Principles of Accounting - Accounting Concepts and Conventions
Question: What do you mean by Basic Accounting Principles? Also, explain the accounting concepts and conventions.
Answer
Introduction
Let us assume, you have the financial statements of two companies – ABC Ltd., and XYZ Ltd. You would like to access their financial performance, compare, analyze, and decide to invest your money in a financially strong company. But, these companies follow their own accounting procedures and methods. If there are no commonalities, no uniformity in the preparation of their financial statements, you’ll not be able to compare them. Will you be able to judge which company is performing better? Obviously, not.So, now you got, why accounting principles are formulated?
To bring these commonalities and uniformity, Accounting Principles are formulated. The accounting principles are formulated and recognized by regulatory bodies throughout the world. These principles are important to be followed by every organization to bring uniformity and consistency in the preparation of financial statements.
Meaning of accounting Principles
Basic Accounting Principles are also known as (GAAP) Generally Accepted Accounting Principles.Accounting principles may be defined as those rules of action or conduct, which are adopted by the accountants, universally, while recording the transactions.
The American Institute of Certified Public Accountants has defined the accounting principle as, “a general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice”.
Categories of Accounting Principles
Accounting Principles are divided into two categories
- Accounting Concepts
- Accounting Conventions
The term ‘Accounting Conventions’ are the customs and traditions, which guide us in preparing accounting statements. We mostly use these conventions in preparing the final accounts, as they are useful for better understanding.
Accounting Concepts
1) Money Measurement ConceptAccording to this accounting concept, accounting records only those transactions which are expressed in terms of money, other transactions which are not expressed in terms of money, however important they are, they are not recorded in books of accounts.
Let us understand this concept with some examples.
For example, You are a manager in an organization, your managerial skills, your knowledge, your hard work is very useful to the business, but will it be recorded in the books of accounts, not, why? Because these traits are qualitative in nature, not in monetary terms. And according to the Money Measurement concept, only monetary events and transactions are recorded in accounting.
Let’s take another example, If the assets are expressed like – 1000 sq/m of building, 2000 kg of raw-material, 10 machines, and 20 chairs and so on. Will these assets be recorded in the books of accounts? Again not. Why? Because these assets are expressed in quantitative terms, but not in monetary terms.
Let us take one more example, If the assets are expressed like – Building of Rs 100000, Raw-material of Rs 20000, Machinery of Rs 10000, Chairs of Rs 2000, and so on. Now, Will these are recorded in the books of accounts? Obviously Yes, because now these assets are expressed in terms of money.
So, I believe now you got the Money Measurement Concept.
Moving to the next Concept, i.e. Business Entity Concept.
2) Business Entity Concept
This accounting concept is also called Separate Entity Concept. According to this concept, a business is considered as a separate entity, distinct from the person who owns it. The owner is different and the business is different. The amount invested by the owner at the time of commencement of the business is called Capital, and capital is treated in accounting as a liability that is considered due to being returned to the owner in the future.
Let us understand this concept with an example.
The owner of the business Purchase a Car for his personal use, will it be considered as the property or asset of the business and recorded in the books of accounts? Not, because according to this concept owner is different from the business, and his personal belongings or personal properties will never be considered as the properties of the business and will not be recorded in the books of accounts.
3) Dual Aspect Concept
This is the basic concept of accounting. According to this accounting concept, no transaction is complete without a double aspect; means to say that for every debit there is a corresponding credit.
For example – Mr. Kumar started the business with a capital of Rs. 100000. Now, this transaction will have one effect on the Cash A/c and a dual effect on Capital A/c. Or we can say, now the business owns Assets (Cash) worth Rs. 100000, and at the same time the business has obligation to repay to Mr. Kumar Rs. 100000 and recorded as ‘Capital’.
This can be represented in the form of equation as:
Capital (owners’ equity) = Assets (Cash)
Rs. 100000 = Rs 100000
For Example – Rs 50000 was borrowed from Ram to further invest in the business. This transaction will increase assets (Cash) as well as Liabilities (Creditors). Thus represented in form of equation as:
Capital (Owners Equity) + Creditors = Assets (Cash)
Rs 100000 = Rs 50000 = Rs 150000
4) Going Concern Concept
According to this concept, it is assumed that business organizations will continue to operate in the foreseeable future and will not be liquidated or forced to discontinue operations for any reason. A going concern is expected to have the following things working in their favor:-
- The business is capable of running its daily operations and has sufficient capital and raw material to do so.
