Accounting Concepts and Conventions
In drawing up accounting statements, whether they are external "financial accounts" or internally-focused "management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of the business and the results of its operation.
The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately the business' activities.
To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently.
The term “Accounting Conventions” refers to the customs or traditions which are used as a guide in the preparation of accounting reports and statements. The conventions are derived by usage and practice. The accountancy bodies of the world may charge any of the convention to improve the quality of accounting information accounting conventions need not have universal application.
Following are important accounting conventions in use:
According to this convention the accounting practices should remain unchanged from one period to another. It requires that working rules once chosen should not be changed arbitrarily and without notice of the effect of change to those who use the accounts.
For example, stock should be valued in the same manner every year.
Similarly depreciation is charged on fixed assets on the same method year after year. If this assumption is not followed, the fact should be disclosed together with reasons.
The principle of consistency plays its role particularly when alternative accounting methods is equally acceptable. Any change from one method to another method would result in inconsistency; they may seem to be inconsistent apparently. In case of valuation of stocks if the company applies the principle “at cost or market price whichever is less” and if this principle accordingly result in the valuation of stock in one year at cost and the market price in the other year, there is no inconsistency here. It is only an application of the principle.
An Enterprise should change its accounting policy in any of the following circumstances only:
(i) To bring the books of accounts in accordance with the issued accounting standard.
(ii) To compliance with the provision of law.
(iii) When under changed circumstances it is felt that new method will reflect more true and fair picture in the financial statement.
Apart from statutory requirement, good accounting practice also demands that significant information should be disclosed in financial statements. Such disclosures can also be made through footnotes. The purpose of this convention is to communicate all material and relevant facts concerning financial position and results of operations to the users. The contents of balance sheet and profit and loss account are prescribed by law. These are designed to make disclosures of all materials facts compulsory. The practice of appending notes relative to various facts and items which do not find place in accounting statements is in pursuance to the convention of full disclosure of material facts.
The convention of disclosure also applies to events occurring after the balance sheet date and the date on which the financial statement are authorized for issue. Such events include bad debts, destruction of plant and equipment due to natural calamities’, major acquisition of another enterprises, etc. such events are likely to have a substantial influence on the earnings and financial position of the enterprises. Their not-disclosure would affect the ability of the users for evaluations and decisions.
This is the policy of playing sale game. It takes into consideration all prospective losses but leaves all prospective profits financial statements are usually drawn up on a conservative basis anticipated profit are ignored but anticipated losses are taken into account while drawing the statements following are the examples of the application of the convention of conservatism.
According to this conventions, the accountant should attach importance to material detail and ignore insignificant details in the financial statement. In materiality principle, all the items having significant economics effect on the business of the enterprises should be disclosed in the financial statement.
The term materiality is the subjective term. It is on the judgment, common sense and discretion of the accountant that which item is material and which is not.
Example: Stationery purchased by the organization though not used fully in the concept. Similarly depreciation small items like books, calculator is taken as 100% in the year if purchase through used by company for more than one year. This is because the amount of books or calculator is very small to be shown in the balance sheet. It is the assets of the company.
Accounting Concepts can be understood as the basic accounting assumption, which acts as a foundation for the preparation of financial statement of an enterprise. Indeed, these form a basis for formulating the accounting principles, methods and procedures, to record and present the financial transactions of business.
These concepts provide an integrated structure and rational approach to the accounting process. Every financial transaction that occurs is interpreted taking into consideration the accounting concepts, which guides the accounting methods.
Four important accounting concepts underpin the preparation of any set of accounts:
1. Going Concern: Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
2. Consistency: Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
3. Prudence: Profits are not recognized until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are "provided for" in the accounts" as soon as their is a reasonable chance that such costs will be incurred in the future.
4. Matching (or "Accruals"): Income should be properly "matched" with the expenses of a given accounting period.
5. Business Entity Concept: This accounting concept separates the business from its owner. As far as accounting is concerned the owner and the business are two separate entities. This will help the accountant identify the business transactions from the personal ones. All forms of business organizations (proprietorship, partnership, company, AOP, etc) must follow this assumption.
