Accounting Concepts and Conventions
Dept. of Fin, XISS, Ranchi (Prof.Bhaskar)
Accounting Concepts and Conventions:
The word concept and convention are synonymous to the words: principle postulates, doctrines, tenets, axioms assumptions etc. However there is a demarcation between the word concept and convention.
Concept: The term concept is used to connote the accounting postulates i e necessary assumptions and i.e. ideas, which are fundamental to accounting practice. Convention: The term 'convention' is used to signify customs or traditions as a guide to the preparation of accounting statements.
Without such a distinction the affairs of a firm will be mixed up with the private affairs of the proprietor and the true picture of the firm will not be available. All the transactions of the business are recorded in the books of the business from the point of view of the business enterprise. In the case of companies the entity concept is more apparent as in the eyes of law it has separate legal entity independent of the persons who contributes towards its capital capital.
Business Entity Concept: y p Money Measurement Concept: Historical record Concept: Cost Concept: Going Concern Concept: Dual Aspect Concept: Realization Concept: Accrual Concept: Matching Concept: Accounting Period Concept / Periodicity Concept: Consistency Concept: Objectivity Concept:
Business Entity or Accounting Entity Concept:
The proprietor of an enterprise is always considered to be p p p y separate and distinct from the business. In this way it becomes possible to record transactions of the business with the proprietor also. Consistency Concept and Accrual Concepts). which he controls.
(According to the International Accounting Standards Committee (IASC) the 3 fundamental accounting assumptions are Going Concern Concept.
Historical record Concept:
According to the historical record concept we record concept. since money is the medium of exchange and the standard of economic value. Therefore we need a common unit of measurement. But.000 may cost 10 times more at the present date. quintals. has two major drawbacks: The monetary unit is an inelastic measuring yardstick as because the purchasing power of money hardly remains stable. which is MONEY. The future transactions can hardly be identified and measured accurately. which may take place in the future.e. it leads to the preparation of a historical record.8/10/2007
Money Measurement Concept:
Money has been adapted by the accounting system as its basic unit of measurement. metres. a building bought in 1960 . now-adays. Business deals in a variety of items having different physical units such as kilograms kilograms. litres etc. since all the transactions are to be recorded in chronological (datewise) order. it is considered desirable to provide additional data showing the effect of changes in the price level on the reported income and the assets & liabilities of the business. 50. only those transactions.
. The P & L A/c cannot disclose the quality of the product manufactured. there total becomes homogeneous and meaningful. This is possible only in the case of past (actually happened) transactions. Also. the sales policy pursued by the enterprise can't be shown in accounting terms similarly working conditions in which the workers work. if these are recorded in a common denomination. for Rs. so recording them and finally adding them will pose problems.g. y p ( . (Therefore.) Many important events can't be recorded simply because they could not be expressed in monetary terms . although indispensable. can't be shown in the books of accounts. which have actually taken place and not those. this concept requires that those transactions alone which are capable of being measured in term of money are only to be recorded in the books of accounts and those facts or events which can't be expressed in terms of money do not find a place in the accounting books – like the death of an efficient manager or receipt of an award etc. It is because accounting record presupposes that the transactions are to be identified and objectively evidenced. Also. For example. the human resource asset cannot be recorded in the B/s.
However. There is too much of subjectivity in assessing the “current worth” or market value or "realizable value”. is called cost. we do not continue to take down the same figure year after year. which is lacking in any other approaches.000 or falls to Rs. is an exchange of money.8/10/2007
Business activity. a piece of land that has been purchased for Rs. Thus. Thus this concept can be regarded as supporting the valuation of asset at historical cost or replacement cost and assets are to be depreciated on the basis of expected life rather than on the basis of market value. 80. There exists objectivity and verifiability in the “cost approach”.S . (The going concern concept is basic to the valuation of assets and the provision of depreciation thereon according to the I. 000 at the time of making the statement will not be considered. The price paid (or agreed to be paid in case of a credit transaction) at the time of purchase. 1. according to the cost concept. in essence. The change in the real worth of a cost with the passage of time is not ordinarily recorded in the account books. at cost) and This cost remains the basis for all subsequent accounting for that asset. For example. The values of the assets are shown in the balance sheet at their acquisition values rather than their disposition values or realization values. Whether its market price increases to Rs. all assets are recorded in books at their original purchase price and continue to be recorded thus.A. 80. The original purchase price only serves as the basis for all subsequent accounting for that asset. The idea d l i the Th id underlying th cost concept i th t t t is that: Assets are recorded at the price paid to acquire it (i.50. it must be clearly understood that.000 will be recorded at that price.e.
