8/10/2007

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.
i e necessary assumptions and
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.

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(According to the International Accounting

Standards Committee (IASC) the 3
fundamental accounting assumptions are
Going Concern Concept, Consistency

Concepts: Concept and Accrual Concepts).

„ Business Entityy Concept:

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 pproprietor
p of an enterprise
p is always
y considered to be
separate and distinct from the business, which he controls.
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 this way it becomes
possible to record transactions of the business with the
proprietor also. 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

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Money Measurement
Concept:
„ Money has been adapted by the accounting system as its basic unit of measurement.
Business deals in a variety of items having different physical units such as kilograms,
kilograms
quintals, metres, litres etc. so recording them and finally adding them will pose problems.
But, if these are recorded in a common denomination, there total becomes homogeneous
and meaningful. Therefore we need a common unit of measurement, which is MONEY.
„ Also, since money is the medium of exchange and the standard of economic value, 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.
„ The concept, although indispensable, has two major drawbacks:
„ The monetary unit is an inelastic measuring yardstick as because the purchasing
power of money hardly remains stable. For example, a building bought in 1960
,
for Rs. 50,000 mayy cost 10 times more at the p present date. ((Therefore,, now-a-
days, 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.)
„ Many important events can't be recorded simply because they could not be
expressed in monetary terms - e.g. the human resource asset cannot be
recorded in the B/s. The P & L A/c cannot disclose the quality of the product
manufactured, the sales policy pursued by the enterprise can't be shown in
accounting terms similarly working conditions in which the workers work, can't be
shown in the books of accounts.

Historical record Concept:

„ According to the historical record concept,
concept we record
only those transactions, which have actually taken
place and not those, which may take place in the
future. It is because accounting record presupposes
that the transactions are to be identified and
objectively evidenced. This is possible only in the
case of past (actually happened) transactions. The
future transactions can hardly be identified and
measured accurately.
„ Also, since all the transactions are to be recorded in
chronological (datewise) order, it leads to the
preparation of a historical record.

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(4)Cost Concept:
„ Business activity, in essence, is an exchange of money. The price paid (or agreed to be
paid in case of a credit transaction) at the time of purchase, is called cost.
„ Th idea
The id underlying
d l i the th costt conceptt is
i that:
th t
„ Assets are recorded at the price paid to acquire it (i.e. at cost) and
„ This cost remains the basis for all subsequent accounting for that asset.
„ The values of the assets are shown in the balance sheet at their acquisition values
rather than their disposition values or realization values. The change in the real
worth of a cost with the passage of time is not ordinarily recorded in the account
books. For example, a piece of land that has been purchased for Rs. 80,000 will be
recorded at that price. Whether its market price increases to Rs. 1, 80,000 or
falls to Rs.50, 000 at the time of making the statement will not be considered.
„ Thus, according to the cost concept, all assets are recorded in books at their original
purchase price and continue to be recorded thus. However, it must be clearly
understood that, we do not continue to take down the same figure year after year. The
original purchase price only serves as the basis for all subsequent accounting for that
asset.
„ 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.
„ There is too much of subjectivity in assessing the “current worth” or market
value or "realizable value”.
„ There exists objectivity and verifiability in the “cost approach”, which is
lacking in any other approaches.

Going Concern Concept:

„ This concept assumes that an enterprise
(except for terminable ventures) will continue
to exist in the foreseeable future. (The going
concern concept is basic to the valuation of
assets and the provision of depreciation
thereon according to the I.A.S - 1). 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.

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Dual Aspect Concept:

„ This is the basic concept of accounting. The recognition that every transaction has two
sides to it is the leading principle of the dual aspect concept. One represented by the asset
of the business and the other by the claims against them.them These two aspects are always
equal to each other.

„ In other words Assets = Liability + Capital or Capital = Asset - Liability. 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.