Example: If the owner brings in additional capital into the business, we will treat this as a liability on the balance sheet of the business.
6. Money Measurement Concept: This accounting concept states that only financial transactions will find a place in accounting. So only those business activities that can be expressed in monetary terms will be recorded in accounting. Any other transaction, no matter how significant, will not find a place in the financial accounts.
So for example, if the company underwent a major management overhaul this would have no effect on the accounting records. This concept is actually one of the major drawbacks of accounting.
7. Going Concern Concept: The going concern concept assumes that a business will continue to operate indefinitely. So it assumes that for the foreseeable future the business will not be winding up. This leads to the assumption that the business will not have to sell its assets any time soon and it will meet all its obligations as well.
So it justifies the financial statements as a part of a continuous series of statements. The current statements are tentative and only reflect the financial position of that particular period of time.
8. Accounting Period Concept: Every organization, according to its needs, chooses a specific period of time to complete an accounting cycle. Generally, the time chosen is a year we call the accounting year. The time period is mentioned in the financial statements.
So the indefinite life of an organization is divided into shorter, generally equal time period. This facilitates a comparison of performances and allows stakeholders to get timely information. Also in most cases, it is also a statutory requirement.
9. Cost Concept: This accounting concept states that all assets of the firm are entered into the books of account at their purchase price (cost of acquisition + transport + installation etc). In the subsequent years to, the price remains the same (minus depreciation charged). The market price of the asset is not taken into consideration.
10. Dual Aspect Concept: This concept is the basic principle of accounting, it is the heart and soul. It basically is one of the golden rules of accounting – for every credit, there must be a corresponding debit. So every transaction we record must have a two-fold effect, i.e. it will be recorded in two places. This is the core concept of the double-entry system of accounting.
Example: Say the business buys an asset worth Rs 10,000/-. So now the Fixed Assets of the company will increase by 10,000/-. But at the same time, the bank or cash balance will reduce by 10,000/-. And so the transaction will have a dual effect in accounting. And also the Balance Sheet will stay balanced.
11. Realisation Concept: According to the realization accounting concept, revenue is only recognized when it is realized. Now revenue is the cash inflow for a business arising from the sale of goods or services. And we assume this revenue as realized only when it legally arises to be received. So in simpler terms, the profit earned will be recorded when it is actually earned.
12. Matching Concept: This concept states that the revenue and the expenses of a transaction should be included in the same accounting period. So to determine the income of a period all the revenues and expenses (whether paid or not) must be included.
The matching accounting concept follows the realization concept. First, the revenue is recognized and then we match the costs associated with the revenue. So costs are matched with revenue, the reverse would be an incorrect system.
13. Full Disclosure Concept: This concept states that all relevant information will be disclosed in the accounting statements. A lot of external users depend on these financial statements for their information to make investing decisions. So no information/transactions etc of relevance to anyone of them will be omitted from these statements for the benefit of the company.
14. Consistency Concept: Once the company decides on a certain accounting policy it should not be frequently changed. Unless there is a statutory requirement or it allows better representation of the accounts accounting policies should be consistent for long periods of time. This allows users to make inter-firm and inter-period comparisons. Also, frequent changes in policies may be to manipulate the accounts and this must be prevented.
15. Conservatism Concept: This accounting concept promotes prudence in accounting. It states that profit should not be included until it is realized. However, losses even those not realized but with the remote possibility of occurring should be included in the financial statements. So all losses are recognized – those that have occurred or are even likely to occur. But only realized profits are recognized.
16. Materiality Concept: Materiality states that all material facts must be a part of the accounting process. But immaterial facts, i.e. insignificant information should be left out. The materiality of a transaction will depend on its nature, value and its significance to the external user. If the information can affect a person’s investing decision then it is definitely a material fact.
17. Objectivity Concept: Finally, we come to the last accounting concept – objectivity. This concept states the obvious assumption that the accounting transaction recorded should be objective, i.e. free from any bias of the person recording it. So each transaction should be verifiable by supporting documents like vouchers, bills, letters, challans, certificates, invoices etc.
