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All About Accounting Concepts and Conventions With Examples

Updated on : Jun 9th, 2024

Accounting is an important part of a business, providing an organised and systematic way to record the financials. However, to implement the accounting processes efficiently, it is important to follow certain principles pointed out in the form of accounting concepts and conventions. If you follow the accounting concepts and principles accurately , it will help you make informed business decisions to grow your company.

In this article, we will dive deeper into the details of accounting concepts and conventions, along with their types, examples and differences.

What are Accounting Concepts?

The accounting concept is a process that helps prepare and record the financial transactions in an organisation, along with organising the bookkeeping processes. When you implement accounting concepts effectively, it encourages businesses to integrate and interpret financial transactions into meaningful accounting processes.

It is always important for business accountants and owners to clearly understand the basic accounting concepts. Such understanding helps in integrating uniformity and consistency within the business accounting processes.

Both accounting concepts and principles are important to implement within the organisation as they help analyse different financial rules, theories and situations and make financial decisions based on them.

Importance of Accounting Concepts

You can understand the aspects of accounting concepts clearly once you understand why knowing and implementing accounting concepts is important for you, which are as follows:

Consistency and comparability

Accounting principles are important because they provide uniformity and comparability in financial reporting. For example, the going concern notion believes that a firm will continue to exist indefinitely. This assumption enables financial statements to be prepared with a long-term perspective, allowing for meaningful comparisons over numerous accounting periods.

Risk management

The prudence concept promotes a cautious approach to financial reporting. This approach aids firms in risk management by recognising possible losses immediately but only recognising rewards when they are realised. Setting up provisions for possible bad debts based on past trends, for example, demonstrates a responsible approach to risk management.

Support in decision-making

Accounting principles give organisations a standardised framework for keeping track of financial transactions, allowing them to produce accurate information quickly. A more accurate depiction of a company's financial situation is provided by the accrual concept, which recognises revenues and costs as they are generated or spent. Because accurate financial reporting gives stakeholders a comprehensive picture of a company's profitability and financial health, it facilitates effective decision-making.

Credibility

Applying accounting principles strengthens financial statements' legitimacy and fosters stakeholder trust. By matching revenues with their associated expenditures, the matching concept keeps profits from being manipulated by ensuring that income aligns with the spending required to produce it. This fosters trust among creditors, investors, and other stakeholders who depend on financial statements to evaluate its health and sustainability.

Types of Accounting Concepts

Here is a list of different types of accounting concepts that you can implement in your business as per the requirements and situations of the company:

1. Going concern concept

According to the going concern concept, a firm will continue to operate indefinitely. This assumption has an impact on financial statement preparation, allowing accountants to portray long-term assets at their historical cost and giving stakeholders a more realistic picture of a company's financial health in the long run.

2. Business entity concept

In terms of the business entity concept, a business is a distinct economic entity from its owners. This notion guarantees that personal and corporate money are kept separate, allowing for transparent financial reporting. It facilitates measuring the success of the firm independent of its owners' financial actions, fostering openness and accountability.

3. Accrual concept

The accrual concept mandates that revenues and costs be recognised as they are received or spent, regardless of financial movements. This idea improves financial statement accuracy by matching them with the economic content of transactions and giving stakeholders a more complete knowledge of a company's financial status.

4. Money measurement concept

According to the money measurement concept, only monetary transactions should be documented in accounting. This approach makes quantification and comparison easier, ensuring that financial statements contain relevant and comparable information for decision-making.

5. Accounting period concept

The accounting period concept separates a company's economic existence into discrete periods, often a fiscal year, for financial reporting. This approach enables timely and consistent reporting, assisting stakeholders to evaluate a company's performance and make educated decisions at precise intervals.

6. Dual aspect concept

According to the dual aspect concept, every financial transaction includes two components: a debit and a credit. This double-entry technique keeps the accounting equation (Assets = Liabilities + Equity) balanced, allowing for a systematic approach to documenting and assessing financial transactions.

7. Revenue realisation concept

As to the income realisation concept, income should be recognised when it is earned, regardless of when payment is received. This notion prevents revenue from being recognised prematurely, aligning financial statements with the actual delivery of products or services and improving the trustworthiness of reported revenues.

8. Historical cost concept

The historical cost concept assesses assets at their original cost, giving financial reporting a solid and objective foundation. This notion improves dependability by minimising subjective values and guaranteeing that financial statements accurately represent asset purchase costs.

Examples of Accounting Concepts In Practice

To understand the above-discussed types of accounting concepts, you need to have a practical understanding so as to implement the same. Here are some examples of each accounting concept you read above.

Going concern concept

In the case of this concept, when valuing its machinery and equipment on the balance sheet, a manufacturing firm expects it will be used for a lengthy period of time, indicating the notion that the business would continue operations indefinitely.

Business entity concept

If the proprietor of a small firm buys a personal laptop, the firm entity concept guarantees that this personal spending is not reported in the company's financial records, preserving a clear boundary between personal and business operations.

Accrual concept

The accrual concept is used by a consulting business that provides services, for example, in December but receives payment in January. The revenue is recognised in December when the service is delivered, regardless of the actual cash received.

Money measurement concept

When a corporation registers the acquisition of a new piece of machinery in monetary terms, it ensures that only transactions with quantifiable monetary worth are included in the financial statements.

Accounting period concept

A corporation that prepares quarterly financial statements follows the accounting period concept by disclosing its financial performance and position every three months, giving stakeholders timely insights into the company's growth.

Dual aspect concept

When a company borrows money from a bank, the dual aspect concept guarantees that both the liability (the loan) and the matching asset (cash) are recorded, keeping the basic accounting equation balanced.

Revenue realisation concept

A software firm recognises revenue if a consumer purchases a software licence, regardless of when the payment is made. This use of the revenue realisation concept corresponds to completing the revenue-generating process.

Historical cost concept

If a corporation buys a building, the historical cost concept requires the asset to be recorded at its original purchase price, giving a solid and objective foundation for the value of the financial statement.

What are Accounting Conventions?

Accounting conventions , also known as doctrine, are known to be principles that act as restrictions regarding organisational transactions that are unclear or complicated . Even though accounting conventions do not act as legally binding, these are considered generally accepted principles helping to maintain consistency within the financial statements of a company.

The standard financial reporting system processes the information and uses accounting conventions to compare the different aspects of the transaction, along with analysing its relevance, application and full disclosure in the financial statements. The accountants in a company adopt the use of these conventions so that they act as a guide while preparing accounting statements and reports.

Importance of Accounting Conventions

To have a clear understanding of what accounting conventions are, it is necessary for you to understand their importance. Let us check below to get a clear idea of the importance of accounting conventions in a business:

Different entity

Accounting norms are critical in dealing with various entities in the financial environment. These conventions guarantee that companies, regardless of their type of business, adopt standardised practices for documenting financial transactions by setting consistent criteria. This consistency is critical for establishing a level playing field, facilitating fair comparisons across companies, and developing a thorough knowledge of financial statements among stakeholders.

Understanding

Accounting conventions provide financial experts and stakeholders with a unified language. They provide a common knowledge of how financial data is recorded and reported, which allows a correct interpretation. This understanding is critical for decision-making because it enables users to analyse financial information and make educated decisions based on a set of standardised rules.

Impact on money

One of the paramount aspects of accounting conventions is their direct impact on representing monetary values in financial statements. These conventions provide a controlled and standardised method of measuring and documenting financial transactions, assuring the accuracy and precision with which an entity's monetary situation is reflected.

The foundation of financial reporting is reliability, and accounting conventions play a critical role in maintaining this vital quality. Financial statements correctly reflect the financial status and performance of a business when standards are used consistently. To make wise decisions, stakeholders—including creditors and investors—depend on the accuracy of financial data.

Comparing various entities in a meaningful way is made possible by uniform accounting rules. This comparability is essential for investors, analysts, and other stakeholders looking to assess the financial standing and performance of different companies. It makes benchmarking easier and helps spot market trends, which leads to better decision-making.

Types of Accounting Conventions

Similar to accounting concepts, accounting conventions also have different types that help implement the concept in business financials efficiently. Here is a list showcasing the types of accounting conventions:

1. Convention of conservatism

One of the most important accounting conventions that accountants apply in the business is the conservatism principle. This principle suggests that if two values are associated with a specific transaction, the lowest must be recorded on the asset or income side of the financial statement. In this case, the possibility of loss is taken care of.

This accounting convention aims to understate profits and assets while dealing with business losses. Such practice mostly helps in enhancing the overall reliability of company stakeholders on the financial statements.

2. Convention of materiality

This accounting convention is related to all the relative information available for an item or event of a company's financial transactions. An item is generally considered material with respect to the influence it has on an investor's decisions. The aspect of materiality differs from one organisation to another.

For instance, in the case of a small company, certain information can be material but the same information may not be material for a large organisation. Hence, the application of materiality convention entirely depends on the context of analysis.

3. Convention of consistency

Consistency convention denotes that the same principles of accounting must be implemented to prepare the business financial statements, year after year. From the prepared financial statements, it is important to draw a meaningful conclusion of the same company when a comparison is made of the statements over a period.

Such financial comparisons can only be made if the same accounting practices and principles are followed uniformly by the firm over a period of time. In the case of different accounting policies implemented every year, the comparison will not stand fruitful, and the result can also impact financial decisions.

4. Convention of full disclosure

The principle of full disclosure mandates the comprehensive revelation of all pertinent details in financial statements. This entails a thorough, impartial, and ample disclosure of accounting information.

‘Adequate’ denotes a satisfactory amount of information to be divulged, ‘fair’ implies equitable treatment for users, and ‘full’ demands a complete and detailed presentation. Consequently, the convention underscores the necessity for financial statements to fully disclose all pertinent information.

Examples of Accounting Conventions In Practice

Once you have understood what the different types of accounting conventions are, it is essential to have a deep knowledge of the same in the form of an example. Let us check below the examples of each accounting convention that we have discussed in the above section.

Conservatism

Suppose in December 2022, Raj agrees to purchase a car from Mohan Motors Inc., which will be delivered to him in January 2023. From the point of view of Mohan Motors Inc., it stands as good news. But, it is possible that in future due to certain unforeseen circumstances, the deal gets broken.

Hence, according to the convention of conservatism, the revenue earned from the sale of the car is not recognised in the books until the actual delivery of the same happens.

Materiality

Let us take into account that a large organisation has incurred a loss of Rs.150,000 due to a certain customer. The net worth of the business is around Rs.300,000,000. Hence, the loss of 0.05% can be considered immaterial for the business.

However, if a small organisation with a net worth of Rs.250,000, a loss of Rs.150,000 will be considered as a loss of material information. Therefore, the situation and context define the application of materiality for both businesses.

Consistency

An organisation must use the same depreciation calculating method for all their fixed assets for all financial years. This helps maintain consistency in the results of depreciation over time.

Full Disclosure

For a business, disclosure of information, such as encumbered assets tends to be a full disclosure. Another example of full disclosure of information by a business is letting the stakeholders know the reason for changing the application of accounting principles or methods.

Key Differences Between Accounting Concepts And Conventions

Now that you are clear about what accounting concepts and conventions are regarding a business financial perspective let us look below to understand the difference between the two:


Meaning	The accounting concept is known to be a process that helps prepare and record the financial transactions in an organisation, along with organising the bookkeeping processes.	Accounting conventions are known to be such principles that act as restrictions regarding organisational transactions that are unclear or complicated.
Based On	It is based on reason, logic and evidence.	Conventions are based on custom, tradition and judgement.
Consistency	Remains consistent as well as stable over a period of time.	May change throughout the period, for instance, if changes in accounting regulations and standards happen.
Applicability	The accounting concept applies to all entities.	Applicability of accounting conventions may change as a power region or country.
Disclosure	Has to be disclosed in the company’s financial statements.	It may be disclosed in the financial statements of a firm to make it easy to compare and understand.