Liabilities (Equities) = Assets

Capital + Outside liabilities =
Assets
„ For example, If you purchase a machine for Rs.8000, you receive machinery on the one
hand and give Rs.8000 on the other. Thus this transaction has a two-fold effect i.e., (i)
increase in one asset and (ii) decrease in another asset. Similarly, if you buy goods worth
Rs.500 on credit, it will increase an asset (stock of goods) on the one hand and increase a
liability (creditors) on the other. Thus, every business transaction involves two aspects:
(i) the receiving aspect and (ii) the giving aspect. In case of the first example you
find that the receiving aspect is machinery and the giving aspect is cash. In the second
example the receiving aspect is goods and the giving aspect is the creditor. If complete
record of transactions is to be made, it would be necessary to record both the aspect in
books of account.

„ Let us understand another accounting implication of the dual aspect

concept. To start with, the initial funds (capital) required by the
business are contributed by the owner. If necessary, additional funds
are provided by the outsiders (creditors). As per the dual aspect
concept all these receipts create corresponding obligations for their
repayment. In other words a contribution to the business, either in
cash or kind, not only increases its resources (assets), but also its
obligations (liabilities/equities) correspondingly. Thus, at any given
point of time, the total assets and the total liabilities must be equal.
This equality is called ‘balance sheet equation’ or ‘accounting
equation’, which is as follows:

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„ 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.
„ 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.
„ (ii)Outsider’s Equity: Outsider’s equities called liabilities is the claim of
outside parties like creditors, bankers etc. against the assets of the
business Thus,
business. Thus all assets of the business are either claimed by the owners
or by the outsiders. Hence the total assets of the business will always be
equal to its liabilities.
When various business transactions take place, they affect the assets and
liabilities in such a way that this equality is always maintained.

Let us take certain examples:

„ E.g. 1) Mr.X started business with Rs.50,000 cash : The cash received by
the business is its asset. According to the business entity concept, business and
the owners are two separate entities. Hence the capital contributed by Mr.X is a
liability to the business.
Thus: Capital = Asset (Capital Rs. 50,000 = Asset - Rs. 50, 000 cash.)
„ E.g. 2) He purchased goods on credit from B Rs. 5000: This increases an
asset (Stock of goods) on the one hand and a liability (creditors) on the other.
Now the equation will be Capital + Liability = Asset .
i.e. (Rs. 50,000 + Rs. 5000 = Rs.5000 + Rs.50,000)
Capital Creditors Stock Cash

„ E.g. 3) He purchased furniture worth Rs. 10,000 and paid cash

This
h increases one asset (furniture)
(f ) and
d decreases
d another
h asset i.e.
cash. Now the equation will be:
Capital + Liabilities = Assets
(Rs. 50,000 + Rs. 5,000 = Rs. 10,000 + Rs.5,000 + Rs.40,000)
Capital Creditor Furniture Stock Cash

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Realization Concept:
„ In accountancy, profit is treated as being realized when the
goodsd or services
i are passed d to the
h customers and d money has
h
been realized or when a legal obligation to pay has been
assumed by the customer. 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, and this is important because otherwise firms may
record profits which is not realized and resort to showing higher profits
than is actually earned. (However it is not always easy to determine
when revenue is realized. In determining profit, 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.)

„ There are certain exceptions like in long term contract ‘work in

progress’ revenue is recognized before completion of the job. Also in
the case of ‘Hire Purchase’ transactions - revenue is recognized in
proportion to the installment over price etc.

REVENUE – Realisation and

not on actual receipt
COST – Recognised when
Accrual Concept: incurred and not when paid

„ Under this system revenue recognition depends on its realization and

nott actual
t l receipt.
i t Like
Lik wise
i costs
t are recognized
i d whenh th
they are
incurred and not when paid.
„ This necessitates certain adjustments in the preparation of income statement. In
relation to revenue the accounts should exclude amounts relating to subsequent
period and provide for revenue recognized but not received in cash. Likewise in
relation to costs: provide for costs incurred but not paid, but exclude - costs
paid for subsequent period.
„ 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. It is, thus,
clear that the operating results prepared on this basis are not in conformity with
generally accepted accounting principles.
„ The essence off the
Th h accruall concept lies
li i the
in h fact
f that
h
net profit is the difference between revenues and
expenses rather than between cash receipt and
expenditure.
„ Any increase in owner’s equity is called revenue and any thing that reduces the
owner’s equity is expense (or loss).

