is expense, not asset.

7-Day Action Plan

Day 1: Memorize the "Business Entity" concept. It is why you can't mix your personal pocket money with your shop's cash box.
Day 2: Look at a Balance Sheet. Notice "Capital" on the Liabilities side? That's Business Entity in action.
Day 3: Check the Footnotes of any company's annual report. That's "Full Disclosure".
Day 4: Calculate your personal Net Worth. (Assets = Liabilities + Equity). That's Dual Aspect.
Day 5: Why do you pay for Netflix before you watch it? (Prepaid Expense - Matching Concept).
Day 6: Read about the "Satyam Scam". It happened because they violated the "Full Disclosure" and "Realization" concepts.
Day 7: Take the quiz below!