ACCOUNTING CONCEPTS AND CONVENTION

WHAT ARE ACCOUNTING CONCEPTS?

Accounting concepts are theoretical ideas, components and

terms that make up the subjects accounting, finance and
economics. These terms help individuals, businesses or
organizations systematically record their financial
information and transactions. Accountants use these
concepts as guidelines to prepare financial reports and other
documents for individuals and businesses. Companies tend
to follow accounting standards, principles and accounting
laws of the countries they operate in. These principles
include concepts and conventions that help those companies
report transactions accurately.

Concepts and principles are critical parts of accounting

because they set up a universal framework for discussing
particular financial situations, rules and theories. The
concepts are crucial, as they can help clarify the details of
complex transactions and assist in resolving any disputes
that may arise while creating financial statements. You could
think of these concepts as ‘what accountants do' and
accounting principles as ‘how they do it.'

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Why are Concepts Necessary in Accounting?

Accountants are professionals who record the financial

transactions of a company. Periodic summaries of these
transactions or financial reports give managers, investors,
analysts and the government relevant financial information
about a company. If every business follows an independent
system for creating and producing summaries and
statements, it could lead to discrepancies and increase the
scope of fraud and financial mismanagement. To overcome
this, accounting bodies, governments and regulatory
agencies use a universally agreed-upon set of principles to
standardize accounting practices.

Concepts are necessary in accounting to establish a

consistent and coherent framework for preparing,
presenting, and interpreting financial information. These
concepts, also known as accounting principles or generally
accepted accounting principles (GAAP), provide a common
language and set of standards for accountants and financial
statement users. The following are some reasons why
concepts are essential in accounting:

 Comparability: Concepts ensure that financial

statements are comparable over time and across
different entities. This comparability allows
investors, creditors, and other stakeholders to

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 make informed decisions when evaluating the
financial performance and position of a company.
 Relevance: Concepts ensure that financial
information is relevant to the decision-making
needs of users. Relevant information is timely,
accurate, and useful for predicting future cash
flows or assessing a company’s ability to meet its
obligations.
 Reliability: Concepts require that financial
information be reliable and verifiable. Reliable
information is free from bias and material error,
allowing users to trust the accuracy of the financial
statements.
 Understandability: Concepts promote
understandability by using clear and consistent
terminology and definitions. Users with a
reasonable level of financial literacy should be able
to comprehend the information presented in the
financial statements.
 Transparency: Concepts require that financial
statements disclose all material information
necessary for users to make informed decisions.
Transparency helps build trust between a company
and its stakeholders, promoting ethical behavior
and accountability.

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 Integrity of the Financial System: Concepts
support the integrity of the financial system by
providing a foundation for laws, regulations, and
auditing standards. Compliance with these
principles helps maintain public trust in the
financial reporting process and reduces the
likelihood of fraudulent activities.
 Professional Competence: Concepts serve as a
basis for the education and training of
accountants, ensuring that they possess the
necessary skills and knowledge to prepare accurate
and meaningful financial statements.
 Global Harmonization: Concepts contribute to
global harmonization by providing a foundation for
international accounting standards, such as the
International Financial Reporting Standards (IFRS).
This harmonization facilitates cross-border trade
and investment by reducing complexity and
increasing comparability across jurisdictions

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What is the difference between a concept and
convention?

Concepts and conventions together make up accounting

principles. Accounting concepts are rules and guidelines that
a company follows to manage accounts that record financial
transactions. Government bodies and financial institutions
legally recognise these concepts, and a legal and regulatory
framework complements their function. One of the primary
benefits of these concepts is that they aid in recording
financial transactions based on evidence and leave little to
no chance for personal or professional bias or gain.
Accounting concepts aid in creating standards, resolving
potential disputes and preventing fraud and irregularities.

Accounting conventions are a set of practises that a business

entity follows over a period of time to prepare its accounts.
Unlike theoretical concepts, conventions are a procedure
that companies universally follow. The purpose of accounting
conventions is to guide accountants while they prepare
financial statements. Accounting conventions are dynamic
and can change when new concepts and principles emerge.
One major advantage of following accounting conventions is
that it ensures similar accounting practises across
businesses, making it easy for stakeholders to interpret the

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financial performance of different companies using the same
benchmark.