Analysing the aspects of accounting concepts and conventions is important for accountants of businesses. Different business, as well as financial decisions, depend on the application of these two aspects. Even though both are different from one another, their implementation in financial statement preparation is necessary for the betterment of the business.

Hence, by reading the points, you can get a distinctive idea of what they are and how they can be applied in your business to achieve success.

Frequently Asked Questions

The accounting concept is known to be a process that helps in preparing and recording the financial transactions in an organisation, along with organising the bookkeeping processes. On the other hand, accounting conventions are known to be such principles that act as restrictions regarding organisational transactions that are unclear or complicated.

Some of the key concepts of accounting are:

Accounting cost concept
Matching concept

Some key conventions of accounting are:

Full disclosure
Materiality

There are 4 accounting conventions that you can implement in your business. They are:

Conservatism or prudence

The matching accounting concept denotes the expenses and revenues incurred in a business to earn revenue, which must belong to the same accounting or financial year. Once your business revenue is realised, you need to assign them in their relevant accounting year.

The accounting period concept separates a company's economic existence into discrete periods, often a fiscal year, for financial reporting. This approach enables timely and consistent reporting, assisting stakeholders in evaluating a company's performance. Therefore, it helps in making educated decisions at precise time intervals.

As per the cost concept, assets should be documented at their historical cost, which is the sum paid to acquire them. This method ensures objective and verifiable valuation, which improves the credibility of financial statements by removing subjective asset valuation estimates.

The accrual concept mandates that revenues and costs be recognised as they are received or spent, regardless of financial movements. This idea improves financial statement accuracy by matching them with the economic content of transactions. Therefore, this gives stakeholders a more complete knowledge of a company's financial status.

There are almost 15 accounting concepts available in accounting.

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3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

If you want to start your own business, you need to maintain detailed and accurate records of business performance in order for you, your investors, and your lenders, to make informed decisions about the future of your company. Financial statements are created with this purpose in mind. A set of financial statements includes the income statement, statement of owner’s equity, balance sheet, and statement of cash flows. These statements are discussed in detail in Introduction to Financial Statements . This chapter explains the relationship between financial statements and several steps in the accounting process. We go into much more detail in The Adjustment Process and Completing the Accounting Cycle .

Accounting Principles, Assumptions, and Concepts

In Introduction to Financial Statements , you learned that the Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial accounting and reporting, including generally accepted accounting principles (GAAP) , for both public- and private-sector businesses in the United States.

As you may also recall, GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements. If US accounting rules are followed, the accounting rules are called US GAAP. International accounting rules are called International Financial Reporting Standards (IFRS) . Publicly traded companies (those that offer their shares for sale on exchanges in the United States) have the reporting of their financial operations regulated by the Securities and Exchange Commission (SEC) .

You also learned that the SEC is an independent federal agency that is charged with protecting the interests of investors, regulating stock markets, and ensuring companies adhere to GAAP requirements. By having proper accounting standards such as US GAAP or IFRS, information presented publicly is considered comparable and reliable. As a result, financial statement users are more informed when making decisions. The SEC not only enforces the accounting rules but also delegates the process of setting standards for US GAAP to the FASB.

Some companies that operate on a global scale may be able to report their financial statements using IFRS. The SEC regulates the financial reporting of companies selling their shares in the United States, whether US GAAP or IFRS are used. The basics of accounting discussed in this chapter are the same under either set of guidelines.

Ethical Considerations

Auditing of publicly traded companies.

When a publicly traded company in the United States issues its financial statements, the financial statements have been audited by a Public Company Accounting Oversight Board (PCAOB) approved auditor. The PCAOB is the organization that sets the auditing standards, after approval by the SEC. It is important to remember that auditing is not the same as accounting. The role of the Auditor is to examine and provide assurance that financial statements are reasonably stated under the rules of appropriate accounting principles. The auditor conducts the audit under a set of standards known as Generally Accepted Auditing Standards. The accounting department of a company and its auditors are employees of two different companies. The auditors of a company are required to be employed by a different company so that there is independence.

The nonprofit Center for Audit Quality explains auditor independence: “Auditors’ independence from company management is essential for a successful audit because it enables them to approach the audit with the necessary professional skepticism.” 1 The center goes on to identify a key practice to protect independence by which an external auditor reports not to a company’s management, which could make it more difficult to maintain independence, but to a company’s audit committee. The audit committee oversees the auditors’ work and monitors disagreements between management and the auditor about financial reporting. Internal auditors of a company are not the auditors that provide an opinion on the financial statements of a company. According to the Center for Audit Quality, “By law, public companies’ annual financial statements are audited each year by independent auditors—accountants who examine the data for conformity with U.S. Generally Accepted Accounting Principles (GAAP).” 2 The opinion from the independent auditors regarding a publicly traded company is filed for public inspection, along with the financial statements of the publicly traded company.

The Conceptual Framework

The FASB uses a conceptual framework , which is a set of concepts that guide financial reporting. These concepts can help ensure information is comparable and reliable to stakeholders. Guidance may be given on how to report transactions, measurement requirements, and application on financial statements, among other things. 3

IFRS Connection

Gaap, ifrs, and the conceptual framework.

The procedural part of accounting—recording transactions right through to creating financial statements—is a universal process. Businesses all around the world carry out this process as part of their normal operations. In carrying out these steps, the timing and rate at which transactions are recorded and subsequently reported in the financial statements are determined by the accepted accounting principles used by the company.

As you learned in Role of Accounting in Society , US-based companies will apply US GAAP as created by the FASB, and most international companies will apply IFRS as created by the International Accounting Standards Board (IASB). As illustrated in this chapter, the starting point for either FASB or IASB in creating accounting standards, or principles, is the conceptual framework. Both FASB and IASB cover the same topics in their frameworks, and the two frameworks are similar. The conceptual framework helps in the standard-setting process by creating the foundation on which those standards should be based. It can also help companies figure out how to record transactions for which there may not currently be an applicable standard. Though there are many similarities between the conceptual framework under US GAAP and IFRS, these similar foundations result in different standards and/or different interpretations.

Once an accounting standard has been written for US GAAP, the FASB often offers clarification on how the standard should be applied. Businesses frequently ask for guidance for their particular industry. When the FASB creates accounting standards and any subsequent clarifications or guidance, it only has to consider the effects of those standards, clarifications, or guidance on US-based companies. This means that FASB has only one major legal system and government to consider. When offering interpretations or other guidance on application of standards, the FASB can utilize knowledge of the US-based legal and taxation systems to help guide their points of clarification and can even create interpretations for specific industries. This means that interpretation and guidance on US GAAP standards can often contain specific details and guidelines in order to help align the accounting process with legal matters and tax laws.

In applying their conceptual framework to create standards, the IASB must consider that their standards are being used in 120 or more different countries, each with its own legal and judicial systems. Therefore, it is much more difficult for the IASB to provide as much detailed guidance once the standard has been written, because what might work in one country from a taxation or legal standpoint might not be appropriate in a different country. This means that IFRS interpretations and guidance have fewer detailed components for specific industries as compared to US GAAP guidance.

The conceptual framework sets the basis for accounting standards set by rule-making bodies that govern how the financial statements are prepared. Here are a few of the principles, assumptions, and concepts that provide guidance in developing GAAP.

Revenue Recognition Principle

The revenue recognition principle directs a company to recognize revenue in the period in which it is earned; revenue is not considered earned until a product or service has been provided. This means the period of time in which you performed the service or gave the customer the product is the period in which revenue is recognized.

There also does not have to be a correlation between when cash is collected and when revenue is recognized. A customer may not pay for the service on the day it was provided. Even though the customer has not yet paid cash, there is a reasonable expectation that the customer will pay in the future. Since the company has provided the service, it would recognize the revenue as earned, even though cash has yet to be collected.

For example, Lynn Sanders owns a small printing company, Printing Plus. She completed a print job for a customer on August 10. The customer did not pay cash for the service at that time and was billed for the service, paying at a later date. When should Lynn recognize the revenue, on August 10 or at the later payment date? Lynn should record revenue as earned on August 10. She provided the service to the customer, and there is a reasonable expectation that the customer will pay at the later date.

Expense Recognition (Matching) Principle

The expense recognition principle (also referred to as the matching principle ) states that we must match expenses with associated revenues in the period in which the revenues were earned. A mismatch in expenses and revenues could be an understated net income in one period with an overstated net income in another period. There would be no reliability in statements if expenses were recorded separately from the revenues generated.

For example, if Lynn earned printing revenue in April, then any associated expenses to the revenue generation (such as paying an employee) should be recorded on the same income statement. The employee worked for Lynn in April, helping her earn revenue in April, so Lynn must match the expense with the revenue by showing both on the April income statement.

Cost Principle

The cost principle , also known as the historical cost principle , states that virtually everything the company owns or controls ( assets ) must be recorded at its value at the date of acquisition. For most assets, this value is easy to determine as it is the price agreed to when buying the asset from the vendor. There are some exceptions to this rule, but always apply the cost principle unless FASB has specifically stated that a different valuation method should be used in a given circumstance.

The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and bonds, which might be recorded at their fair market value. This is called mark-to-market accounting or fair value accounting and is more advanced than the general basic concepts underlying the introduction to basic accounting concepts; therefore, it is addressed in more advanced accounting courses.

Once an asset is recorded on the books, the value of that asset must remain at its historical cost, even if its value in the market changes. For example, Lynn Sanders purchases a piece of equipment for $40,000. She believes this is a bargain and perceives the value to be more at $60,000 in the current market. Even though Lynn feels the equipment is worth $60,000, she may only record the cost she paid for the equipment of $40,000.

Full Disclosure Principle

The full disclosure principle states that a business must report any business activities that could affect what is reported on the financial statements. These activities could be nonfinancial in nature or be supplemental details not readily available on the main financial statement. Some examples of this include any pending litigation, acquisition information, methods used to calculate certain figures, or stock options. These disclosures are usually recorded in footnotes on the statements, or in addenda to the statements.

Separate Entity Concept

The separate entity concept prescribes that a business may only report activities on financial statements that are specifically related to company operations, not those activities that affect the owner personally. This concept is called the separate entity concept because the business is considered an entity separate and apart from its owner(s).

For example, Lynn Sanders purchases two cars; one is used for personal use only, and the other is used for business use only. According to the separate entity concept, Lynn may record the purchase of the car used by the company in the company’s accounting records, but not the car for personal use.

Conservatism

This concept is important when valuing a transaction for which the dollar value cannot be as clearly determined, as when using the cost principle. Conservatism states that if there is uncertainty in a potential financial estimate, a company should err on the side of caution and report the most conservative amount. This would mean that any uncertain or estimated expenses/losses should be recorded, but uncertain or estimated revenues/gains should not. This understates net income, therefore reducing profit. This gives stakeholders a more reliable view of the company’s financial position and does not overstate income.

Monetary Measurement Concept

In order to record a transaction, we need a system of monetary measurement , or a monetary unit by which to value the transaction. In the United States, this monetary unit is the US dollar. Without a dollar amount, it would be impossible to record information in the financial records. It also would leave stakeholders unable to make financial decisions, because there is no comparability measurement between companies. This concept ignores any change in the purchasing power of the dollar due to inflation.

Going Concern Assumption

The going concern assumption assumes a business will continue to operate in the foreseeable future. A common time frame might be twelve months. However, one should presume the business is doing well enough to continue operations unless there is evidence to the contrary. For example, a business might have certain expenses that are paid off (or reduced) over several time periods. If the business will stay operational in the foreseeable future, the company can continue to recognize these long-term expenses over several time periods. Some red flags that a business may no longer be a going concern are defaults on loans or a sequence of losses.