Going Concern Concept:
This concept assumes that an enterprise (except for terminable ventures) will continue to exist in the foreseeable future. In spite of these limitations. accountants prefer this approach for the following reasons: It is very difficult and time consuming to ascertain the market value.
In other words a contribution to the business. (i) increase in one asset and (ii) decrease in another asset.e.8/10/2007
Dual Aspect Concept:
This is the basic concept of accounting.Liability. To start with. additional funds are provided by the outsiders (creditors). the total assets and the total liabilities must be equal. Similarly. not only increases its resources (assets). If necessary. which is as follows:
. but also its obligations (liabilities/equities) correspondingly.
Let us understand another accounting implication of the dual aspect concept. This equality is called ‘balance sheet equation’ or ‘accounting equation’. equal to each other. at any given point of time. In case of the first example you find that the receiving aspect is machinery and the giving aspect is cash. This concept forms the basis for the whole of financial accounting the two sides of the equation will always have the same totals as we are dealing with the same thing from two different points of view. Thus. if you buy goods worth Rs. every business transaction involves two aspects: (i) the receiving aspect and (ii) the giving aspect. it would be necessary to record both the aspect in books of account. you receive machinery on the one hand and give Rs. As per the dual aspect concept all these receipts create corresponding obligations for their repayment. the initial funds (capital) required by the business are contributed by the owner. it will increase an asset (stock of goods) on the one hand and increase a liability (creditors) on the other.500 on credit. The recognition that every transaction has two sides to it is the leading principle of the dual aspect concept..8000. either in cash or kind. If complete record of transactions is to be made. One represented by the asset of the business and the other by the claims against them These two aspects are always them. Thus this transaction has a two-fold effect i. In other words Assets = Liability + Capital or Capital = Asset .8000 on the other. In the second example the receiving aspect is goods and the giving aspect is the creditor.
Liabilities (Equities) = Assets Capital + Outside liabilities = Assets
For example. Thus. If you purchase a machine for Rs.
50.000 = Asset .g.Rs.e. 000 cash. 50.8/10/2007
The term asset denotes the resources (property) owned by the business while the term ‘equities’ denotes the claims of various parties against the business assets. they affect the assets and liabilities in such a way that this equality is always maintained.000) Capital Creditors Stock Cash
E. 10. Let us take certain examples: E. Hence the capital contributed by Mr.000 cash : The cash received by the business is its asset. According to the business entity concept. i. 50.000 + Rs.000 + Rs. 5000 = Rs.5.40.000 + Rs. 50. 3) He purchased furniture worth Rs.000 + Rs. Now the equation will be: Capital + Liabilities = Assets (Rs. 1) Mr.X started business with Rs.50.) E. When various business transactions take place. business Thus all assets of the business are either claimed by the owners or by the outsiders. (Rs. business and the owners are two separate entities. Now the equation will be Capital + Liability = Asset . (ii)Outsider’s Equity: Outsider’s equities called liabilities is the claim of outside parties like creditors.000) Capital Creditor Furniture Stock Cash
.g.000 = Rs. 10. Hence the total assets of the business will always be equal to its liabilities.X is a liability to the business. 5000: This increases an asset (Stock of goods) on the one hand and a liability (creditors) on the other. bankers etc. against the assets of the business. 5.g.5000 + Rs. 2) He purchased goods on credit from B Rs.e. Thus.000 and paid cash This increases one asset (furniture) and decreases another asset i.50. Equities are of two types: (i) Owner’s Equity: Owner’s equity called capital is the claim of the owners against the assets of the business. h (f ) dd h cash. Thus: Capital = Asset (Capital Rs.
The Th essence of the accrual concept li f h l lies i the f in h fact that h net profit is the difference between revenues and expenses rather than between cash receipt and expenditure. Unless the above condition is fulfilled no sale can be said to have taken place and no profit or income can be said to have arisen. Likewise in relation to costs: provide for costs incurred but not paid.
Under the cash system of accounting revenue recognition does not take place until cash is received and costs are recorded only after they are paid. (However it is not always easy to determine when revenue is realized.
Any increase in owner’s equity is called revenue and any thing that reduces the owner’s equity is expense (or loss). In determining profit.
This necessitates certain adjustments in the preparation of income statement. and this is important because otherwise firms may record profits which is not realized and resort to showing higher profits than is actually earned.8/10/2007
In accountancy. but exclude . credit sales are taken into consideration. which in future may turn out to become a bad debt and the actual income may turn out less than it was thought to be.revenue is recognized in proportion to the installment over price etc. clear that the operating results prepared on this basis are not in conformity with generally accepted accounting principles.