IMPORTANT CONCEPTS IN ACCOUNTING

Accounting bodies classify concepts as based on

assumptions or based on principles. Every type of business
including a sole proprietorship, partnership or a public or
private company—records its financial transactions based on
these assumptions and principles. These are some of the
important concepts in accounting:

1. BUSINESS ENTITY CONCEPT

The business entity, economic entity or separate entity

concept assumes that a business is independent of its
owner. A business may not record its owner's personal
expenses, income, liabilities and assets. It aids in tracking a
business's expenses, incomes and tax deductions without
any ambiguity. In addition, it safeguards a business owner's
personal finances and helps build their creditworthiness. It
reflects cash flow and financial position more accurately.
This clear distinction helps stakeholders and creditors take
appropriate business decisions based on a company's
performance rather than the owner's financial position.

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The business entity concept in accounting is a fundamental
principle that separates the financial affairs of a business
from those of its owners. It is based on the idea that a
business is a separate entity from its owners, and therefore
its financial transactions should be recorded and reported
independently. This concept is crucial for accurate financial
reporting and analysis as it helps in providing a clear picture
of the financial position and performance of the business.

Key Aspects of the Business Entity Concept:

 Separate Legal Entity: According to this concept, a

business is considered a separate legal entity from its
owners. This means that the business’s financial
transactions are recorded separately from the personal
finances of the owners.
 Limited Liability: One of the advantages of the
business entity concept is that it provides limited
liability protection to the owners. In case of any debts or
legal obligations of the business, the owners’ personal
assets are generally protected.
 Financial Reporting: The business entity concept
guides how financial statements are prepared. Income
statements, balance sheets, and cash flow statements
reflect only the financial activities of the business itself,
excluding any personal transactions of the owners.

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 Decision Making: By treating the business as a
separate entity, stakeholders can make informed
decisions based on the financial performance and
position of the business without being influenced by
personal transactions of the owners.
 Taxation: The concept also impacts how taxes are
calculated and paid. Businesses are required to file
separate tax returns, further emphasizing their distinct
identity from their owners.

Importance of Business Entity Concept:

 Accurate Financial Reporting: By following this

concept, businesses can provide accurate and reliable
financial information to stakeholders, enabling them to
assess the company’s performance objectively.
 Investor Confidence: Investors and creditors rely on
financial statements prepared under this concept to
evaluate the financial health and stability of a business
before making investment decisions.
 Legal Compliance: Adhering to the business entity
concept ensures that businesses comply with
accounting standards and regulations, promoting
transparency and accountability.
 Comparability: Treating a business as a separate entity
allows for easier comparison with other businesses in

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 the same industry or sector, facilitating benchmarking
and analysis

2. GOING CONCERN CONCEPT

Going concern concept prescribes that accountants prepare

financial statements on the assumption that a business may
continue its operations for the foreseeable future. Under this
concept, the definition of a foreseeable future is a period of
12 months from the end date of the reporting period. If a
business owner or the management is invested in scaling
down business operations to zero, they cannot apply the
going concern concept for accounting. Accountants may no
longer apply the going concern concept if a company is:

 Unable to pay dividends

 Unable to raise credit from banks and financial services
 Facing losses and negative operating cash flow
 Facing an adverse financial position
 Unable to pay back crucial debts
 Facing an unfavourable legal or regulatory action
against it

3. MONEY MEASUREMENT CONCEPT

This is an accounting concept based on assumption, and it

stipulates that companies record only those transactions
that they can quantify and measure in terms of money. If

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they cannot assign a monetary value to a transaction, they
do not record it in their annual financial statement. Though
these transactions affect a company's financial performance,
they may not find a place in financial statements, as
monetising them can be challenging. Some examples of non-
monetary value include employee competence, product
quality, employee efficiency, market sentiment, business
productivity and stakeholder satisfaction.

4. ACCOUNTING PERIOD CONCEPT

The accounting period concept prescribes a timeframe within

which a business records and reports its financial
performance for the purview of internal and external
stakeholders. An accounting period of a company may
coincide with the fiscal year. A company can determine a
timeframe for internal reporting, like three or six months, or
prepare monthly financial reports to analyse their cash flow
positions. The management can determine a convenient
accounting period for internal reporting, but the reporting for
investor, government and tax purposes is typically for the
period of one year.

