Accounting Concepts and Conventions
Accounting concepts and conventions as used in accountancy are the rules and guidelines by which the accountant lives. All accounts and accounting statements should be created, preserved and presented according to the concepts and conventions.
-These generally accepted accounting principles are a set of rules and practices that are recognized as a general guide for financial reporting purposes.
-Generally accepted means that these principles must have substantial authoritative support.
The Accruals concept assumes that revenue and expenses are taken account of when they occur and not when the cash is received or paid out. The purpose of this concept is to make sure that all revenues and costs are recorded in the appropriate statement at the appropriate time. The accrual concept under accounting assumes that revenue is realised at the time of sale of goods or services irrespective of the fact when the cash is received. Similarly, expenses are recognised at the time of services provided, irrespective of when cash is paid.
In brief, accrual concept requires that revenue is recognised when realized, and expenses are recognised when they become due and payable without regard to the time of cash receipt or cash payment. Thus, when a profit statement is compiled, the cost of goods sold relevant to those sales should be recorded accurately and in full in that statement. Costs concerning a future period must be carried forward as a prepayment for that period and not charged in the current profit statement. For example, payments made in advance such as the prepayment of rent would be treated in this way. Similarly, expenses paid in arrears must, although paid after the period to that they relate, also be shown in the current period’s profit statement: by means of an accruals adjustment.
Matching concept states that the revenue and the expenses incurred to earn the revenue must belong to the same accounting period. Therefore, the matching concept implies that all revenues earned during an accounting year, whether received/not received during that year and all cost incurred, whether paid/not paid during the year should be taken into account while ascertaining profit or loss for that year. It guides how the expenses should be matched with revenue for determining exact profit or loss for a particular period.
Revenue should be recognized in the accounting period in which it is earned.
Expenses should be matched with revenues in the period in which the revenues are earned. (i.e. the need for prepaid expenses)
-It helps in knowing actual expenses and actual income during a particular time period.
-It helps in calculating the net profit of the business.
Prudence Concept or Concept of Conservatism
It is this concept more than any other that has given rise to the idea that accountants are pessimistic boring people!! Basically the concept says that whenever there are alternative procedures or values, the accountant will choose the one that results in a lower profit, a lower asset value and a higher liability value. The concept is summarised by the well known phrase ‘anticipate no profit and provide for all possible losses’.
Revenue and profits are included in the balance sheet only when they are realized (or there is reasonable ‘certainty’ of realizing them) but liabilities are included when there is a reasonable ‘possibility’ of incurring them.
The Prudence Concept assumes:
-Assets should not be overvalued
-Liabilities should not be undervalued
-The financial statements does not reflect overstatement or understatement of gains or losses but neutral
-Profit or revenue only recorded when they are realized.
Because the methods employed in treating certain items within the accounting records may be varied from time to time, the concept of consistency has come to be applied more and more rigidly. Because of these sorts of effects, it is now accepted practice that when an entity chooses to treat items such as depreciation in a particular way in the accounts it should continue to use that method year after year. If it is NECESSARY to change the accounting method being employed then an explanation of the change and the effects it is having on the results must be shown as a note to the accounts being presented.
Separate Entity Concept
The business entity concept states that a business and the owner(s) are two separate Legal Entities.
Being an artificial person, a company has an existence independent of its members. It can own property, enter into contract and conduct any lawful business in its own name. It can sue and can be sued in the court of law. A shareholder cannot be held responsible for the acts of the company.
The best example here concerns that of the sole trader or one man business: in this situation you may have the sole trader taking money by way of ‘drawings’: money for his own personal use. Despite it being his business and apparently his money, there are still two aspects to the transaction: the business is ‘giving’ money and the individual is ‘receiving’ money. So, the affairs of the individuals behind a business must be kept separate from the affairs of the business itself.
This concept restrains accountants from recording of owner’s private/ personal transactions. It also facilitates the recording and reporting of business transactions from the business point of view.
These, then, are some basic concepts and conventions on which the accountant bases all of his accounting work. We can see evidence of such work in the published annual reports and accounts that all publicly quoted companies are required to prepare and publish. The concepts and conventions also apply to the millions of businesses world wide that do not publish their accounts.