- The business has the ability to pay off its debts during the accounting period.
- The service or product offered by the company is in demand in the market.
- There should be no changes in the law governing the business.
To understand this concept let’s take an example - The accountant while valuing the assets of the enterprise does not take into account their current resale values as there is no immediate expectation of selling it. The original cost of the assets is considered and depreciation is charged on the assets over the years for the life of the asset. This distribution of expenditure i.e. depreciation is possible only because of the going concern concept, which is, the business shall be carried on for at least the life of the asset or beyond.
I think the going concern concept is clear now, moving to the next concept which is the Cost Concept.
5) Cost Concept
Cost Concepts is of special significance only for fixed assets. Which is recorded in the books of account at cost i.e., at the price actually paid for acquiring the assets. The depreciation is deducted from the original value which is the initial purchase price of the asset will highlight the book value of the asset at the end of the accounting period. The marketing value of the asset should not be taken into consideration.
Now, the question is, why the assets are not recorded at market value?
The main reason is that the market value of the asset is subject to fluctuations due to demand and supply forces. The entry of market value of the asset will require the frequent update of information to the tune of changes in the market.
Will it be possible to record the changes taken place in the market then and there? Obviously not. That’s why Assets are not recorded at the market value.
6) Accounting Period Concept
As we already know, considering the ‘Going Concern Concept’, every business would exist for a longer duration. That longer duration is divided into appropriate segments or periods for studying the results shown by the business for each period.
The specific period is normally one year. This time interval is called the ‘accounting period’. This period can further be divided into four Quarters - Q1, Q2, Q3, and Q4, of three months each.
At the end of each accounting year, the Profit and Loss Account and Balance Sheet are prepared. Profit and Loss Accounts show the financial results, while the Balance Sheet shows the financial position.
7) Matching Concept
One of the objectives of every business firm is to know its results for a given period of time. In order to know the profit and loss of the business, the costs incurred during a given period are matched against the revenue earned during that period. This helps to know the profit or loss of the business during a period of time. If the revenue exceeds the cost it represents the profits. On the other hand, if the cost exceeds the revenue, it represents the loss.
8) Realization Concept
This concept deals with the point of time at which the revenue is taken as earned. According to this concept, revenue is realized when goods and services produced by a business are transferred to the customer irrespective of whether cash from the transaction has been received or not.
Let’s understand this concept with an example:
For example, ABC Ltd. received an order in January, delivered the goods in February, and received the payment in March.
Now, according to the realization concept, when did the revenue is earned?
Revenue is earned in February i.e., when the transfer of goods took place, notwithstanding the fact that the order was received in January and cash was received in March.
1) Convention of Conservatism
‘Playing safe’ is the main idea underlying this convention. In the initial stages of accounting, not actual profits, but, even anticipated profits have been recorded. But, the anticipated profits have not materialized. This has shaken the confidence in accounting. In consequence, Accounting has started to follow the rule “anticipate no profit and provide for all possible losses”.
For example, the closing stock is valued at cost price or market price, whichever is lower. The effect of the above is that in case, the market price comes down, then the ‘anticipated loss’ is to be provided for. But, if the market price goes up, then the ‘anticipated profits’ are to be ignored. When the lower of the two is taken into account for the valuation of closing stock, no anticipated profit is booked, but all possible loss is taken care of.
Basically, the concept says that whenever there are two equally acceptable methods, the one, which is more conservative, will be accepted. When a judgment is based on general estimates, if there is a dilemma as to which is correct, the most conservative estimate will be accepted. When there is a probability of getting profit or loss, profit will be ignored, but the loss will be taken into account.
2) Convention of Materiality
The materiality convention of accounting states that the business should include only the important or relevant facts in the financial statements.
Material facts refer to any information if excluded or misreported in the financial statements that could influence the decision of the users of such financial statements.
Thus, if excluding or misreporting certain information impacts the decision of the users of the financial statements, such information is material in nature.
Likewise, if excluding or misreporting certain information does not influence the decisions of the users of such statements, such information is not material or immaterial in nature.
For Example - If information related to capital, stock, or sales is excluded or misreported could influence the decision of users of such information, and this information is material in nature.
On the other hand, information related to clubbing of pens, pencils, stick notes, etc. under different heads (stationary) is not of material nature.
Therefore, items of material nature are recorded in detail separately under their respective heads. However, items that are immaterial in nature are clubbed together under different accounting heads.