5. ACCRUAL CONCEPT

Accrual is a fundamental concept that guides how a

business can record cash or credit transactions. Under this
concept, a business records a financial transaction in the

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period it occurs. It does not consider whether the business
pays or receives cash at the time of the transaction, or if it
pays cash after a certain period. For example, a company
records a credit purchase at the time of purchase rather
than when it pays back the seller. This helps record and
report income, expenses, liabilities and receivables
accurately. All modern accounting systems follow the accrual
concept in recording financial transactions.

6. REVENUE REALISATION CONCEPT

Under the revenue realisation or revenue recognition

concept, a seller records potential revenue from a
transaction, regardless of whether they have or have not
received proceeds. The ownership of a product transfers from
a buyer to a seller during a sale. A seller recognises the
transaction by creating a receivable against the buyer's name
in their ledger. An accountant

creates another entry when they receive the due amount in

the future.

7. FULL DISCLOSURE CONCEPT

The full disclosure concept requires a business entity to

furnish necessary information for the benefit of those who
read financial statements and reports for investment,
taxation or audit purposes. This concept aims to provide

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important financial information to investors, creditors,
shareholders, clients, and other stakeholders. Disclosure
policies cover revenue recognition, depreciation, inventory,
taxes, earnings, stock value, leases and liabilities.

8. DUAL ASPECT CONCEPT

Dual aspect concept states that every transaction affects two

accounts of a business. A business then records both
aspects to enable accurate accounting. Every financial
transaction has a credit or debit or a giver or receiver aspect.
If an accounting process does not represent both, it may lead
to faults in the final accounting record. The dual aspect
concept is the foundation of the double-entry system of
bookkeeping, which is now a standard method for auditing
and taxation.

9. MATERIALITY CONCEPT

The materiality concept prescribes guidelines to identify if a

piece of financial information is material and whether it can
influence the person reading a company's financial
statements. Based on this concept, an accountant or a
business may remove negligible transactions that may not
have a bearing on final accounts. This concept is open to
subjective interpretation and the basis for using the

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materiality concept varies with the size of a company. While
a large company may round off figures in the final accounts
to crores, a small firm may round off their figures to lakhs.

10. VERIFIABLE OBJECTIVE EVIDENCE CONCEPT

Under this concept, a business can record only those

transactions that they can furnish documentary proof for.
Without proper and valid documentary evidence, a
transaction can be biased or undependable, and it can
increase the scope of financial irregularities. For example, a
retail employee may present a bill for purchases and sales,
and corroborate it with sale and purchase invoices.

11. HISTORICAL COST CONCEPT

The historical cost concept states that a business may record

assets and liabilities at their historical cost rather than their
current market or sale value. It helps to maintain consistent,
reliable and verifiable financial information. Including the
current value of an entity can result in financial
irregularities.

Key Aspects of Historical Cost Concept:

 Original Purchase Price: Under the historical cost

concept, assets are initially recorded at the price paid to
acquire them. This includes not only the purchase price

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 but also any additional costs incurred to bring the asset
to its present condition and location.
 Stability and Objectivity: Historical cost is considered
a more reliable measure compared to other valuation
methods like fair value, as it is based on actual
transactions and can be verified objectively.
 Conservatism: The historical cost concept aligns with
the principle of conservatism in accounting, which
suggests that assets should not be overstated. By
recording assets at their original cost, this principle
ensures a more cautious approach to financial
reporting.
 Historical Cost Principle vs. Fair Value: While fair
value accounting has gained popularity for certain types
of assets, such as marketable securities, the historical
cost concept remains relevant for many other types of
assets like property, plant, and equipment.
 Impact on Financial Statements: The application of
the historical cost concept affects the balance sheet by
providing a stable and consistent basis for reporting
assets. However, it may not reflect the true economic
value of assets in cases where their market values have
significantly changed over time.
 Depreciation: When it comes to long-term assets like
buildings or machinery, historical cost serves as the

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 basis for calculating depreciation expenses over their
useful lives. This allows for a systematic allocation of an
asset’s cost over time.

Criticism of Historical Cost Concept:

 Lack of Relevance: Critics argue that historical cost

may not reflect the current economic reality of assets,
especially in times of inflation or rapidly changing
market conditions.
 Potential for Overstating or Understating Asset
Values: Since assets are recorded at their original cost,
there is a risk that their carrying values on the balance
sheet may not accurately represent their true worth.
 Impact on Decision-Making: Some believe that relying
solely on historical cost information may limit the
usefulness of financial statements for decision-making
purposes, as it does not consider factors like market
fluctuations or changes in asset values.

