ACCOUNTING CONCEPTS AND CONVENTIONS

LEARNING OBJECTIVES

After going through this unit, you will be able to understand the:
 meaning and types of accounting concepts
 meaning and types of accounting conventions
 difference between accounting concepts and conventions

3.1 ACCOUNTING CONCEPTS

Accounting concepts form the base for preparing the set of rules and guidelines that help
record financial transactions of a firm. Accounting concepts are developed based on
observations and established through agreement. The basic concepts that are being used while
preparing financial statements are explained below-

3.1.1 Business Entity Concept

In accounting, business is considered as a unit, different from its owners. According to the
concept of Business Entity, a business has 1) separate existence, 2) distinct legal identity and
3) limited liability. The entity concept reveals that only business transactions are recorded and
that the net result is related to business only.

As per law, this concept is not applicable for sole proprietorship and partnership firms. The
owners or partners of the firm are jointly accountable for their firm’s liabilities, whereas in a
limited liability company, the firm is liable to the owner only to the extent of the amount
invested by the owner. However, for accounting purposes, the concept of accounting entity is
followed in all kinds of organisations and is considered to be the base for the accounting
process.

For example, Mehta Group Limited had borrowed money and had invested it in their business.
When the lenders asked Mr. Mehta to return their money, he refused by saying that he was not
personally responsible for the money because it belonged to the company. Is Mr Mehta’s
response ethical?

Mr Mehta’s response is acceptable and can be justified as follows: As per the underlying
principle of Business Entity, the company has a separate identity, and no person can be held
responsible for the losses incurred or profits gained by the firm.
3.1.2 Going Concern Concept

The ‘Going Concern’ concept assumes that a business entity has an infinite life. Events and
opportunities may come and go, but the business is believed to remain forever. This implies
that existing resources will be used to fulfil the objective of a continuing entity, and therefore,
resources are valued by their future usage rather than by their current market value.

For Example, A well-known astrologer predicted that the world would end in 2015. The Chief
financial officer of ABC limited has a firm belief in the predictions of the astrologer. Therefore,
the accountant decides to show this in the books of a company and prepares the statements as
if the firm has a life only till 2015. Does this logic make sense?

This is undoubtedly an incorrect practice, because a business has an infinite life, unless there
are facts to indicate otherwise.

3.1.3 Money Measurement Concept

In accounting, all the transactions are measured and recorded monetarily. This concept
provides a simple way to measure and summarise transactions easily. Moreover, in theory
money is a stable unit of measurement, and its value remains stable always. However, in
reality, money is not a stable unit, and its value changes over time. As per accounting, assets
are recorded at the cost of purchase, and this price remains the same always. However, the
same is not true, because the cost of purchasing any item changes with time. Moreover, non-
monetary transactions, such as employee morale, goodwill and quality of products, are also
important for a firm; however, these are not recorded during accounting.

3.1.4 Matching Concept

Here, profits earned during a period will be matched against the expenses incurred during the
same year. The Matching concept suggests that to determine the profitability, expenses
incurred to generate the revenue are to be matched against that revenue. Therefore, it is a vital
concept that can be used for measuring the financial results of a company.

For Example, PQR Appliance Limited have been selling kitchen appliances for the past 30 years
in Alwar. It purchases a large appliance from wholesalers in Delhi for Rs 45,000 and resells it to
a local restaurant in Alwar for Rs 60,000. Therefore, as per the matching concept, PQR
Appliances should match their cost (Rs 45,000) with the revenues (Rs 60,000) earned at the end
of the accounting period.

3.1.5 Periodicity Concept

The net income of a business can be measured accurately by evaluating the difference between
the value of the asset at the time of commencing a business and the value when closing the
business. However, as per the going concern concept of accounting, a firm has an infinite life,
and therefore, one has to wait for a long time to know the performance of the business.
However, this is not beneficial for the business, because people concerned would want
information regularly on how the business is faring. Therefore, a shorter and convenient time is
chosen for the measurement of income and reporting the same regularly. Usually, a 12-month
period is chosen for preparing and reporting financial statements. This time interval is known as
the accounting period, and the concept is known as the periodicity concept.

In India, the accounting period is from 1st April (of the previous year)to 31st March (of the
ensuing year).

3.1.6 Cost Concept

According to this concept, the cost of the asset is recorded as the price paid to purchase it,
which is considered to be the basis for all subsequent accounting for the asset. This is also
called the historical cost, because the cost of acquiring assets is based on the date of
purchasing assets. Because this is a monetary concept, resources, for example, knowledge,
skills, increase in team work in the organisation and reputation of a firm, will not be recorded as
assets.

For Example, if 1000 units of an item were purchased one month back at Rs 10 per unit and the
price today is Rs 11 per unit, the cost of the inventory appearing in the balance sheet will be Rs
10,000, and not Rs 11,000.

3.1.7 Realisation Concept

This concept deals with the revenue realised by a firm. Revenue from the sale of goods should
be recognised when the goods are transferred to the buyer for a price. The ‘Realisation
concept’ does not necessarily demand cash sales; in fact, credit sales are also equally
considered if there is no uncertainty in the realisation of money from those sales. Hence, the
basis for revenue recognition is the sale of goods and performance of service.
For Example, the revenue for the sale of goods in 2014 by AB jewellers was Rs 4, 00,000.
However, only Rs 2, 50,000 was received for these transactions and the rest was on credit basis.
The company also got more orders for jewellery in 2014. The total revenue recognised by the
firm was Rs 4, 00,000, because the realisation concept does not demand only cash sales, and
merely by getting orders, it does not signify that sales have been done.