Time Period Assumption

The time period assumption states that a company can present useful information in shorter time periods, such as years, quarters, or months. The information is broken into time frames to make comparisons and evaluations easier. The information will be timely and current and will give a meaningful picture of how the company is operating.

For example, a school year is broken down into semesters or quarters. After each semester or quarter, your grade point average (GPA) is updated with new information on your performance in classes you completed. This gives you timely grading information with which to make decisions about your schooling.

A potential or existing investor wants timely i nformation by which to measure the performance of the company, and to help decide whether to invest. Because of the time period assumption, we need to be sure to recognize revenues and expenses in the proper period. This might mean allocating costs over more than one accounting or reporting period.

The use of the principles, assumptions, and concepts in relation to the preparation of financial statements is better understood when looking at the full accounting cycle and its relation to the detailed process required to record business activities ( Figure 3.2 ).

Concepts In Practice

Tax cuts and jobs act.

In 2017, the US government enacted the Tax Cuts and Jobs Act. As a result, financial stakeholders needed to resolve several issues surrounding the standards from GAAP principles and the FASB. The issues were as follows: “Current Generally Accepted Accounting Principles (GAAP) requires that deferred tax liabilities and assets be adjusted for the effect of a change in tax laws or rates,” and “implementation issues related to the Tax Cuts and Jobs Act and income tax reporting.” 4

In response, the FASB issued updated guidance on both issues. You can explore these revised guidelines at the FASB website (https://www.fasb.org/taxcutsjobsact#section_1).

The Accounting Equation

Introduction to Financial Statements briefly discussed the accounting equation, which is important to the study of accounting because it shows what the organization owns and the sources of (or claims against) those resources. The accounting equation is expressed as follows:

Recall that the accounting equation can be thought of from a “sources and claims” perspective; that is, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, everything a company owns must equal everything the company owes to creditors (lenders) and owners (individuals for sole proprietors or stockholders for companies or corporations).

In our example in Why It Matters , we used an individual owner, Mark Summers, for the Supreme Cleaners discussion to simplify our example. Individual owners are sole proprietors in legal terms. This distinction becomes significant in such areas as legal liability and tax compliance. For sole proprietors, the owner’s interest is labeled “owner’s equity.”

In Introduction to Financial Statements , we addressed the owner’s value in the firm as capital or owner’s equity . This assumed that the business is a sole proprietorship. However, for the rest of the text we switch the structure of the business to a corporation, and instead of owner’s equity, we begin using stockholder’s equity , which includes account titles such as common stock and retained earnings to represent the owners’ interests. The primary reason for this distinction is that the typical company can have several to thousands of owners, and the financial statements for corporations require a greater amount of complexity.

As you also learned in Introduction to Financial Statements , the accounting equation represents the balance sheet and shows the relationship between assets, liabilities, and owners’ equity (for sole proprietorships/individuals) or common stock (for companies).

You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure that the two sides of the accounting equation are always equal. We explore the components of the accounting equation in more detail shortly. First, we need to examine several underlying concepts that form the foundation for the accounting equation: the double-entry accounting system, debits and credits, and the “normal” balance for each account that is part of a formal accounting system.

Double-Entry Bookkeeping

The basic components of even the simplest accounting system are accounts and a general ledger . An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. As you know from Introduction to Financial Statements , each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.

Accounting is based on what we call a double-entry accounting system , which requires the following:

Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
The sum of the debits must equal the sum of the credits for each transaction.

In order for companies to record the myriad of transactions they have each year, there is a need for a simple but detailed system. Journals are useful tools to meet this need.

Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. This graphic representation of a general ledger account is known as a T-account . The concept of the T-account was briefly mentioned in Introduction to Financial Statements and will be used later in this chapter to analyze transactions. A T-account is called a “T-account” because it looks like a “T,” as you can see with the T-account shown here.

A debit records financial information on the left side of each account. A credit records financial information on the right side of an account. One side of each account will increase and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr , respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded accounting equation . You will learn more about the expanded accounting equation and use it to analyze transactions in Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions .

As we can see from this expanded accounting equation, Assets accounts increase on the debit side and decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This becomes easier to understand as you become familiar with the normal balance of an account.

Normal Balance of an Account

The normal balance is the expected balance each account type maintains, which is the side that increases. As assets and expenses increase on the debit side, their normal balance is a debit. Dividends paid to shareholders also have a normal balance that is a debit entry. Since liabilities, equity (such as common stock), and revenues increase with a credit, their “normal” balance is a credit. Table 3.1 shows the normal balances and increases for each account type.

Type of account	Increases with	Normal balance
Asset	Debit	Debit
Liability	Credit	Credit
Common Stock	Credit	Credit
Dividends	Debit	Debit
Revenue	Credit	Credit
Expense	Debit	Debit

When an account produces a balance that is contrary to what the expected normal balance of that account is, this account has an abnormal balance . Let’s consider the following example to better understand abnormal balances.

Let’s say there were a credit of $4,000 and a debit of $6,000 in the Accounts Payable account. Since Accounts Payable increases on the credit side, one would expect a normal balance on the credit side. However, the difference between the two figures in this case would be a debit balance of $2,000, which is an abnormal balance. This situation could possibly occur with an overpayment to a supplier or an error in recording.

We define an asset to be a resource that a company owns that has an economic value. We also know that the employment activities performed by an employee of a company are considered an expense, in this case a salary expense. In baseball, and other sports around the world, players’ contracts are consistently categorized as assets that lose value over time (they are amortized).

For example, the Texas Rangers list “Player rights contracts and signing bonuses-net” as an asset on its balance sheet. They decrease this asset’s value over time through a process called amortization . For tax purposes, players’ contracts are treated akin to office equipment even though expenses for player salaries and bonuses have already been recorded. This can be a point of contention for some who argue that an owner does not assume the lost value of a player’s contract, the player does. 5

1 Center for Audit Quality. Guide to Public Company Auditing . https://www.iasplus.com/en/binary/usa/aicpa/0905caqauditguide.pdf
2 Center for Audit Quality. Guide to Public Company Auditing . https://www.iasplus.com/en/binary/usa/aicpa/0905caqauditguide.pdf
3 Financial Accounting Standards Board. “The Conceptual Framework.” http://www.fasb.org/jsp/FASB/Page/BridgePage&cid=1176168367774
4 Financial Accounting Standards Board (FASB). “Accounting for the Tax Cuts and Jobs Act.” https://www.fasb.org/taxcutsjobsact#section_1
5 Tommy Craggs. “MLB Confidential, Part 3: Texas Rangers.” Deadspin. August 24, 2010. https://deadspin.com/5619951/mlb-confidential-part-3-texas-rangers

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Principles and concepts of accounting

Study resources
FA2 Maintaining Financial Records
Technical articles

Learning outcome A1 from the FA2 syllabus is related to ‘The key principles, concepts and characteristics of accounting’. This learning outcome causes difficulties for some candidates. These difficulties may arise because the learning outcome is more theoretical than other parts of the syllabus and tends to be examined in narrative style questions, which some candidates may find more difficult than calculation-based questions.

It is important to note that the principles and concepts of accounting are distinct from the ‘qualitative accounting characteristics’ and this differentiation is clearly set out in the Detailed Study Guide (‘the study guide’).

The focus for this article is the principles and concepts of accounting. There is a complimentary FA2 article titled ‘Qualitative accounting characteristics’ (see 'Related links') which provides more detail on the qualitative accounting characteristics.

For the purposes of the FA2 exam, there is a list of principles and concepts of accounting which you need to be familiar with and which can be found in learning outcome A1(a) in the study guide:

Going concern

Accrual basis, materiality, consistency, duality (dual aspect), business entity, historical cost.

What candidates need to know about each of these is:

how it is defined, and
how it should be applied.

Each of these principles and concepts are considered below. Where a formal definition is provided by the Conceptual Framework for Financial Reporting (the Conceptual Framework), that definition is given, followed by an elaboration of the key points of that definition that candidates need to understand.

Definition: ‘ Financial statements are normally prepared on the assumption that the reporting entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or to cease trading. If such an intention or need exists, the financial statements may have to be prepared on a different basis. If so, the financial statements describe the basis used.

The basic point about the going concern principle is that it is assumed that the entity will continue to operate for the foreseeable future. For FA2, candidates do not need to consider the time period that might be regarded as the ‘foreseeable future’. This is an advanced issue that will be considered in later exams. The same can be said of issues such as:

circumstances in which the going concern assumption might not apply;
what different basis could be used; and
who decides whether the going concern assumption should apply.

While an awareness of what is meant by ‘a different basis’ might be expected (for example, break up basis), candidates would not be expected to apply that basis to calculate values in the FA2 exam.

The Conceptual Framework refers to ‘accrual accounting’, also known as ‘the accruals concept’ or simply as ‘accruals.’

Definition: ‘ Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period.’

Essentially, what accrual accounting means is that the date on which cash is paid or received is often not necessarily the same as the date that the actual transaction takes place, but this should not delay the transaction being recorded. In transactions between businesses, it is common for payment not to be made on the same date that an order is made or that goods are transferred.

Although the definition might seem a little complicated at first reading, this is essentially a simple idea. If Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can wait until 25 March to actually pay for the goods, accrual accounting requires that the transaction is recorded when the sale/purchase takes place rather than when cash changes hands. Thus, the initial sale and purchase transaction is recorded on 25 January.

Accrual accounting means that the accounting records will include balances for receivables (amounts that the entity expects to receive in the future as a result of past transactions) and payables (amounts that the entity expects to pay out in the future as a result of past transactions). When preparing financial statements, it will be necessary to recognise any costs that have been paid, but not yet consumed (prepaid expenses), as well as costs that have been consumed, but not yet paid for (accrued expenses).

It is worth remembering that, while a number of the theoretical aspects of the syllabus are linked in the same way as has been noted above, candidates should ensure that they understand the key points of each principle or concept in isolation first of all. Once a good understanding has been developed at an individual level, it will be easier to make the links between the various principles and concepts.

Definition : ‘Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide financial information about a specific reporting entity.’

There are some key issues within this definition that candidates should be aware of.

The first is that materiality is different to complete accuracy. For example, we can see this in practice in the published financial statements of large businesses. These often report values in $000 or $m. While the exact values to the single dollar are not communicated, the essential (material) information is provided as an aid to decision making.

This leads to the second issue – materiality is related to the fact that the purpose of financial statements is to provide information so that it can be used to make decisions about whether to undertake transactions with a particular entity. So reporting to the nearest $000 or $m instead of the nearest $, will often still allow informed decisions to be made.

The final issue is that materiality is affected by both:

whether information is included or omitted from financial statements, and
whether it is sufficiently informative.

It is not necessary, and often not helpful, to simply include as much detail as possible in the financial statements. Consideration should be given to the fact that excessive detail may not actually improve presentation and therefore not assist users of financial statements. For example, important information could be obscured by including it among large amounts of insignificant detail.

Candidates in FA2 will not be required to decide on an appropriate cut off level for materiality. This is a more advanced issue, which requires the exercise of professional judgment.

Definition: ‘The use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities.’

Consistency is a straightforward principle and is intended to enhance financial reporting by making it easier for users to make comparisons. In that sense it contributes to the achievement of comparability which is one of the qualitative characteristics of useful financial information (see the related article ‘Qualitative accounting characteristics’).

By requiring similar items to be treated in the same way, this contributes to making comparisons more meaningful.

Consistency should be applied in two ways:

‘from period to period’ – ie by a single entity, and
‘across entities’ – ie between entities in the same period.

In practical terms, this means that consistency helps to achieve comparability. For instance, it should be possible for users to understand how a business has performed in the year by comparing it to the results of the previous year. This is only possible if the figures and information are prepared using consistent methods across each year. Consistency across entities means that it should be possible to compare one business’s performance with a competitor and therefore make informed investment decisions.

This does not mean that everything in the accounts needs to be treated the same by every entity.

Definition : ‘The exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses.’