In conclusion, while the historical cost concept remains a

cornerstone of accounting principles due to its reliability and
objectivity, critics argue that it may not always provide a true
reflection of an entity’s financial position. As accounting
standards continue to evolve, finding a balance between
historical cost and fair value measurements becomes crucial
for transparent and informative financial reporting

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ACCOUNTING CONVENTIONS

1. Conservatism

2. Consistency

3. Full disclosure

4. Materiality

1. CONSERVATISM CONVENTION IN ACCOUNTING

In accounting, conservatism is a financial reporting principle

that requires accountants to be more certain of the certainty
or definiteity of a loss than a gain when preparing financial
statements. This means that if there is uncertainty about the
recognition of a gain or a loss, the accountant should
recognize the loss first and not recognize the gain until there
is more certainty about its existence. This principle is also
known as the “prudence” concept.

The conservatism convention is used to promote

transparency and reliability in financial reporting by
ensuring that financial statements provide a conservative
estimate of a company’s financial position and performance.
This means that financial statements prepared using the
conservatism convention will tend to understate rather than
overstate a company’s true financial position and
performance.

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There are several specific ways in which the conservatism
convention is applied in accounting:

 Revenue Recognition: Revenue is only recognized

when it is earned and can be measured reliably. This
means that if there is any uncertainty about whether
revenue has been earned or not, the accountant should
not recognize it until there is more certainty.
 Expense Recognition: Expenses are recognized as soon
as they are incurred, even if the related revenue has not
yet been earned. This means that if a company incurs
an expense but has not yet earned the related revenue,
the expense will still be recognized in the current period.
 Asset Valuation: Assets are valued at their historical
cost rather than their current market value. This means
that if an asset’s market value increases, the increase
will not be recognized in the financial statements until
the asset is sold or disposed of.
 Liability Valuation: Liabilities are valued at their
estimated future settlement amount, rather than their
historical cost. This means that if a liability’s estimated
future settlement amount increases, the increase will be
recognized in the financial statements immediately.
 Contingent Liabilities: Contingent liabilities are only
recognized in the financial statements if it is more likely
than not that they will become actual liabilities. If there

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 is uncertainty about whether a contingent liability will
become an actual liability, it will not be recognized in
the financial statements until it becomes more certain.

The conservatism convention is an important principle in

accounting because it helps to ensure that financial
statements provide a reliable and transparent picture of a
company’s financial position and performance. By requiring
accountants to be more certain of losses than gains, the
conservatism convention helps to promote prudence and
caution in financial reporting, which can help to protect
investors and other stakeholders from being misled by overly
optimistic or aggressive financial reporting practices

2. CONSISTENCY CONVENTION IN ACCOUNTING

The consistency convention in accounting refers to the

principle that once a company chooses an accounting
method or principle, it should continue to use that method
consistently in the future. This convention ensures that
financial statements are comparable across different periods,
allowing users of the financial information to make
meaningful comparisons and analyze trends over time.

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Importance of Consistency Convention:

 Comparability: By consistently applying the same

accounting methods, users can compare financial
statements from different periods and assess the
company’s performance and financial position
accurately.
 Reliability: Consistency enhances the reliability of
financial information by reducing fluctuations caused
by changes in accounting methods. It provides a stable
basis for decision-making.
 Transparency: Following the consistency convention
promotes transparency in financial reporting, as it
reduces the potential for manipulation or bias in
presenting financial results.

Application of Consistency Convention

 Accounting Policies: Companies should disclose their

accounting policies in the financial statements to inform
users about the methods used and any changes made
during the reporting period.
 Changes in Accounting Methods: If a company decides
to change its accounting methods, it must disclose the
reasons for the change and its impact on financial

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 statements. The new method should be applied
retrospectively unless it is impractical to do so.
 Disclosure: Full disclosure of any changes in
accounting policies or estimates is essential to ensure
transparency and allow users to understand how these
changes may affect the comparability of financial
information.

Conclusion on Consistency Convention:

In conclusion, the consistency convention plays a vital role in

maintaining the integrity and reliability of financial reporting.
By adhering to this principle, companies can provide
consistent and comparable information that aids users in
making informed decisions.

3. MATERIALITY CONVENTION IN ACCOUNTING

The Materiality Convention in accounting is a fundamental

principle that guides accountants in determining whether a
financial item or transaction should be recorded and
disclosed in the financial statements. The concept of
materiality is based on the idea that only information that
could influence the economic decisions of users of financial
statements needs to be included. Materiality is a relative
concept, meaning that what is considered material can vary
depending on the specific circumstances of each case.

