Accounting Concepts and Conventions

Concepts/conventions/principles
Accounting Concepts are broad basic assumptions that underlie the periodic financial accounts of business enterprises. Examples of concepts include:

  • The going concern concept: implies that the business will continue in operational existence for the foreseeable future, and that there is no intention to put the company into liquidation or to make drastic cutbacks to the scale of operations. Financial statements should be prepared under the going concern basis unless the entity is being (or is going to be) liquidated or if it has ceased (or is about to cease) trading. The directors of a company must also disclose any significant doubts about the company’s future if and when they arise. The main significance of the going concern concept is that the assets of the business should not be valued at their ‘breakup’ value, which is the amount that they would sell for it they were sold off piecemeal and the business were thus broken up.
  • The accruals concept (or matching concept): States that revenue and costs must be recognized as they are earned or incurred, not as money is received or paid. They must be matched with one another so far as their relationship can be established or
    justifiably assumed, and dealt with in the profit and loss account of the period to which they relate.
  • The Prudence Concept: The prudence concept states that where alternative procedures, or alternative valuations, are possible, the one selected should be the one that gives the most cautious presentation of the business’s financial position or
    results. Therefore, revenue and profits are not anticipated but are recognized by inclusion in the profit and loss account only when realized in the form of either cash or of other assets the ultimate cash realization of which can be assessed with reasonable
    certainty: provision is made for all liabilities (expenses and losses) whether the amount of these is known with certainty or is best estimate in the light of the information available. Assets and profits should not be overstated, but a balance must be achieved to
    prevent the material overstatement of liabilities or losses.
  • Consistency concept: The consistency concept states that in preparing accounts consistency should be observed in two respects.

1.Similar items within a single set of accounts should be given similar accounting treatment.
2.The same treatment should be applied from one period to another in accounting for similar items. This enables valid comparisons to be made from one period to the next.

  • Business entity concept: The concept is that accountants regard a business as a separate entity, distinct from its owners or managers. The concept applies whether the business is a limited company (and so recognized in law as a separate entity) or a
    sole proprietorship or partnership (in which case the business is not separately recognized by the law.
  • Money measurement concept: The money measurement concept states that accounts will only deal with those items to which a monetary value can be attributed. For example, in the statement of financial position of a business, monetary values can
    be attributed to such assets as machinery (e.g. the original cost of the machinery; or the amount it would cost to replace the machinery) and stocks of goods (e.g. the original cost of goods, or, theoretically, the price at which the goods are likely to be
    sold).
    The monetary measurement concept introduces limitations to the subject matter of accounts. A business may have intangible assets such as the flair of a good manager or the loyalty of its workforce. These may be important enough to give it a clear
    superiority over an otherwise identical business, but because they cannot be evaluated in monetary terms they do not appear anywhere in the accounts.
  • Separate valuation principle: The separate valuation principle states that, in determining the amount to be attributed to an asset or liability in the statement of financial position, each component item of the asset or liability must be determined
    separately.
    These separate valuations must then be aggregated to arrive at the statement of financial position figure. For example, if a company’s stock comprises 50 separate items, a valuation must (in theory) be arrived at for each item separately; the 50
    figures must then be aggregated and the total is the stock figure which should appear in the statement of financial position.
  • Materiality concept: An item is considered material if it’s omission or misstatement will affect the decision making process of the users. Materiality depends on the nature and size of the item. Only items material in amount or in their nature will
    affect the true and fair view given by a set of accounts. An error that is too trivial to affect anyone’s understanding of the accounts is referred to as immaterial. In preparing accounts it is important to assess what is material and what is not, so that time and money are not wasted in the pursuit of excessive detail.
    Determining whether or not an item is material is a very subjective exercise. There is no absolute measure of materiality. It is common to apply a convenient rule of thumb (for example to define material items as those with a value greater than 5% of the net profit disclosed by the accounts). But some items disclosed in accounts are regarded as particularly sensitive and even a very small misstatement of such an item would be regarded as a material error. An example in the accounts of a limited company might be the amount of remuneration paid to directors of the company. The assessment of an item as material or immaterial may affect its treatment in the accounts. For example, the profit and loss account of a business will show the expenses incurred by he business grouped under suitable captions (heating and lighting expenses, rent and rates expenses etc); but in the case of very small expenses it may be appropriate to lump them together under a caption such as ‘sundry expenses’, because a more detailed breakdown would be inappropriate for such immaterial amounts.
  • Historical cost convention: It’s a basic principle of accounting (some writers include it in the list of fundamental accounting concepts) is that resources are normally stated in accounts at historical cost, i.e. at the amount that the business paid to acquire them. An important advantage of this procedure is that the objectivity of accounts is maximized: there is usually objective, documentary evidence to prove the amount paid to purchase an asset or pay an expense. Historical cost means transactions are recorded at the cost when they occurred. In general, accountants prefer to deal with costs, rather than with ‘values’. This is because valuations tend to be subjective and to vary according to what the valuation is for. For example, suppose that a company acquires a machine to manufacture its products. The machine has an expected useful life of four years. At the end of two years the company is preparing a statement of financial position and has decided what monetary amount to attribute to the asset.
  • Objectivity (neutrality): An accountant must show objectivity in his work. This means he should try to strip his answers of any personal opinion or prejudice and should be as precise and as detailed as the situation warrants. The result of this should be that any number of accountants will give the same answer independently of each other. Objectivity means that accountants must be free from bias. They must adopt a neutral stance when analysing accounting data. In practice objectivity is difficult. Two accountants faced with the same accounting data may come to different conclusions as to the correct treatment. It was to combat subjectivity that accounting standards were developed.
  • Realization concept: Revenue and profits are recognized when realized. The concept states that revenue and profits are not anticipated but are recognized by inclusion in the income statement only when realized in the form of either cash or of other assets the ultimate cash realization of which can be assessed with reasonable certainty.
  • Duality: Every transaction has two-fold effect in the accounts and is the basis of double entry bookkeeping.
  • Substance over form: It’s the principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form e.g. a non current asset on hire purchase although is not legally owned by the enterprise until it is fully paid for, it is reflected in the accounts as an asset and depreciation provided for in the normal accounting way.
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