REVENUE – Realisation and not on actual receipt COST – Recognised when incurred and not when paid
Under this system revenue recognition depends on its realization and not actual receipt. It is. Also in the case of ‘Hire Purchase’ transactions . In relation to revenue the accounts should exclude amounts relating to subsequent period and provide for revenue recognized but not received in cash. profit is treated as being realized when the goods or services are passed to the customers and money h d i d h d has been realized or when a legal obligation to pay has been assumed by the customer.
.) There are certain exceptions like in long term contract ‘work in progress’ revenue is recognized before completion of the job.costs paid for subsequent period. thus. Lik wise costs are recognized when th t t l i t Like i t i d h they are incurred and not when paid.
you would record the income in your books in November. FIFO. In other words. you would record the $1.
Continued:It's important to understand the basics of the two principal methods of keeping track of a business's income and expenses: cash method and accrual method ( i d h h d d l h d (sometimes called cash b i and accrual b i ) i ll d h basis d l basis). Under the cash method. you would record the payment in January. WDV)
Accrual basis of acc
It is there
Cash basis of acc. and expenses are counted when you receive the goods or services. Under the accrual method. or the services occur. 1956 Option of choosing alternative methods to suit the requirement ( like LIFO. income is not counted until cash (or a check) is actually received. Using the cash method accounting. Under the accrual method. Under the cash method.
. including sales and purchases. In a nutshell.000 for it in July. and doesn't get paid until three months later in January. to record a transaction. Example Your computer installation business finishes a job in November. and expenses are not counted until they are actually paid. Example You purchase a new laser printer on credit in May and pay $1.) Recognition under Companies Act. or actually pay money out of your checking account. SLM. these methods differ only in the timing of when transactions. No. two months later. transactions are counted when the order is made. the month when the money is actually paid.
There is no question of prepaid or outstanding I/E Will show a lower income
Income statement will relatively show a higher Income Will show a lower income Recognised Yes
3 4 5
Will show a higher income Not Recognised No.
Basis of Distinction
Treatment of Prepaid/ Outstanding Exp or Accrued or Unaccrued income in B/s Impact on Income ( in case of prepaid expenses and accrued income.8/10/2007
Distinction between accrual basis of accounting and cash basis of accounting
Sl.000 payment in May. regardless of when the money for them (receivables) is actually received or paid. when you take the laser printer and become obligated to pay for it. You don't have to wait until you see the money. Under the accrual method. income is counted when the sale occurs. are credited or debited to your accounts.) Impact on Income ( in case of outstanding exp and unaccrued inc. you would record a $1. The accrual method is the more commonly used method of accounting. the item is delivered.000 payment for the month of July.
Matching concept is an essential part of accrual accounting. It requires that expenses f i h for an accounting period should b i i d h ld be matched against related incomes. A transaction should normally be identified with a particular period but there may be transaction that relate to many accounting periods like a plant with a life span of 5 years purchased for Rs. Such period wise income determination leads to comparison of the results of successive periods. As many business keep accounts on accrual basis. the transaction relates to 5 accounting period shown in the form of depreciation The main depreciation. The result of this matching is the net income or net loss.
consequence of the periodicity concept is the application of the arbitrary allocation and apportionment of indirect costs. keeping account on an income and expenditure basis. it is necessary that the accounting system should match periodically the revenues earned against expenses incurred. This is the essence of Matching Concept).e. accountants choose g g . Twelve-month period in normally adopted for this purpose.
Accounting Period Concept / Periodicity Concept:
To find out "how the business is going on. (Thus all cost which are applicable to the revenue of the period should be charged against that revenue in order to determine the net income of the business. This time interval is called accounting period and is also called natural business year. This method requires the proper allocation of income and expenditure into appropriate periods so that relevant incomes and expenses are matched. 10000/=. The profit of an accounting period is the revenues from transactions less expense incurred in producing these revenues. i. some convenient period of time to ascertain income for that period.
. rather than recognizing revenues as being earned at the time when cash is received or recognizing expenses when cash is paid and thereby making comparison by cash receipts against cash payments.
The evidence substantiating the business transitions should be objective i. that accountants be consistent in applying principles and procedures to similar situations. It is for this reason that assets are recorded at historical costs and shown thereafter-historical cost less depreciation. If in treating a given event. two or more contradictory methods are used. free from the bias of the accountants or others. Only in such an event it would be possible for the auditors to verify accounts and certify them as true or otherwise. it may yield conflicting results not only among similar business but also result in misleading comparisons of interpretation for a business unit for successive years of its own operation Therefore it is very important operation.e. Transactions recorded should be supported by verifiable documents. difficult for h if h l (However in recent years replacement costs are used for specific purposes.8/10/2007
It is possible to adopt a variety of principles and procedures for recording financial events.