There is often uncertainty about the eventual outcome of certain events and transactions. This means that estimates need to be made when preparing financial statements. Prudence requires that, whenever such uncertainty exists, preparers of financial statements take a careful approach to the figures and information that they include in the financial statements.

Arguably, the biggest risk in this regard is that a business will be inclined to be optimistic about results and therefore overstate assets and income or understate liabilities and expenses. There could be financial incentives for business owners to do this and therefore the prudence principle must be observed to ensure this does not happen.

Equally, preparers should not be ‘overly prudent’ to the extent that they pick the lowest possible outcome simply to avoid the risk of overstating assets and income or understating liabilities and expenses. This would still not provide a fair presentation of the financial position or financial performance of the entity and, therefore, it is important that caution is exercised to avoid this as well.

‘Duality’ refers to the fact that every transaction has a ‘dual aspect’ and therefore requires the use of ‘double entry’ accounting. Double entry is often easier to do than to explain. For this reason, candidates would be wise to complete as many practice questions as possible before taking the exam. It is also the reason why the topic can only be touched on briefly in a short article such as this.

There is no definition of double entry in the Conceptual Framework – although it is probably fair to say that this is the most fundamental underpinning principle in accounting. In the absence of a formal definition, it is best to start by understanding the term ‘dual aspect’. The dual aspect means that each party in a transaction is affected in two ways by the transaction and that every transaction gives rise to both a debit entry (Dr) and a credit entry (Cr).

Given that the value of the debit entries is the same as the value of the credit entries for any given transaction, it follows that when a number of transactions have been recorded, the total value of the debit entries will still be the same as the total value of the credit entries. This is the basis of the accounting equation.

All of this can be explained by considering the transaction that was included in the discussion on accruals. This was that Andrea agrees to buy goods from Brian on 25 January and Brian agrees that Andrea can wait until 25 March to pay for the goods.

This straightforward example allows a key point about double entry to be made. Clearly there are two parties involved in the transaction. While both parties will record the transaction, that is not what is meant by double entry. It is important to remember that when preparing accounting entries, we are only dealing with a single entity – either Andrea or Brian.

From Andrea’s point of view the dual aspect is:

she has obtained goods, and
she has also incurred the responsibility to pay for the goods at a later date.

In a real-life situation (and in an exam question), it will be clear whether the goods have been bought with the intention of selling them at a profit, or if they have been bought for consumption/use within the business. For the moment, let’s assume that Andrea has bought the goods for resale. That means we can now identify the two accounts in which entries will be made:

goods for resale (or ‘purchases’ as is more often used to describe this account), and
trade payables.

The next step is to decide which account will have the debit entry and which will have the credit entry. One way of doing this is to use a memory AID. The upper-case letters have been used because the word itself is the AID – Asset Increase Debit.

This AID reminds us that, if an asset has been increased, then a debit entry is required. The AID can be expanded by changing one element within it at a time to the opposite state, leading to the opposite entry:

Asset decreased	Credit
Liability increased	Credit

It can therefore be deduced that:

Liability decreased

Debit

Using this logical approach, it should be possible to identify which accounts will be affected and then consider how they will be affected.

Thus, if Andrea has incurred the responsibility to pay for the goods, she has clearly increased a liability. That means a credit entry is required in her trade payables account. It follows that the entry in her purchases account will be a debit.

The business entity principle simply means that, for the purpose of maintaining accounting records, the business is treated as a separate entity from the owner(s) of the business. The Conceptual Framework refers to a ‘reporting entity’ which is an entity that is required, or chooses, to prepare financial statements.

As FA2 only relates to unincorporated businesses (sole traders and partnerships), this might seem like an unrealistic differentiation. However, a business entity is not necessarily a separate legal entity and candidates should simply deal with transactions from the perspective of the business.

In our example, Andrea has been identified as the owner of the business. As she is a sole trader (ie her business is unincorporated), there are some important legal points to be noted. The first is that there is no legal differentiation between Andrea and her business. Following from that, Andrea will be personally responsible for any debts that the business incurs, and her personal assets may be used to settle business debts.

However, her personal assets are not included in the business records. In addition, if Andrea withdraws money for personal expenses, the nature of the expense is not recorded. All that is necessary is to record the fact that Andrea withdrew funds – with a debit entry in the drawings account and credit entry in the bank account.

Theoretically, there are a number of bases that could be used to derive the value at which transactions are recorded. However, historical cost is the only one of these that needs to be considered in the context of FA2.

Definition: ‘Historical cost measures provide monetary information about assets, liabilities and related income and expenses, using information derived, at least in part, from the price of the transaction or other event that gave rise to them.’

In simple terms this means that, for FA2, assets and liabilities will continue to be recorded at the value at which they were initially recorded and that value will be based on the value at the date of the transaction.

The historical cost of assets and liabilities will still be updated over time to depict accounting transactions like depreciation or the fulfilment of part or all of a liability. But it will not be updated to reflect the current value of a similar asset or liability which might be acquired or taken on.

By ensuring that the key points of each of these principles and concepts are understood, candidates should be better prepared to answer questions that might arise in the exam.

Written by a member of the FA2 examining team

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1.7 Accounting Principles, Concepts and Assumptions

The Financial Accounting Standards Board (F.A.S.B.) is an independent, nonprofit organization that sets the standards for financial accounting and reporting, including generally accepted accounting principles (G.A.A.P.) , for both public- and private-sector businesses in the United States.

GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements. If US accounting rules are followed, the accounting rules are called US GAAP. International accounting rules are called International Financial Reporting Standards (I.F.R.S.) . Publicly traded companies (those that offer their shares for sale on exchanges in the United States) have the reporting of their financial operations regulated by the Securities and Exchange Commission (S.E.C.) .

The SEC is an independent federal agency that is charged with protecting the interests of investors, regulating stock markets, and ensuring companies adhere to GAAP requirements. By having proper accounting standards such as US GAAP or IFRS, information presented publicly is considered comparable and reliable. As a result, financial statement users are more informed when making decisions. The SEC not only enforces the accounting rules but also delegates the process of setting standards for US GAAP to the FASB.

The Conceptual Framework

Revenue Recognition Principle

Expense Recognition (Matching) Principle

Cost Principle

Full Disclosure Principle

Separate Entity Concept

Conservatism

Monetary Measurement Concept

Going Concern Assumption

Time Period Assumption

CONCEPTS IN PRACTICE

Tax cuts and jobs act.

In response, the FASB issued updated guidance on both issues. You can explore these revised guidelines at the FASB website .

Accounting Principles and Assumptions Regulating Revenue Recognition

Revenue and expense recognition timing is critical to transparent financial presentation. GAAP governs recognition for publicly traded companies. Even though GAAP is required only for public companies, to display their financial position most accurately, private companies should manage their financial accounting using its rules. Two principles governed by GAAP are the revenue recognition principle and the matching principle. Both the revenue recognition principle and the matching principle give specific direction on revenue and expense reporting.

The revenue recognition principle , which states that companies must recognize revenue in the period in which it is earned, instructs companies to recognize revenue when a four-step process is completed. This may not necessarily be when cash is collected. Revenue can be recognized when all of the following criteria have been met:

There is credible evidence that an arrangement exists.
Goods have been delivered or services have been performed.
The selling price or fee to the buyer is fixed or can be reasonably determined.
There is reasonable assurance that the amount owed to the seller is collectible.

The accrual accounting method aligns with this principle, and it records transactions related to revenue earnings as they occur, not when cash is collected. The revenue recognition principle may be updated periodically to reflect more current rules for reporting.

For example, a landscaping company signs a $600 contract with a customer to provide landscaping services for the next six months (assume the landscaping workload is distributed evenly throughout the six months). The customer sets up an in-house credit line with the company, to be paid in full at the end of the six months. The landscaping company records revenue earnings each month and provides service as planned. To align with the revenue recognition principle, the landscaping company will record one month of revenue ($100) each month as earned; they provided service for that month, even though the customer has not yet paid cash for the service.

Let’s say that the landscaping company also sells gardening equipment. It sells a package of gardening equipment to a customer who pays on credit. The landscaping company will recognize revenue immediately, given that they provided the customer with the gardening equipment (product), even though the customer has not yet paid cash for the product.

Accrual accounting also incorporates the matching principle (otherwise known as the expense recognition principle ), which instructs companies to record expenses related to revenue generation in the period in which they are incurred. The principle also requires that any expense not directly related to revenues be reported in an appropriate manner. For example, assume that a company paid $6,000 in annual real estate taxes. The principle has determined that costs cannot effectively be allocated based on an individual month’s sales; instead, it treats the expense as a period cost. In this case, it is going to record 1/12 of the annual expense as a monthly period cost. Overall, the “matching” of expenses to revenues projects a more accurate representation of company financials. When this matching is not possible, then the expenses will be treated as period costs.

For example, when the landscaping company sells the gardening equipment, there are costs associated with that sale, such as the costs of materials purchased or shipping charges. The cost is reported in the same period as revenue associated with the sale. There cannot be a mismatch in reporting expenses and revenues; otherwise, financial statements are presented unfairly to stakeholders. Misreporting has a significant impact on company stakeholders. If the company delayed reporting revenues until a future period, net income would be understated in the current period. If expenses were delayed until a future period, net income would be overstated.

Gift Card Revenue Recognition

Gift cards have become an essential part of revenue generation and growth for many businesses. Although they are practical for consumers and low cost to businesses, navigating revenue recognition guidelines can be difficult. Gift cards with expiration dates require that revenue recognition be delayed until customer use or expiration. However, most gift cards now have no expiration date. So, when do you recognize revenue?

Companies may need to provide an estimation of projected gift card revenue and usage during a period based on past experience or industry standards. There are a few rules governing reporting. If the company determines that a portion of all of the issued gift cards will never be used, they may write this off to income. In some states, if a gift card remains unused, in part or in full, the unused portion of the card is transferred to the state government. It is considered unclaimed property for the customer, meaning that the company cannot keep these funds as revenue because, in this case, they have reverted to the state government.

Long Description

Hierarchical group of boxes representing the organizations that create generally accepted accounting principles (GAAP) and the principles, conventions, assumptions, and concepts that support GAAP. The top box is labeled SEC (enforces GAAP). The box below that is labeled FASB (sets GAAP). The box below that is labeled GAAP Accounting Standards. Below that are four boxes labeled left to right: Expense Recognition Principle; Full Disclosure Principle; Conservatism Convention; Going Concern Assumption. Below that are five boxes labeled left to right: Revenue Recognition Principle; Cost Principle; Separate Entity Concept; Monetary Measurement Concept; Time Period Assumption. Return

1 Financial Accounting Standards Board. “The Conceptual Framework.” http://www.fasb.org/jsp/FASB/Page/BridgePage&cid=1176168367774

2 Financial Accounting Standards Board (FASB). “Accounting for the Tax Cuts and Jobs Act.” https://www.fasb.org/taxcutsjobsact#section_1

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Accounting Concepts and Conventions

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Sally Messenger 3 &
Humphrey Shaw 4

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When preparing final accounts the aim is to present a “true and fair view” of the financial position of the business. This statement has not yet been defined in any legislation or court case but is generally accepted to mean a “fair view” without bias. In order to achieve this accountants are required to base their work on a set of principles which are usually referred to as concepts and conventions . These principles are important for two reasons:

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Messenger, S., Shaw, H. (1993). Accounting Concepts and Conventions. In: Financial Management. Palgrave, London. https://doi.org/10.1007/978-1-349-13080-1_2

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What Are Accounting Principles, Concepts and Conventions?

Accounting is a fundamental aspect of running a business. It involves recording, analyzing, and interpreting financial transactions to provide an accurate picture of the company’s financial health.

However, following certain principles, concepts, and conventions is essential to ensure that accounting information is consistent and reliable.

