Accounting Concepts and Conventions

Accounting Concepts and Conventions

Accounting is generally considered as the language' of the business.

It records business transactions which have taken place during the

accounting period and communicates the results thereof in the form of

financial statements, such as, Profit and Loss Account and Balance-

Sheet etc. There are certain set rules for preparing the financial statements. These rules are usually called General Accepted Accounting Principles (GAAP) and have been commonly accepted by the

professional accounting world as general guidelines for preparing the

financial statements.

Accounting principles, rules of conduct and action are described by

various terms such as concepts, conventions, assumption etc.

ACCÓUNTING CONCEPTS

Accounting concept means the necessary assumption or conditions

upon which accounting is based. A list of accounting concepts which

are generally used is given below:

1. Entity concept

2. Dual aspect concept

3. Going concern concept

4. Accounting period concept

5. Money measurement concept

6. Cost concept

7.Revenue realisation concept

8, Matching concept

9. Verifiable objective evidence concept

10. Accrual concept.

1.Entity concept 

According to this concept, business is treated as a

unit or entity apart from its owners, creditors, managers and others. This means that the proprietor of an enterprise is always considered to be separate and distinct from the business which he controls. Similarly in a partnership business, the firm is quite separate from the individual

partners who are its members. Thus the concept of separate entity is

applicable to all forms of business organisation 1.e. proprietorship, partnership or a company. For example, the owner's house, his investments in securities, his personal car, and personal income and expenditure should be kept separate from the accounts of his business entity. Similarly if the owner is doing some other business, its records are kept separate.

The concept is very helpful to find out the financial position of the

business. Moreover, it is easy to determine the earning capacity of the

business.

2.Dual aspect concept

 (The main aim of doing business is to earn

profit. The profit earned is added to the capital at the end of the

accounting period. Capital is what remains to the owner when all

outside liabilities are paid off from the available assets of the business

and can be computed by the following balance sheet equation:

Capital =Assets – Liabilities

 Or

Assets = Liabilities + Capital

The equation is the basis of accounting. The above equation can be

elaborated further by replacing the terms "Liabilities" and "Assets" by

various types of inabilities and assets.

Assets (eg. building, land, machinery, furniture, stock in trade, debtors, Bank, cash, bills to be received) 

= Capital e.g. Proprietor's capital.

+ Liabilities eg. Loan bank creditors bill payable outstanding expenses  income in advance

Whenever any transaction takes place, it has to be recorded in two

more accounts to balance the equation. This concept of recording

transactions is called "double entry system" All business transactions

are recorded on the basis of this concept. No transaction is complete

without dual aspect concept. In fact this concept is the foundation on

which whole of the book-keeping and accounting is based.

The concept is of great help in disclosing the true position of the

business. It is also helpful in detecting errors in account.

3.Going concern concept

According to this concept a business will have an indefinite life unless it is likely to be sold or liquidated in the Most of the enterprises continue to operate profitably for indefinite periods and are regarded as going concerns. On the basis of this concept the outside parties enter into long term contracts with the enterprise by giving loans, purchase bonds or invest funds in long-term The fixed assets are also recorded at the cost when it was acquired and carried in the balance sheet at actual cost less depreciation  charge. The fixed assets, as at present are not shown at their market value due to continuity concept.

Due to this concept working life of an asset is taken into consideration for the purpose of writing off depreciation. Accountant does not

stop writing transactions in books of account even the condition of

business deteriorate or going down. He remains hopeful about the

continuity of business.

4.Accounting period concept

It is also known as "Periodicity Concept or "Time Period Concept". According to this concept the economic

life of an enterprise is divided into arbitrary periods usually 12 months

periods to report on its performance and financial position to its users.

n reality, the net income of an enterprise can be measured by

comparing the assets of the business existing at the time of its com-

mencement with those existing at of its liquidation. Since the

Life of business is assumed to be indefinite, it is not feasible to measure

the income according to the above concept. The proprietor, investors,

They need to creditors and others cannot wait for such a long time. They need to Know the position of business more frequently and at regular intervals.

