Accounting Concepts

and Conventions

By : Gaurang Badheka
MA, Sem - 1
 Accounting concept
• Recording has been based on certain
assumptions.

e.g.
Can we made depreciation using straight
line method for 2001, but using reducing
balance method for 2002, using
revaluation method for 2003……???
 True and fair picture
• A firm should disclose all significant
information in the financial statements to
the concerned parties so that the users
may have a true and fair view of the state
of affairs of the firm.
 The need of objectivity
• Financial accounting ensures objectivity by
using generally agreed methods in
preparing financial statements. This helps
to provide objective, uniform and useful
accounting information for different user.
 GAAP
• GENERALLY ACCEPTED ACCOUNTING
PRINCIPLES

• Ground rules which define the parameters

and constraints within which accounting
reports are generated.
 GAAP
• It is a combination of authoritative
standards set by policy boards and the
accepted ways of doing accounting

• In India, it is set by the Accounting

Standards Board (ASB) of the Institute of
Chartered Accountants of India (ICAI)
 Accounting principles
• Accounting principles can be subdivided
into two categories:

1. Accounting Concepts; and

2. Accounting Conventions.
 Accounting principles
 Accounting Concepts
 Accounting Conventions
• The term ‘concept’ is used to connote
accounting postulates, that is necessary
assumptions and conditions upon which
accounting is based. The term ‘convention’ is
used to signify customs and traditions as a
guide to the presentation of accounting
statements.
Accounting concepts
 Business entity concept
• This concept starts with the fact that the
organization is a separate entity with its
own identity
• Accounts and transactions are classified
and analyzed from the point of view of the
entity.
• Books and accounts which are the records
of the business, clearly identify the
business entity to which the statements
are related.
 Business entity concept
• Example

• A director’s private car should not be

included in the fixed assets of the
company.

• Insurance premiums for the owner’s house

should be excluded from the expense of
the business
 Money measurement concept
• Money is the medium of exchange and the
standard of economic value.

• This concept requires that those

transactions alone that are capable of
being measured in terms of money are
only to be recorded in the books of
accounts.
 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.
 Dual aspect concept
• The claims against the assets of a business unit are by the
creditors and the owners.
• The total assets of a business are equal to its total liabilities.
• Liabilities to outsiders are known as liabilities but liabilities to
the owner, in accounting parlance, are referred to as capital.
• This concept expresses the relationship that exists among
assets, liabilities and the capital in the form of an accounting
equation which is expressed in the simplest form as under:
ASSETS = LIABILITIES + CAPITAL
OR
CAPITAL = ASSETS – LIABILITIES
 Going concern concept
• This concept assumes that the business
will continue in operation for as long as
possible and will not be dissolved in the
immediate future.

• From the accountant’s standpoint, Profit

and Loss Account and Balance Sheet are
drawn up on the assumption that the
business unit will be kept continuously
alive for the greatest length of time.
 Going concern concept
• Example

• Fixed assets are shown at cost less

accumulated depreciation.

• Possible losses form the closure of

business will not be anticipated in the
accounts
 Periodicity concept
• Financial Statements should be prepared
at regular intervals to ascertain information
about the business for all sorts of
purposes – performance evaluation, tax
computation, budgetary control and the
like.

• Period-income determination leads to

comparisons of the results of successive
periods.
 Consistency concept
• Whatever accounting method a business
unit decides to adopt, a consistent
approach principles and procedures to
similar situations to be adopted.

• Inconsistency in reporting can cause

misleading interpretations and therefore,
wrong conclusions.
 Consistency concept
• Example

• Depreciation method of certain fixed

assets once adopted should be used in
the following years.
 Materiality concept
• The concept of materiality is the threshold
for recognition of a transaction in
accounting process.

• In the accounting sense, an item is only

recorded when it is considered to be
useful or important to a user of a financial
statement.
 Materiality concept
• Example
– Small payments such as postage, stationery
and cleaning expenses should not be
disclosed separately. They should be grouped
together as sundry expenses
– The cost of small-valued assets such as
pencil sharpeners and paper clips should be
written off to the profit and loss account as
revenue expenditures, although they can last
for more than one accounting period
 Historical cost concept
• Historical cost refers to the cost at the time of
acquisition.
• Since accounting is basically the recording of
past happening, accountants use the
acquisition price as the most objective
measurement inasmuch as it is supported by
the evidence of a transaction.
• An asset will ordinarily be recorded at its cost
and this cost will be the basis for all
subsequent accounting for the asset.
 Historical cost concept
• Example

• A fixed asset acquired at a cost of

$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
$100,000.
 Conservatism concept
• Where there is a reasonable choice of accounting
treatments, the concept of conservatism refers to early
recognition of unfavorable events.
• This concept requires an accountant to record an
event in such a way as will show a weaker state of
affairs than what actually exists and thereby drawing
attention to events that result in the lowest value of an
income.
• Since this concept requires the accountant to
underplay favorable prospects, it is often stated as
follows: ‘Recognize all losses and anticipate no
gains’.
 Conservatism concept
• Example

• Provision for bad debts.

