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What is Financial Accounting?
Financial accounting is a specialized branch of accounting that keeps track of a company’s financial transactions. Using standardized guidelines, the transactions are recorded, summarized, and presented in a financial report or financial statement such as an income statement or a balance sheet.
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.
Accounting Concepts
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.
Accounting Conventions: There are four main accounting conventions designed to assist accountants:
Conservatism: Playing it safe is both an accounting principle and convention. It tells accountants to err on the side of caution when providing estimates for assets and liabilities. That means that when two values of a transaction are available, the lower one should be favoured. The general concept is to factor in the worst-case scenario of a firm’s financial future.
Consistency: A company should apply the same accounting principles across different accounting cycles. Once it chooses a method it is urged to stick with it in the future, unless it has a good reason to do otherwise. Without this convention, investors’ ability to compare and assess how the company performs from one period to the next is made much more challenging.
Full disclosure: Information considered potentially important and relevant must be revealed, regardless of whether it is detrimental to the company.
Materiality: Like full disclosure, this convention urges companies to lay all their cards on the table. If an item or event is material, in other words important, it should be disclosed. The idea here is that any information that could influence the decision of a person looking at the financial statement must be included