Accounting Concepts & Conventions

ACCOUNTING PRINCIPLES

Accounting principles is a body of doctrines commonly associated with the theory and procedures of accounting serving as an explanation of current practices and as a guide for selection of conventions or procedures where alternative exists. Accounting Principles can be divided into Accounting Concepts & Accounting Conventions.

Accounting principles must satisfy the following conditions:

1.       They should be based on real assumptions.

2.       They must be simple, understandable and explanatory

3.       They must be followed consistently.

4.       They should be able to reflect future predictions.

5.       They should be informational for the users

ACCOUNTING CONCEPTS

Accounting concepts define the assumptions on the basis of which the financial statements of a business are prepared. The word concept means idea or notion which has universal application. Financial statements are interpreted in the light of the concepts which govern the accounting procedures. Concepts are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid. These accounting concepts lay the foundation on the basis of which the accounting principles are formulated.

Accounting Concepts are:

1.       Business Entity Concept

2.       Dual Aspect Concept

3.       Going Concern Concept

4.       Cost Concept

5.       Money Measurement Concept

6.       Accounting Period or Periodicity Concept

7.       Matching Concept

8.       Realisation Concept

9.       Accrual Concept

Now let us study each Accounting Concept in Detail:

1.            Business Entity Concept:- This concept states that the business organization/ firm is a different entity in itself distinct from its owners, i.e. in case of a sole trading concern the sole trader and the business are completely different identities. In simple words, the business and the businessmen are not one and the same. This concept is applicable in all forms of business like sole trading concern, partnership, Joint Stock Company, etc. In other words the business has a separate identity of its own which is different from that of the owner/s of the business. It is due to this concept that the capital brought in by the owner of the business is treated as a liability in the books of the business and any expense incurred by the business for the owner is treated as drawing and hence deducted from the capital. Business entity concept helps in distinguishing the business expenses and the personal expenses which in turn would lead to show a true and fair view of the business results.

    

    Importance of Business entity concept or Separate Entity Concept: Business entity concept is significant since it forms a base or foundation for other accounting concepts or principles. Business entity concept helps to determine the true and fair view of financial position of a business by making a business as an independent entity which implies that personal property of owners does not get accounted while preparing the financial statements. It is helpful in determining the actual figure of profit or loss for an accounting period since owner’s personal expenses and revenues are overlooked

2.        Dual Aspect Concept:-As the name suggests the concept of Dual Aspect states that every business transaction would have 2 Aspects, i.e. the “Giving Aspect” and the “Receiving Aspect”. In simpler terms, every business transaction has a Debit Effect and a Credit Effect. For example, purchase of goods for cash has the Receiving of goods and Giving of cash. Every business transaction has two aspects and each aspect is of same value. It is this concept that gives us the Accounting equation of

                               

 CAPITAL + LIABILITY = ASSETS

In fact Balance sheet is the diagrammatic representation of this equation. Therefore in Balance sheet on one side we write Capital and Liabilities and on the other side Assets. That is the reason why we always say “Balance sheet should always tally”. 

Let us understand the impact of this decision.

Suppose Rishi starts business with ₹ 100000, this transaction is recorded at 2 places in books of accounts of the business.

a)       Receiving Aspect: Business has received ₹ 100000 in cash (Asset),

b)       Giving Aspect: Rishi has a claim of ₹ 100000 in business (Capital/Liability)

Importance of Dual Concept:

Reproduction of accounts from incomplete record is possible due to the fact that commercial accounting is done on the basis of double entry system and there are always high chances that one aspect of the financial transactions would be available to the business which can be used to produce accounts and financial statements. Double entry system helps trace out errors and mistakes in recording the transactions or economic events in the books of accounts.

Implementation of double entry system helps identify different type of financial frauds, embezzlements and misappropriations because recording a transaction twice in the books of accounts makes it difficult for misappropriation.

Pursuing duality concept results in the availability of full information about assets, liabilities, capital, income and expenses.

It is because of double entry system that the trial balance can be prepared to check the arithmetic accuracy of accounts.

3.       

            Going Concern Concept: The term ‘going concern’ means that the business is expected to continue for a foreseeable long future. Business accounts are prepared on this basis that there is neither any need nor any intention to close the business activities in a near future  In case if there is any such intention then the business accounts would be prepared on different basis and such basis should be disclosed. Due to this concept there exist various other concepts like periodicity, cost, accrual, etc.

Suppose the business purchased an Asset at a cost of ₹ 200000 and incurred further installation and transportation charges ₹ 40,000. That means that the total amount invested by business for the asset is ₹ 240000. Now if the business aims to continue the business then the balance sheet will show asset at ₹ 240000, however if the businessman plans to discontinue the business and sell off the asset then the balance sheet would need to show the asset at its present market value rather than its cost. This is the impact of Going Concern Concept on the business accounts.

