Accounting theory and standard

Discuss the basic accounting concepts and conventions.

Accounting principles are men-made. These principles are drawn from practical
practice of accounting. According to the terminology committee of AICPA (American
Institute of Cost and Professional Accountants), the word principles is used to mean a
general law or rule adopted or preferred as a guide to action; a settled ground or basis of
conduct or practice.
Accounting principles are classified into two categories:
1. Accounting Concepts; and
2. Accounting Conventions.

ACCOUNTING CONCEPTS
The term concept is used to connote basic accounting postulates, i.e. necessary
assumptions and conditions upon which the science of accounting is based. It refers to
accounting propositions under which accounting works. Postulates are the basic
assumptions on which principles rest. They are derived from the economic and political
environment and the modes of thought and customs of all segments of the business
community.
Though many accounting concepts are used but there is a general agreement on the
following concepts.
1. Business Entity Concept
2. Going Concern Concept
3. Cost Concept
4. Dual Aspect Concept
5. Money Measurement Concept
6. Accounting Period Concept
7. Realisation Concept
8. Matching Concept
9. Accrual Concept
10.

Objective Evidence Concept

1

BUSINESS ENTITY CONCEPT

According to this concept, business should be treated as a separate entity from its
owners. Accounts should be prepared to give information about the business and not about
those who own it. A distinction is made between the business transactions and personal
transactions. The accountant should record transactions relating to business only. The
private transactions of the owner will be recorded separately and will have no bearing on
the business transactions. However, the private transactions of the owner which are related
to the business will be recorded because they become business transactions. These
transactions can be introducing capital, drawing of money or goods for personal use,
payment of personal taxes from the business, etc.
The accounting equation i.e. Assets + Liabilities = Capital is an expression of the
entity concept because it shows that the business itself owes the assets and in turn owes to
the various claimants

GOING CONCERN CONCEPT

It is presumed that the concern will continue to exist for an indefinite period of time.
A business unit is deemed to be a going concern and not a gone concern. The present
resources of the concern are utilised to attain the objectives of the business. This concept
is very important in relation to the preparation of financial statement. While preparing final
accounts of a concern, fixed assets are shown in the balance sheet at a going concern
value and not at their market value. Basing on this concept the accountant shows prepaid
expenses as an asset even though they may be virtually unsaleable.
If this concept is not followed then the business will hamper as the supplier will not
supply goods and services and other persons will not have business dealings with the
business entity if they have the feeling that the concern will be liquidated.

COST CONCEPT
According to this concept, an asset should be recorded in the books of accounts at
the price paid to acquire it and that this cost is the basis for all subsequent accounting of
the asset. For example, if a piece of land is purchased for Rs.50000, this amount will be
recorded as cost of land even though another person was willing to pay Rs.80000 for the
2

same piece of land. This concept doesnt mean that the asset will always be shown at cost,
but it means that cost becomes basis for all future accounting for the asset. Asset is
recorded at cost at the time of its purchase but is systematically reduced by charging
depreciation.

DUAL ASPECT CONCEPT

This concept lies at the heart of the whole accounting system. Modern accounting
system is based on dual aspect concept. It is based on the principle that for every debit
transaction, there is a corresponding credit transaction. There must be a giver of benefit
and also a taker of it. The debit will be equal to credit. The dual aspect concept has created
the system of double entry book keeping. The resources owned by the business are known
as assets and claims of various parties are known as equities.

MONEY MEASUREMENT CONCEPT

According to this concept, only those transactions are recorded which can be
expressed in terms of money. Money provides a mechanism by which real resources can be
transferred among different individuals. The advantage of expressing business transactions
in terms of money is that money serves a common denominator by means of which
heterogeneous facts about a business can be expressed in terms of number which are
capable of additions and subtractions. In other words, money measurement system
provides a yardstick against which different forms of wealth can be measured.
However, there are two limitations of money measurement concept:
a) This concept ignores the qualitative aspect of things.
b) The impacts of inflationary changes are not adjustable in this principle.

ACCOUNTING PERIOD CONCEPT

According to the going concern concept, the business will run for an indefinite period
of time. For practical purposes, financial position and profitability of a concern should be
assessed at regular intervals. So the entire life of the concern is divided into small and
identical parts. Each part is called as an accounting period. Normally accounting period

adopted is one year as it helps to take any corrective action, to pay income tax, to absorb
the seasonal fluctuations and for reporting to the outsiders.

REALISATION CONCEPT
According to this concept, revenue is considered to earn on the date at which it is
realised i.e. on the date when the property in goods passes to the buyer and he becomes
legally liable to pay. This can be illustrated with the help of an example. A customer at
Ranchi places an order with a manufacturer at Delhi on 1 st January. On receipt of the
order, the manufacturer manufactures goods and delivers goods to the customer on 1 st
February who makes payment on 1st March after enjoying the credit period of one month.
In this case, revenue was not realised on 1 st January (when the order was received) not on
1st March (when payment was received from customer) but on 1 st February when the goods
were delivered to the customer.
There are two exceptions to this principle. First exception is related to the contracts
taking a number of years for completing and second exception is when goods are sold at
hire-purchase basis.