3.1.8 Accrual Concept

This suggests that revenue is recognised, when the sale is complete or services are delivered. It
is not necessary that cash must be received by the seller. Similarly, expenses are recognised
when they are incurred and not when paid. The accounting process takes the date of
transaction into account rather than the date of the actual receipt of the revenue or the date of
actual payment for cost.

For Example, an airline sells its tickets; even weeks before the flight departure, it does not
record the payments as revenue because the flight, that is, the event on which the revenue is
based, has not taken off yet.

A business records its utility (e.g. electricity and water) bills as soon as it receives them and not
when they are paid, because the service has already been used. The company disregards the
date when the payment will be made.

3.1.9 Dual Aspect Concept

Here, every business transaction involves two aspects, namely, for every benefit that is being
received by a firm, there is a corresponding benefit provided by the firm. The dual aspect
concept is based on the double entry system in accounting. The basic accounting equation can
be written as follows:
Assets = Capital + Liabilities
Or
Assets = Equities (Capital)
The term “capital” refers to the fund (i.e. money) provided by the owner of the firm.
“Liabilities” refer to the funds provided by outsiders. “Assets” represent the resources owned
by the firm.

Suppose that Shyam starts a consultancy firm by investing Rs 50,000, and uses a building worth
Rs 2, 00,000 as his premises. This information is recorded at two places in the book of accounts
– asset and capital account. It means that the business acquires assets worth
Rs 2, 50,000 and this is equal to the owner’s fund of Rs 50,000 (in cash) and building worth Rs 2,
00,000. This relationship also can be presented in the form of an accounting equation as
follows:
Assets = Capital + Liabilities
Rs 6, 00,000= Rs 50,000+ Rs 2, 00,000

3.2 ACCOUNTING CONVENTIONS

An accounting convention is defined as “a rule of practice which has been approved by

common consents”. It is a common procedure that is adopted by common
agreement. It acts like a master plan that guides one to choose the procedure applied for the
collection, measurement and reporting of financial data. The most common and frequently
used accounting conventions are Conservatism, Consistency, Materiality and Disclosure.

3.2.1 Conservatism

‘Conservatism’ refers to the policy of playing safe. It is a proactive method of recognising all
unfavourable events. The rule of thumb for the convention of conservatism is “Anticipate no
gains but provide for all losses and if in doubt, write it off”. This clearly suggests that one must
not expect any profits but make provisions for all losses. This principle leads to the over-
statement of expenses and losses and the understatement of income and gains. This principle is
applicable in the case of uncertain events and where estimations are supposed to be made, for
instance, while forecasting sales, preparing the budget and estimating the cost of a new
project.

3.2.2 Consistency

The convention of ‘Consistency’ states that accounting practices and methods remain
unchanged from one accounting period to another. This method allows one to easily compare
financial statements. As per Accounting Standard-I, it is assumed that accounting methods
remain the same over time, and that any change in the methods will be disclosed with the
specific reason. There are three types of consistencies, namely (1) Vertical, (2) Horizontal and
(3) Dimensional. ‘Vertical consistency’ refers to the consistency within inter-related elements of
the financial statements, namely, Income statement and balance sheet. ‘Horizontal consistency’
is said to be maintained among financial statements from a year to another. Dimensional
consistency enables the comparison of the performance of one organisation with that of
another in the same industry.
3.2.3 Materiality

The concept of ‘Materiality’ is concerned with practicability and feasibility. It places emphasis
on the relative importance of the given information to help judge what is important to include
and what is not. It provides guidance in the selection of items to be disclosed in the financial
statements of an enterprise.

For example, increased administrative cost, loss of market share and fall in the value of a
company’s share has a substantial effect on the financial statement and hence should be
disclosed. However, an expense of Rs 2,000 for a firm having Rs 50, 00,000 turn-over is
immaterial and can be written off from the books of accounts. Hence, the ‘Materiality’ concept
altogether works on the principle of relativeness. For instance, something that is insignificant
for one firm might be important for another firm.

3.2.4 Disclosure

This requires revealing all the necessary financial information by fairly preparing and presenting
information of business activities in the financial statements of a firm. It works like a
communication channel between the company and the users of financial information of that
company. The convention of disclosure leads to an openness, because it requires sharing and
presenting of all the required information to its potential users through well-prepared financial
statements.

3.3 DISTINCTION BETWEEN CONCEPTS AND CONVENTIONS

The accounting conventions and concepts discussed above are the essential aspects that
influence the nature of accounting policies. These are however different from one another in
many ways. The distinction between accounting concepts and conventions are summed up in
Table 3.1.

Table 3.1 Difference between Concepts and Conventions

S.No. Basis of Difference Concepts Conventions

1 Origin It is based on the
assumptions that form the
foundation of accounting
principles
2 Precedence Accounting concepts are
It is based on the general
agreement accepted by all
during the course of time
The same is not true for
 followed by accounting accounting conventions
conventions
3 Personal Judgement Accounting concepts are Personal judgements play a
not influenced by major role in influencing
individual judgements accounting conventions
4 Accounting Standard GAAP is followed GAAP is not followed
5 Legal Status Accounting Concepts are Accounting conventions are
established by law established by the common
accounting process