 Realisation concept
• This concept is governed by the Concept of
Conservatism.
• Revenue should only be brought into account
when it is actually realized.
• But in future customers may not pay their
dues or may return the goods. In fact, the
actual income may turn out less than it was
thought to be.
• In principle, revenue can be recognized at the
point of sale or at the point when cash is
collected or at any intermediate point.
 Realisation concept
• Example

• 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.
 Recognition of revenue
• The realization concept develops rules for the
recognition of revenue
• The concept provides that revenues are
recognized when it is earned, and not when
money is received
• A receipt in advance for the supply of goods
should be treated as prepaid income under
current liabilities
• Since revenue is a principal component in the
measurement of profit, the timing of its
recognition has a direct effect on the profit
 Realisation criteria for revenue
• The uncertain profits should not be estimated,
whereas reported profits must be verifiable
• Revenue is recognized when
1. The major earning process has substantially
been completed
2. Further cost for the completion of the
earning process are very slight or can be
accurately ascertained, and
3. The buyer has admitted his liability to pay for
the goods or services provided and the
ultimate collection is relatively certain
 Realisation concept - example
• Example
– Goods sent to our customers on sale or return
basis
– This means the customer do not pay for the
goods until they confirm to buy. If they do not
buy, those goods will return to us
– Goods on the ‘sale or return’ basis will not be
treated as normal sales and should be
included in the closing stock unless the sales
have been confirmed by customers
Problems in revenue recognition
• Normally, revenue is recognized when
there is a sale
• The point of sales in the earning process
is selected as the most appropriated time
to record revenues
• However, if revenue is earned in a long
and continuous process, it is difficult to
determine the portion of revenue which is
earned at each stage
• Therefore, revenue is permitted to be
recorded other than at the point of sales
 Realisation concept- exception
1. Long-term contracts
– Owning to the long duration of long-term contracts,
part of the total profit estimated to have been arisen
from the accounting period should be included in
the profit and loss account
2. Hire Purchase Sale
– Hire purchase sales have long collection period.
Revenue should be recognized when cash received
rather than when the sale (transfer of ownership) is
made
– The interest charged on a hire purchase sale
constitutes the profit of transaction
 Realisation concept- exception
3. Receipts from subscriptions
- A publisher receives subscriptions before it sends
newspapers or magazines to its customers
- It is proper to defer revenue recognition until the
service is rendered.
- However, part of subscription income can be
recognized as it is received in order to match
against the advertising expenses incurred
 Matching concept
• Revenues and expenses of the same
accounting period to be matched with
each other
• Thus the need to account for
– Prepaid or outstanding expenses
– Incomes received in advance and those
outstanding
• Distinguish between product costs and
period costs
 Matching concept
• Example
– Expenses incurred but not yet paid in current
period should be treated as accrual/accrued
expenses under current liabilities
– Expenses incurred in the following period but
paid for in advance should be treated as
prepayment expenses under current asset
– Depreciation should be charged as part of the
cost of a fixed asset consumed during the
period of use
 Problems in matching concept
• Normally, expenses represents resources
consumed during the current period. Some
costs may benefit several accounting
periods, for example, development
expenditures, depreciation on fixed assets.
 Recognition criteria
• Association between cause and effect
– Expenses are recognized on the basis of a
direct association between the expenses
incurred on the basis of a direct association
between the expenses incurred and revenues
earned
– For example, the sales commissions should
be accounted for in the period when the
products are sold, not when they are paid
 Recognition criteria
• Systematic allocation of costs
– When the cost benefit several accounting periods,
they should be recognized on the basis of a
systematic and rational allocation method
– For example, a provision for depreciation should be
made over the estimated useful life of a fixed asset
• Immediate recognition
– If the expenses are expected to have no certain future
benefit or are even without future benefit, they should
be written off in the current accounting period, for
example, stock losses, advertising expenses and
research costs
 Objectivity
• Meaning
– The accounting information should be free
from bias and capable of independent
verification
– The information should be based upon
verifiable evidence such as invoices or
contracts
 Objectivity
• Example
– The recognition of revenue should be based
on verifiable evidence such as the delivery of
goods or the issue of invoices
 Disclosure
• Meaning
– Financial statements should be prepared to
reflect a true and fair view of the financial
position and performance of the enterprise
– All material and relevant information must be
disclosed in the financial statements
 Uniformity
• Meaning
– Different companies within the same industry
should adopt the same accounting methods
and treatments for like transactions
– The practice enables inter-company
comparisons of their financial positions