MATCHING CONCEPT
According to this concept, the costs of the concern are matched to its revenues in
order to know the profit or loss of a concern for a particular period. A correct statement of
income requires a distinction between present, past and future expenditure. The distinction
between capital and revenue expenditure is also necessary. The revenue and cost of the
same period are matched. When an income of a particular accounting period is taken into
profit and loss account then all expenses of that period whether paid or not is also debited
to profit and loss account. Similarly, if expenditure is paid for a future period and not the
period in which it had been paid then such expenditure should be not shown in the profit
and loss account. The expenditures whose utility is derived over a number of years are
taken to balance sheet as deferred expenditure. Capital expenditure becomes a part of cost
over a number of years i.e. through depreciation.

ACCRUAL CONCEPT
4

It is based on realization concept.

According to realization concept, revenue is

recognized when it is realized i.e. when sale is complete or services are given and it is
immaterial when the cash is received or not. Similarly, to ascertain correct profit or loss or
an accounting period, expenses are recognized in the accounting period in which the help
in earring the revenue whether cash is paid or not. Thus, to ascertain correct profit or loss
for an accounting period and to show the true and fair financial position of the business at
the end of the accounting period, will make a record of all expenses and income relating to
the accounting period whether actual cash has been paid or received or not. Outstanding
expenses, prepaid expenses, accrual income, income received in advance are the outcome
of the accrual concept.

OBJECTIVE EVIDENCE CONCEPT

According to this concept entries in accounting records and data reported in
financial statements must be based on objectively determined evidence. As far as possible,
every entry in accounting records should be supported by some objective evidence but
estimation of future possible losses for creating provisions on reserve should be made
basing on objective factors such as past experience and reliable forecast of future business
activities.

ACCOUNTING CONVENTIONS
The term conventions denote circumstances or predictions which guide accountant
while preparing the accounting statements. Certain accounting conventions are followed
by the accountants while preparing financial records.

These conventions are not only

useful to the business but also to those who want to deal with the business. Some of the
conventions are1. Conventions of Conservatism.
2. Convention of Full disclosure.
3. Convention of Consistency.
4. Convention of Materiality.

Convention of Conservatism

Conservatism means taking the gloomy view of a situation. The working rule of this
convention is anticipate no-profits but provide for all possible losses. It means that if
there is a possibility of loss it should be taken into account at the earliest on the other
hand the prospect of profit should be ignored up to the time it doesnt materialize.
Whenever there is a choice before the accountant, he should use it for the lower side.
Conservatism should not mean understanding or earning or assets.

Both

overstatement and understatement of earning an asset is bad. Understatement of one year

will mean overstatement in subsequent year.

For example- If the closing stock is

understated, it will reduce the profit of that year. The closing stock of that year will become
opening stock of next year and it will increase the profit because trading account will be
debited with a lower amount so there should be a cautious approach in using conservatism
too.

This attitude is generally defended by saying that earning in the direction of

conservatism as less severe implication than earning in the direction of overstating of net
income.

Convention of Full Disclosure

According to this convention an accountant should disclose all significant
information in the financial statements prepared by him.

All information which is of

material interest to proprietors, creditors and investors should be disclosed in accounting

statements. In simple words the accounting statements prepared by the accountant should
be reliable and informative and circumstances permit.
The Indian Companies Act contains many provisions which make it obligatory on the
part of companies to disclose full financial facts. The profit and loss account and balance
sheet are prepared according to Proforma given by the company law. This is done to make
discloser of all material facts compulsory.

Convention of Consistency
The convention of consistency means the same accounting principles should be used
for preparing financial statements for different periods. It enables the management to draw
important conclusions regarding the working of the concern over a longer period. It allows
a comparison in the performance of different periods. It doesnt mean that there should be
no change in accounting provisions. There should all be a scope for improvement but the
changes should be notified in the statements.
6

Consistency may be of three types

(a) Vertical
(b) Horizontal
(c) Dimensional

Vertical consistency maintained within inter-related financial statements of the same

period. If a change had been made in dealing of two aspects of the same statements then it
is vertical inconsistency. For example if one method of depreciation is used while preparing
profit and loss accounting and another method is fallowed while preparing the balance e
sheet, it will be the case of vertical inconsistency. When the figure of one financial year is
compared to the figure of another financial year of the same organisation it will be a case of
horizontal consistency.

Dimensional consistency will arise when financial statements of

two different organizations, in the same industry are compared.

Convention of Materiality
According to this convention, only those events should be recoded which have a
significant bearing and insignificant things should be ignored.

The avoidance of

insignificant things will not materially affect the records of the business. It should be seen
that the3 effort involved in recording the event should be worth the labour involved in it.
There is no formula in making distinctions between material and immaterial events. It is a
matter of judgment and it is left to the accountants to take a decision.