Importance of Going Concern Concept:

It serves as the basis for the preparation of financial statement, since financial statements are highly influenced by the continuity or discontinuity of a business.
The calculation of depreciation expenses are affected by the estimation of successful future operations of the business.

In case of a business is going to discontinue its operations, assets need to be valued at breakup value which is commonly less than the market value of assets.

4.       

              Cost Concept: This concept states that the value of the asset is to be determined by its historical cost, in other words, its acquisition cost. Although there are various other basis for the valuation of the asset accountants usually prefer cost concept due to objectivity. For eg. if the machine is purchased for ₹ 50000, then it would be shown in the books at ₹ 50000 only irrespective of its present cost of replacement or market value is not considered as they are not objective and cannot be proved when needed. This concept would also be needed for the purpose of depreciation as it can be easily calculated on the basis of cost as it would remain constant, but if any other base is used then the amount of depreciation would keep on changing from year to year.

Importance of Cost Concept: This Concept helps the business to know the true and fair value of its fixed assets as per the accounting records known as the Book Value. The market price of the fixed asset is not considered as the business does not consider to sell this asset in near future.

5.      

          Money Measurement Concept: As per this concept only those transactions which can be measured in terms of money should be recorded in the books of accounts. Since money is the common medium of exchange and standard measure of value, the concept needs only such transactions be recorded which has some form of money value. There may be some transactions which would have an impact on the results of the business but does not involve any money so these transactions would not be recorded in business.

For example the employees of the business and their loyalty is a very important asset for the business but because it cannot be measured in terms of money they are not recorded in accounting.

Measuring unit of money is taken as the currency of the ruling country, i.e. in India it would be INR and USD in United States of America.

6.       

               Accounting Period or Periodicity Concept: Every business is started with the intention to earn profit. It is important for the businessman to know the results of his business and also the financial position of his business. For this purpose the life of the business is divided into small periods, normally of 12 months, i.e. 1 year. This concept makes it convenient for the business to make its final accounts and also to plan its future course of action. This concept is based on the concept of Going concern, because if the life of business is known then it would not be necessary to divide the life in small periods as in the case of Joint Venture.

Importance of Periodicity concept:

It serves the basic purpose of knowing the profits and losses of the business for a particular period of time, which is the basic aim of any business.

7.       

             Matching Concept: This is one of the most important concepts of accounting as it is this concept which helps the business to know the actual amount of profit earned by any business in a given period of time. This concept states that the income of the period is to be matched with the expenses of that period. This is the only reason for the existence of accrual concept and it is only due to this concept that the depreciation is provided on the fixed assets each year.

Example: If the purchase for the year is ₹ 100000, sales is ₹ 150000 and closing stock is ₹ 25000 with no opening stock then the profit of the business would be ?

In absence of matching concept the profit would be sales less purchase i.e. ₹50000.

However we all know that the profit in the above transaction is not 50000 but ₹75000. This is calculated as Sales less Purchase add closing stock. The reason the closing stock is considered for the purpose of calculation of profit is that it is not an expense of current period.

Importance of Matching Concept: The financial statement of the company, mainly its Income Statement is prepared based on this concept. It is due to this concept that the outstanding items are added and pre paid items are deducted, as it would give the most appropriate results of the business for a certain period.

       Realisation Concept: This concept is also known as Revenue Recognition Principle in accounting, this refers to the application of accrual concept towards the recognition of revenue (income). Under this principle, revenue is recognized by the seller when it is earned irrespective of whether cash from the transaction has been received or not.

In case of sale of goods, revenue must be recognised when the seller transfers the risks and rewards associated with the ownership of the goods to the buyer. This is generally deemed to occur when the goods are actually transferred to the buyer. Where goods are sold on credit terms, revenue is recognized along with a corresponding receivable which is subsequently settled upon the receipt of the due amount from the customer.

ABC Motors is a car dealer, it receives orders from customers in advance against 20% down payment, ABC Motors delivers the cars to the respective customers within 30 days upon which it receives remaining 80% if the price. In accordance with revenue realization principle, ABC Motors must not recognize any revenue until the cars are delivered to the respective customers as that is the point when the risks and rewards incidental to the ownership of the cars are transferred to the buyers.

9. Accrual Concept:  This concept may also be understood as the Due Concept. According to this concept any business activity is to be recorded as soon as it occurs, irrespective of actual for of cash. This concept helps in recording the credit transactions and also the entries for Outstanding expenses. It is due to this concept that even though no payment is made for the outstanding expenses or the expenses which are due but not paid are still shown in the books of accounts.