Twelve month period is normally adopted for this purpose. According

to the Companies Act and the Banking Company Act, accounts are to be

prepared for a twelve-month period. The time period is called

"Accounting Period". Either a calendar year (January, I to December,

31St) may be accounting year or April, 1 to March, 31st of next year

may be accounting year.

 The Concept is very helpful in comparison of financial position as

Well as of earning concept of one year to that of another year. These

Comparisons help the management in planning and increasing the efficiency of business.

The proprietor and outsiders can drive various conclusions according to their needs.

5.Money measurement concept 

According to this concept all business transactions are required to be recorded in terms of money

Those transactions that are not capable of being recorded in terms of money are not recorded in the accounting books, because the monetary unit relevant, simple and understandable. By expressing all assets and liabilities in terms of money, it is possible to include them during

preparation of financial statements) For example, if a business enterprise has a cash balance of Rs 10,000, a double storeyed building, 2 acres of land, 20 machines, 500 Kg of raw material, 15 working tables etc., it is not possible to account for all these assets, in the absence of money measurement concept. But if they are expressed in monetary terms ie Rs 10,000 cash, Rs 15,00,000 of building, Rs 45,00,000 of land Rs 3,50,000 of machine, Rs 50,000 of raw material, it is possible to add

them and use them for comparison or any other purpose.

This concept, however, has one major limitation. According

money measurement concept a transaction 1s recorded at its money value on the date of occurrence but subsequent changes in the money value are not taken into account. For example, a building purchased for

Rs 12,80,000 in 1955 and another purchased for the same amount in

1985, are recorded at the same price, although the one purchased in 1955

may now be worth ten timesi more thaņ its value recorded in the account

books. (e.g. rise in value due to rise in land prices, cost of construction,

raw material used etc.).

6.Cost concept

 According to this concept all transactions art

recorded at their monetary cost of acquisition. The majority of assels

and liabilities are recorded in the account books at the price paid

acquire the same. However they are carried forward from year to year a

acquisition cost, irrespective of any subsequent increase or decreasc

their cost.

Rs 6,40,000 its present market value will not be taken into account at

n

For example, if a piece of land was purchased 1

the

of

time of preparation of final statements (the market value of that pIee

land may now be around, say, Rs 21,00,000 or so).

Another important feature of this concept is that it is not necessu

show the assets year after year for an indefinite period at the cOst pr

The assets recorded at cost price at the time of purchase are systci

y to

rice

cally reduced due to depreciation, till their economic life is ovet mati-

i..

they have, been fully depreciated and sold as serap.

The concept is applicable to fixed assets only and current assets are

not affected by it. The fixed assets are given in balance sheet, in accord-

ance to their cost. The market price is ignored according to this concept.

7.Revenue realisation concept 

It is also known as Revenue Recogni-

tion Concept. According to this concept revenue is measured by the

amount charged for goods sold or services rendered to customers. The

GAAP (generally accepted accounting principles) require that revenue is

recognised in respect of the period during which the sale is deemed to

have occurred. Similarly revenue from services rendered is recognised

when services have been performed to the satisfaction of the customer

and he has to pay for it.

For example, a firm gets an order in the month of March to supply

the goods, but due to some reason the goods is supplied in the month of

The revenue will be realised only in the month of June, when the

sale actually takes place. This concept is of some significance as it

helps in stopping business firms from recording those incomes or profits

that may be obtained as a result of making sales at some future date.

The sale can however take place only when the cost has been received or

June.

a legal obligation to pay has been incurred by the consumer.

The following three bases are used for determining the period in

which revenue is realised:-

(i)Sales basis: The revenue is recognised or realised when a sale is

completed. The sale is completed when assets, such as, cash or

a promise to pay cash are transferred from the buyer to the seller

in exchange for title to goods or services.

