These are underlying concepts and conventions which an accountant has to have in the back of his mind while doing the accounting work. These concepts and conventions are universally followed and understood .
There are 9 concepts and 3 conventions.
1. Separate Business Entity Concept : In this concept Business & the Owner have separate legal status according to accounting point of view. The proprietor is considered as a creditor only to the extent of capital brought in business by him.
The amount of capital invested in business by the owner will be shown as a ‘liability’
in the books of accounts of business and can be claimed by him against the business for capital brought in by him. In case of limited company, this distinction can be easily made as the company has a legal entity of its own. Like a natural person it can engage itself in economic activities of buying, selling, producing, lending, borrowing and consuming of goods & services. However, it is difficult to show this distinction in the case of sole proprietorship and partnership. It may be noted that it is only for the accounting purpose that partnership & sole proprietorship are treated as separate from the owner(s), though law does not make such distinction. Infact, the business entity concept is applied to make it possible for the owners to assess the performance of their business and of managers those who are responsible for the proper use of fund supplied by owners, banks & others.
2. Money Measurement Concept : Accounting records only those transactions which are expressed in monetary terms. This concept imposes two limitations. Firstly, there are several facts which though very important to the business and exert a great influence on the productivity and profitability of the enterprise, cannot be recorded in the books of accounts because they cannot be expressed in terms of money like quality of products, efficiency of the employees, death of the manager, etc. These are significant events, but non-financial transactions. Secondly, use of money implies that we assume stable or constant value of rupee. Taking this assumption means that the changes in the money value in future dates are conveniently ignored. For eg. A piece of land purchased in 1990 for Rs. 2 lakh and another bought for the same amount in 1998 are recorded at same price, although the first purchased in 1990 may be worth 2 times higher than the value recorded in the books because of rise in land values.
3. Dual Aspect Concept : In this concept every transaction has dual (two) effects – debit and credit. Because of such effect, the net profit will increase or decrease. In sale of goods for cash there are two aspects, one is delivery of goods and other is immediate receipt of cash. The ‘double entry’ book keeping has come into vogue because for every transaction there is two effect and the total amount debited is always equal to total the amount credited. It follows from ‘dual aspect concept’ that any point in time owners’ equity and liabilitiesfor an accounting entity will be equal to assets owned by that entity. This could be expressed as the following equalities:
Assets = Liabilities + Owners Equity …………(1)
Owners Equity = Assets – Liabilities ………...(2)
The above relation is known as the ‘Accounting Equation’. The term ‘Owners Equity’ denotes the resources supplied by the owners of the entity and the term ‘liabilities’denotes the claim of outside parties such as creditors, debenture-holders, bank against the assets of the business.
4. Going Concern Concept : According to this concept, it is assumed that the business will continue to operate for a long time in the future i.e. it has a perpetual existence and the accountant, while valuing the assets do not take into account forced sale value of them. The enterprise is viewed as a going concern, i.e., as continuing in operations atleast in foreseeable future . In other words, there is neither the intention nor the necessity to liquidate the particular business venture in the predictable future. Because of this assumption, the accountant while valuing the assets do not take into account forced sale value of them. Infact , the assumption that the business is not expected to be liquidated in the foreseeable future establishes the basis for many of the valuations and allocations in accounts. For example, the accountant charges depreciation of fixed assets value. It is this assumption which underlies the decision of investors to commit capital to enterprise. If the accountant has good reasons to believe that the business, or some part of it is going to be liquidated or that it will cease to operate then the resources could be reported at their current values.
5. Accounting Period Concept : In this concept of accounting, generally, a period of 12 months is selected to find out profit or loss of the business and the financial position of the company. Sometimes, we publish the report on quarterly basis. Therefore, this concept means, period for which financial statement is prepared. This period is also known as ‘determining period’.
