Accounting is a fundamental aspect of running a business. It involves recording, analyzing, and interpreting financial transactions to provide an accurate picture of the company’s financial health.
However, following certain principles, concepts, and conventions is essential to ensure that accounting information is consistent and reliable.
This article will explore the basics of accounting principles, concepts, and conventions. We will explain what they are and how they contribute to producing accurate financial statements
Accounting is sometimes called the business language since it is how a firm interacts with the outside world. For this language to be universally understood, it must adhere to a set of standardised norms. These requirements are known as accounting principles.
Accounting principles are “the collection of ideas generally associated with accounting theory and practise, acting as an explanation of present practises and a guide for the choosing of conventions or methods where alternatives exist.”
Accounting principles are, in a nutshell, recommendations that define standards for effective accounting methods and procedures in reporting a business’s financial condition and performance over time. These principles can be categorised as:
- Accounting Concepts; and
- Accounting Conventions
The term “accounting concept” refers to the fundamental presumptions on which the preparation of the financial accounts of an organisation engaged in business is based. They serve as a basis for developing various techniques and processes for documenting and presenting the transactions involving the company’s activity.
There are 12 accounting concepts. The following is a list of the fundamental accounting concepts:
1. Business Entity Concept
According to this concept, business enterprise is treated as a separate entity from its owner. This is why owner A/c is shown as a liability for the business entity. Business transactions are recorded in the books of the account owner’s transactions in his personal books of account. This concept helps free the business from the owner’s personal affairs.
Firstly, it allows for more accurate financial reporting since the business’ income and expenses can be tracked independently. Secondly, by separating personal and business finances, it helps prevent fraud or conflicts of interest between individuals associated with the company. Additionally, it protects shareholders and investors by limiting their liability to only what they have invested in the company.
As per this concept, only those transactions are recorded in books of account which can be measured in terms of money. Since money is a common standard of payment and capable of being recorded, only monetary items take place in books of account. Transactions, even if they affect the result of the business enterprise but cannot be measured in terms of money, are not recorded in business books.
For example, the employees of an organisation are the most valuable asset to a business enterprise. Still, as they cannot be measured in terms of money, they are not recorded in terms of money. Generally, the transactions are recorded in terms of the ruling currency of the country where the business enterprise is situated.
Another aspect of this concept is that the records of the transactions are to be kept not in physical units but in monetary units. For example, at the end of 2011, an organisation may have a factory on a piece of land measuring 15 acres, an office building containing 50 rooms, 50 personal computers, 30 office chairs and tables, 120 kg of raw materials etc.
These are expressed in different units. But for accounting purposes, they are to be recorded in money terms. In this case, the cost of factory land maybe say $1 million, the office building $10 million, computers $10 million, office chairs and tables $2 million, raw materials $3 million etc.
3. Matching concept
As per the matching concept, all expenses matched with the revenue of that period should only be considered. Any past or future year’s expenses and revenues are excluded using certain adjustments. This concept is based on the accrual concept as it considers the occurrence of expenses and income and does not concentrate on the actual inflow or outflow of the cash. It leads to adjusting certain items like prepaid and outstanding items and unearned or accrued incomes.
Not every expense needs to identify every income. Some expenses are related to revenue, and some are time-bound. E.g. Selling expenses are related to sales, but rent, salaries etc., are recorded on an accrual basis for the particular accounting period.
Let’s take an example – suppose Mr John started the retail business of cloth. He purchased 5000 pcs. Of the cloth @ $100 per piece and sold 4000 pcs @ $150 per piece during the accounting period 1st January 2010 to 31st December 2010 and pays rent for the premises at the end of each month, i.e. for 11 months @ $2000 each and paid to suppliers $400,000 and received $500,000 from the customer. Now we shall see how this concept works-
As per the concept of accrual, the revenue for the period shall be recognised as $6,00,000 (4000 pcs X $150 each), which accrued and not the cash received, i.e. $ 400000 and rent for the premises shall be recorded for the whole 12 months, i.e. $24000 and not $22000, i.e. 11 months X $2000 each.
4. Going concern Concept
The financial statements are normally prepared to assume that an enterprise is a going concern and will continue operation. Simply stated, every business entity is assumed to have an infinite life, and it will not be dissolved shortly. This is an important accounting assumption, as it provides a basis for showing the value of assets on the balance sheet.
For example, a company purchases a plant and machinery for $100000, and its life span is ten years. According to this concept, some amount will be shown as expenses and the balance amount as an asset every year. Thus, if an amount is spent on an item that will be used in business for more than one year, it will not be proper to charge the entire amount from the revenues of the year in which the item is acquired. Only a proportionate value is shown as the expense in the year of purchase, and the remaining balance is shown as an asset on the balance sheet.
Please note that this is not the entire list of accounting standards. There are 12 accounting standards.
The term “convention” refers to a custom, tradition, or practice based on general agreement amongst the various accounting organisations and serves to direct the accountant in generating financial statements. It acts as a guide in selecting or using a certain technique.
Accounting convention is a practice that all accounting people use to calculate and record all financial transactions. In a given business, there are some standards, rules and guidelines that accountants follow and they ensure that all transactions are correctly accounted for and presented.
Financial statements, including the profit and loss account as well as the balance sheet, are created following the following accounting conventions:
The consistency convention entails that accounting practices must be consistent yearly. Only when accounting rules are adhered to consistently from year to year will the results of different years be comparable. The principle of valuing the stock at cost or market price, whichever is lower, must be adhered to to achieve comparable results from year to year. Likewise, if depreciation is charged on fixed assets using the diminishing balance method, it must be done annually. The rationale for this principle is that frequent changes in accounting treatment would render the financial statements unreliable to those who use them.
The consistency convention does not imply that it cannot be altered once a particular accounting method has been adopted. When an accounting change is desirable, it must be fully disclosed in the financial statements, along with its impact in rupee amounts on the reported income and financial position of the year in which the change is made.
In addition to statutory requirements, good accounting practice requires that all material information be disclosed fully and fairly in the financial statements. In accounting statements, all information of material interest to owners, creditors, and investors should be disclosed. This convention is gaining importance as the majority of large business units are organised as joint-stock companies in which ownership and management are separated.
Typically, financial statements are prepared on a conservative basis. Two principles are directly derived from conservatism.
(a) The accountant should not anticipate income and should account for all potential losses.
(b) When faced with a choice between two methods for valuing an asset, the accountant should select the method that results in the lower value.
According to the materiality convention, when producing the final accounts, accountants should record only what is material and disregard irrelevant elements. The accountant should determine whether a transaction is substantially based on his or her professional knowledge and sound judgement.
A thing can be material for one purpose but irrelevant for another. The materiality of the items on the profit and loss statement should be evaluated in connection to the profits displayed on the profit and loss statement.
And for the items appearing in the balance sheet, materiality may be evaluated in respect to the groups to which the assets or liabilities belong, e.g., for every item of current liabilities, materiality should be evaluated in proportion to the total current liabilities.