Accounting concepts and conventions

Generally accepted accounting principles (GAAP)

Accounting is the language of business. To make the language convey the same meaning to all people, accountants all over the world have developed certain rules, procedures and conventions, which represents a consensus view by the profession of good accounting practices and procedures and are generally referred to as Generally accepted accounting principles (GAAP)

Principles
Fundamental belief or a general truth which once established does not change It is incorrect to apply the term with respect to accounting which is merely an art involving adaptation for the attainment of some useful results by its applications. AICPA defines Accounting principle as, a guide to action, a settled ground or basis of conduct or common practice

Characteristics of accounting principles

1. They do not have authoritativeness as universal principles of natural sciences 2. It is in the process of evolution 3. The general acceptance of an accounting principle depends on how well it meets the three criteria: relevance, objectivity and feasibility Relevance-Usefulness to the stakeholder Objective- Not influenced by personal bias Feasibility- It can be applied without undue complexity or cost

Accounting concepts and conventions

Accounting concepts:-They are basic assumptions or conditions upon which the science of accounting is based. They are considered as postulates. Accounting conventions:- It denotes circumstances or tradition which guides the accountants while preparing the accounting statements. Basic difference between them is that concepts are concerned with maintenance of accounts where as conventions are applicable while preparing financial statements i.e., Profit and Loss A/c and Balance sheet

Accounting concepts
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Business entity Money measurement Going concern Cost Dual aspect Accounting period Matching Realisation Objective evidence Accrual

Business entity concept

In accounting, the separate entity concept treats a business as distinct and separate from its owners. Capital supplied by the owner is considered as a liability because of this concept The accounting equation Asset=Liabilities + Capital is based on this concept The business stands apart from other organizations as a separate economic unit. It is necessary to record the business's transactions separately, to distinguish them from the owner's personal transactions. This concept can be extended to accounting separately for the various divisions of a business in order to ascertain the financial results for each division. An example is a sole trader or one man business: the sole trader takes money from the business by way of 'drawings i.e., money for his own personal use.

Money measurement concept

Money is the only practical unit of measurement that can be employed to achieve homogeneity of financial data Advantage of this method is that money serves as a common denominator by means of which heterogeneous facts about a business can be expressed in terms of money Limitations of this concept is that it is not recording transactions or events which cannot be expressed in terms of money and it do not take care of inflation effects

Going concern concept

Business unit has a reasonable expectation of continuing business at a profit for an indefinite period of time It is because of this concept that suppliers supply goods and services on credit and bank provide loans to businesses This assumption provides justification for recording fixed assets at original cost and depreciating them over the life of the asset Going concern support the treatment of prepaid expenses as assets

Cost concept
An asset will be recorded in the books at the price paid to acquire it and that this cost is the basis for all subsequent accounting for the asset Asset is recorded at cost at the time of purchase but is systematically reduced in its value by charging depreciation It is possible to remove the cost of fixed assets completely from the accounts altogether by writing off their cost as depreciation Inflation accounting is advocated to remove the drawbacks of cost concept

Dual aspect concept

Every financial transaction has two-fold aspect, a) yielding of a benefit and b) giving of that benefit Accounting equation is based on this concept also Thus a giver necessarily implies a receiver and a receiver necessarily implies a giver Thus every debit must have a corresponding credit and vice versa.

Accounting period concept

Measurement of income or loss of a business entity is relatively simple on a whole-life basis. A complete and accurate picture of the degree of success achieved by a business unit cannot be obtained until it is liquidated. But the stakeholders do not want to wait till the end and are interested in periodic results in order to take corrective actions The principle of classifying the expenditure into capital and revenue is done on the basis of this concept.

Matching concept
The matching concept is an accounting principle wherein the expenses are recognized and recorded in the same accounting period when the revenues are recognized. Matching concept undertakes the expenses of a particular accounting period are the costs of the assets used to earn the revenue that is recognized in that period. In the matching concept the expenses in a period are matched with the revenues generated for the same period; the result is the net income or loss for that period. The matching concept may require the knowledge of accrual accounting

Realisation concept
This concept emphasises that profit should be considered only when realised. The question is at what stage profit should be deemed to have accrued? Whether at the time of receiving the order or at the time of execution of the order or at the time of receiving the cash? For answering this question the accounting is in conformity with the law and Recognises the principle of law i.e., the revenue is earned only when the goods are transferred. It means that profit is deemed to have accrued when property in goods passes to the buyer, viz., when sales are made.

Objective evidence concept

All information must be maintained objectively, which means that it is free of bias and subject to verification. Objectivity is closely tied to reliability. Objective evidence consists of anything that can be physically verified such as a bill, check, invoice, or bank statement. In the event something cannot be supported objectively, a number of subjective methods are used to develop an estimate. The determination of items such as depreciation expense and allowance for doubtful accounts are based on subjective factors. Still even subjective factors are influenced by objective evidence such as past experience.

Accrual concept
The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. So: - Any money that is owed by a business in the current accounting period must be accrued and added to expenses - Any money that is owed to a business in the current accounting period must be accrued and added to income

Accounting conventions
1. 2. 3. 4. Convention of Full disclosure Convention of Materiality Convention of Consistency Convention of Conservatism

Convention of Full disclosure

The disclosure of all significant information is one of the important accounting conventions. It implies that accounts should be prepared in such a way that all material information is clearly disclosed to the reader. The term disclosure does not imply that all information that any one could desire is to be included in accounting statements. The term only implies that there is to a sufficient disclosure of information which is of material in trust to proprietors, present and potential creditors and investors. The idea behind this convention is that any body who want to study the financial statements should not be mislead. He should be able to make a free judgment. The disclosures can be in the way of foot notes.

Convention of Materiality
According to this convention only those events or items should be recorded which have a significant bearing and insignificant things should be ignored. This is because otherwise accounting will be unnecessarily over burden with minute details. There is no formula in making a distinction between material and immaterial events. It is a matter of judgment and it is left to the accountant for taking a decision. It should be noted that an item material for one concern may be immaterial for another. Similarly, an item material in one year may not be material in the next year.

Convention of Consistency
Once a business has adopted an accounting method, it should use the same method for all subsequent events of the same character unless it has sound reason to change. This concept is followed to promote the comparability of financial statements This concept advocates that there must be consistent treatment for similar items within each accounting period and from one period to the next. Consistency does not mean inflexibility. It does not forbid introduction of improved accounting techniques. If a change becomes necessary, the change and its effect should be stated clearly.

Three types of consistency

Vertical consistency -The vertical consistency is maintained within inter-related financial statements of the same period. If a change has been made in dealing with two aspects of the same statement then it will be vertical inconsistency. For example, different methods and rates of depreciation is used for different assets of same nature Horizontal consistency- When figures of one financial year are compared with the figures of another financial year of the same organization it will be a case of horizontal consistency. Three dimensional consistency- Three dimensional consistency will arise when financial statements of two different organizations, in the same industry, are compared.

Convention of Conservatism
This convention means a caution approach or policy of "play safe". This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration. If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialise. On account of this reason, the accountants follow the rule 'anticipate no profit but provide for all possible losses'. E.g.:- Inventory valuation, creation of reserves Critics point out that conservatism to an excess degree will result in the creation of secrets reserves. This will be quite contrary to the doctrine of disclosure.