6. Cost Concept : In this concept, transactions are entered in the books of accounts at the amounts actually involved. Fixed Assets are recorded at ‘Historical Cost’. Historical cost is the price paid to acquire that particular asset. For eg. If a business buys a plant for Rs.5 lakh the asset would be recorded in the books at Rs.5 lakh, even if its market value at that time happens to be Rs.6 lakh. Thus, assets are recorded at their original purchase price. This concept doesn’t mean that all assets remain on the accounting records at their original cost for all times to come. The assets may systematically be reduced in its value by charging ‘depreciation’. The prime purpose of depreciation is to allocate the cost of an asset over its useful life and to adjust its cost. However, a balance sheet based on this concept can be very misleading as it shows assets at cost even when there are wide difference between their costs and market values. Despite this limitation you will find that the cost concept meets all the three basic norms of relevance, objectivity and feasibility.
7. The Matching Concept : This concept is based on the Accounting Period Concept. In this concept, cost & revenue must be related to the events arising in the same financial year. Revenue earned during the period is compared with the expenditure incurred for earning that revenue. Revenue is the total amount realized from the sale of goods or provision of services together with earnings interest, dividend and other items of income
8. Accrual Concept : This concept makes a distinction between the receipt of cash and the right to receive it, and the payment of cash and the legal obligation to pay it. This concept provides a guideline to the accountant as to how he should treat the cash receipts and the right related thereto
9. Realisation Concept : This concept is technically understood as the process of converting non cash resources and rights into money whereas according to the accounting principle, it is used to identify precisely the amount of revenue to be recognized & the amount of expense to be matched to such revenue for the purpose of income measurement. According to this concept revenue is recognized when sale is made i.e. at the point when the property in goods passes to the buyer & he becomes legally liable pay. However, in case of construction contracts revenue is often recognized on the basis of a proportionate or partial completion method. Similarly in case of long run installment sales contracts, revenue is regarded as realized only in proportion to the actual cash collection.
The conventions are some of the methods followed over a period of time and has been accepted universally as customs.
- Convention of Materiality : This convention states that items of small significance need to be given strict theoretically correct treatment. The cost of recording and showing in financial statement events in business which are insignificant in nature may not be well justified by the utility derived from that information. For eg. An ordinary calculator costing Rs.100 may last for ten years. However, the effort involved in its cost over the ten year period is not worth the benefit that can be derived from this operation. When a statement of outstanding debtors is prepared for sending to top management, figures may be rounded to the nearest ten or hundred. This convention will unnecessarily over burden an accountant with mare details in case he is unable to find an objective distinction between material and immaterial evens. It should be noted that an item material to one party may be immaterial for another. Another example – After auditing, printing and circulating of the accounts to the share holders it is observed that a bill of printing and stationery amounting to Rs.100/- remained to be accounted in that relevant year, in such case if Rs.100/- is not material as compared to the profit or sales of the company than based on the convention of materiality the expense can be booked in next year and the account of last year need not be re-audited, printed and circulated, since it wont materially affect the accounts. Though this is against the concept of matching, periodicity and accrual, but this convention prevails over the concepts.
- Convention of Conservatism : This convention requires that the accountants must follow the policy of “Playing safe” while recording business transactions and events. That is why, the accountants follow the rule anticipate no profit but provide for all possible losses, while recording the business events. This rule means that an accountant should record lowest possible value for assets and revenues, and the highest possible value for liabilities & expenses. According to this concept revenues or gains should be recognized only when they are realized in form of cash or assets. Eg. Closing Stock is valued at cost or market price whichever is less. Or we make provisions for Doubtful debts in our books, these are examples of convention of conservatism..Though these are at times against the concept – of Realisation or Cost. Hence conventions at times supersedes the concepts.
- Convention of Consistency : This convention requires that once a firm decided on certain accounting policies & methods & has used these for some time it should continue to follow the same methods or procedures for all subsequent similar events & transactions unless it has a sound reason to do otherwise. Accounting practices should remain unchanged from one period to another. For eg: If depreciation is charged on fixed assets according to SLM this method should be followed year after year.