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Definition and Importance of Materiality

Materiality is defined as the significance or importance of an

item or event in relation to other items in the financial
statements. The concept of materiality is crucial in
accounting because it helps ensure that financial statements
are relevant, reliable, and understandable to users. By
focusing on material items, accountants can avoid cluttering
the financial statements with immaterial details that could
potentially obscure important information.

Determining Materiality

Determining materiality involves both quantitative and

qualitative considerations. Quantitatively, materiality is often
expressed as a percentage of a base amount, such as total
assets, net income, or revenue. Accountants use professional
judgment to assess whether an item’s omission or
misstatement could influence the economic decisions of
users. Qualitatively, factors such as the nature of the item,
its context within the financial statements, and its potential
impact on stakeholders are also taken into account.

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Application of Materiality Convention

The Materiality Convention is applied throughout the

accounting process, from recording transactions to preparing
financial statements. Accountants must exercise professional
judgment to evaluate the materiality of items based on both
quantitative thresholds and qualitative factors. Materiality
considerations also extend to disclosures in footnotes and
other supplementary information accompanying the financial
statements.

Challenges and Criticisms

While the Materiality Convention is a widely accepted

principle in accounting, there are challenges and criticisms
associated with its application. One common criticism is that
materiality judgments are subjective and can vary among
different accountants or organizations. Additionally, there
may be pressure to downplay certain items as immaterial to
present a more favorable picture of the company’s financial
position.

In conclusion, the Materiality Convention plays a vital role in

ensuring that financial reporting remains relevant and useful
for decision-making purposes. By focusing on material items
that could impact users’ economic decisions, accountants

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uphold the integrity and transparency of financial
statements

4. Full Disclosure Convention in Accounting

The Full Disclosure Convention in accounting is a

fundamental principle that requires a company to provide all
necessary information in its financial statements and
accompanying footnotes. This convention ensures that users
of the financial statements have access to all relevant
information to make informed decisions. The goal of full
disclosure is to provide transparency and clarity regarding a
company’s financial position, performance, and any potential
risks.

Importance of Full Disclosure

The Full Disclosure Convention is crucial for several reasons:

 Transparency: By disclosing all relevant information,

stakeholders can have a clear understanding of the
company’s financial health and performance.
 Decision-making: Investors, creditors, regulators, and
other users rely on financial statements to make
decisions. Full disclosure helps them assess the
company’s risks and opportunities accurately.

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 Compliance: Many accounting standards, such as
Generally Accepted Accounting Principles (GAAP) and
International Financial Reporting Standards (IFRS),
mandate full disclosure to ensure compliance with
reporting requirements.
 Legal Requirements: In some cases, companies are
legally obligated to disclose certain information to
prevent fraud or misrepresentation.

Examples of Full Disclosure

Some common examples of full disclosure in financial

reporting include:

 Notes to Financial Statements: These provide

additional details about specific accounts, transactions,
and accounting policies used by the company.
 Contingent Liabilities: Companies must disclose
potential liabilities that may arise from pending
lawsuits, warranties, or other obligations.
 Related Party Transactions: Any transactions with
related parties, such as executives or major
shareholders, must be disclosed to prevent conflicts of
interest.
 Accounting Policies: Companies should disclose their
accounting methods and any changes made to these
policies during the reporting period.

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Challenges of Full Disclosure

While full disclosure is essential for transparency, it can also

present challenges for companies:

 Complexity: Providing extensive disclosures can make

financial statements more complex and difficult to
understand for users who are not familiar with
accounting principles.
 Competitive Disadvantage: Companies may be
hesitant to disclose sensitive information that could give
competitors an advantage or harm their reputation.
 Costs: Gathering and preparing detailed disclosures can
be time-consuming and costly for companies, especially
if they need to hire external experts for assistance.

In conclusion, the Full Disclosure Convention plays a vital

role in ensuring transparency and accountability in financial
reporting. By providing comprehensive information in
financial statements, companies can build trust with
stakeholders and facilitate informed decision-making

Conclusion: Accounting concepts and conventions play a

crucial role in maintaining the integrity and reliability of
financial reporting. By adhering to these principles,
accountants can ensure transparency, accuracy, and
relevance in presenting financial information to stakeholders

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