Chapter 5 Accounting Concepts and Conventions

Overview
1. Introduction
2. Accounting concepts
3. Qualitative characteristics of accounting information

1 Introduction

 The recording of transactions in the books is for the purpose of preparing the financial
statements, which should provide information about the financial performance and position of the
business.
 These financial statements are not used by owners of the business alone. There are a lot of other
people who are interested in the financial statements, such as bankers, government, employees,
suppliers, customers etc.
 Therefore, financial statements have to be prepared based on generally accepted rules and
procedures on how transactions should be recorded. These rules have been derived and
developed over the years from trade or business customs and general accounting practices and
they are collectively known as “accounting concepts”.

2 Accounting Concepts

2.1 Business entity concept

 The affairs of a business are to be treated as being separate from the non-business activities
of its owner(s).
 Items recorded in the books of the business (accounting records) are, therefore, restricted
to the business transactions only. All other owner’s personal transactions should be
BBFA 1043 Chapter
recorded in 5 Accounting
his/her Concepts
personal books of&record.
Conventions LTJ 2018 1
 However, when the owner brings in/injects assets into the business, this transaction is now
a business transaction (it involves the business) and therefore recorded as capital in the
books of the business. Similarly, when the owner withdraws assets from the business, this
involves the business and is recorded as drawings in the business’ books.
 It should be noted that drawings are only limited to sole proprietorships and partnerships.
Drawings are not allowed if the business is a company.

2.2 Going concern concept

 It is assumed that the business will continue to operate indefinitely for the foreseeable
future.
 No intention to liquidate / cease the business or scale down the operation of business at any
point of time. Therefore assets are acquired by the business to generate income and they are
recorded at their original cost.
 The significance of this concept is in the valuation of the assets and liabilities of the
business i.e. because we assume the business to continue in operations, we value them at
the historical cost. If we assume that the business is going to close down/cease, we will
value the assets at the forced sale price, which are not the same as the historical cost.
Therefore, how we see the continuity of the business will affect our valuation of its assets
and liabilities.
 2.3 Money measurement concept

 Accounting information is concerned only with those facts that can be measured in
monetary units and most people will agree to the monetary value of the transactions.
Whatever is not measurable in monetary terms (i.e. how much RM), cannot be shown in
the accounting records.
 There are a lot of factors that are important to the business but cannot be measured
accurately in monetary terms like workers’ morale (motivation), workers’ relationship with
each other, staff welfare, work place environment, quality of the management team,
customer relationship, presence of competitors etc. These are crucial for the continuity of
the business but there are not shown nor recorded in the accounting records. This is one of
the limitations of the accounting.
 Therefore, accounting records/reports/statements can never tell us everything about a
business. This limitation can be overcome by the business providing some additional non-
accounting information such as written reports, explanatory notes, surveys etc.

2.4 Accounting period/Time interval concept

 The life of the business is assumed to be continuous for a long period of time (going
concern concept). However, we need to measure the performance and financial position
of the business from time to time. In order to do this, the life of the business is usually
divided into periods of equal length (normally one year) so that we can measure its
performance and position. The period of one year is used mainly to coincide with the
calendar year. For practical purposes, most accounts are even closed monthly.
 Therefore, Financial Statements are usually prepared for each accounting period (normally
one year) to assess the performance (profitability) of the business (Statement of Profit or
Loss) and the financial position (Statement of Financial Position) of the business.

BBFA 1043 Chapter

2.5 Historical 5 Accounting Concepts & Conventions
cost concept LTJ 2018 2

 Business activities are recorded at costs and prices at the time of transactions.
 As such, assets acquired are recorded at their original cost/purchase price as stated in the
invoice/bills and subjected to depreciation charges. Liabilities are also recorded at the value
when the liability was incurred. Eg:- when we take a loan of RM50,000, this value will be
recorded as such.
 In reality, we know that the historical cost of the assets that are recorded in the accounts is
not realistic because the value of our assets fluctuate (change) very frequently. The values
of the assets in the accounts do not really show the true values whereby the assets can be
realised (sold/replaced).
 Many attempts had been made to record these assets at other than the historical cost like
replacement cost, market price etc. Nevertheless, these other values cannot be accurately
verified (not like the historical cost whereby the value can be easily be obtained from the
purchase invoice) and are very subjective.
 Therefore, the historical cost concept is still being used with some regular revaluations
being made as and when necessary.

