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Accounting - Accounting Concepts, Principles and Conventions

Accounting - Accounting Concepts, Principles and Conventions

Accounting Concepts
Figure 1: Accounting concepts, principles and conventions form the backbone of the accounting information system.

Learning Outcomes

  • Grasp the basic accounting concepts, principles and conventions and observe their implications while recording transactions and events.
  • Identify the three fundamental accounting assumptions:
    • Going Concern
    • Consistency
    • Accrual
  • Understand the qualitative characteristics that will help to develop the skill in course of time to prepare financial statements.

2.1 Introduction

  • Let us imagine a situation where you are a proprietor and you take copies of your books of account to five different accountants. You ask them to prepare the financial statements on the basis of the above records and to calculate the profits of the business for the year.
  • After few days, they are ready with the financial statements and all the five accountants have calculated five different amounts of profits and that too with very wide variations among them.
  • To avoid this, a generally accepted set of rules have been developed. This generally accepted set of rules provides unity of understanding and unity of approach in the practice of accounting.
  • Accounting is a language of the business. Financial statements prepared by the accountant communicate financial information to the various stakeholders for decision-making purpose.
KNOWLEDGE NUGGET

  • GAAPs: Generally Accepted Accounting Principles
  • GAAPs are the backbone of the accounting information system
  • In India, companies use AS or Ind-AS frameworks as applicable
  • Globally, countries use the framework under IFRS

2.2 Accounting Concepts

  • Accounting concepts define the assumptions on the basis of which financial statements of a business entity are prepared.
  • The word concept means idea or notion, which has universal application.
  • Concepts are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid.
  • Unlike physical science, accounting concepts are only result of broad consensus.

2.3 Accounting Principles

  • "Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting serving as an explanation of current practices and as a guide for selection of conventions or procedures where alternatives exist."
  • Accounting principles must satisfy the following conditions:
    • They should be based on real assumptions;
    • They must be simple, understandable and explanatory;
    • They must be followed consistently;
    • They should be able to reflect future predictions;
    • They should be informational for the users.

2.4 Accounting Conventions

  • Accounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted by various organizations over a period of time.
  • These conventions are derived by usage and practice.
  • The accountancy bodies of the world may change any of the convention to improve the quality of accounting information.
  • Accounting conventions need not have universal application.

2.5 Concepts, Principles and Conventions — An Overview

(a) Entity Concept

  • Entity concept states that business enterprise is a separate identity apart from its owner.
  • Business transactions are recorded in the business books of accounts and owner's transactions in his personal books of accounts.
  • This concept helps in keeping business affairs free from the influence of the personal affairs of the owner.
  • Entity concept means that the enterprise is liable to the owner for capital investment made by the owner.
ENTITY CONCEPT — EXAMPLE

  • Mr. X started business investing ₹ 7,00,000 with which he purchased machinery for ₹ 5,00,000 and maintained the balance in hand.
  • If Mr. X spends ₹ 5,000 to meet his family expenses from the business fund, it should not be taken as business expenses and would be charged to his capital account.

(b) Money Measurement Concept

  • As per this concept, only those transactions, which can be measured in terms of money are recorded.
  • Transactions, even if they affect the results of the business materially, are not recorded if they are not convertible in monetary terms.
  • However, the concept has its own limitations. Transactions and events that cannot be expressed in terms of money are not recorded in the business books.
  • Employees of the organization are assets but their measurement in monetary terms is not possible, therefore not included in the books of account.
  • This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit assumption that purchasing power of the money is not of sufficient importance as to require adjustment.

(c) Periodicity Concept

  • This is also called the concept of definite accounting period.
  • According to this concept, accounts should be prepared after every period and not at the end of the life of the entity. Usually, this period is one calendar year.
  • We generally follow from 1st April of a year to 31st March of the immediately following year.
PERIODICITY CONCEPT — KEY POINTS

  • Facilitates comparing financial statements of different periods
  • Uniform and consistent accounting treatment for ascertaining profit and assets
  • Matching periodic revenues with expenses for getting correct results

(d) Accrual Concept

  • Under accrual concept, the effects of transactions and other events are recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid).
  • Revenue is the gross inflow of cash, receivables and other consideration arising in the course of the ordinary activities of an enterprise.
  • Expense is a cost relating to the operations of an accounting period or to the revenue earned during the period.
  • Accrual Concept: Revenue — Expenses = Profit
ACCRUAL CONCEPT — TIMING DIFFERENCES

  • Cash received before revenue: Liability created (received in advance)
  • Cash received after revenue: Asset called Trade Receivables created
  • Cash paid before expense: Asset called Trade Advance created
  • Cash paid after expense: Liability called Trade Payables created

(e) Matching Concept

  • In this concept, all expenses matched with the revenue of that period should only be taken into consideration.
  • If any revenue is recognized, then expenses related to earn that revenue should also be recognized.
  • This concept is based on accrual concept as it considers the occurrence of expenses and income and do not concentrate on actual inflow or outflow of cash.
  • Periodic Profit = Periodic Revenue — Matched Expenses

(f) Going Concern Concept

  • The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future.
  • Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations.
  • The valuation of assets of a business entity is dependent on this assumption.
  • If Going Concern assumption is under question, the same information should be communicated to the stakeholders.

