29ACCOUNTING Concepts Conventions

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ACCOUNTING CONCEPTSand

CONVENTIONS


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Accounting is a social science has itsconcepts and pr inc ip les that used in

app ly ing the accoun t ing cyc le to

achieve accoun t ing funct ions and

object ives.


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ACCOUNTING CONCEPTS

Account ing concepts refer to

the nature of the econom ic

env ironment in whichaccount ing operates .

Recording has been based oncertain assumptions.


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Classification

ASSUMPTIONS

1. Economic entity

2. Going concern

3. Monetary unit

4. Periodicity

PRINCIPLES

1. Historical cost

2. Revenue recognition

3. Matching

4. Full disclosure

CONSTRAINTS

1. Cost-benefit

2. Materiality

3. Industry practice

4. Conservatism


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Accounting Concepts

1. Money measurement concept

2. The going concern concept

3. The business entity concept

4. The realisation concept

5. Accrual /Matching concept

6. Historical Cost Concept

7. Periodicity

8. Dual Aspect


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Accounting Conventions

1. Materiality Concept

2. Prudence/Conservatism Concept

3. Consistency Concept4. Disclosure


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Money measurement concept

It can be measured in money

Most people will agree to the money valueof the transaction.

Assumes that the value or purchasingpower of money is constant, ignoring theeffects of inflation or deflation.

Monetary Unit - money is thecommon denominator.


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Money measurement concept

e.g.

Accounting doesnt tell how goodthe quality of employees skills are

although this is important for thesuccess of a business.


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The Going concern concept

This concept implies that the business willcontinue to operate for the foreseeablefuture.

This is why we use the historical costconcept and ignore the current marketvalue in asset valuation.

Going Concern - company to lastlong enough to fulfill objectives and

commitments.


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The Going concern concept

e.g.

Fixed assets areshown at cost lessaccumulateddepreciation.


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The Business entity concept

This concept implies that the affairs of abusiness are to be treated as being quiteseparate from the non-business activitiesof its owners.

Personal transactions of the owner shouldnot be included.

Economic Entity company keepsits activity separate from its ownersand other businesses.


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The Business entity concept

e.g.

A directors private car

should not be included inthe fixed assets of thecompany.


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The Realisation concept

This concept holds to the view that profit

can only be taken into account whenrealisation has occurred.

Generally, sales revenue arising from the

sale of goods is recognised when thegoods are delivered to the customers.

Revenue Recognition - generally occurs (1)when realized or realizable and (2) whenearned.


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The Realisation concept

e.g.

Profit is earned when goodsor services are provided tocustomers. Thus it isincorrect to record profitwhen order is received, or

when the customer pays forthe goods.


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Accrual concept

The accrual concept says that net profit isthe difference between revenues andexpenses.

Determining the expenses used up toobtain the revenues is referred to asmatching expenses against reveues.

Income and costs are recognised as theyare earned and incurred but not as theyare received or paid.


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Matching - efforts (expenses) should be matched withaccomplishment (revenues) whenever it is reasonable and practicable todo so. Let the expense follow the revenues.

Expense Recognition


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Accrual concept

e.g.

Expenses have to take intoaccount of amounts payable

at the end of an accountingyear even though the cashhas not yet been paid.


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Historical Cost concept

Assets are normally shown at their originalcosts of acquisition.

Any changes in the market value after the

purchase are ignored. Historical cost is the most objective

measure of the value of an asset.

However, it cannot reflect the currentvalue of an asset.


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Historical Cost concept

E.g.

A fixed asset acquired at a costof Rs.100,000 would be recorded

at this amount in the books.Even if its market value mayhave gone up or down in future, itshould be recorded at its original

cost Rs.sssssss100,000.


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Periodicity Time Period Assumption

The life of an entity is divided into shorteconomic time periods on which reportingstatements are fashioned.

Periodicity - company can divide its

economic activities into time periods.


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Dual Aspect

Transaction has two fold effect: Debit &Credit.

Accounting Equation: A = C / E + L

Assets = Liabilities


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Conventions


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Materiality

Financial statement should separatelydisclose significant items for they wouldinfluence decisions of users.

Accounting does not serve a usefulpurpose if the effort of recording atransaction in a certain way is notworthwhile.

In other words do not waste your time inthe elaborate recording of trivial items.


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Materiality

e.g.

A stock ofstationery worths$10 should betreated as anexpense when it

was bought.
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Prudence/Conservaitsm

The accountant should always be on theside of safety.

The prudence concept means thatnormally he will take the figure which willunderstate rather than overstate the profit.

Provision is made for all known liabilities.


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Prudence/Conservaitsm

E.g.

Provision for doubtful debtsshould be deducted from

debtors in balance sheet.


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Consistency

When a firm has once fixed a method for theaccounting treatment of an item, it will enter allsimilar items that follow in exactly the same way.

Frequent changes in the accounting methodswould lead to misleading profits calculated from

the accounting records.

It states that when a firm has chosen a method

for the accounting treatment of an item, allsimilar items should be treated in the same way.


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Consistency

E.g.

Depreciation method of

certain fixed assets onceadopted should be used inthe following years.


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Disclosure

The financial statements of a firm must

include all information necessary for the

formation of valid decisions by the users. Any information that might be relevant to

an investor or creditor should be

disclosed, either in the body of thefinancial statements or in the notesattached thereto.


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Exercises
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Assumptions

Brief Exercise :Identify which basic assumption ofaccounting is best described in each item below.

(a) The economic activities of FedEx Corporationare divided into 12-month periods for thepurpose of issuing annual reports.

(b) Solectron Corporation, Inc. does not adjustamounts in its financial statements for theeffects of inflation.

(c) Walgreen Co. reports current and noncurrent

classifications in its balance sheet.(d) The economic activities of General Electric

and its subsidiaries are merged foraccounting and reporting purposes.

Periodicity

Going Concern

MonetaryUnit

EconomicEntity


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Contd.

Brief Exercise Identify which basic principle ofaccounting is best described in each item below.

(a) Norfolk Southern Corporation reports revenuein its income statement when it is earned instead ofwhen the cash is collected.

(b) Yahoo, Inc. recognizes depreciation expense fora machine over the 2-year period during which thatmachine helps the company earn revenue.

(c) Oracle Corporation reports information about

pending lawsuits in the notes to its financialstatements.

(d) Eastman Kodak Company reports land on itsbalance sheet at the amount paid to acquire it, eventhough the estimated fair market value is greater.

RevenueRecognition

Matching

Full

Disclosure

HistoricalCost


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Cost Benefit the cost of providing the information must beweighed against the benefits that can be derived from using it.

Materiality - an item is material if its inclusion or omission wouldinfluence or change the judgment of a reasonable person.

Industry Practice - the peculiar nature of some industries andbusiness concerns sometimes requires departure from basicaccounting theory.

Conservatism when in doubt, choose the solution that will be leastlikely to overstate assets and income.

Constraints


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Brief Exercise What accounting constraints areillustrated by the items below?

(a) Zips Farms, Inc. reports agricultural cropson its balance sheet at market value.

(b) Crimson Tide Corporation does not accrue acontingent lawsuit gain of $650,000.

(c) Wildcat Company does not disclose anyinformation in the notes to the financialstatements unless the value of the informationto users exceeds the expense of gathering it.

(d) Sun Devil Corporation expenses the cost ofwastebaskets in the year they are acquired.

IndustryPractice

Conservatism

Constraints

Cost-Benefit

Materiality

29ACCOUNTING Concepts Conventions

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