ACCOUNTING CONCEPTS AND CONVENTIONS

STRUCTURE
2.0 Objective
2.1 Introduction
2.2 Meaning and essential features of Accounting Principles
2.3 Accounting Principles
2.4 Accounting Concepts
2.5 Accounting Conventions
2.6 Accounting Standards
2.7 Summary
2.8 Keywords
2.9 Self Assessment Questions
2.10 Suggested Readings
2.0 OBJECTIVE
After studying this lesson, you should be able :
(a) to know the need for a conceptual frame work of accounting;
(b) to understand and describe the generally accepted accounting
principles (GAAP); and
(c) to appreciate the importance and advantages of uniformity in
accounting policies and practices.
2.1 INTRODUCTION
Accounting is often called the language of business because the purpose of
accounting is to communicate or report the results of business operations and its
various aspects to various users of accounting information. In fact, today, accounting
statements or reports are needed by various groups such as shareholders, creditors,
potential investors, columnist of financial newspapers, proprietors and others.
In view of the utility of accounting reports to various interested parties, it becomes
imperative to make this language capable of commonly understood by all. Account(
2)
ing could become an intelligible and commonly understood language if it is based
on generally accepted accounting principles. Hence, you must be familiar with
the accounting principles behind financial statements to understand and
use them properly.
2.2 MEANING AND FEATURES OF ACCOUNTING PRINCIPLES
For searching the goals of the accounting profession and for expanding
knowledge in this field, a logical and useful set of principles and procedures
are to be developed. We know that while driving our vehicles, follow
a standard traffic rules. Without adhering traffic rules, there would be
much chaos on the road. Similarly, some principles apply to accounting.
Thus, the accounting profession cannot reach its goals in the absence of a
set rules to guide the efforts of accountants and auditors. The rules and
principles of accounting are commonly referred to as the conceptual framework
of accounting.
Accounting principles have been defined by the Canadian Institute of
Chartered Accountants as “The body of doctrines commonly associated with
the theory and procedure of accounting serving as an explanation of current
practices and as a guide for the selection of conventions or procedures
where alternatives exists. Rules governing the formation of accounting axioms
and the principles derived from them have arisen from common experience,
historical precedent statements by individuals and professional bodies
and regulations of Governmental agencies”. According to Hendriksen
(1997), Accounting theory may be defined as logical reasoning in the form
of a set of broad principles that (i) provide a general frame of reference by
which accounting practice can be evaluated, and (ii) guide the development
of new practices and procedures. Theory may also be used to explain existing
practices to obtain a better understanding of them. But the most important
goal of accounting theory should be to provide a coherent set of logi
cal principles that form the general frame of reference for the evaluation
and development of sound accounting practices.
The American Institute of Certified Public Accountants (AICPA) has
advocated the use of the word” Principle” in the sense in which it means
“rule of action”. It discuses the generally accepted accounting principles
as follows :
adopted by the accountants universally while recording accounting transactions.
2.3 ACCOUNTING PRINCIPLES
In dealing with the framework of accounting theory, we are confronted
with a serious problem arising from differences in terminology. A number
of words and terms have been used by different authors to express and
explain the same idea or notion. The various terms used for describing the
basic ideas are: concepts, postulates, propositions, assumptions, underly
ing principles, fundamentals, conventions, doctrines, rules, axioms, etc. Each
of these terms is capable of precise definition. But, the accounting profession
has served to give them lose and overlapping meanings. One author
may describe the same idea or notion as a concept and another as a convention
and still another as postulate. For example, the separate business entity
idea has been described by one author as a concept and by another as
conventions. It is better for us not to waste our time to discuss the precise
meaning of generic terms as the wide diversity in these terms can only serve
to confuse the learner. We do feel, however, that some of these terms/ideas
have a better claim to be called ‘concepts ‘ while the rest should be called
‘conventions’. The term ‘Concept’ is used to connote the accounting postulates,
i.e., necessary assumptions and ideas which are fundamental to accounting
practice. In other words, fundamental accounting concepts are
broad general assumptions which underline the periodic financial statements
of business enterprises. The reason why some of the these terms should be
called concepts is that they are basic assumptions and have a direct bearing
on the quality of financial accounting information. The term ‘convention’
is used to signify customs or tradition as a guide to the preparation of accounting
statements. The following are the important accounting concepts
and conventions:
2.4 ACCOUNTING CONCEPTS
The more important accounting concepts are briefly described as follows:
1. Separate Business Entity Concept. In accounting we make a distinction
between business and the owner. All the books of accounts records
day to day financial transactions from the view point of the business rather
than from that of the owner. The proprietor is considered as a creditor to
the extent of the capital brought in business by him. For instance, when a
person invests Rs. 10 lakh into a business, it will be treated that the business
has borrowed that much money from the owner and it will be shown as
a ‘liability’ in the books of accounts of business. Similarly, if the owner of
a shop were to take cash from the cash box for meeting certain personal
expenditure, the accounts would show that cash had been reduced even though
it does not make any difference to the owner himself. Thus, in recording a
transaction the important question is how does it affects the business ? For
example, if the owner puts cash into the business, he has a claim against the
business for capital brought in.