KEY CHARACTERISTICS OF ACCOUNTING INFORMATION
There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:
Obviously, if each business organisation conveys its information in its own way, we will have a babel of unusable financial data. Personal systems of accounting may have worked in the days when most companies were owned by sole proprietors or partners, but they do not anymore, in this era of joint stock companies. These companies have thousands of stakeholders who have invested millions, and they need a uniform, standardized system of accounting by which companies can be compared on the basis of their performance and value.
Therefore, accounting principles based on certain concepts, convention, and tradition have been evolved by accounting authorities and regulators and are followed internationally.
These principles, which serve as the rules for accounting for financial transactions and preparing financial statements, are known as the “Generally Accepted Accounting Principles,” or GAAP.
The application of the principles by accountants ensures that financial statements are both informative and reliable. It ensures that common practices and conventions are followed, and that the common rules and procedures are complied with. This observance of accounting principles has helped developed a widely understood grammar and vocabulary for recording financial statements.
However, it should be said that just as there may be variations in the usage of a language by two people living in two continents, there may be minor differences in the application of accounting rules and procedures depending on the accountant.
Example: Two accountants may choose two equally correct methods for recording a particular transaction based on their own professional judgement and knowledge.
Accounting principles are accepted as such if they are:
2. Usable in practical situations
4. Feasible (they can be applied without incurring high costs)
5. Comprehensible to those with a basic knowledge of finance
Accounting principles involve both accounting concepts and accounting conventions. Here are brief explanations.
BASIC ACCOUNTING TERMS
Here is a quick look at some important accounting terms.
Accounting equation: The accounting equation, the basis for the double-entry system (see below), is written as follows:
Assets = Liabilities + Stakeholders’ equity
This means that all the assets owned by a company have been financed from loans from creditors and from equity from investors. “Assets” here stands for cash, account receivables, inventory, etc., that a company possesses.
Accounting methods: Companies choose between two methods—cash accounting or accrual accounting. Under cash basis accounting, preferred by small businesses, all revenues and expenditures at the time when payments are actually received or sent are recorded. Under accrual basis accounting, income is recorded when earned and expenses are recorded when incurred.
Account receivable: The sum of money owed by your customers after goods or services have been delivered and/or used.
Account payable: The amount of money you owe creditors, suppliers, etc., in return for goods and/or services they have delivered.
Accrual accounting: See “accounting methods.”
Assets (fixed and current): Current assets are assets that will be used within one year.
For example, cash, inventory, and accounts receivable (see above). Fixed assets (non-current) may provide benefits to a company for more than one year—for example, land and machinery.
Balance sheet: A financial report that provides a gist of a company’s assets and liabilities and owner’s equity at a given time.
Capital: A financial asset and its value, such as cash and goods. Working capital is current assets minus current liabilities.
Cash accounting: See “accounting methods.”
Cash flow statement: The cash flow statement of a business shows the balance between the amount of cash earned and the cash expenditure incurred.
Credit and debit: A credit is an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is entered on the right in an accounting entry. A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is entered on the left in an accounting entry.
Double-entry bookkeeping: Under double-entry bookkeeping, every transaction is recorded in at least two accounts—as a credit in one account and as a debit in another.
For example, an automobile repair shop that collects Rs. 10,000 in cash from a customer enters this amount in the revenue credit side and also in the cash debit side. If the customer had been given credit, “account receivable” (see above) would have been used instead of “cash.” (Also see “single-entry bookkeeping,” below.)
Financial statement: A financial statement is a document that reveals the financial transactions of a business or a person. The three most important financial statements for businesses are the balance sheet, cash flow statement, and profit and loss statement (all three listed here alphabetically).
General ledger: A complete record of financial transactions over the life of a company.
Journal entry: An entry in the journal that records financial transactions in the chronological order.
Profit and loss statement (income statement): A financial statement that summarizes a company’s performance by reviewing revenues, costs and expenses during a specific period.
Single-entry bookkeeping: Under the single-entry bookkeeping, mainly used by small or businesses, incomes and expenses are recorded through daily and monthly summaries of cash receipts and disbursements. (Also see “double-entry bookkeeping,” above.)