ACCOUNTING CONCEPTS & PRICIPLES

ACCOUNTING CONVENTIONS, CONCEPTS & PRINCIPLES

In order to maintain proper accounting records and to prepare acceptable financial statements, there are several accounting conventions, concepts and principles which developed over the period of time. Some of these are followed by force of custom and practice while a number of them have been enforced through laws and accounting standards. All the accounting rules which developed during the long history of accounting subject may be referred to as conventions, concepts, assumptions, or Generally Accepted Accounting Principles (GAAP), and many to them have become part of International Accounting Standards (IAS) and also enforced by other laws.

All these concepts and principles are stated hereunder with their meanings and brief descriptions. Most of them relate to the preparation and presentation of financial statements, as the basic function of accounting is to provide information to the users of these statements and to enhance the usefulness of accounting data.

The most fundamental accounting concepts that must be followed are:

Fair Presentation
Financial Statements should be “Fairly Presented”, and additional disclosures should be made, beyond those required by IAS, when and where necessary, to achieve the objective of fair presentation. Notes to the Accounts are an example of the same. The financial statements should be presented in accordance with the stated accounting policies of the enterprise, in a manner which provides relevant, reliable, comparable and understandable information, to make it a fair presentation.

Going Concern
This fundamental concept of Going Concern allows for the assumption that the business entity has a reasonable expectation of continuing in business at a profit for an indefinite period of time. Any business enterprise, normally, is not set up for a specific period of time.

In other words, the business enterprise will continue in operational existence for a foreseeable future and this implies that all available information for a foreseeable future should be provided, and not only for the next twelve months.

Accruals and Matching Concept
The Accrual Basis of Accounting means that Assets, Liabilities, Equity, Income and Expenses are recognized when they occur and not when cash or its equivalent is received or paid.
So the related Matching Concept becomes relevant and it signifies that all the costs / expenses should be set off against the sales / revenues they have contributed to. In other words, all incomes and charges relating to the period to which the financial statements relate should be taken into account without regard to the date of receipt or payment.

Consistency
In order that the Concept of Comparability is properly followed the principle of Consistency will have to be adopted.

So it is assumed that the successive Profit and Loss Statements and the Balance Sheets of a business enterprise are based consistently on the same generally accepted accounting principles as previously chosen by the enterprise. A particular accounting method once adopted should not be changed from period to period.

Changes may be made, (presentation, classification, valuation) but the change and its impact on the financial statements must be clearly disclosed.

Some other fundamental accounting concepts are also stated below.

Materiality
The concept of materiality means that the information that is material should not be mixed up or aggregated with other items.
However, the determination of what is material and what is un-important requires the exercise of judgment.

If combining transactions could mislead the user of the financial statements, the amounts should be split out. So any financial information that is material should be mentioned in the financial statements – i.e. if considered of interest to the users of these statements.

An item is “material” if knowledge of the same might reasonably influence the decision of the user of financial statements.

Historical Cost Concept
Under this principle, all the values in respect of business transactions are based on the historical costs incurred.

Thus Financial Statements are prepared based on historical cost values, as their objective evidence exists and this makes them more reliable. This provides the basis for valuation of assets.

Money Measurement Concept
Accounting information has traditionally been related to recording only such events and transactions to which a monetary value can be attributed. Or in other words, all business transactions are recorded in terms of money, because it is the common factor in all business transactions.

Stable Monetary Unit or Stability of Currency
As diverse business transactions are expressed / recorded in terms of a common unit of measurement, namely the monetary unit, so the stability of monetary unit becomes very important. Transactions that happen over a period of time must reflect a single currency and exchange rate. This will allow one year’s set of accounts to be compared with another regardless of the rate of inflation. The effect of inflation or devaluation of currency is presented in a separate statement.

Business Entity / Accounting Entity Concept
This concept implies that a Business Enterprise is separate and distinct from the persons who supply the resources it uses.

In other words, the financial accounting information relates only to the activities of the Business Entity and not to the activities of its owner. The affairs of the business are separate from the non-business activities of its owners. The extent of application of this concept is different for different forms of business organizations.

The Basic Accounting Equation reflects the Accounting Entity Concept. The equation relates to the independent Economic Unit.

Dual Aspect Concept or Duality
This concept means that there are two aspects of accounting (double-side effect of each business transaction), one represented by the assets of the business and the other by rights/claims against them, and that these two aspects are always equal.

Also known as Duality Concept, this is generally expressed as the Dual Effect of each transaction. Double entry system is the name given to the method of recording business transactions for the Dual Aspect Concept.

Realization
The principle of Realization (or Revenue Recognition) implies that a transaction should be recognized when the event from which the transaction stems has taken place, e.g. Sale on credit is recorded or recognized when the sale is made (goods delivered) and invoice raised for the Customer, without waiting until the sale amount is received.

Accounting Period or Time Interval Concept
For accounting purposes, the lifetime of the business is divided into arbitrary periods of fixed length, usually one year.

The Financial Statements are normally prepared at the end of each arbitrary period, (or at specified time intervals) normally referred to as the Accounting Period.

Prudence / Conservatism
Accountants should always err on the side of caution (or should always be on the side of safety) in their estimates and valuations. So accountants are expected to be professionally conservative.

This is called the concept of Prudence, which requires that such method or procedure should be preferred for preparing financial statements which yield lesser amount of net profit or asset value. The concept advocates “anticipate no profits and provide for all losses”.