2.6 Accrual/Matching concept

 Matching concept is applied in the determination of profit for a particular period.

 The cost/expenses incurred in an accounting period are matched with the revenue earned
in the same accounting period, regardless of the payment made or revenue received. If
there are not for this period, we will exclude them from this period as accruals and
prepayments.
  Whether we have received from the customer or not, we will include the sales in the
accounts when the goods/service had been delivered to the customer (Customers who still
owe us are accounted as trade receivables). Whether we have paid to the supplier or not, we
will include the purchases/expenses in the accounts once we have received the
goods/services (Suppliers whom we have not paid are accounted as trade payables).
 Expenses are recorded in the Statement of Profit or Loss when incurred (consumed,
received or used). Similarly, revenues are recorded when realised (sale has taken place).

Revenue - Expenses = Profit/ (loss)

(Realised) (Incurred)

Revenue received + revenue not Expenses paid + expenses not yet paid
yet received - Revenue received – expenses prepaid
in advance

2.7 Dual aspect concept

 There are two aspects of accounting, one represented by the assets of the business and the other
by the claims against them. These two aspects are always equal to each other. [Assets =
Liabilities + Equity]. It is noted that every business transaction has two effects in the
accounting equation.

Assets = Liabilities + Equity

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 For every change on the left side, there is an exactly equal and opposite change on the
right side of the accounting equation. After every transaction has taken place, the Accounting
Equation will still balance i.e. the total value on the left side equals the total value on the right
side. This is called the Dual Effect.
 This also explains the double entry system of recording transactions, i.e. for every debit side
of a transaction, there is a credit side and both the debit and credit are always equal to each
other.

2.8 Prudence/conservatism

 In the course of his/her daily work, the accountant often needs to make estimates. Example
of situations that call for estimates are when deciding to write off bad debts (which debt
needs to be written off), making allowance for doubtful debts (how many %), valuation
of inventories (how much is the inventories worth now, any impairment?) etc. In coming up
with the estimates, the accountant has to exercise a certain degree of caution in the exercise
of the judgement required under conditions of uncertainty.
 The underlying principle is that the accountant should not paint too good a picture of the
business lest the actual results do not turn out to be so good. In such situation, it is usual for
accountant to be more cautious or conservative i.e. to predict a not so optimistic result that
may give users false hopes.
 If the actual result is better than expected/predicted, very few people will complain but not
the other way round.
  It is this conservative outlook of the accountant that gives rise to the concept of prudence
(conservatism). Because of this, sometimes the accountants are seen to be very negative and
risk adverse. It is not true because one of the most important duties of the accountant is to
safeguard the business’ assets and being careful is crucial.

 Therefore, prudence concepts requires that:

a) Assets and Income should not be overstated;

b) Liabilities and Expenses should not be understated.
c) All foreseeable losses should be recognised in the accounts and reported
immediately.
d) Any possible profits should only be recognised when it has actually happened.

2.9 Consistency

 When the users of accounting information measure the performance of a business and its
financial position, it is very often that they compare the results with either the previous
period’s results or the results of a similar business entity (usually its competitors). This
will enhance the quality of the comparison.
 In order to do this, similar accounting policies must be used in preparing and reporting the
similar items in the financial statements from period to period and between the different
businesses. For example, the depreciation method and recognition of sales should be
maintained from period to period. This is comparing like with like.
 Nevertheless, it does not mean that the policies cannot be changed. If there is any change in
the accounting policy, the amount of difference that arise due to the change in policy should
be determined and reported, to enable meaningful comparison to be made.

