ACCOUNTING CONCEPTS

and
CONVENTIONS
• Accounting is a social science has its
concepts and principles that used in
applying the accounting cycle to
achieve accounting functions and
objectives.
ACCOUNTING CONCEPTS
Accounting concepts refer to
the nature of the economic
environment in which
accounting operates .

Recording has been based on

certain assumptions.
 Classification

ASSUMPTIONS PRINCIPLES CONSTRAINTS

1. Economic entity 1. Historical cost 1. Cost-benefit
2. Going concern 2. Revenue recognition 2. Materiality
3. Monetary unit 3. Matching 3. Industry practice
4. Periodicity 4. Full disclosure 4. Conservatism
 Accounting Concepts
1. Money measurement concept
2. The going concern concept
3. The business entity concept
4. The realisation concept
5. Accrual /Matching concept
6. Historical Cost Concept
7. Periodicity
8. Dual Aspect
 Accounting Conventions
1. Materiality Concept
2. Prudence/Conservatism Concept
3. Consistency Concept
4. Disclosure
 Money measurement concept
• It can be measured in money
• Most people will agree to the money value of
the transaction.
• Assumes that the value or purchasing power
of money is constant, ignoring the effects of
inflation or deflation.

• Monetary Unit - money is the

common denominator.
 Money measurement concept

• e.g.
• Accounting doesn’t tell how good
the quality of employees’ skills are
although this is important for the
success of a business.
 The Going concern concept
• This concept implies that the business will
continue to operate for the foreseeable
future.
• This is why we use the historical cost
concept and ignore the current market
value in asset valuation.
• Going Concern - company to last
long enough to fulfill objectives and
commitments.
 The Going concern concept
• e.g.
• Fixed assets are
shown at cost less
accumulated
depreciation.
 The Business entity concept
• This concept implies that the affairs of a
business are to be treated as being quite
separate from the non-business activities
of its owners.
• Personal transactions of the owner should
not be included.
• Economic Entity – company keeps
its activity separate from its owners
and other businesses.
 The Business entity concept
• e.g.
• A director’s private car
should not be included in
the fixed assets of the
company.
 The Realisation concept
• This concept holds to the view that profit
can only be taken into account when
realisation has occurred.
• Generally, sales revenue arising from the
sale of goods is recognised when the
goods are delivered to the customers.

• - generally occurs (1)

Revenue Recognition
when realized or realizable and (2) when
earned.
 The Realisation concept
• e.g.
• Profit is earned when goods
or services are provided to
customers. Thus it is
incorrect to record profit
when order is received, or
when the customer pays for
the goods.
 Accrual concept
• The accrual concept says that net profit is
the difference between revenues and
expenses.
• Determining the expenses used up to
obtain the revenues is referred to as
matching expenses against reveues.
• Income and costs are recognised as they
are earned and incurred but not as they
are received or paid.
Matching - efforts (expenses) should be matched with
accomplishment (revenues) whenever it is reasonable and practicable to
do so. “Let the expense follow the revenues.”

Expense Recognition
 Accrual concept
• e.g.
• Expenses have to take into
account of amounts payable
at the end of an accounting
year even though the cash
has not yet been paid.
 Historical Cost concept
• Assets are normally shown at their original
costs of acquisition.
• Any changes in the market value after the
purchase are ignored.
• Historical cost is the most objective
measure of the value of an asset.
However, it cannot reflect the current
value of an asset.
 Historical Cost concept
• E.g.
• A fixed asset acquired at a cost
of Rs.100,000 would be recorded
at this amount in the books.
Even if its market value may
have gone up or down in future, it
should be recorded at its original
cost Rs.sssssss100,000.
 Periodicity – Time Period Assumption

• The life of an entity is divided into short

economic time periods on which reporting
statements are fashioned.
• Periodicity - company can divide its
economic activities into time periods.
 Dual Aspect
• Transaction has two fold effect: Debit &
Credit.
• Accounting Equation: A = C / E + L
• Assets = Liabilities
Conventions
 Materiality
• Financial statement should separately
disclose significant items for they would
influence decisions of users.
• Accounting does not serve a useful
purpose if the effort of recording a
transaction in a certain way is not
worthwhile.
• In other words do not waste your time in
the elaborate recording of trivial items.
 Materiality
• e.g.
• A stock of
stationery worths
$10 should be
treated as an
expense when it
was bought.
 Prudence/Conservaitsm
• The accountant should always be on the
side of safety.
• The prudence concept means that
normally he will take the figure which will
understate rather than overstate the profit.
• Provision is made for all known liabilities.
 Prudence/Conservaitsm

• E.g.
• Provision for doubtful debts
should be deducted from
debtors in balance sheet.
 Consistency
• When a firm has once fixed a method for the
accounting treatment of an item, it will enter all
similar items that follow in exactly the same way.
• Frequent changes in the accounting methods
would lead to misleading profits calculated from
the accounting records.
• It states that when a firm has chosen a method
for the accounting treatment of an item, all
similar items should be treated in the same way.
 Consistency
• E.g.

• Depreciation method of
certain fixed assets once
adopted should be used in
the following years.
 Disclosure

• The financial statements of a firm must

include all information necessary for the
formation of valid decisions by the users.
• Any information that might be relevant to
an investor or creditor should be
disclosed, either in the body of the
financial statements or in the notes
attached thereto.
Exercises
 Assumptions
Brief Exercise : Identify which basic assumption of
accounting is best described in each item below.
(a) The economic activities of FedEx Corporation
are divided into 12-month periods for the Periodicity
purpose of issuing annual reports.
(b) Solectron Corporation, Inc. does not adjust
Monetary
amounts in its financial statements for the
Unit
effects of inflation.
(c) Walgreen Co. reports current and noncurrent
classifications in its balance sheet.
Going Concern

(d) The economic activities of General Electric

and its subsidiaries are merged for Economic
accounting and reporting purposes. Entity
 Contd.
Brief Exercise Identify which basic principle of
accounting is best described in each item below.
(a) Norfolk Southern Corporation reports revenue Revenue
in its income statement when it is earned instead of Recognition
when the cash is collected.
(b) Yahoo, Inc. recognizes depreciation expense for
a machine over the 2-year period during which that Matching
machine helps the company earn revenue.
(c) Oracle Corporation reports information about Full
pending lawsuits in the notes to its financial Disclosure
statements.
(d) Eastman Kodak Company reports land on its
Historical
balance sheet at the amount paid to acquire it, even
Cost
though the estimated fair market value is greater.
 Constraints
Cost Benefit – the cost of providing the information must be
weighed against the benefits that can be derived from using it.

Materiality - an item is material if its inclusion or omission would

influence or change the judgment of a reasonable person.

Industry Practice - the peculiar nature of some industries and

business concerns sometimes requires departure from basic
accounting theory.

Conservatism – when in doubt, choose the solution that will be least

likely to overstate assets and income.
 Constraints
Brief Exercise What accounting constraints are
illustrated by the items below?
(a) Zip’s Farms, Inc. reports agricultural crops Industry
on its balance sheet at market value. Practice
(b) Crimson Tide Corporation does not accrue a
contingent lawsuit gain of $650,000. Conservatism

(c) Wildcat Company does not disclose any

information in the notes to the financial Cost-Benefit
statements unless the value of the information
to users exceeds the expense of gathering it.
(d) Sun Devil Corporation expenses the cost of
Materiality
wastebaskets in the year they are acquired.