ACCOUNTING CONVENTIONS

Accounting conventions emerge out of accounting practices, commonly known as accounting principles adapted by various organisations over a period of time. These conventions are derived by usage and practice. The accountancy bodies of the world may change any of the conventions to improve the quality of accounting information and reporting standards. Accounting conventions need not have any universal application like in case of accounting concepts.

Accounting Conventions are:

1.       Convention of Full Disclosure

2.       Convention of Consistency

3.       Convention of Materiality

4.       Convention of Conservatism

1.       Convention of Full Disclosure (AS 1): This convention states that the accounts must be prepared with honesty and all the material fact should be disclosed. This concept is so important (because of divorce in ownership and management) that the companies act has made enough provision for this convention and also gives relevant importance to this convention, therefore this convention is also given the topmost priority while framing the accounting standards as AS-1 is regarding the convention of Full Disclosure. The term disclosure does not imply that all information that anyone could conceivably desire is to be included in accounting statements. The term only implies that there is to be a sufficient disclosure of information which is of material interest to proprietors, present andpotential creditors and investors.The practice of appending notes relative to various facts or items which do not find place in accounting statements is in pursuance to the convention of full disclosure of material facts.

Examples are:

(a)     Contingent Liabilities appearing as a footnote in balance Sheet

(b)     Market value of the investments appearing as a note.

2.       Convention of Consistency: This convention states that the accounting practices and methods should not change from one period to another, in simple words they need to be consistent over a period of time. The concept enables the management to compare the performance of the business from one period to the other.  The comparison for one accounting period with that in the past is possible only when the convention of consistency is followed. But the idea of consistency does not imply non-flexibility as not to permit the introduction of improved techniques of accounting.   According to A.S. – 1 consistency is a fundamental assumption and it is assumed that accounting policies are consistent from one period to another. Where this assumption is not followed, the fact should be disclosed together with reasons.

For example, in applying the principle that fixed asset is depreciated over its useful life a company may adopt any of the several methods of depreciation, viz., written-down-value method, straight-line method, sinking fund method, etc.  But in keeping with the convention of consistency it is expected that the company would consistently follow the same method of depreciation which is chosen. Any change from one method to another would result in inconsistency.

The same is the case in valuation of closing stock.

3.       Convention of Materiality: The role of this convention cannot be over-emphasised in as much as accounting will be unnecessarily overburdened with more details in case an accountant is not able to make an objective distinction between material and immaterial matters.

American Accounting Association (AAA) defines the term materiality as under:“An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investor”.

Kohler has defined materiality as under:

“The characteristic attaching to a statement, fact, or item whereby its disclosure or the method of giving its expression would be likely to influence the judgement of a reasonable person.”

Example of materiality is the question of allocation of costs. An item of small value (Eg. Calculator) may last for three years and technically, its cost must be allocated to every one of the three years. Since its value is small, it can be treated as the expense in the year of purchase. Another example of the convention of materiality is that the accounts avoid paise and enter only the rounded off amount in rupees. Such a decision is in accordance with the principle of materiality. Likewise, unimportant items can be either left out or merged with other items. Sometimes items are shown as footnotes or in parentheses according to their relative importance. It should be noted that an item material for one concern may be immaterial for another. And similarly, an item material in one year may not be material in the next year.

As per A.S. – 1, materiality should govern the selection and application of accounting policies. According to the consideration of materiality financial statement should disclose all items which are material enough to affect evaluations or decisions.

4.       Convention of Conservatism: - This is the convention of Playing Safe. This convention states that the business should expect future losses but not future profits. The purpose of this convention is to prepare the business to face the worst possible but not to anticipate the future gains. Due to this concept we create the provision for doubtful debts on debtors but a provision for doubtful creditors is not created. It is the concept of conservatism due to which the closing stock is valued at cost or market price, whichever is less. In simple words, the concept makes the business to think negative regarding the future profits of the business which is the most positive thing about the concept.

Following are the examples of the application of the convention of conservatism:

(a) Making the provision for doubtful debts and discount on debtors in anticipation of actual bad debts and
discounts.

(b) Valuing the stock in trade at market price or cost price, whichever is less.

(c) Creating provision against fluctuation in the price of investments.

(d) Charging of small capital items, like crockery, to revenue.

(e) Adopting written-down-value method of depreciation as against straight-line method.The written-down-
      value method of depreciation is more conservative in approach.

(f) Amortization of intangible assets like goodwill which has indefinite life.

(g) Showing joint life policy at surrender value as against the amount paid.

(h) Not providing for discount on creditors.