(g) Cost Concept

  • By this concept, the value of an asset is to be determined on the basis of historical cost, in other words, acquisition cost.
  • It is highly objective and free from all bias.
  • However, the cost concept creates distortion too:
    • In inflationary situation, acquisition cost loses its relevance.
    • Historical cost-based accounts may lose comparability.
    • Many assets do not have acquisition costs (e.g., Human assets).

(h) Realisation Concept

  • Any change in value of an asset is to be recorded only when the business realises it.
  • Accountants try to cover all probable losses but do not count any probable gain.
  • If accountants anticipate decrease in value they count it, but if there is increase in value they ignore it until it is realised.

(i) Dual Aspect Concept

  • This concept is the core of double entry book-keeping. Every transaction or event has two aspects.
  • Basic Accounting Equation:
    • Equity (E) + Liabilities (L) = Assets (A)
    • Or, Equity (E) = Assets (A) — Liabilities (L)
DUAL ASPECT — EFFECTS OF TRANSACTIONS

  • (1 & 3): Increase one Asset, Decrease other Asset
  • (2 & 6): Increase Asset, Increase Liability
  • (4 & 8): Decrease Asset, Decrease Liability
  • (5 & 7): Increase Liability, Decrease other Liability

(j) Conservatism

  • Conservatism states that the accountant should not anticipate any future income however they should provide for all possible losses.
  • When there are many alternative values of an asset, an accountant should choose the method which leads to the lesser value.
  • The golden rule of current assets valuation — 'cost or market price whichever is lower' originated from this concept.
CONSERVATISM — KEY POINTS

  • Prudence: Judgement about possible future losses
  • Neutrality: Unbiased outlook to identify possible losses
  • Faithful representation: Of alternative values
  • Example: Market price declines from ₹20,000 to ₹17,000 — recognise loss of ₹3,000 even before sale

(k) Consistency

  • In order to achieve comparability of the financial statements of an enterprise through time, the accounting policies are followed consistently from one period to another.
  • A change in an accounting policy is made only in certain exceptional circumstances:
    • To bring the books of accounts in accordance with the issued Accounting Standards.
    • To comply with the provision of law.
    • When under changed circumstances, new method will reflect a true and fair picture.

(l) Materiality

  • Materiality principle permits other concepts to be ignored, if the effect is not considered material.
  • This principle is an exception to full disclosure principle.
  • All items having significant economic effect should be disclosed; insignificant items need not be disclosed.
  • Materiality depends not only upon the amount but also upon the size of the business, nature and level of information.

2.6 Fundamental Accounting Assumptions

  • There are three fundamental accounting assumptions:
    • (i) Going Concern
    • (ii) Consistency
    • (iii) Accrual
  • If nothing has been written about the fundamental accounting assumption in the financial statements, then it is assumed that they have already been followed.
  • If any of the above-mentioned fundamental accounting assumption is not followed, then this fact should be specifically disclosed.
THREE FUNDAMENTAL ACCOUNTING ASSUMPTIONS

  • Going Concern: Enterprise will continue in operation for the foreseeable future
  • Consistency: Accounting policies followed consistently from one period to another
  • Accrual: Effects of transactions recognised when they occur, not when cash is received or paid

2.7 Financial Statements

  • The aim of accounting is to keep systematic records to ascertain financial performance and financial position of an entity and to communicate the relevant financial information to the interested user groups.
  • The financial statements are basic means through which the management of an entity makes public communication of the financial information.
  • They are structured financial representations of the financial position and the performance of an enterprise.

