ACCOUNTING CONCEPTS & COVENTIONS

Business Entity
Concept: The business entity concept treats a business as a separate entity from
its owners or other businesses. Financial transactions of the business are
recorded and reported independently of the owners' personal transactions.
Examples:
Sole Proprietorship: John's Bakery is owned by John. Even though John is the sole
owner, the bakery's financial transactions (like income from sales and expenses
for supplies) are separate from John's personal finances.
Corporation: XYZ Corporation is a legally separate entity from its shareholders.
This means that the company's debts and legal liabilities are separate from those
of its shareholders.
Historical Cost
Concept: The historical cost concept involves recording assets and liabilities at
their original purchase cost, regardless of changes in market value.
Examples:
Building Purchase: A company purchases a building for $500,000. Ten years later,
its market value is $800,000. However, in the company's financial statements, the
building is still recorded at the original purchase cost of $500,000.
Equipment Acquisition: A firm buys machinery for $100,000. Despite the
machinery's depreciation or potential increase in market value, it remains listed in
the accounts at the initial purchase price of $100,000.
Duality
Concept: The duality concept in accounting states that every financial transaction
has two equal and opposite effects – one on the assets and the other on the
liabilities or equity.
Examples:
Purchasing Inventory on Credit: When a business buys inventory on credit, it
increases assets (inventory) and simultaneously increases liabilities (accounts
payable).
Receiving a Loan: When a company receives a loan, its assets (cash) increase, and
simultaneously, its liabilities (loan payable) also increase.
Money Measurement
Concept: The money measurement concept states that only those transactions
and events that can be measured in monetary terms are recorded in the
accounting records.
Examples:
Revenue Recognition: A company sells products worth $10,000. This sale is
recorded because it can be quantified in monetary terms.
Expense Recording: An enterprise pays $1,200 for rent. This transaction is
recorded as it represents a monetary outflow.
Time Interval
Concept: The time interval concept in accounting suggests that the life of a
business should be divided into appropriate segments for reporting purposes,
usually in the form of fiscal quarters or years.
Examples:
Quarterly Reports: A corporation releases financial statements every quarter,
showing its performance over these three-month periods.
Annual Financial Statements: Businesses often prepare annual financial
statements, which provide a financial overview of the past year's operations.
Going Concern
Concept: The going concern concept assumes that a business will continue to
operate for the foreseeable future, and is not likely to be liquidated or forced to
halt operations.
Examples:
Long-term Assets Depreciation: A company purchases a building and depreciates
it over 30 years, assuming the business will use it for a considerable period.
Multi-Year Contracts: A business enters into a five-year lease agreement,
indicating the expectation of continuity for at least that period.
Prudence
Concept: Prudence in accounting means being cautious when estimating figures.
Revenues and profits are not overstated, and all liabilities and losses are
adequately accounted for.
Examples:
Doubtful Debts Provision: A company makes a provision for doubtful debts,
recognizing that some customers may not pay their invoices.
Conservative Inventory Valuation: A firm values its inventory at the lower of cost
or net realizable value, reflecting a cautious approach.
Consistency
Concept: The consistency concept implies that a company should use the same
accounting methods and policies from period to period, allowing for meaningful
comparison of financial statements over time.
Examples:
Depreciation Method: If a company uses the straight-line method for depreciating
assets, it continues this method in subsequent accounting periods.
Revenue Recognition Policy: A business consistently applies the same revenue
recognition policy each fiscal year.
Accrual
Concept: The accrual concept states that income and expenses are recorded
when they are earned or incurred, not necessarily when cash is received or paid.
Examples:
Accrued Expenses: A company records utility expenses in the month they are
incurred, even if the payment is made the following month.
Earned Revenue: A service company records revenue when the service is
performed, not when it receives payment.
Realization
Concept: The realization concept in accounting refers to the point at which
revenue is recognized. It is generally at the point when goods are sold or services
are rendered, and it is reasonably certain that payment will be received.
Examples:
Sale of Goods: A retailer recognizes revenue at the point of sale when goods are
sold to a customer.
Completion of Service: A consulting firm recognizes revenue upon completion of a
consulting project.
Matching
Concept: The matching principle dictates that expenses should be matched with
revenues in the period in which the revenue was earned, to provide a more
accurate picture of financial performance.
Examples:
Cost of Goods Sold: A company matches the cost of goods sold with the revenue
from those goods in the same period.
Depreciation Expense: The depreciation expense for an asset is matched with the
revenues generated by using that asset.
Separate Recognition
Concept: This principle involves recognizing and reporting elements of financial
statements separately to ensure clarity and accuracy in financial reporting.
Examples:
Listing Assets and Liabilities Separately: On a balance sheet, assets, liabilities, and
equity are reported as separate categories.
Separate Disclosure of Operating and Non-operating Items: In an income
statement, operating income and expenses are reported separately from non-
operating items like interest income or expenses.
Substance over Form
Concept: This principle emphasizes that financial transactions and their substance
should be recorded in the financial statements rather than just their legal form.
Examples:
Finance Lease: Even if a lease is not legally an asset purchase, it's recorded as an
asset if it effectively transfers the risks and rewards of ownership.
Sale and Leaseback: A transaction where a company sells an asset and leases it
back is treated as a financing arrangement rather than a simple sale.
Full Disclosure
Concept: The full disclosure principle requires that all material and relevant
financial information is disclosed in the financial statements or in the notes to the
statements.
Examples:
Contingent Liabilities: A company discloses its contingent liabilities in the notes to
the financial statements, even if they may not become actual liabilities.
Changes in Accounting Policies: If a company changes its accounting policies, it
discloses this change and its effects on the financial statements.
Subjectivity
Concept: Subjectivity refers to how someone's judgment is shaped by personal
opinions and feelings instead of outside influences. Subjective information is
influenced by one's personal perspective, beliefs, opinions, and emotions, making
it unique to the individual.
Examples
Valuation of Intangible Assets: The valuation of intangible assets, like goodwill,
often involves a significant degree of subjectivity. The process may include
estimating future cash flows and determining appropriate discount rates, both of
which can vary based on the accountant's judgment and assumptions.
Estimation of Allowance for Doubtful Accounts: The process of estimating the
allowance for doubtful accounts (the amount of receivables a company does not
expect to collect) is subjective. It's based on past experiences, customer
creditworthiness, and other factors, which can vary from one accountant to
another.
Objectivity
Concept: Objectivity involves making judgments based on unbiased facts and
without the influence of personal feelings or prejudices. Objective statements are
based on observable phenomena and are the same regardless of who observes
them.
Examples
Recording of Cash Transactions: The recording of cash transactions in accounting
is objective. For instance, if a company receives $10,000 in cash from sales, this
amount is objectively recorded as such in the financial statements, regardless of
any personal opinions or biases.
Calculation of Depreciation Using the Straight-Line Method: The calculation of
depreciation using the straight-line method is an objective process. Once the cost,
salvage value, and useful life of an asset are determined, the annual depreciation
expense is calculated using a standard formula, leaving no room for personal
interpretation or bias.