In sofar as a limited company is concerned, this distinction can be easily maintained
because a company has a legal entity of its own. Like a natural person it can
engage itself in economic activities of buying, selling, producing, lending, borrowing
and consuming of goods and services. However, it is difficult to show this distinction
in the case of sole proprietorship and partnership. Nevertheless, accounting
still maintains separation of business and owner. It may be noted that it is only
for accounting purpose that partnerships and sole proprietorship are treated as separate
from the owner (s), though law does not make such distinction. Infact, the business
entity concept is applied to make it possible for the owners to assess the performance
of their business and performance of those whose manage the enterprise.
The managers are responsible for the proper use of funds supplied by owners,
banks and others.
2. Money Measurement Concept. In accounting, only those business
transactions are recorded which can be expressed in terms of money. In
other words, a fact or transaction or happening which cannot be expressed
in terms of money is not recorded in the accounting books. As money is
accepted not only as a medium of exchange but also as a store of value, it
has a very important advantage since a number of assets and equities, which
are otherwise different, can be measured and expressed in terms of a common
denominator.
We must realise that this concept imposes two limitations. Firstly,
there are several facts which though very important to the business, cannot
be recorded in the books of accounts because they cannot be expressed in
money terms. For example, general health condition of the Managing Director
of the company, working conditions in which a worker has to work,
sales policy pursued by the enterprise, quality of product introduced by the
enterprise, though exert a great influence on the productivity and profitability
of the enterprise, are not recorded in the books. Similarly, the fact
that a strike is about to begin because employees are dissatisfied with the
poor working conditions in the factory will not be recorded even though
this event is of great concern to the business. You will agree that all these
have a bearing on the future profitability of the company.
Secondly, use of money implies that we assume stable or constant value
of rupee. Taking this assumption means that the changes in the money value
in future dates are conveniently ignored. For example, a piece of land purchased
in 1990 for Rs. 2 lakh and another bought for the same amount in
1998 are recorded at the same price, although the first purchased in 1990
may be worth two times higher than the value recorded in the books because
of rise in land values. Infact, most accountants know fully well that
purchasing power of rupee does change but very few recognise this fact in
accounting books and make allowance for changing price level.
3. Dual Aspect Concept. Financial accounting records all the transactions
and events involving financial element. Each of such transactions
requires two aspects to be recorded. The recognition of these two aspects
of every transaction is known as a dual aspect analysis. According to this
concept every business transactions has dual effect. For example, if a firm
sells goods of Rs. 10,000 this transaction involves two aspects. One aspect
is the delivery of goods and the other aspect is immediate receipt of cash
(in the case of cash sales). Infact, the term ‘double entry’ book keeping has
come into vogue because for every transaction two entries are made. According
to this system the total amount debited always equals the total
amount credited. It follows from ‘dual aspect concept’ that at any point in
time owners’ equity and liabilities for any accounting entity will be equal
to assets owned by that entity. This idea is fundamental to accounting and
could be expressed as the following equalities:
Assets = Liabilities + Owners Equity ...............(1)
Owners Equity = Assets - Liabilities ...............(2)
The above relationship is known as the ‘Accounting Equation’. The term
‘Owners Equity’ denotes the resources supplied by the owners of the entity
while the term ‘liabilities’ denotes the claim of outside parties such as creditors,
debenture-holders, bank against the assets of the business. Assets are
the resources owned by a business. The total of assets will be equal to total
of liabilities plus owners capital because all assets of the business are
claimed by either owners or outsiders.
4. Going Concern Concept. Accounting assumes that the business
entity will continue to operate for a long time in the future unless there is
good evidence to the contrary. The enterprise is viewed as a going concern,
that is, as continuing in operations, at least in the foreseeable future. In
other words, there is neither the intention nor the necessity to liquidate the
particular business venture in the predictable future. Because of this assumption,
the accountant while valuing the assets do not take into account
forced sale value of them. Infact, the assumption that the business is not
expected to be liquidated in the foreseeable future establishes the basis for
many of the valuations and allocations in accounting. For example, the accountant
charges depreciation of fixed assets values. It is this assumption
which underlies the decision of investors to commit capital to enterprise.