(ii) Cash basis : The revenue is realised when amount from sales is

actually collected. This basis is adopted when there is some

doubt about the collection of the amount in respect of sale. The

cash basIS is generally used in those cases where the sale 1s

made on instalment basis. (i.e. Hire-purchase sale)

(iii) Production basis: The revenue can also be recognised on tne

basis of production. This basis is adopted when the sale basis

fails.

Tails. For example, in long-term construction projects, revenue

1S usually recognised before the completion of the project.

8.Matching concept 

This concept holds that expenses are recognised

In Same period as associated revenues. The expenses recognised are

Revenues whenever it is reasonable and practicable to do so.

This concept is very helpful for correct determination of profile

income, which is a measure of performance. This means that

expense incurred in generating periodic revenues is deducted from tho

revenues to ascertain the amount of periodiC income. The expenses are

not recognised when cash is paid, or when work is performed or when

the product is produced, but they are recognised when the service or the product actually makes contribution to revenue. All expenses that will only generate revenue in the current accounting period are recognised as expenses associated with the current period.

9.Verifiable objective evidence concept 

According to this concept

the accounting data must be definite, verifiable and free from personal

bias. This means that all accounting transactions should be made on the

basis of supporting business documents, such as, invoices, vouchers and 

receipts, which are verifiable by the auditors at a later stage. Moreover

the users of financial statements should have the feeling that the given

data is based on documental evidence and is not subject to the bias of

either the management or the Accountants who have prepared the

accounts.

10.Accrual concept 

According to this concept, the revenues which

become due but not received in cash, must be recorded in the books

when it becomes due and not that when it is received in cash. Similarly,

expenses which become due but not yet paid in cash must be recorded in

the books as expenses for the period when they become due. The

accrual concept of accounting states that income is measured by differ

ence between revenue and expenses and not by increase or decrease in

cash. Income increases the owner's equity and loss decreases it.

The concept is helpful in recording cash and credit transactions. It

helps in assessing the financial position of the business at the close of

the year. Moreover, the earning capacity of the business during the

given period can be easily found out.

ACCOUNTING CONVENTIONS

The term 'convention' is used to denote established customs or

traditional practices as a guide to the preparation of accounting statements. The following conventions are commonly used:

(i) Disclosure

(ii) Materiality

(iii) Consistency

(iv) Conservatism

Convention of disclosure 

The convention of disclosure implies

that all material informations must be disclosed and the accounts are

prepared honestly. It is essential that there should be full disclosure of

all important and necessary information along with the detail while

preparing the financial statements. It is beneficial to all those persons

who are interested in the business to know the correct position of the

business.

Convention of materiality 

According to this convention, an item

is regarded as material if there is a reason to believe that knowledge of it

would influence the decision of an informed investor. The unimportant

The financial

items are either left out or merged with other items. The financial

statements are expected to disclose all material items, the knowledge of

which might influence the decisions of the users of financial statements.

Convention of consistency

 If the management of company wants

to draw important conclusion regarding its working over a number of

years, it is essential that the same accounting methods are followed from

one accounting period to the other. The comparison of the result of one

accounting period with those of another is possible only if the conven-

For example, if a company

follows the straight line method of depreciation in the first year, it is

expected to follow the same method in future also in order to maintain

the convention of consistency. Any change from one method to another

tion of consistency is strictly followed.

would result in inconsistency.

Convention of conservatism '

Conservatism means a guideline

which chooses from acceptable accounting alternatives the one for

recording events or transactions which reports the least favourable im-

mediate effect on assets, income and owners equity. The convention of

conservatism provides to "play safe". It takes into consideration all

prospective losses but leaves out all prospective profits. The convention

of conservatism is applied in the following cases:-

1. When there is uncertainty inherent in the activity, e.g. uncertainty as to the useful life of an asset, occurrence of loss,

realisation of income and remaining utility of an asset.

Which of general estimates is correct, the most conservative

2. When there are two equally acceptable methods, then the one

which is more conservative will be employed.

3.When judgement is based on the estimates and doubt exists as to

would be selected.

4. When there is a possibility of the occurrence of a loss or profit

losses will be considered and profits will be overlooked.