This article will explore the basics of accounting principles, concepts, and conventions. We will explain what they are and how they contribute to producing accurate financial statements

Accounting Principles

Accounting is sometimes called the business language since it is how a firm interacts with the outside world. For this language to be universally understood, it must adhere to a set of standardised norms. These requirements are known as accounting principles.

Accounting principles are “the collection of ideas generally associated with accounting theory and practise, acting as an explanation of present practises and a guide for the choosing of conventions or methods where alternatives exist.”

Accounting principles are, in a nutshell, recommendations that define standards for effective accounting methods and procedures in reporting a business’s financial condition and performance over time. These principles can be categorised as:

Accounting Concepts; and

Accounting Conventions

Accounting concepts.

The term “accounting concept” refers to the fundamental presumptions on which the preparation of the financial accounts of an organisation engaged in business is based. They serve as a basis for developing various techniques and processes for documenting and presenting the transactions involving the company’s activity.

There are 12 accounting concepts. The following is a list of the fundamental accounting concepts:

1. Business Entity Concept

According to this concept, business enterprise is treated as a separate entity from its owner. This is why owner A/c is shown as a liability for the business entity. Business transactions are recorded in the books of the account owner’s transactions in his personal books of account. This concept helps free the business from the owner’s personal affairs.

Firstly, it allows for more accurate financial reporting since the business’ income and expenses can be tracked independently. Secondly, by separating personal and business finances, it helps prevent fraud or conflicts of interest between individuals associated with the company. Additionally, it protects shareholders and investors by limiting their liability to only what they have invested in the company.

2. Money Measurement Concept

As per this concept, only those transactions are recorded in books of account which can be measured in terms of money. Since money is a common standard of payment and capable of being recorded, only monetary items take place in books of account. Transactions, even if they affect the result of the business enterprise but cannot be measured in terms of money, are not recorded in business books.

For example, the employees of an organisation are the most valuable asset to a business enterprise. Still, as they cannot be measured in terms of money, they are not recorded in terms of money. Generally, the transactions are recorded in terms of the ruling currency of the country where the business enterprise is situated.

Another aspect of this concept is that the records of the transactions are to be kept not in physical units but in monetary units. For example, at the end of 2011, an organisation may have a factory on a piece of land measuring 15 acres, an office building containing 50 rooms, 50 personal computers, 30 office chairs and tables, 120 kg of raw materials etc.

These are expressed in different units. But for accounting purposes, they are to be recorded in money terms. In this case, the cost of factory land maybe say $1 million, the office building $10 million, computers $10 million, office chairs and tables $2 million, raw materials $3 million etc.

3. Matching concept

As per the matching concept, all expenses matched with the revenue of that period should only be considered. Any past or future year’s expenses and revenues are excluded using certain adjustments. This concept is based on the accrual concept as it considers the occurrence of expenses and income and does not concentrate on the actual inflow or outflow of the cash. It leads to adjusting certain items like prepaid and outstanding items and unearned or accrued incomes.

Not every expense needs to identify every income. Some expenses are related to revenue, and some are time-bound. E.g. Selling expenses are related to sales, but rent, salaries etc., are recorded on an accrual basis for the particular accounting period.

Let’s take an example – suppose Mr John started the retail business of cloth. He purchased 5000 pcs. Of the cloth @ $100 per piece and sold 4000 pcs @ $150 per piece during the accounting period 1st January 2010 to 31st December 2010 and pays rent for the premises at the end of each month, i.e. for 11 months @ $2000 each and paid to suppliers $400,000 and received $500,000 from the customer. Now we shall see how this concept works-

As per the concept of accrual , the revenue for the period shall be recognised as $6,00,000 (4000 pcs X $150 each), which accrued and not the cash received, i.e. $ 400000 and rent for the premises shall be recorded for the whole 12 months, i.e. $24000 and not $22000, i.e. 11 months X $2000 each.

4. Going concern Concept

The financial statements are normally prepared to assume that an enterprise is a going concern and will continue operation. Simply stated, every business entity is assumed to have an infinite life, and it will not be dissolved shortly. This is an important accounting assumption , as it provides a basis for showing the value of assets on the balance sheet.

For example, a company purchases a plant and machinery for $100000, and its life span is ten years. According to this concept, some amount will be shown as expenses and the balance amount as an asset every year. Thus, if an amount is spent on an item that will be used in business for more than one year, it will not be proper to charge the entire amount from the revenues of the year in which the item is acquired. Only a proportionate value is shown as the expense in the year of purchase, and the remaining balance is shown as an asset on the balance sheet.

Please note that this is not the entire list of accounting standards. There are 12 accounting standards.

The term “convention” refers to a custom, tradition, or practice based on general agreement amongst the various accounting organisations and serves to direct the accountant in generating financial statements. It acts as a guide in selecting or using a certain technique.

Accounting convention is a practice that all accounting people use to calculate and record all financial transactions. In a given business, there are some standards, rules and guidelines that accountants follow and they ensure that all transactions are correctly accounted for and presented.

Financial statements, including the profit and loss account as well as the balance sheet, are created following the following accounting conventions:

Consistency

The consistency convention entails that accounting practices must be consistent yearly. Only when accounting rules are adhered to consistently from year to year will the results of different years be comparable. The principle of valuing the stock at cost or market price, whichever is lower, must be adhered to to achieve comparable results from year to year. Likewise, if depreciation is charged on fixed assets using the diminishing balance method, it must be done annually. The rationale for this principle is that frequent changes in accounting treatment would render the financial statements unreliable to those who use them. The consistency convention does not imply that it cannot be altered once a particular accounting method has been adopted. When an accounting change is desirable, it must be fully disclosed in the financial statements, along with its impact in rupee amounts on the reported income and financial position of the year in which the change is made.

In addition to statutory requirements, good accounting practice requires that all material information be disclosed fully and fairly in the financial statements. In accounting statements, all information of material interest to owners, creditors, and investors should be disclosed. This convention is gaining importance as the majority of large business units are organised as joint-stock companies in which ownership and management are separated.

Conservatism

Typically, financial statements are prepared on a conservative basis. Two principles are directly derived from conservatism.

(a) The accountant should not anticipate income and should account for all potential losses.

(b) When faced with a choice between two methods for valuing an asset, the accountant should select the method that results in the lower value.

Materiality

According to the materiality convention, when producing the final accounts , accountants should record only what is material and disregard irrelevant elements. The accountant should determine whether a transaction is substantially based on his or her professional knowledge and sound judgement. A thing can be material for one purpose but irrelevant for another. The materiality of the items on the profit and loss statement should be evaluated in connection to the profits displayed on the profit and loss statement. And for the items appearing in the balance sheet, materiality may be evaluated in respect to the groups to which the assets or liabilities belong, e.g., for every item of current liabilities , materiality should be evaluated in proportion to the total current liabilities.

What Are Accounting Conventions, And Why Do They Matter?

Accounting conventions are often non-mandatory but essential parts of business for millions of firms out there. Despite that, accountants often mistake conventions for regulations and vice-versa. In this article, we summarized everything you need to know about accounting conventions, so read on to be fully up-to-date on the topic.

Understanding the historical context and evolution of accounting conventions provides a deeper insight into their significance and application today. Accounting conventions have developed over centuries, influenced by economic events, business practices, and regulatory changes. Initially, these conventions emerged as best practices among accountants to address common issues in financial reporting. Over time, they have been formalized by accounting bodies to ensure consistency and reliability in financial statements.

Accounting Conventions Simply Explained

Accounting conventions are rules businesses employ to determine how to record specific business transactions that accounting standards do not yet completely cover. Although not obligatory, these guidelines and practices are typically recognized by accounting organizations.

In essence, they are made to encourage uniformity and assist accountants in resolving real-world issues that might occur when compiling financial accounts.

Main Takeaways

Accounting conventions serve as a set of rules that businesses may use to decide how to record transactions that are not yet entirely covered by accounting standards.
Although they are not enforceable by law, they are usually recognized by accounting organizations.
The accounting convention is no longer relevant if an oversight group establishes a guideline that covers the same subject.
There are four generally accepted accounting conventions: materiality, complete disclosure, consistency, and conservatism.

How To Interpret An Accounting Convention

Sometimes, a certain circumstance is not governed by a clear rule in the accounting standards. In these circumstances, accounting conventions may be used.

There are many presumptions, conceptions, norms, and traditions in accounting. Accounting norms that support concepts like relevance, dependability, materiality, and comparability often work to standardize the financial reporting process.

In other words, accounting conventions fill in the areas where accounting standards fall short. The accounting convention is no longer relevant if a regulatory body, such as The Securities and Exchange Commission (SEC) or Financial Accounting Standards Board (FASB) , establishes a standard that covers the same subject.

There are currently fewer accounting conventions that can be used as the scope and level of complexity of accounting standards continue to grow. Even accounting practices are not rigid rules. Alternatively, they can change over time to reflect fresh perspectives on the most effective ways to record transactions.

Accounting norms are crucial because they guarantee that transactions are recorded uniformly by several organizations. Investors may more easily evaluate the financial performance of various companies, including rival ones operating in the same sector, by using a consistent technique. Despite this, accounting practices are far from perfect. They can be vaguely defined at times, giving businesses and their accountants room to bend or exploit them to their benefit possibly.

To illustrate the application of accounting conventions, consider the following examples:

Conservatism Convention: A company estimates its inventory at a lower value to account for potential market declines. If the cost of inventory is SAR 100,000 but the market value drops to SAR 90,000, the company records the inventory at SAR 90,000.
Full Disclosure Convention: A company discloses potential legal liabilities in its financial statements, even if the outcome of the litigation is uncertain, to provide a complete picture of its financial health.
Materiality Convention: A company includes all significant transactions in its financial statements. For example, a transaction worth SAR 10,000 is considered material and must be reported, whereas a SAR 100 transaction may not be.

Read more: 7 Common Accounting Mistakes Small Business Owners Make _

The Four Main Accounting Conventions

To help accountants, there are four primary accounting conventions:

Conservatism

This convention urges us to always go with the safe choice. It advises accountants to provide estimates for assets and liabilities that are on the conservative side.

This signifies that the lesser value should be preferred when there are two possible values for a transaction. The fundamental idea is to take the worst-case scenario of a company's financial future into account.

Full disclosure

Regardless of whether the information is harmful to the organization, it must be disclosed if it is thought to be potentially useful and relevant.

Materiality

Similar to full disclosure, this tradition calls for firms to show all of their cards. It should be disclosed if something is material, which is another way of saying important.

The rationale behind this is that all information that can affect a person's judgment after seeing the financial statement must be provided.

Consistency

Throughout many accounting cycles, a business should use the same accounting standards. If it adopts a way, it is advised to continue with it going forward unless there is a compelling reason not to.

Without this convention, it would be considerably harder for investors to compare and evaluate the company's performance over time.

Read more about International Financial Reporting Standards (IFRS) .

Areas Where Accounting Conventions Apply

Inventory valuation may be based on accounting conservatism. Conservatism requires that the reported value of inventory be equal to the lowest of the historical cost or replacement cost.

Additionally, line item changes for market value or inflation are prohibited by accounting rules. This implies that book value may occasionally be lower than market value. For instance, even if a building is worth more, it should still be recorded as costing SAR 100,000 when it was first acquired.

The conservatism convention is frequently used to estimate casualty losses and uncollectible accounts receivable. A business cannot record a gain if it anticipates winning a lawsuit unless it complies with all revenue recognition standards.

However, a projected economic effect must be shown in the notes to the financial statements if a lawsuit claim is anticipated to be unsuccessful. Additionally, contingent obligations such as royalties or unearned income must be mentioned.

Read also: Financial Accounting: A Comprehensive Overview

The Conclusion

Overall, we can say that while accounting conventions are not always mandatory to follow, they contain restrictions and rules that are simply necessary to comply with in many instances. By knowing all accounting conventions, accountants can ensure full regulatory compliance and present their figures in the most acceptable way possible.