Only on the basis of this assumption can the accounting process remain
stable and achieve the objective of correctly reporting and recording on
the capital invested, the efficiency of management, and the position of the
enterprise as a going concern. However, if the accountant has good reasons
to believe that the business, or some part of it is going to be liquidated or
that it will cease to operate (say within six-month or a year), then the resources
could be reported at their current values. If this concept is not followed,
International Accounting Standard requires the disclosure of the fact
in the financial statements together with reasons.
5. Accounting Period Concept. This concept requires that the life
of the business should be divided into appropriate segments for studying
the financial results shown by the enterprise after each segment. Although
the results of operations of a specific enterprise can be known precisely
only after the business has ceased to operate, its assets have been sold off
and liabilities paid off, the knowledge of the results periodically is also
necessary. Those who are interested in the operating results of business
obviously cannot wait till the end. The requirements of these parties force
the businessman ‘to stop’ and ‘see back’ how things are going on. Thus, the
accountant must report for the changes in the wealth of a firm for short
time periods. A year is the most common interval on account of prevailing
practice, tradition and government requirements. Some firms adopt financial
year of the government, some other calendar year. Although a twelve
month period is adopted for external reporting, a shorter span of interval,
say one month or three month is applied for internal reporting purposes.
This concept poses difficulty for the process of allocation of long
term costs. All the revenues and all the cost relating to the year in operation
have to be taken into account while matching the earnings and the cost
of those earnings for the any accounting period. This holds good irrespective
of whether or not they have been received in cash or paid in cash. Despite
the difficulties which stem from this concept, short term reports are
of vital importance to owners, management, creditors and other interested
parties. Hence, the accountants have no option but to resolve such difficulties.
6. Cost Concept. The term ‘assets’ denotes the resources land building,
machinery etc. owned by a business. The money values that are assigned
to assets are derived from the cost concept. According to this concept an
asset is ordinarily entered on the accounting records at the price paid to
acquire it. For example, if a business buys a plant for Rs. 5 lakh the asset
would be recorded in the books at Rs. 5 lakh, even if its market value at that
time happens to be Rs. 6 lakh. Thus, assets are recorded at their original
purchase price and this cost is the basis for all subsequent accounting for
the business. The assets shown in the financial statements do not necessarily
indicate their present market values. The term ‘book value’ is used for
amount shown in the accounting records.
The cost concept does not mean that all assets remain on the account
ing records at their original cost for all times to come. The asset may systematically
be reduced in its value by charging ‘depreciation’, which will
be discussed in detail in a subsequent lesson. Depreciation have the effect
of reducing profit of each period. The prime purpose of depreciation is to
allocate the cost of an asset over its useful life and not to adjust its cost.
However, a balance sheet based on this concept can be very misleading as
it shows assets at cost even when there are wide difference between their
costs and market values. Despite this limitation you will find that the cost
concept meets all the three basic norms of relevance, objectivity and feasibility.
7. The Matching concept. This concept is based on the accounting
period concept. In reality we match revenues and expenses during the accounting
periods. Matching is the entire process of periodic earnings measurement,
often described as a process of matching expenses with revenues.
In other words, income made by the enterprise during a period can be measured
only when the revenue earned during a period is compared with the
expenditure incurred for earning that revenue. Broadly speaking revenue is
the total amount realised from the sale of goods or provision of services
together with earnings from interest, dividend, and other items of income.
Expenses are cost incurred in connection with the earnings of revenues.
Costs incurred do not become expenses until the goods or services in question
are exchanged. Cost is not synonymous with expense since expense is
sacrifice made, resource consumed in relation to revenues earned during
an accounting period. Only costs that have expired during an accounting
period are considered as expenses. For example, if a commission is paid in
January, 2002, for services enjoyed in November, 2001, that commission
should be taken as the cost for services rendered in November 2001. On
account of this concept, adjustments are made for all prepaid expenses,
outstanding expenses, accrued income, etc, while preparing periodic reports.
8. Accrual Concept. It is generally accepted in accounting that the
basis of reporting income is accrual. Accrual concept makes a distinction
between the receipt of cash and the right to receive it, and the payment of
cash and the legal obligation to pay it. This concept provides a guideline to
the accountant as to how he should treat the cash receipts and the right
related thereto. Accrual principle tries to evaluate every transaction in terms
of its impact on the owner’s equity. The essence of the accrual concept is
that net income arises from events that change the owner’s equity in a specified
period and that these are not necessarily the same as change in the
cash position of the business. Thus it helps in proper measurement of income.