2.7.1 Qualitative Characteristics of Financial Statements

  • Qualitative characteristics are the attributes that make the information provided in financial statements useful to users.
QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

  • 1. Understandability: Information must be readily understandable by users with reasonable knowledge of business and accounting.
  • 2. Relevance: Information must be relevant to the decision-making needs of users. It has predictive and confirmatory roles.
  • 3. Reliability: Information must be free from material error and bias and can be depended upon by users.
  • 4. Comparability: Users must be able to compare financial statements through time and between different enterprises.
  • 5. Materiality: Information is material if its misstatement could influence the economic decisions of users.
  • 6. Faithful Representation: Information must represent faithfully the transactions and other events it purports to represent.
  • 7. Substance over Form: Transactions must be accounted for in accordance with their substance and economic reality, not merely legal form.
  • 8. Neutrality: Information must be free from bias and should not influence decision-making to achieve a predetermined outcome.
  • 9. Prudence: Inclusion of a degree of caution in exercise of judgments, such that assets/income are not overstated and liabilities/expenses are not understated.
  • 10. Full, Fair and Adequate Disclosure: Financial statements must disclose all reliable and relevant information to help users take reasonable decisions.
  • 11. Completeness: Information must be complete within the bounds of materiality and cost.
FOUR PRINCIPAL QUALITATIVE CHARACTERISTICS

  • Understandability
  • Relevance
  • Reliability
  • Comparability

Summary

  • Accounting concepts define the assumptions on the basis of which financial statements of a business entity are prepared.
  • The following are the widely accepted accounting concepts:
    • Entity concept
    • Money measurement concept
    • Periodicity concept
    • Accrual concept
    • Matching concept
    • Going Concern concept
    • Cost concept
    • Realisation concept
    • Dual aspect concept
    • Conservatism
    • Materiality
  • Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting.
  • Accounting conventions emerge out of accounting practices adopted by various organizations over a period of time.
  • There are three fundamental accounting assumptions:
    • Going Concern
    • Consistency
    • Accrual
  • Qualitative characteristics are the attributes that make the information provided in financial statements useful to users.

Test Your Knowledge

True and False

  • 1. The concept helps in keeping business affairs free from the influence of the personal affairs of the owner is known as the matching concept. False
  • 2. Entity concept means that the enterprise is liable to the owner for capital investment made by the owner. True
  • 3. Accrual means recognition as money is received or paid and not of revenue and costs as they are earned or incurred. False
  • 4. The Conservatism Concept states that no change should be counted unless it has materialized. False
  • 5. The concept of consistency implies non-flexibility as not to allow the introduction of improved method of accounting. False
  • 6. The materiality depends only upon the amount of the item and not upon the size of the business, nature and level of information, level of the person making the decision etc. False
  • 7. Accrual basis of accounting is the method of recording transactions by which revenues and costs and assets and liabilities are reflected in the accounts in the period in which actual receipts or actual payments are made. False

Multiple Choice Questions

1. (i) All the following items are classified as fundamental accounting assumptions except (a) Consistency.
(b) Business entity.
(c) Going concern.
(ii) Two primary qualitative characteristics of financial statements are (a) Understandability and materiality.
(b) Relevance and reliability.
(c) Neutrality and understandability.
(iii) Kanika Enterprises follows the written down value method of depreciating machinery year after year due to (a) Comparability.
(b) Convenience.
(c) Consistency.
(iv) A purchased a car for ₹ 5,00,000, making a down payment of ₹ 1,00,000 and signing a ₹ 4,00,000 bill payable due in 60 days. As a result of this transaction (a) Total assets increased by ₹ 5,00,000.
(b) Total liabilities increased by ₹ 4,00,000.
(c) Total assets increased by ₹ 4,00,000 with corresponding increase in liabilities by ₹ 4,00,000.
(v) Mohan purchased goods for ₹15,00,000 and sold 4/5th of the goods amounting ₹18,00,000 and met expenses amounting ₹2,50,000 during the year, 2022. He counted net profit as ₹3,50,000. Which of the accounting concept was followed by him? (a) Entity.
(b) Periodicity.
(c) Matching.
(vi) A businessman purchased goods for ₹25,00,000 and sold 80% of such goods during the accounting year ended 31st March, 2022. The market value of the remaining goods was ₹4,00,000. He valued the closing Inventory at cost. He violated the concept of (a) Money measurement.
(b) Conservatism.
(c) Cost.
(vii) Capital brought in by the proprietor is (a) Increase in asset and increase in liability
(b) Increase in liability and decrease in asset
(c) Increase in asset and decrease in liability
(viii) During the life-time of an entity, accounting provides financial statements in accordance with which basic accounting concept: (a) Conservatism
(b) Matching
(c) Accounting period
(ix) A concept that a business enterprise will not be liquidated in the near future is known as: (a) Going concern
(b) Economic entity
(c) Monetary unit
2. (i) Assets are held in the business for the (a) Resale.
(b) Conversion into cash.
(c) Earning revenue.
(ii) Revenue from sale of products, is generally, realised in the period in which (a) Cash is collected.
(b) Sale is made.
(c) Products are manufactured.
(iii) The concept of conservatism when applied to the balance sheet results in (a) Understatement of assets.
(b) Overstatement of assets.
(c) Overstatement of capital.
(iv) Decrease in the amount of trade payables results in (a) Increase in cash.
(b) Decrease in bank over draft account.
(c) Decrease in assets.
(v) The determination of expenses for an accounting period is based on the principle of (a) Objectivity.
(b) Materiality.
(c) Matching.
(vi) Economic life of an enterprise is split into the periodic interval to measure its performance is as per (a) Entity.
(b) Matching.
(c) Periodicity.
3. (i) If an individual asset is increased, there will be a corresponding (a) Increase of another asset or increase of capital.
(b) Decrease of another asset or increase of liability.
(c) Decrease of specific liability or decrease of capital.
(ii) Purchase of machinery for cash (a) Decreases total assets.
(b) Increases total assets.
(c) Retains total assets unchanged.
(iii) Consider the following data pertaining to Alpha Ltd.:
Cost of machinery purchased on 1st April, 2021: ₹10,00,000
Installation charges: ₹1,00,000
Market value as on 31st March, 2022: ₹12,00,000
While finalizing the annual accounts, if the company values the machinery at ₹12,00,000. Which of the following concepts is violated?		 (a) Cost.
(b) Matching.
(c) Accrual.
High-Yield Interactive Quiz — Accounting Concepts, Principles and Conventions

