Accounting Concepts and conventions

Accounting concepts and conventions are the underlying theories and principals which govern the way
we record transactions and make adjustments in the books of the business. These concepts help us in
deciding a course of action which we can apply when it comes to transactions which we haven’t treated
before.

The importance of these concepts, with respect to accounting, is that it helps in standardizing accounts
everywhere and to clear confusions and arguments related to the subject and also acts as a benchmark
for deciding future accounting treatments.

The importance of these accounting concepts, with respect to the exam, is for theoretical questions and
MCQs.

The relevant accounting principles are:

1. Prudence
2. Materiality
3. Accruals/ Matching
4. Historical cost concept
5. Going concern
6. Time interval
7. Realisation
8. Separate entity
9. Money measurement
10. Dual aspect
11. Consistency
12. Objectivity
13. Substance over form

The explanation of each of the concepts is given below.

Prudence: The prudence concept says that while recording the transactions of a business an
accountant will use a prudent or a rational approach. This means that if the business anticipates profits
from any transaction then this profit will not be recorded until the profit has realized i.e. the transaction
has occurred. For example an anticipated sale will not be recorded until the customer has actually
bought the goods.

If the business anticipates any loss then a provision is to be made immediately for that liability. The most
common example for this is the provision of bad debts. Since bad debts are something a business
anticipates it creates a provision for it.
Materiality: To understand the materiality concept we have to understand that a material amount is
something which affects your decision. This amount is not an absolute amount but a relative amount.
For example a stock figure for $10,000 may be very material for a sole proprietorship since it is a small
business but the same amount of stock for a multinational may not be as material because the size of
the business is compared to the amount is very large.

The accounting convention of materiality says that when deciding the treatment for a transaction its
materiality of the transaction will be considered. This concept can be understood by the following
example. According to accounting policy an asset used for more than one year is to be classified as a
fixed asset, but if the business buys a calculator it will be written off as an expense in the first year
because the amount is insignificant i.e. immaterial.

We can see the application of the materiality concept in the revaluation method of depreciation. Since
loose tools are immaterial in amount they are aggregated and depreciated using the revaluation
method.
In short the materiality concept also says that we will record all the transactions for the business but if
an immaterial discrepancy arises then we will write it off instead of wasting resources on that amount.

Accruals/ Matching: The accruals or the matching cost concept says that in the calculation of profit,
the expenses charged against revenues will be only those expenses which were incurred against that
revenue. The application of this concept can be seen in the trading account. To calculate the gross profit
we don’t subtract purchases from sales because all the purchases were not sold. We calculate the cost
of goods sold because that’s the cost of the goods we sold hence resulting in stock figures.

This can be further explained by an example for rent. If the business premises have been rented for
$24,000 per annum and the payment of rent is $20,000 then the amount charged in the profit and loss
account will be $24,000 even though we paid less. This would result in an accrual of $4000.

In short, the matching cost concept says that the expenses charged in the final accounts will be the
expenses incurred in the year and not the amount paid in that year.

Historical cost concept: The historical cost concept says that the amount to be recorded in the
books of account will be the amount which the business paid for it, not the current market value for that
transaction. If the business buys a fixed asset for $5,000 and it is available for $6000 in the market then
the business will still record it at the price it paid for the asset.

Going concern: The going concern concept states that the accounts of the business will be made
keeping in mind that the business will be operational in the foreseeable future. This means that there is
no reason to assume that the business will go bankrupt and shutdown. This assumption is relevant
because it affects the valuation of stock and fixed assets. When a business acquires an asset, it
depreciates the asset based on its useful life. Estimating the useful life of the asset is an application of
the going concern concept because the estimated life means the business will be operational in the
future. Another application is selling and purchasing on credit. The existence of debtors at the end of the
year means that the business will be continuing in the future.
Time Interval concept: The time interval concept states that the financial statements of a business will
be only compared if they are of the same accounting period. This means the trading profit for an year
will only be compared with the trading profit for an year or the profit for the first quarter of an year will
only be compared to the first quarter of another year.

Realization: The realization concept stated that any transaction will only be recorded in the books of the
business when it is confirmed beyond doubt. This means that any expense paid will only be recorded
when the payment is handed over or the services against that expense have been received. Similarly the
acquisition of an asset will not be recorded in the decision process but only when its possession is taken
over or a payment is made.

Separate entity: This concept says the although the owner of a business and the business are
considered as one entity in the eyes of the law, for accounting purposes we will consider the business
and the owner as two separate entities. This means that the transactions of the business and the
personal transactions of the owner will be treated separately. The books of the business will only
contain transactions related to the business. Any personal payments will be treated as a drawing of the
owner. The purpose of this concept is to distinguish the expense and performance of the business.

Money measurement concept: The money measurement concept says that only items with a monetary
value will be recorded in the accounts of the business. Items which cannot be given a monetary value
will not be recorded in the accounts of a business. Example of this is non-purchased goodwill. Since the
value of this kind of goodwill cannot be ascertained it cannot be recorded in the books. More examples
would include skilled labor, staff morale and customer loyalty.

Dual aspect: The dual aspect concept forms the basis of the double entry accounting system. This
concept says that every transaction will have two affects, one debit and one credit, by the same
amount. All journal entries have two affects because of this concept.

Consistency: The consistency concept says that the accounting policies used in the accounts of a
business will not be changed from one year to another. This means that if the straight line method of
depreciation is used to depreciate an asset, then the same method will be used every year. This ensures
comparability between the financial statements of different years as the same policies are used. If
policies cud be freely amended the credibility of financial statements would be compromised as they
would be altered to increase or decrease profit.

The exception to this rule is that a business can change the accounting policy if the new policy
gives a true and fair and more realistic view to the accounts. For example if it is more realistic to
depreciate equipment on the revaluation method then the change in method can be allowed but then
the effect of this policy will have to be adjusted retrospectively.

Objectivity: The objectivity concept states that the financial information reported in the accounts of
a business is reported in a neutral way and free from bias of any kind. The information is not reported
for any stakeholder’s advantage.

Substance over form: This concept states that accountants prefer the physical substance of a
transaction over the legal form. This means that the practicality of the situation will be accepted over a
strictly legal approach. For example, an asset leased by a company is not legally theirs but the
practicality of the situation is that the asset belongs to the company. This is why it will be recorded as an
asset purchased by the business.