Future Trends and Challenges

The landscape of accounting conventions is continually evolving. Emerging trends such as the use of artificial intelligence (AI) and blockchain technology are reshaping accounting practices. These technologies promise greater accuracy and transparency but also pose new challenges in terms of standardization and regulation. Additionally, there is ongoing debate about the relevance and effectiveness of current conventions in addressing modern financial complexities.

If you’d like to learn more about accounting principles, or accounting policies, check out one of our related articles now—see you there!

Frequently Asked Questions (FAQs)

What are accounting conventions.

Accounting conventions are guidelines used to resolve issues in financial reporting when there is no specific accounting standard covering the transaction. They ensure consistency and comparability in financial statements.

Why are accounting conventions important?

They help maintain uniformity in financial reporting, making it easier for investors to compare the financial performance of different companies. They also aid in the accurate representation of a company's financial position.

What is the conservatism convention?

The conservatism convention advises accountants to choose the more conservative estimate when there are multiple possible values for a transaction. This means reporting lower asset values and higher liability values to avoid overstatement.

How does the full disclosure convention work?

The full disclosure convention requires companies to disclose all relevant information in their financial statements, regardless of whether the information is favorable or unfavorable, to provide a complete picture of the company's financial health.

What is the difference between IFRS and GAAP regarding accounting conventions?

IFRS is more principles-based, providing general guidelines that can be applied broadly, while GAAP is more rules-based, offering specific instructions for various scenarios. Both frameworks incorporate accounting conventions differently.

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Understanding Accounting Concepts: A Comprehensive Guide

Understanding the fundamental principles and accounting concepts is essential for every business owner, accountant, or financial professional. The fundamental financial accounting concepts and principles include accrual accounting, materiality, conservatism, and consistency. Whether you are a beginner looking to learn the basics or an experienced accountant seeking to refresh your knowledge, our page will provide the tools and insights needed to succeed in finance. So what are you waiting for? Start your journey towards financial expertise today!

What are Accounting Concepts

Accounting concepts refer to the fundamental principles and assumptions that guide preparing and presenting an organisation’s financial statements. These concepts provide a framework for recording and reporting financial transactions accurately, consistently, and objectively.

Important Accounting Concepts with their meanings and examples

Get insights into the types of accounting concepts with their meanings. Then, you can convert them into helpful accounting concepts in pdf or accounting concepts ppt for a quick overview of accounting concepts and standards.

Accruals Accounting Concept

Accrual accounting is a concept of accounting that records financial transactions when they occur, regardless of when the payment is made or received.
It recognises revenue and expenses when earned or incurred, regardless of the timing of the associated cash flows.
In accrual accounting, revenue is recognised when earned, typically when the goods or services get delivered to the customer.
Similarly, expenses are recognised when incurred, typically when the goods or services are received from the supplier.

Conservatism Concept

The conservatism or prudence concept is an accounting principle that requires a cautious approach in preparing financial statements.
The principle suggests that when in doubt, the accountant should choose the option that will result in a lower reported profit or a higher reported loss.
It means conservatism avoids overstating assets and income and understating liabilities and expenses.
For example, the principle suggests that a company should recognise a cost or loss immediately, even if uncertain, but delay revenue recognition until reasonably assured.

Consistency Concept

The consistency concept is an accounting principle that requires a company to use the same accounting methods and procedures from one accounting period to another.
The principle suggests that a company should consistently apply the same accounting policies so that financial statements are comparable between different accounting periods.
For example, suppose a company uses the straight-line method to depreciate its fixed assets in one accounting period. In that case, it should continue to use the same procedure in subsequent accounting periods.
If a company changes its accounting policies, it must disclose the change in the financial statements and explain its reason.

Cost Accounting Concept

Cost accounting is a branch concerned with determining and analysing the cost of goods or services a company produces.
The cost accounting concept involves the identification, measurement, and analysis of the cost elements of the products or services produced by the company.
The cost accounting concept is essential for a company to understand its production costs, set prices, and improve profitability.
Cost accounting involves identifying the various cost elements, such as direct materials, direct labour, and manufacturing overheads, and allocating these costs to the products or services produced.

Dual Aspect Concept

The dual aspect concept, also known as the duality principle, is a fundamental accounting concept that states that every financial transaction has two aspects – a debit aspect and a credit aspect – that are equal in value and opposite in direction.
This concept forms the basis of double-entry bookkeeping, the standard method of recording financial transactions.
Under the dual aspect concept, when a company receives money, it will record a debit entry to an asset account and a credit entry to a liability or equity account.
Similarly, when a company pays money, it will record a credit entry to an asset account and a debit entry to a liability or equity account. It means that the total value of debit entries in the books of accounts must always equal the total value of credit entries.

Economic Entity Concept

The economic entity concept is an accounting principle that assumes a business organisation is separate from its owners, shareholders, or any other entity.
This concept requires that the business’s financial transactions must be recorded and reported separately from the personal transactions of the owners or shareholders.
Under the economic entity concept, a company’s financial statements should represent only the financial transactions of the business entity and not those of its owners or shareholders.
It signifies the business’s financial statements should include only the assets, liabilities, revenues, and expenses related to the business operations and not include any personal transactions or assets of the owners or shareholders.

Going Concern Concept

The going concern concept is an accounting principle that assumes that a company will continue to operate indefinitely and will not be forced to liquidate its assets or cease operations shortly.
This principle requires that the company’s financial statements reflect this assumption.
Under the going concern concept, the company’s assets are recorded at their book value rather than their liquidation value, assuming the company will continue using them to generate revenue. The liabilities are also registered with the expectation that the company will be able to meet its obligations as they become due.

Matching Concept

The matching concept, or the matching principle, is linked to the Periodicity and Accrual concepts.
It demands the recognition of expenses in the same period the related revenue generates.
The regulation states that the costs incurred to generate revenue should be matched against that revenue in the same accounting period.
For example, suppose a company sells goods and recognises revenue in a particular accounting period. In that case, the cost of goods sold and any other expenses related to the sale should be recognised in the same period.

Materiality Concept

It states that a financial statement item is considered material if its omission or misstatement can affect the economic decisions of users of the financial statements.
This principle requires that a company discloses all vital information in its financial statements.
The materiality concept states that not all information is relevant or essential to decision-making. Instead, the principle allows accountants to focus on items significant to the users of financial statements, such as investors, creditors, and other stakeholders.

Money Measurement Concept

The money measurement concept is an accounting principle that only measurable transactions and events in monetary terms should be recorded in the financial statements.
This concept implies that only information that can be quantified in terms of money should be included in the accounting records.
Under this concept, non-monetary items, such as goodwill, employee morale, or customer satisfaction, are not recognised in the financial statements, even though they may be critical to the success of the business.

Periodicity Concept

The periodicity concept is an accounting principle that requires businesses to divide their financial activities into equal periods, such as months, quarters, or years.
This principle assumes that a company can meaningfully track and report its financial performance over specific periods.
Under the periodicity concept, a business must prepare financial statements at regular intervals, such as monthly or quarterly, and at the end of each fiscal year. It allows for comparing financial information over different periods, enabling stakeholders to assess the business’s financial performance and identify trends.

Realisation Concept

The realisation concept is an accounting principle that recognises revenue when earned rather than when payment is received.
This principle requires that revenue be recognised when the goods or services have been delivered or rendered, and the earnings process is complete, regardless of when payment is received.
For example, suppose a company provides a service to a customer and completes the service in a given accounting period. In that case, revenue should be recognised in that period, even if the payment is not received till later.
Such is because the earnings process is complete, and the company has fulfilled its obligations to the customer.
The realisation concept is vital because it helps to ensure that revenue is recognised in the appropriate accounting period and that financial statements accurately reflect the company’s economic performance. This principle also ensures consistency in recognising revenue, regardless of when payment is received.

What Are Generally Accepted Accounting Principles (GAAP)?

One cannot run a business without adhering to rules, regulations, or guidelines for recording and reporting financial transactions. Following them prevent chaos, confusion, fraud and disastrous consequences for the business and its stakeholders.
The Generally Accepted Accounting Principles (GAAP) is a framework for companies to maintain consistent and reliable financial records in the US market. The Financial Accounting Standards Board (FASB) is responsible for developing and updating GAAP.
GAAP is a set of accounting standards and principles that guide preparing and presentation financial statements. These principles ensure that financial statements are transparent, accurate, and comparable across organisations and industries.
GAAP covers revenue recognition, expense reporting, balance sheet presentation, and disclosure requirements. Some of the fundamental GAAP principles include the matching principle, the going concern principle, and the cost principle.

Significance of GAAP

For starters, they help to ensure that financial statements are accurate and reliable, which is crucial for making informed business decisions.
They also provide consistency and comparability across different companies, making analysing financial statements easier and making industry-wide comparisons.
Businesses can maintain the trust of their stakeholders, make informed decisions, and thrive in a competitive marketplace.

Although compliance with GAAP is not mandatory by law for all businesses, many companies follow these principles to ensure the integrity of their financial reporting. As a result, GAAP is a crucial component of modern accounting, providing a common framework for businesses to report their financial information accurately and consistently.

Accounting Principles vs Accounting Concepts

Imagine you’re building a house. You have a blueprint outlining the design and layout, but you must follow specific building codes and regulations to ensure the structure is safe and sound. It is similar to the relationship between accounting principles and accounting concepts.
Accounting principles are like the building codes for financial reporting. Businesses must follow specific guidelines and standards when preparing financial statements.
These principles are based on rules and regulations established by organisations such as the Financial Accounting Standards Board (FASB) or the International Accounting Standards Board (IASB). Some examples of accounting principles include the matching principle, the cost principle, and the revenue recognition principle.
On the other hand, financial accounting concepts are broader and more general. They are fundamental ideas or assumptions that underlie accounting principles.
These concepts help to provide a framework for understanding and interpreting financial information. Some examples of accounting concepts include the entity concept, the going concern concept, and the materiality concept.

In simple terms, accounting principles are like the specific rules you must follow when building a house. At the same time, types of accounting concepts are like the underlying principles and assumptions that guide the design and construction of the house.

Understanding the difference between accounting principles and accounting concepts is essential for businesses and individuals who need to make financial decisions based on accurate and reliable information. By following accounting principles and understanding financial accounting concepts, companies can maintain transparency and accountability, build trust with their stakeholders, and make informed decisions that drive success and growth.

Difference Between Accounting Concepts and Conventions

Let’s take a walk down memory lane to your childhood. Do you remember playing a game of pretend with your friends? You might have been a superhero, a princess, or a detective. Accounting concepts and conventions are a game of pretend. They’re ideas and rules that help accountants act that financial statements accurately reflect a business’s financial position and performance.

Types of accounting concepts are fundamental ideas or assumptions that underlie the accounting process.
They help to provide a framework for understanding and interpreting financial information. Examples of accounting concepts include the going concern concept, the materiality concept, and the entity concept.
Accounting conventions, on the other hand, are generally accepted practices that have evolved.
They are not formal rules or standards, but traditions or customs followed in the accounting profession. Examples of accounting conventions include the conservatism convention, the consistency convention, and the entire disclosure convention.

So, what’s the difference between accounting concepts and conventions? Well, accounting concepts are fundamental ideas or assumptions that are used to develop accounting principles and standards. They help to provide a framework for understanding and interpreting financial information.

Accounting conventions, on the other hand, are practices that have evolved and are generally accepted within the accounting profession. They guide how to apply accounting principles in specific situations.
Accounting concepts are like the underlying principles that guide the game of pretend, while accounting conventions are like the rules and traditions that help to shape how the game is played.
Understanding the difference between accounting concepts and conventions is vital for businesses and individuals who need to make financial decisions based on accurate and reliable information.
By following accounting concepts and conventions, accountants can ensure that financial statements are transparent, consistent, and comparable across different organisations and industries.