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Distinction between accrual basis of

accounting and cash basis of accounting

Sl. Basis of Distinction Accrual basis of acc Cash basis of acc.

No.
1 Treatment of Prepaid/ Outstanding Exp It is there There is no question of
or Accrued or Unaccrued income in B/s prepaid or outstanding
I/E
2 Impact on Income ( in case of prepaid Income statement will Will show a lower income
expenses and accrued income.) relatively show a higher
Income
3 Impact on Income ( in case of Will show a lower income Will show a higher
outstanding exp and unaccrued inc.) income
4 Recognition under Companies Act, 1956 Recognised Not Recognised

5 Option of choosing alternative methods Yes No.

to suit the requirement ( like LIFO, FIFO,
SLM, WDV)

Continued:-

„ It's important to understand the basics of the two principal methods of keeping track of a business's
i
income andd expenses: cashh method
h d andd accruall method
h d (sometimes
( i called
ll d cash
h basis
b i and d accruall basis).
b i )
In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases,
are credited or debited to your accounts. The accrual method is the more commonly used method of
accounting.
„ Under the accrual method, transactions are counted when the order is made, the item is delivered, or the
services occur, regardless of when the money for them (receivables) is actually received or paid. In other
words, income is counted when the sale occurs, and expenses are counted when you receive the goods or
services. You don't have to wait until you see the money, or actually pay money out of your checking
account, to record a transaction.
„ Under the cash method, income is not counted until cash (or a check) is actually received, and expenses
are not counted until they are actually paid.
„ Example Your computer installation business finishes a job in November, and doesn't get paid until three
months later in January. Under the cash method, you would record the payment in January. Under the
accrual method, you would record the income in your books in November.

„ Example You purchase a new laser printer on credit in May and pay $1,000 for it in July, two months
later. Using the cash method accounting, you would record a $1,000 payment for the month of July, the
month when the money is actually paid. Under the accrual method, you would record the $1,000 payment
in May, when you take the laser printer and become obligated to pay for it.

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Matching Concept:
„ Matching concept is an essential part of accrual accounting. It
requires
i that
h expenses forf an accounting
i period
i d should
h ld be
b
matched against related incomes, 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. As many business
keep accounts on accrual basis, i.e. keeping account on an income and
expenditure basis, it is necessary that the accounting system should
match periodically the revenues earned against expenses incurred. The
result of this matching is the net income or net loss.

„ This method requires the proper allocation of income and expenditure

into appropriate periods so that relevant incomes and expenses are
matched. The profit of an accounting period is the revenues from
transactions less expense incurred in producing these revenues. (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 is the essence of Matching Concept).

Accounting Period Concept

/ Periodicity Concept:
„ To find out "how the business is g goingg on,, accountants choose
some convenient period of time to ascertain income for
that period. Twelve-month period in normally adopted for
this purpose. This time interval is called accounting period and
is also called natural business year. Such period wise income
determination leads to comparison of the results of successive
periods. 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. 10000/=. Here, the transaction relates to 5
depreciation The main
accounting period shown in the form of depreciation.
consequence of the periodicity concept is the application of the
arbitrary allocation and apportionment of indirect costs.

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Consistency Concept:
„ It is possible to adopt a variety of principles and
procedures for recording financial events. If in
treating a given event, two or more
contradictory methods are used, 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.
operation Therefore it is very important
that accountants be consistent in applying
principles and procedures to similar situations.

Objectivity Concept:
„ As p per this concept p all accounting g must be based on
objective evidence.
„ Transactions recorded should be supported by verifiable
documents. Only in such an event it would be possible for the
auditors to verify accounts and certify them as true or
otherwise. The evidence substantiating the business transitions
should be objective i.e. free from the bias of the accountants or
others. It is for this reason that assets are recorded at historical
costs and shown thereafter-historical cost less depreciation. If
the assets are shown on replacement cost basis the objectivity
i lost
is l andd it
i becomes
b diffi l for
difficult f authors
h to verify
if such
h values.
l
(However in recent years replacement costs are used for
specific purposes.