3) Convention of Disclosure
The Convention of disclosure requires that all material and relevant facts concerning financial statements should be fully disclosed. Full disclosure means that there should be full, fair, and adequate disclosure of accounting information. Adequate means a sufficient set of information to be disclosed. Fair indicates an equitable treatment of users. Full refers to the complete and detailed presentation of information. Thus, the convention of disclosure suggests that every financial statement should fully disclose all relevant information.
4) Convention of Consistency
Convention of consistency implies that the basis followed in different accounting periods should be the same. It also signifies that the accounting practices and methods should remain consistent from one accounting year to another. For example - If a particular method of depreciation is adopted for a particular fixed asset, the same method should be followed for that assets year after year.
The specific period is normally one year. This time interval is called the ‘accounting period’. This period can further be divided into four Quarters - Q1, Q2, Q3, and Q4, of three months each.
At the end of each accounting year, the Profit and Loss Account and Balance Sheet are prepared. Profit and Loss Accounts show the financial results, while the Balance Sheet shows the financial position.
7) Matching Concept
One of the objectives of every business firm is to know its results for a given period of time. In order to know the profit and loss of the business, the costs incurred during a given period are matched against the revenue earned during that period. This helps to know the profit or loss of the business during a period of time. If the revenue exceeds the cost it represents the profits. On the other hand, if the cost exceeds the revenue, it represents the loss.
8) Realization Concept
This concept deals with the point of time at which the revenue is taken as earned. According to this concept, revenue is realized when goods and services produced by a business are transferred to the customer irrespective of whether cash from the transaction has been received or not.
Let’s understand this concept with an example:
For example, ABC Ltd. received an order in January, delivered the goods in February, and received the payment in March.
Now, according to the realization concept, when did the revenue is earned?
Revenue is earned in February i.e., when the transfer of goods took place, notwithstanding the fact that the order was received in January and cash was received in March.
Accounting Conventions
Accounting Conventions are the customs and traditions, followed by accountants as guidelines in preparing accounting statements.1) Convention of Conservatism
‘Playing safe’ is the main idea underlying this convention. In the initial stages of accounting, not actual profits, but, even anticipated profits have been recorded. But, the anticipated profits have not materialized. This has shaken the confidence in accounting. In consequence, Accounting has started to follow the rule “anticipate no profit and provide for all possible losses”.
For example, the closing stock is valued at cost price or market price, whichever is lower. The effect of the above is that in case, the market price comes down, then the ‘anticipated loss’ is to be provided for. But, if the market price goes up, then the ‘anticipated profits’ are to be ignored. When the lower of the two is taken into account for the valuation of closing stock, no anticipated profit is booked, but all possible loss is taken care of.
Basically, the concept says that whenever there are two equally acceptable methods, the one, which is more conservative, will be accepted. When a judgment is based on general estimates, if there is a dilemma as to which is correct, the most conservative estimate will be accepted. When there is a probability of getting profit or loss, profit will be ignored, but the loss will be taken into account.
2) Convention of Materiality
The materiality convention of accounting states that the business should include only the important or relevant facts in the financial statements.
Material facts refer to any information if excluded or misreported in the financial statements that could influence the decision of the users of such financial statements.
Thus, if excluding or misreporting certain information impacts the decision of the users of the financial statements, such information is material in nature.
Likewise, if excluding or misreporting certain information does not influence the decisions of the users of such statements, such information is not material or immaterial in nature.
For Example - If information related to capital, stock, or sales is excluded or misreported could influence the decision of users of such information, and this information is material in nature.
On the other hand, information related to clubbing of pens, pencils, stick notes, etc. under different heads (stationary) is not of material nature.
Therefore, items of material nature are recorded in detail separately under their respective heads. However, items that are immaterial in nature are clubbed together under different accounting heads.
3) Convention of Disclosure
The Convention of disclosure requires that all material and relevant facts concerning financial statements should be fully disclosed. Full disclosure means that there should be full, fair, and adequate disclosure of accounting information. Adequate means a sufficient set of information to be disclosed. Fair indicates an equitable treatment of users. Full refers to the complete and detailed presentation of information. Thus, the convention of disclosure suggests that every financial statement should fully disclose all relevant information.
4) Convention of Consistency
Convention of consistency implies that the basis followed in different accounting periods should be the same. It also signifies that the accounting practices and methods should remain consistent from one accounting year to another. For example - If a particular method of depreciation is adopted for a particular fixed asset, the same method should be followed for that assets year after year.