Importance of Accounting Concepts

Accounting is a fundamental aspect of any successful business, and understanding the importance of accounting concepts is essential for maintaining accurate financial records. Accounting concepts provide a framework for financial reporting, ensuring that financial statements are transparent , consistent, and reliable.

Importance of Accounting Concepts:

Provides a framework for financial reporting: Accounting concepts are the fundamental principles and assumptions that underlie financial reporting. They provide a framework for interpreting and presenting financial information, ensuring that financial statements are consistent, reliable, and transparent.
Ensures compliance with accounting standards: By following accounting concepts, businesses can ensure compliance with accounting standards and regulations. It is essential for maintaining transparency and accuracy in financial reporting, which helps to build trust with stakeholders and investors.
Facilitates informed decision-making: Accounting concepts help businesses to make informed decisions based on accurate and reliable financial information. It is essential for making strategic decisions, identifying areas for improvement, and forecasting future performance.
Enhances comparability across different organisations: Financial statements become more comparable across various organisations and industries by following accounting concepts. It makes it easier for investors and stakeholders to compare the financial performance of different companies, facilitating informed decision-making.
Improves financial management: Accounting concepts are also crucial for improving financial management within a business. By following sound accounting principles and concepts, companies can monitor and manage their finances more effectively, identify potential risks and opportunities, and optimise financial performance.

In conclusion, understanding the importance of accounting concepts is essential for maintaining accurate financial records, complying with accounting standards, and making informed decisions. By following sound accounting principles and concepts, businesses can ensure transparency, consistency, and reliability in financial reporting, ultimately contributing to their long-term success and growth.

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Frequently Asked Questions

Accounting Concept refers to the fundamental principles and assumptions that are the basis of the preparation of financial statements. Accounting Convention refers to the established practices and procedures that are commonly accepted and followed in accounting

The fundamental accounting concepts and principles are guidelines that provide a framework for financial accounting. Here are some of the essential concepts and principles:

Going Concern Concept: This concept accepts that a business will continue to operate for the anticipated future, and its financial statements get prepared on this basis.
Dual Aspect Concept: This principle states that every transaction has two aspects, a debit and a credit, which must be recorded in a company’s financial records.
Accrual Accounting Concept: This concept requires companies to record transactions in the period in which they occur rather than when cash is received or paid.
Consistency Concept: This principle requires a company to apply the same accounting methods and practices from one accounting period to the next.
Materiality Concept: This principle states that financial information is to be disclosed if it is material or significant enough to affect the judgment of a reasonable person.
Conservatism Concept: This principle suggests that when there are uncertainties in accounting, a company should choose the least likely option to overstate assets or income.
Matching Concept: This principle requires that expenses be matched with the revenues they helped generate in the same accounting period.
Cost Concept: This principle requires that assets are recorded on a company’s financial statements at their historical cost.
Economic Entity Concept: This concept states that the business entity and its owner are separate and distinct entities, and their financial transactions should be treated accordingly.
Money Measurement Concept: This principle suggests that only financial transactions that can be measured in monetary terms should be recorded in a company’s financial statements.

Understanding and applying these principles and concepts is essential for ensuring the accuracy and integrity of financial reporting and, ultimately, for making informed business decisions.

The purpose of the going concern assumption in accounting is to provide a basis for preparing financial statements that reflect the financial position and performance of a business. The hypothesis assumes that a company will continue to operate for the foreseeable future and will not be forced to liquidate or cease operations due to financial difficulties.

This principle states that financial information is to be disclosed if it is material or significant enough to affect the judgment of a reasonable person.

The money measurement concept is an accounting principle that only those transactions and events that can be measured in monetary terms should be recorded in the financial statements. This concept implies that only information that can be quantified in terms of money should be included in the accounting records.

The consistency concept is an accounting principle that requires a company to use the same accounting methods and procedures from one accounting period to another. The principle suggests that a company should consistently apply the same accounting policies so that financial statements are comparable between different accounting periods.

For example, suppose a company uses the straight-line method to depreciate its fixed assets in one accounting period. In that case, it should continue using the same manner in subsequent accounting periods. If a company changes its accounting policies, it must disclose the change in the financial statements and explain its reason.

The significance of accounting concepts in finance is due to the following reasons:

Provides a framework for financial reporting
Ensures compliance with accounting standards
Facilitates informed decision-making
Enhances comparability across different organisations
Improves financial management

The realisation concept is an accounting principle that recognises revenue when earned rather than when payment is received. This principle requires that revenue be recognised when the goods or services have been delivered or rendered, and the earnings process is complete, regardless of when payment is received.

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Accounting Concepts and Principles

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on March 14, 2023

Fact Checked

Why Trust Finance Strategists?

Accounting concepts.

Accounting concepts are basic assumptions on which we base our accounting records. They are the things that we assume but, in certain cases, that may not be correct.

For example, one of the most common assumptions is that money has a stable value. We all know that this is not really correct because inflation continuously erodes the value of monetary units.

However, it would be tedious and of no great value to keep amending every company’s accounting records on the basis of an ever-changing value of the monetary unit. For this reason, we assume that money has a stable value.

Everyone accepts this assumption and all accounting records and statements prepared on the basis of this assumption are generally accepted by all concerned.

In this fact—namely, acceptance by all concerned—lies the importance of adhering to these accounting concepts or assumptions.

Common accounting concepts are given below:

Cost concept of accounting
Business entity concept
Money measurement concept
Going concern concept
Dual aspect of accounting concept

Accounting Principles

Accounting principles are the rules that have emerged from the use of basic accounting concepts. These rules have evolved over a long period of time; they represent the collective wisdom of accounting history.

Adherence to these rules ensures that accounting records are maintained on more or less the same basis by all business units and can, therefore, be relied upon and used for comparison.

As a business language, accounting must be simple to understand for the people who own or manage the company’s affairs. So, to achieve that purpose, standards were invented that were uniform, scientific, and easily adaptable for all.

These standards are known as accounting principles .

If these principles didn’t exist, the situation would be disastrous. Every accountant would practice accounting on their own terms and conditions, making it impossible for people attached to the company’s affairs to understand them.

Uniformity would also be missing. Therefore, accounting principles play a crucial role in ensuring that accounting practices are uniform, scientific, and easily adaptable.

It is imperative to follow accounting principles when measuring business routines, which may include incomes , expenses, and other aspects.

Significant accounting principles are mentioned as follows:

Principle of objective evidence
Accounting period principle
Matching principle
Accrual principle
Conservatism or prudence principle
Consistency principle
Materiality principle
Principle of adequate disclosure

Do you want to test your knowledge about Accounting Concepts and Principles? Take the quiz we have prepared for you here .

Accounting Concepts and Principles FAQs

What are the fundamental accounting concepts and principles.

The fundamental accounting concepts and principles include the accrual basis of accounting, the matching principle, the revenue recognition principle, the going concern assumption, the consistency principle, the materiality concept, the cost concept, the full disclosure principle, and the objectivity concept.

How does the accrual basis of accounting work?

The accrual basis of accounting recognizes revenues and expenses in the period incurred, regardless of when cash is received or paid. This means that a company records transactions in the period they occur, rather than when payment is made or received.

How does the matching principle function in accounting?

The matching principle states that all costs associated with the generation of revenue should be recorded in the same period as when the revenue is earned. This allows companies to more accurately measure their performance and profitability by matching their associated expenses with the revenues generated from them.

What is the purpose of going concern assumption?

The going concern assumption states that a business will remain in operation for the foreseeable future. This means that a company does not need to liquidate its assets and settle its accounts immediately, as it has every intention of continuing to operate as normal.

What is the materiality concept?

The materiality concept states that transactions and events must be reported if they are material, meaning they have a significant effect on the financial statements of a business. This means that companies must disclose all information relevant to their financial statements in order to provide an accurate picture of their performance.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

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Accounting Concepts: Types, Examples & Principles

Theory Base of Accounting consists of accounting concepts, principles, rules, guidelines, and standards that help an individual understand the basics of accounting. These Concepts are developed over time to bring consistency and uniformity to the accounting process.

GAAP or Generally Accepted Accounting Principles are the rules and procedures defined and developed by the Financial Accounting Standards Board (FASB) that an organization has to follow for the proper creation of financial statements consistent with the industry standards. The General Accepted Accounting Principles are also known as Accounting Concepts . The primary objective of GAAP is to ensure a basic level of consistency in the accounting statements of an organization. Financial statements prepared with the help of GAAP can be easily used by the external users of the accounts of a company.

Basic Accounting Concepts

These are the basic ideas or assumptions under the theory base of accounting that provide certain working rules for the accounting activities of an organization. There are 13 important Accounting Concepts that are to be followed by companies to prepare true and fair financial statements.

Table of Content

Business Entity Concept

Money measurement concept, going concern concept, accounting period concept, cost concept, dual aspect or duality concept, revenue recognition concept, matching concept, full disclosure concept, consistency concept, conservatism concept, materiality concept, objectivity concept.

The business entity concept states that the business enterprise is separate from its owner. In simple terms, for accounting purposes, the business and its owners are treated separately. If an owner invests money in the business, it will be treated as a liability for the business. However, if the owner takes out some money from the business for personal use, it will be considered drawings. Therefore, assets and liabilities of a business are the business’s assets and liabilities, not the owner’s. Hence, the books of accounts include the accounting records from the point of view of the business instead of the owner. For example, the amount of 1,00,000 in ABC Ltd. by its owner Raj will be considered a liability to the business. The business entity concept applies to partnerships , companies, sole proprietorships , small enterprises, and large enterprises.

The money measurement concept says that a business should record only those transactions which can be expressed in monetary terms. It means that transactions like purchase and sale of goods, rent payment, expenses payment, earning of revenue, etc., will be recorded in the books of accounts of the firm. However, transactions or happenings, like the research department’s creativity, machinery breakdown, etc., will not be recorded in the books of accounts of the firm. Besides, the records of transactions of a firm should not be recorded in physical units, such as 3 acre land, 20 computers, 40 chairs, etc., instead, they should be recorded in monetary terms, such as ₹13 lakh for land, ₹15 lakh for computers, and ₹2 lakh for chairs, etc., in the books of accounts.

However, there are two drawbacks of this concept in accounting. Firstly, according to this concept, the accounting of a business is limited to the recording of information that can be expressed in a monetary unit, but does not involve or record essential information that cannot be expressed in monetary units. Secondly, the concept has the limitations of the monetary unit itself.

The going concern concept assumes that an organization would continue its business operations indefinitely. It means that it is assumed that the business will run for a long period of time, and will not liquidate in the foreseeable future. It is one of the most important assumptions or concepts of accounting. It is because the going concern concept provides the firm with the basis to show its assets’ value in the balance sheet.

For example, if an organization purchases machinery for ₹1,00,000, it would not be fair to show the full amount of the machinery in one year, as the company will be getting service or production with the help of machinery for several years. Therefore, the going concern concept by assuming that the business will not liquidate in the foreseeable future states that the firm should record the machinery’s value for its estimated life span. Let’s say, the life span of the said machinery is 10 years. Now, the firm may charge ₹10,000 for 10 years from the profit and loss account.

The accounting period concept defines the time span at the end of which an organization has to prepare its financial statements to determine whether they have earned profits or incurred losses during a specified time span. It also states the exact position of the firm’s assets and liabilities at the end of the specified time span. This information is used by different internal and external users of the organization for various purposes regularly. The financial statements are prepared regularly because it helps them in the decision-making process, and no firm can wait for long to know its results. The normal interval for the preparation of the financial statements is one year. This time interval of one year is known as the accounting period. According to the Companies Act, 2013 and the Income Tax Act, an organization has to prepare its income statements annually. However, in some cases, like the retirement of a partner between the accounting period, etc., the firm can prepare interim financial statements.