As per this concept all accounting must be based on p p g objective evidence. If the assets are shown on replacement cost basis the objectivity is lost and i b i l d it becomes diffi l f authors to verify such values.
In order to make the message contained in the financial statement clear & meaningful the income statement (P&L A/c) & the Statement showing the financial position (B/s) are drawn up according to the under mentioned conventions:
Consistency: Disclosure: Materiality: Convention of Conservatism:
which do not find place in accounting statement. which is of material interest to proprietors. otherwise comparison of one accounting period with another would not be possible.
The concept of disclosure also applies to events occurring after p pp g the B/s date and the date in which the financial statements are
Apart from legal requirements good accounting practice also demands that all significant information should be disclosed.8/10/2007
The accounting practice should remain the same from one year to another. Such events are likely to have a substantial influence on the earnings and financial position of the enterprise. is in pursuance to the convention of full disclosure of material facts. Changing method would lead to distortion . destruction of plant and equipment due to natural calamities.
authorized for issue. Like contingent liabilities appearing as a note. It implies that accounts must be honestly prepared and all material information must be disclosed therein.for instance it would not be proper to value stock in trade according to one method one year and another in the next year. Their non-disclosure would affect the ability of the users of such statements to make proper evaluations and decisions. market value of investments appearing as a note. The term disclosure does not imply that all information that anyone py y could conceivably desire is to be included in accounting statements. Once a firm has fixed a method of treating an item it should do so for like items and also maintain the same method thereafter. Consistency however does not mean inflexibility. The practice of appending notes relative to various facts or items. Such events include bad debts. The term only implies that there is to be a sufficient disclosure of information. present and potential creditors and investors. A firm can change the method used as necessary and where it is affected the effect of such change should be stated. & the like. major acquisition of another entp.
Showing JLP at surrender value against the amount paid. regulation. This is also reiterated in IAS-5. to effect evaluations or decisions. rather than straight-line method. Creating provision against fluctuation in the price of investments. Charging of small capital items like crockery to revenue revenue.
It is now agreed that information known after the date of B/S must also be disclosed. which is less conservative in approach. This Accounting principle i given recognition i IAS 1 which recommends th observance of i i l is i iti in IAS-1.)
The American Accounting Association (AAA) defines the term materiality. Amortization of intangible assets like GW. Valuation of stock in trades at MP/Cost Price whichever is less. Some of the examples of material financial information to be disclosed are: Loss
Convention of Conservatism:
Policy of Playing Safe
This is the policy of 'playing safe'. (It should be noted that an item material for one concern should be immaterial for another and similarly an item material in one year may be immaterial in the next. hi h d the b f prudence in the framing of accounting policies. Another example of materiality is the question of allocation of costs. An item of small value may last for more years and technically its cost must be spread over this period. which are material ……. agreement etc. which has indefinite life.8/10/2007
This convention states that accounting records should consists of only
those t th transactions th t are significant f ti that i ifi t from th point of view of the i t f i f determination of income materiality. Adoption of WDV method of depreciation. It is true that uncertainties surround many transaction and therefore exercise of prudence in financial statement . of application of convention of conservatism: Provision for bad and doubtful debts. Not providing for discount on creditors. likely fall in the value of stocks increase in wage bill under recently concluded stocks. It takes into consideration all prospective losses but leaves all prospective profits.
of market due to competition or Govt.
. E.g. As per IAS-1 financial statements should disclose all items. Since the amount involved is pretty small it may be treated as an expense in the year of purchase. which states that all material information should be disclosed that is necessary to make the financial statements clear & understandable. but prudence does not justify the creation of secret or hidden reserves. Considering the loss relating to premium on redemption of debenture when they are issued at par or discount but redeemable at premium at the time of re-issue. as "An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed invertors".becomes necessary.
. the most conservative would be selected. which is in direct conflict with the doctrine of full disclosure. then: the one. estimated liability etc. When there is possibility of the occurrence of a loss or profit. If the principle is stretched without reservation it results in the creation of secret reserves.g. occurrence of loss. losses will be considered and profits will be overlooked. When there is judgment based on estimates and doubts exists as to which of the several estimates in correct. will be accepted. Application of the principle: pp p p
Where there is an uncertainty inherent in the activity e. which is more conservative. When there are two equally accepted methods. Since the main aim of published accounts is to convey and not to conceal the information the policy of secrecy is being abandoned in favour of the modern and more logical policy of disclosure. The principle of conservation however should be applied cautiously. realization of income.8/10/2007
The principle has effect on: Income statement: Here the principle results in lower net income than would otherwise be the case. useful life of an asset. B/S: When applied to the B/S the approach results in understatement of assets and capital and overstatement of liable and provisions.