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Conventions:
„ 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:

Conventions:
„ Consistency:
„ Disclosure:
„ Materiality:
„ Convention of Conservatism:

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Consistency:

„ The accounting practice should remain the

same from one year to another. Changing
method would lead to distortion - for instance it
would not be proper to value stock in trade according
to one method one year and another in the next
year. 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, otherwise comparison
of one accounting period with another would not be
possible. Consistency however does not mean
inflexibility. A firm can change the method used as
necessary and where it is affected the effect of such
change should be stated.

Disclosure:
„ Apart from legal requirements good accounting practice also demands
that all significant information should be disclosed. It implies that
accounts must be honestly prepared and all material information must
be disclosed therein.

„ The term disclosure does not imply p y that all information that anyone
y
could conceivably desire is to be included in accounting statements.
The term only implies that there is to be a sufficient disclosure of
information, which is of material interest to proprietors, present
and potential creditors and investors. The practice of appending notes
relative to various facts or items, which do not find place in accounting
statement, is in pursuance to the convention of full disclosure of
material facts. Like contingent liabilities appearing as a note,
market value of investments appearing as a note.

„ The concept
p of disclosure also applies
pp to events occurring
g after
the B/s date and the date in which the financial statements are
authorized for issue. Such events include bad debts, destruction of
plant and equipment due to natural calamities, major
acquisition of another entp. & the like. Such events are likely to
have a substantial influence on the earnings and financial position of
the enterprise. Their non-disclosure would affect the ability of the users
of such statements to make proper evaluations and decisions.

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Materiality:
„ This convention states that accounting records should consists of only
those transactions
th t ti th t are significant
that i ifi t from
f th point
the i t off view
i off
determination of income materiality.
„ The American Accounting Association (AAA) defines the term materiality, 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". As per IAS-1 financial
statements should disclose all items, which are material ……. to effect
evaluations or decisions. This is also reiterated in IAS-5, which states that all
material information should be disclosed that is necessary to make the financial
statements clear & understandable.
„ Some of the examples of material financial information to be disclosed are: Loss
of market due to competition or Govt. regulation, likely fall in the
value of stocks,
stocks increase in wage bill under recently concluded
agreement etc.
„ It is now agreed that information known after the date of B/S must
also be disclosed.
„ 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. Since the amount involved is pretty small it may be treated as
an expense in the year of purchase. (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.)

Convention of Policy of Playing

Safe

Conservatism:
„ This is the policy of 'playing safe'. It takes into consideration all
prospective losses but leaves all prospective profits. This Accounting
principle
i i l isi given
i recognition
iti i IAS-1,
in IAS 1 which
hi h recommends
d the
th observance
b off
prudence in the framing of accounting policies. It is true that uncertainties
surround many transaction and therefore exercise of prudence in financial
statement - becomes necessary, but prudence does not justify the creation of
secret or hidden reserves.

„ E.g. of application of convention of conservatism:

„ Provision for bad and doubtful debts.
„ Valuation of stock in trades at MP/Cost Price whichever is less.
„ Creating provision against fluctuation in the price of investments.
„ Charging of small capital items like crockery to revenue.
revenue
„ Adoption of WDV method of depreciation, rather than straight-line method,
which is less conservative in approach.
„ Amortization of intangible assets like GW, which has indefinite life.
„ Showing JLP at surrender value against the amount paid.
„ Not providing for discount on creditors.
„ 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.

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„ The principle has effect on:

„ Income statement: Here the principle results in lower net income than
would otherwise be the case.
„ B/S: When applied to the B/S the approach results in understatement of
assets and capital and overstatement of liable and provisions.
„ The principle of conservation however should be applied cautiously. If the
principle is stretched without reservation it results in the creation of secret
reserves, which is in direct conflict with the doctrine of full disclosure. 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.
„ Application
pp of the p
principle:
p
„ Where there is an uncertainty inherent in the activity e.g. useful life of an asset, occurrence of loss,
realization of income, estimated liability etc.
„ When there are two equally accepted methods, then: the one, which is more conservative, will be
accepted.
„ When there is judgment based on estimates and doubts exists as to which of the several estimates
in correct, the most conservative would be selected.
„ When there is possibility of the occurrence of a loss or profit, losses will be considered and profits
will be overlooked.

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