2.10 Materiality
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 Information is material if its omission or misstatement could influence the economic
decisions of users (If the information is material or important, by omitting or misstating it,
users are caused to make decisions differently). Materiality depends on the size and nature
of the item/information. Eg. A calculator can be used for more than one year. By nature it
should be accounted for as a non-current asset i.e. recorded as an asset and then depreciated
over its useful life. However, because of its immaterial/small value, it is written off as an
expense in the statement of profit or loss in the year it is bought. Similarly, a computer is
recorded as a non-current asset in a sole proprietor’s accounting record but is treated as an
expense in the books of a multi-national business.
 Each material item should be presented separately (e.g. loss on disposal of land and
buildings, directors’ salaries)
 Immaterial items can be aggregated together with other similar immaterial items (totalled up
together as one item e.g. water and electricity, tables and chairs, salaries and wages)

2.11 Objectivity

 The measurement and display of the financial effect is based upon a factual occurrence
(e.g. source documents are the objective evidence of transactions that occurred).
 The information that is included in the accounting records must be verifiable (based on
proof or fact that can be seen) and not be based on subjectivity.
 2.12 Substance over form

 Transactions and other events must be accounted for and presented in accordance with
their substance and economic reality and not merely their legal form.
 E.g. a car on hire purchase is not legally owned by the business until all the hire purchase
instalments are paid to the financier/bank. So, who should record the car as asset in the
statement of financial position? Legally, the bank is the owner of the car but in substance,
the car is used daily by the hirer. The hirer can use the car however he/she likes. Therefore,
the car should be shown as an asset in the hirer’s statement of financial position. The amount
owing to the bank for this car will also be shown separately as a liability in the same
statement of financial position.

2.13 Realisation

 Revenue and profit can only be taken into account when realisation has occurred and that
realisation occurs only when the ultimate cash realised is capable of being determined with
reasonable certainty.

 Several criteria have to be observed before realisation can occur:

a) goods or services are provided/delivered to the buyers;
b) the buyer accepts liability to pay for the goods or services;
c) the monetary value of the goods or services has been established;
d) the buyer will be in a situation to be able to pay for the goods or services.
 E.g. An order received from a customer for delivery of goods next month will only be
realised as revenue when goods are finally delivered and accepted by the customer next
month.
 E.g. Receiving 3 months’ rental income, which includes 2 months’ deposit will realise
revenue (or income) of only one month because the 2 months’ deposit are not yet realised as
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 E.g. Goods sold on consignment basis are not yet realised as revenue because realisation
occurs only when the goods are sold to the final customers.

3. Qualitative characteristics of accounting information

In order to help the various users in their decision making, accounting information should
possess the following characteristics:
 Understandability
 Reliability
 Relevance
 Comparability

3.1 Understandability

Accounting information presented in the financial statements must be readily

understandable by the users. If not, the information presented is just a pool of data. Of
course we have to assume that the users do have some reasonable basic knowledge of
business, economics and accounting in order to understand the information. The users are
also assumed to be willing to study the information with reasonable diligence.
3.2 Reliability

The information presented must be free from material error and bias and can be depended
upon by the users to represent the events and transactions faithfully or correctly. Unless the
users perceive that the information presented is reliable, they will not depend on the
information to make any decisions.

3.3 Relevance

Information in financial statements is relevant when it can influence the economic decisions
of users. It should help the users to evaluate the past, present and future events relating to an
entity. It should also help users to confirm or correct past evaluations they have made
regarding the business entity. To put it simply, if I want to buy a car, what is the relevant
information to me? Perhaps it should be a catalogue of all the cars that are available in the
market. A list of property prices is not relevant to me in this matter.

3.4 Comparability

Accounting information should also be comparable i.e. users can compare the information
with others. Usually, users will compare the information with another business in the same
industry (similar size, location etc.) or with the past results of the same business. It’s only
through comparison that users can know whether the business is performing well or not. In
order to be comparable, the accounting information must be prepared based on the same
accounting methods/practices (consistency). Only then will the comparison be meaningful.

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