Principles Of Financial

Accounting

Project :-

Accounting Concept And

Convention
By Abhey Jindal

175/18
Accounting Concepts
Accounting concepts is basically the accounting rules that should be follow
while preparing the financial statements and accounts

Some of them are :

 Matching Concept
 Realisation Concept
 Objective Evidence Concept
 Accrual Concept

1. Matching Concept
Definition

Matching Principle requires that expenses incurred by an organization must be charged to

the income statement in the accounting period in which the revenue, to which those
expenses relate, is earned.

Explanation

 Prior to the application of the matching principle, expenses were charged to the
income statement in the accounting period in which they were paid irrespective of
whether they relate to the revenue earned during that period.
 This resulted in non recognition of expenses incurred but not paid for during an
accounting period (i.e. accrued expenses) and the charge to income statement of
expenses paid in respect of future periods (i.e. prepaid expenses).
 Application of matching principle results in the deferral of prepaid expenses in
order to match them with the revenue earned in future periods.
 Similarly, accrued expenses are charged in the income statement in which they are
incurred to match them with the current period's revenue.

2. Realisation Concept
Definition

Realisation concept in accounting, also known as revenue recognition principle, refers to

the application of accruals 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.

Explanation

In case of sale of goods, revenue must be recognized 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.

In case of the rendering of services, revenue is recognized on the basis of stage of

completion of the services specified in the contract.

Any receipts from the customer in excess or short of the revenue recognized in
accordance with the stage of completion are accounted for as prepaid income or accrued
income as appropriate.

3. Objective Evidence Concept

Definition
Principle of objective evidence (or principle of objectivity) states that no accounting record should be
made unless it is supported by independently verifiable (i.e., objective) evidence. Generally such
evidence is in writing, or should be reduced to writing before an accounting entry is made.

Explanation

 All transactions must be evidenced by a document, e.g., cash sales are evidenced by cash
memos, credit sales by invoices, payments through bank by check etc.

 Purchase of things of larger value like land, building, motor vehicles, etc. is generally
supported by elaborate legal documentation like title deeds, sale deed etc.

 If the principle of objective evidence is not adhered to, the accounting records will lose their
credibility and financial statements will fail to portray the true picture of the business.

4. Accrual Concept
Definition
Accrual concept is the most fundamental principle of accounting which requires recording
revenues when they are earned and not when they are received in cash, and recording
expenses when they are incurred and not when they are paid

Explanation
 Financial statements are prepared under the Accruals Concept of accounting which
requires that income and expense must be recognized in the accounting periods to
which they relate rather than on cash basis.
 An exception to this general rule is the cash flow statement whose main purpose is
to present the cash flow effects of transaction during an accounting period.
 Accounting Conventions
An accounting convention is a common practice used as a guideline when
recording a business transaction. Accounting conventions are a necessary
part of the accounting profession, since they result in transactions being
recorded in the same way by multiple organizations.

They are as Follow :-

 Convention of Consistency
 Convention of Full Disclosure
 Convention of Conservatism
 Convention of Materiality
 1. Convention of Consistency
Financial statements of one accounting period must be comparable to another in order
for the users to derive meaningful conclusions about the trends in an entity's financial
performance and position over time.

Comparability of financial statements over different accounting periods can be ensured by

the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the
reliability and relevance of financial statements.

A change in the accounting policy may also be imposed by changes in accountancy

standards. In these circumstances, the nature and circumstances leading to the change
must be disclosed in the financial statements.

Financial statements of one entity must also be consistent with other entities within the
same line of business.

This should aid users in analyzing the performance and position of one company relative
to the industry standards.

It is therefore necessary for entities to adopt accounting policies that best reflect the
existing industry practice.
2. Convention of Full Disclosure
The full disclosure concept is an accounting principle that requires management
to report all relevant information about the company’s operations to creditors
and investors in the financial statements and footnotes.

In other words, GAAP requires that management tell external users material
information about the company that they can use to base their decisions on.

The purpose of the full disclosure principle is to share relevant and material
financial information with the outside world.

Since outsiders don’t know the details of a company’s business deals, contracts,
and loans, it’s difficult to form an opinion of the entity.

Relevant information to outsiders is anything that could change an external

user’s decision about the company.

This can include transactions that have already occurred as well as future events
contingent on third parties.

Any type of information that could sway the judgment of an outsider should be
included in the financial statements in an effort to be transparent.
 4. Convention of Conservatism
The principle of conservatism gives guidance on how to record uncertain events and
estimates.

The principle of conservatism states that you should always error on the most
conservative side of any transaction.

Most of the time this means minimizing profits by recording uncertain losses or
expenses and not recording uncertain or estimated gains.

Since accounting standards and GAAP are always concerned with the usefulness of
financial data to financial statement users, you can understand why the FASB doesn’t
want financial information to over estimated or error on the high side.

Generally, a more conservative estimate should always be used. When estimating

allowance for doubtful accounts, casualty losses, or other unknown future events you
should always error on the side of conservatism. In other words, you should tend to
take the position that is records the most expenses and least income.
3. Convention of Materiality
While matching concept and accrual concept require an accountant to accurately
calculate the exact cost to be charged to income statement for any particular period,
the materiality principle states that this should be done only to the extent that it is
material.

Unnecessary details should be avoided as the cost of going into such details is often
greater than the benefit of the exercise.

For example, if a box file is bought for $5, it is likely that it will last for five years or
more. Yet it would be tedious, time consuming, expensive and generally inconvenient
to treat a file cover costing $5 as a fixed asset and depreciate it over five years using
straight line method. It would be far easier to call the entire cost of $5 as an expense
for the year in which the box file is bought. It would not materially misstate the profit
for that year (or remaining four years).

It is difficult to set a limit as to what is material, as this would differ from organization
to organization. For large multinational companies an expense of $200 may be too
small to capitalize while a retail shop might consider assets costing $200 large enough
to be treated as an asset rather than an expense. Most companies have internal rules
about such limits. Once such rules or limits are set, they should be consistently applied.
 Motivational Story Of
Jeff Bezos
CEO of Amazon.com

Jeff had founded Amazon.com in 1994

He first got the idea to start an Internet enterprise in 1994. He was surfing the Internet in search of
new ventures for D.E. Shaw & Co. to invest in. That is when he stumbled upon a statistic stating that
World Wide Web usage was growing by 2,300% a month.

This coincided with a then-new US Supreme Court ruling holding that mail order catalogs were not
required to collect sales taxes in states where they lack a physical presence.
Bezos immediately recognized the expansive possibilities of selling online and began exploring the
possibilities of developing an Internet business around it.
He jotted down a list of 20 potential products that held the potential to sell through the Internet.
After reviewing the list, books turned out to become the obvious choice! Primarily because of the -
number of titles that existed. Jeff noticed that even the largest superstores could stock only a mere
fraction of what the available books, and a “virtual” bookstore could offer millions of titles.
And it was decided! Jeff passed up a fat bonus, packed his wife, and their dog and headed for a
cross-country drive from New York to Seattle. MacKenzie drove during the trip, while Jeff jotted
down the business plan and started calling prospective investors.
And just like that – Amazon.com was formed!
And finally in July 1995, with an option of more than 1 million titles, Amazon.com opened its virtual
doors and called itself “Earth’s Biggest Book Store”.
In the next three years, Amazon.com grew on to become from a company with 100 employees that
drew sales of more than $15.7 million, to a company , to a company of more than 3,000 employees
and more than $610 million in sales, in just 3 years.