Q1. Which concept states that business enterprise is a separate identity apart from its owner?

Correct Answer: B. Entity concept states that business enterprise is a separate identity apart from its owner. Business transactions are recorded in the business books of accounts and owner's transactions in his personal books.

Q2. As per which concept, only those transactions which can be measured in terms of money are recorded?

Correct Answer: B. As per Money Measurement Concept, only those transactions which can be measured in terms of money are recorded. Transactions that cannot be expressed in terms of money are not recorded.

Q3. Which concept requires that accounts should be prepared after every period and not at the end of the life of the entity?

Correct Answer: C. According to Periodicity concept, accounts should be prepared after every period and not at the end of the life of the entity. Usually, this period is one calendar year (1st April to 31st March).

Q4. Under accrual concept, revenue and costs are recognised:

Correct Answer: B. Under accrual concept, the effects of transactions and other events are recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid).

Q5. Which concept states that all expenses matched with the revenue of that period should only be taken into consideration?

Correct Answer: B. In matching concept, all expenses matched with the revenue of that period should only be taken into consideration. Periodic Profit = Periodic Revenue — Matched Expenses.

Q6. The valuation of assets of a business entity is dependent on which assumption?

Correct Answer: B. The valuation of assets of a business entity is dependent on Going Concern concept, which assumes that an enterprise will continue in operation for the foreseeable future.

Q7. By cost concept, the value of an asset is determined on the basis of:

Correct Answer: B. By cost concept, the value of an asset is to be determined on the basis of historical cost, in other words, acquisition cost. It is highly objective and free from all bias.

Q8. The basic accounting equation is:

Correct Answer: B. The basic accounting equation is: Equity (E) + Liabilities (L) = Assets (A) or Equity (E) = Assets (A) — Liabilities (L).

Q9. Which concept states that accountant should not anticipate any future income but should provide for all possible losses?

Correct Answer: C. Conservatism states that the accountant should not anticipate any future income however they should provide for all possible losses. The golden rule is 'cost or market price whichever is lower'.

Q10. Which of the following is NOT a fundamental accounting assumption?

Correct Answer: C. The three fundamental accounting assumptions are Going Concern, Consistency and Accrual. Materiality is an accounting concept but not a fundamental assumption.

Q11. Which qualitative characteristic of financial statements requires that information must be free from material error and bias?

Correct Answer: C. Reliability means information must be free from material error and bias and can be depended upon by users to represent faithfully that which it purports to represent.

Q12. Which concept requires that transactions must be accounted for in accordance with their substance and economic reality, not merely legal form?

Correct Answer: C. Substance over Form requires that transactions are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.

Q13. A purchased a car for ₹5,00,000 with down payment of ₹1,00,000 and a bill payable of ₹4,00,000. What is the effect on total assets?

Correct Answer: C. Total assets increased by ₹4,00,000 with corresponding increase in liabilities by ₹4,00,000 (the bill payable). The down payment of ₹1,00,000 is cash outflow.

Q14. Which concept permits other concepts to be ignored if the effect is not considered material?

Correct Answer: B. Materiality principle permits other concepts to be ignored if the effect is not considered material. It is an exception to the full disclosure principle.

Q15. The concept of consistency when applied means:

Correct Answer: B. Consistency means accounting policies are followed consistently from one period to another to achieve comparability. However, it does not imply non-flexibility as not to allow the introduction of improved methods.

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