Accounting Principles and Conventions

"The rules and practices that make accounting universal and reliable."

After learning concepts (fundamental assumptions), we now explore principles (rules) and conventions (practices) that guide accounting.

The Hierarchy

What are GAAP?

GAAP = Generally Accepted Accounting Principles

Definition: A common set of accounting rules, standards, and procedures that companies must follow when compiling financial statements.

Purpose:

• Ensure comparability between companies
• Ensure reliability and consistency
• Protect stakeholders from misleading information

Major Accounting Principles

1. Revenue Recognition Principle

"Recognize revenue when earned, not when cash received."

Rule: Revenue should be recognized in the accounting period when:

• Goods/services are delivered/performed
• Certainty of receiving payment exists

Example:

• Jan 15: Delivered goods worth ₹1,00,000 (payment in February)
• Record: Revenue in January (when delivered)

2. Cost Principle (Historical Cost)

"Record assets at their original purchase cost, not market value."

Rule: Assets recorded at actual cost at time of acquisition.

Example:

• 2020: Bought land for ₹50 Lakhs
• 2024: Market value = ₹2 Crores
• Balance Sheet shows: ₹50 Lakhs (historical cost)

Exception: If value permanently impaired, write it down.

3. Full Disclosure Principle

"Disclose all material information that affects financial decisions."

Rule: Financial statements must include all relevant information via:

• Notes to accounts
• Schedules
• Annexures

Example: Infosys must disclose:

• Pending lawsuits
• Contingent liabilities
• Related party transactions
• Significant accounting policies

4. Objectivity Principle

"Accounting should be based on verifiable, objective evidence."

Rule: Financial statements should be based on documentary evidence, not personal judgment.

Evidence Accepted:

• Invoices, receipts, vouchers
• Contracts, agreements
• Bank statements

Not Accepted:

• Personal estimates without basis
• Guesswork

Accounting Conventions

Conventions = Customs or traditions followed by accountants over time.

1. Convention of Conservatism (Prudence)

"Anticipate all losses, but recognize profits only when realized."

Rules:

• ✅ Provide for expected losses
• ❌ Do NOT anticipate profits
• ✅ Value inventory at lower of cost or market price
• ✅ Create provisions for doubtful debts

Example:

• Stock: Cost = ₹10,000, Market Price = ₹8,000
• Value at: ₹8,000 (lower of the two)

Another Example:

• Lawsuit pending against company: ₹50 Lakhs possible loss
• Action: Create provision for ₹50 Lakhs (anticipate loss)

2. Convention of Consistency

"Use the same accounting methods year after year."

Rule: Once you choose an accounting policy, stick with it. Don't change unless there's a valid reason.

Example:

• If you use FIFO for inventory in 2023, use FIFO in 2024, 2025, etc.
• If you must change to Weighted Average, disclose it clearly

Why? To ensure comparability across years.

3. Convention of Materiality

"Ignore insignificant items; focus on material information."

Rule: If an item is immaterial (too small to affect decisions), it can be treated simply.

Example:

• TCS buys stapler for ₹50
• Should be: Asset (capitalize & depreciate)
• Actually done: Expense immediately (immaterial amount)

Material vs Immaterial:

• For a ₹100 Crore company, ₹50 is immaterial
• For a small shop, ₹50,000 is material

4. Convention of Disclosure (Full Disclosure)

"Provide all significant information to users."

(Same as Full Disclosure Principle - sometimes listed as convention)

Rule: Don't hide material facts. Transparency is key.

Comparison: Principles vs Conventions

Real-World Case Study

Summary of Key Conventions

Exam Tip

Common Question: "Stock cost ₹50,000, market price ₹45,000. At what value should it be shown?"

Answer: ₹45,000 (lower of cost or market) - Convention of Conservatism

Quiz: Principles and Conventions