9. Realisation Concept. Realisation is technically understood as
the process of converting non-cash resources and rights into money. As
accounting principle, it is used to identify precisely the amount of revenue
to be recognised and the amount of expense to be matched to such revenue
for the purpose of income measurement. According to realisation concept
revenue is recognised when sale is made. Sale is considered to be made at
the point when the property in goods passes to the buyer and he becomes
legally liable to pay. This implies that revenue is generally realised when
goods are delivered or services are rendered. The rationale is that delivery
validates a claim against the customer. However, in case of long run construction
contracts revenue is often recognised on the basis of a propor
tionate or partial completion method. Similarly, in case of long run instalment
sales contracts, revenue is regarded as realised only in proportion to
the actual cash collection. In fact, both these cases are the exceptions to
the notion that an exchange is needed to justify the realisation of revenue.
2.5 ACCOUNTING CONVENTIONS
1. Convention of Materiality. Materiality concept states that items
of small significance need not be given strict theoretically correct treatment.
Infact, there are many events in business which are insignificant in
nature. The cost of recording and showing in financial statement such events
may not be well justified by the utility derived from that information. For
example, an ordinary calculator costing Rs. 100 may last for ten years.
However, the effort involved in allocating its cost over the ten year period
is not worth the benefit that can be derived from this operation. The cost
incurred on calculator may be treated as the expense of the period in which
it is purchased. Similarly, when a statement of outstanding debtors is prepared
for sending to top management, figures may be rounded to the nearest
ten or hundred.
This convention will unnecessarily overburden an accountant with
more details in case he is unable to find an objective distinction between
material and immaterial events. It should be noted that an item material for
one party may be immaterial for another. Actually, there are no hard and
fast rule to draw the line between material and immaterial events and hence,
It is a matter of judgement and common sense. Despite this limitation, It is
necessary to disclose all material information to make the financial statements
clear and understandable. This is required as per IAS-1 and also reiterated
in IAS-5. As per IAS-1, materiality should govern the selection and
application of accounting policies.

2. Convention of Conservatism. This concept requires that the accountants

must follow the policy of ‘’playing safe” while recording business
transactions and events. That is why, the accountant follow the rule
anticipate no profit but provide for all possible losses, while recording the
business events. This rule means that an accountant should record lowest
possible value for assets and revenues, and the highest possible value for
liabilities and expenses. According to this concept, revenues or gains should
be recognised only when they are realised in the form of cash or assets
(i.e. debts) the ultimate cash realisation of which can be assessed with reasonable
certainty. Further, provision must be made for all known liabilities,
expenses and losses, Probable losses regarding all contingencies
should also be provided for. ‘Valuing the stock in trade at market price or
cost price which ever is less’, ‘making the provision for doubtful debts on
debtors in anticipation of actual bad debts’, ‘adopting written down value
method of depreciation as against straight line method’, not providing for
discount on creditors but providing for discount on debtors’, are some of
the examples of the application of the convention of conservatism.
The principle of conservatism may also invite criticism if not applied
cautiously. For example, when the accountant create secret reserves,
by creating excess provision for bad and doubtful debts, depreciation, etc.
The financial statements do not present a true and fair view of state of
affairs. American Institute of Certified Public Accountant have also indicated
that this concept need to be applied with much more caution and care
as over conservatism may result in misrepresentation.
4. Convention of Consistency. The convention of consistency requires
that once a firm decided on certain accounting policies and methods
and has used these for some time, it should continue to follow the same
methods or procedures for all subsequent similar events and transactions
unless it has a sound reason to do otherwise. In other worlds, accounting
practices should remain unchanged from one period to another. For example,
if depreciation is charged on fixed assets according to straight line method,
this method should be followed year after year. Analogously, if stock is
valued at ‘cost or market price whichever is less’, this principle should be
applied in each subsequent year.
However, this principle does not forbid introduction of improved
accounting techniques. If for valid reasons the company makes any departure
from the method so far in use, then the effect of the change must be
clearly stated in the financial statements in the year of change. The application
of the principle of consistency is necessary for the purpose of comparison.
One could draw valid conclusions from the comparison of data drawn
from financial statements of one year with that of the other year. But the
inconsistency in the application of accounting methods might significantly
affect the reported data.