The cost concept of accounting states that an organization should record all of its assets at their purchase price in the books of accounts. This amount also includes any transportation cost, acquisition cost, installation cost, and any other cost spent by the firm for making the asset ready to use. For example, Radha Ltd. purchased machinery for ₹60 lakh in July 2021. It has also spent a sum of ₹10,000 on transportation, ₹20,000 on its installation, and ₹15,000 on making it ready to use. The total amount at which the organization will record the value of machinery in the books of account would be ₹60,45,000.

Therefore, the cost concept or historical cost concept states that since the company is not going to sell the assets as per the going concern concept, there is no point in revaluing the assets and showing their current value. Besides, for practical reasons also, the accountants of an organization prefer to report the actual costs to its market values. However, the asset amount listed in the books of accounts of the firm does not indicate the value at which it can sell the asset.

The dual aspect or duality concept is the foundation of any business. The concept describes the basis of recording business transactions in the books of accounts. According to the concept, every transaction of the business has a two-fold effect. Hence, it should record every transaction in two places. In simple words, two accounts will be affected by a single transaction. This concept can be expressed as the Accounting Equation:

Assets = Liabilities + Capital

The accounting equation states that the total of assets of an organization is always equal to the total of its owners’ and outsiders’ claims. These claims or equity of the firm’s owners is also known as Capital or Owner’s Equity, and the outsiders’ claims are known as Liabilities or Creditors’ Equity. For example, Rohan started a business by investing a sum of ₹1 crore. This amount will increase the cash (asset side) of the business, and will also increase its capital by the same amount, i.e., ₹1 crore. Therefore, the effect of the transaction will be shown in two accounts, i.e., cash and capital account. The dual concept forms the base of the Double Entry System of Accounting.

The revenue recognition concept , also known as the realisation concept , as the name suggests, defines that an organization should record its revenue from business only when it is realised, not when the firm has received the cash. Let us understand the concept with the help of an example . Suppose a client pays ₹5,000 in advance for a product. The company will not realise the amount of revenue until its work on the product is complete. Therefore, the firm will initially record the amount as a liability in the unearned revenue account. Once the product has shipped to the client, it will be transferred to the revenue account. Let us take another example of delayed payment. Suppose a company ships its goods amounting to ₹10,000 to its customer on the credit of 30 days. The company will realise the same as soon as the goods have been shipped even though it will receive the amount in the future.

The matching concept states that an organization should recognize its expenses in the same financial year if the expense is related to the revenue of that year. In simple words, if a firm is earning revenue in an accounting period, even though it incurs the expenses related to that revenue in the next accounting year, the expense will be realized in the same accounting year when the revenue has been realized by the firm. For example, if a salesman sells goods worth ₹10,00,000 in February 2022 on a 6% commission made in May 2022, the commission expense of 6% will be charged in the accounting year in which the sales have been made, i.e., 2021-2022. A company should keep in mind that the matching concept should be followed only after the realisation concept has been fulfilled.

As the name suggests, the full disclosure concept states that an organization should disclose all the facts regarding its financial performance. It is because the information mentioned in the financial statements is used by different internal and external users, like investors, banks, creditors, management, employees, financial institutions, etc., for making financial decisions. Hence, the concept says that all relevant and material facts or figures about an organisation must be disclosed in its financial statements. To fully ensure this concept, an organization has to prepare its Balance Sheet and Profit & Loss Account based on the format provided by the Indian Companies Act 1956. Besides, different regulatory bodies, like SEBI, also make it compulsory for companies to completely disclose the true and fair picture of their state of affairs and profitability.

The consistency concept states that there should be consistency or uniformity in the accounting practices and policies followed by an organization. It is because the accounting information provided by an organization through its financial statements would be beneficial only when it allows its users in making a comparison between the statements of different years or with statements of other firms. However, it does not mean that the organization cannot change its accounting policies when necessary. The firm can make required changes in its policies by properly indicating the probable effect of the changes on its financial results. For example, if a company’s management wants to compare the net profit of the current year with the previous year, it can do so only when the accounting policies followed by the company in both years are the same. For example, if a company has used the SLM depreciation method in the previous year and the WDV method of depreciation in the current year; it would not be able to compare the figures.

The conservatism or prudence concept believes in playing safely, while recording the transactions in the book of accounts. According to this concept, an organization should adopt a conscious approach and should not record its profits until they are realised. However, it states that the organization should realise any loss even if the company has not incurred it yet, or if there is a slight possibility of loss to occurring in the future. No matter how pessimist attitude this concept shows, it is essential for an organization to deal with uncertainty and allows them to protect the interest of creditors against any unwanted distribution of its assets. For example, if an organization feels that a certain debtor will not pay the amount in the future, it should open a Provision for Doubtful Debts Account . Similarly, an organization should not record its increase in the market value of stock until it is sold.

The materiality concept suggests that an organization should focus on material facts only. In simple words, an organization should not waste its time on immaterial facts that do not help in determining its income for the period. In order to differentiate a fact as material or immaterial, one should consider its nature and the amount involved. Therefore, a fact will be considered material if the accountant believes that the information can influence the decisions of a user of the financial statements. For example, the original cost of stationery is insignificant to the users of financial statements. Hence they are not included in the closing stock of the statements and are shown under expenses. Similarly, suppose the company has incurred an expense on the marketing of the firm or its products. In that case, it will be shown in the financial statements as it is a material fact for the users and can change their decisions.

The objectivity concept of accounting states that an organization should record transactions in an objective manner. It means that the recording should be free from any kind of biasness by accountants and other people. Objectivity in the recording of transactions is possible when the transactions of the firm are supported by verifiable vouchers or documents. The purpose of the objectivity concept is that it does not let the firm’s management and accountants’ opinions impact the financial statements and provide a false image. The concept can be helpful for an organization in creation of its goodwill. Besides, it warns the companies about the penalties if there is any sort of misinterpretation in the financial statements.

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Accounting Concepts

What Does Accounting Concepts Mean?

In India, there are several rules which need to be followed while walking or driving on the road as it enables the smooth flow of traffic. Similarly, there are accounting rules that an accountant should follow while recording business transactions or recording accounts. They may be termed as accounting concepts. Hence, it can be said that:

“The term accounting concepts refer to basic rules, assumptions, and principles which act as a primary standard for recording business transactions and maintaining books of accounts”.

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What are the Objectives of the Accounting Concept?

The primary aim of accounting is to maintain uniformity and regularity in the preparation of accounting statements.

Accounting concepts act as an underlying principle that helps accountants in the preparation and maintenance of business records.

It aims to understand the business rules and regulations that are required to be followed by all types of business entities, and hence simplifying the detailed and comparable financial information.

What are the Different Accounting Concepts?

Following are the different accounting concepts that are widely used all around the world and hence are termed as universally accepted accounting rules. The different accounting concepts are:

Business Entity Concept

This concept assumes that the organization and business owners are two independent entities. Hence, the business translation and personal transaction of its owner are different. For example, when the business owner invests his money in the business, it is recorded as a liability of the business to the owner. Similarly, when the owner takes away from the business cash/goods for his/her personal use, it is not treated as a business expense. Thus, the accounting transactions are recorded in the books of accounts from the organization's point of view and not the person owning the business.

Suppose Mr. Birla started a business. He invested Rs 1, 00, 000. He purchased goods for Rs 50,000, furniture for Rs. 40,000, and plant and machinery for Rs. 10,000 and Rs 2000 remained in hand. These are the assets of the business and not of the business owner. According to the business entity concept, Rs.1,00,000 will be assumed by a business as capital i.e. a liability of the business towards the owner of the business.

Now suppose, he takes away Rs. 5000 cash or goods for the same worth for his domestic purposes. This withdrawal of cash/goods by the owner from the business is his private expense and not the business expense. It is termed as Drawings.

Therefore, the business entity concept states that the business and the business owner are two separate/distinct persons. Accordingly, any expenses incurred by the owner for himself or his family from business will be considered as expenses and it will be represented as drawings.

Accrual Concept

The term accrual means something is due, especially an amount of money that is yet to be paid or received at the end of the accounting period. It implies that revenue is realized at the time of sale through cash or not whereas expenses are recognized when they become payable whether cash is paid or not. Therefore, both the transactions are recorded in the accounting period in which they relate.

In the accounting system, the accrual concept tells that the business revenue is realized at the time goods and services are sold irrespective of the fact when cash is received for the same. For example, On March 5, 2021, the firm sold goods for Rs 55000, and the payment was not received until April 5, 2021, the amount was due and payable to the firm on the date goods and services were sold i.e. March 5, 2021. It must be included in the revenue for the year ending March 31, 2021.

Similarly, expenses are recognized at the time services are provided, irrespective of the fact that cash paid for these services are made. For example, if the firm received goods costing Rs.20000 on March 9, 2021, but the payment is made on April 7, 2021, the accrual concept requires that expenses must be recorded for the year ending March 31, 2021, although no payment has been made until this date though the service has been received and the person to whom the payment should have been made is represented as a creditor of business firm.

In brief, the accrual concept states that revenue is recognized when realized and expenses are recognized when they become due and payable irrespective of the cash receipt or cash payment.

Accounting Cost Concept

The accounting cost concept states all the business assets should be written down in the book of accounts at the price assets are purchased, including the cost of acquisition, and installation. The assets are not recorded at their market price. It implies that the fixed assets like plant and machinery, building, furniture, etc are recorded at their purchase price. For example, a machine was purchased by ABC Limited for Rs.10,00,000, for manufacturing bottles. An amount of Rs.2,000 was spent on transporting the machine to the factory site. Also, Rs.2000 was additionally spent on its installation. Hence, the total amount at which the machine will be recorded in the books of accounts would be the total of all these items i.e. Rs.10, 040, 00. This cost is also termed as historical cost.

Dual Aspect

The dual aspect is the basic principle of accounting. It provides the basis for recording business transactions in the books of accounts. This concept assumes that every transaction recorded in the books of accountants is based on dual concepts. This implies that the transaction that is recorded affects two accounts on their respective opposite sides. Hence, the transaction should be recorded at dual places. It implies that both aspects of the transaction should be recorded in the books of account. For example, goods purchased in exchange for cash have two aspects such as paying cash and receiving goods. Therefore, both the aspects should be registered in the books of accounts. The duality of the transaction is commonly expressed in the terms of the following equation given below:

Assets = Liabilities + Capital

The dual concept implies that every transaction has a similar effect on assets and liabilities in such a way that the value of total assets is always equal to the value of total liabilities.

Going Concepts

The Going concept in accounting states that a business activities will be carried by any firm for an unlimited duration This simply means that every business has continuity of life. Hence, it will not be dissolved shortly. This is an important assumption of accounting as it provides a base for representing the asset value in the balance sheet.

For example, the plant and machinery was purchased by a company of Rs. 10 lakhs and its life span is 10 years. According to the Going concept, every year some amount of assets purchased by the business will be represented as an expense and the balance amount will be shown as an asset in the books of accounts. Thus, if an amount is incurred on an item that will be used in business for several years ahead, it will not be proper to charge the amount from the revenues of that particular year in which the item was purchased Only a part of the purchase value is shown as an expense in the year of purchase and the remaining balance is shown as an asset in the balance sheet.

Money Measurement Concept

The money measurement concept assumes that the business transactions are made in terms of money i.e. in the currency of a country. In India, such transactions are made in terms of the rupee. Hence, as per the money measurement concept, transactions that can be expressed in terms of money should be recorded in books of accounts. For example, the sale of goods worth Rs. 10000, purchase of raw material Rs. 5000, rent paid Rs.2000 are expressed in terms of money, hence these transactions can be recorded in the books of accounts.

Accounting Period Concepts

Accounting period concepts state that all the transactions recorded in the books of account should be based on the assumption that profit on these transactions is to be ascertained for a specific period. Hence this concept says that the balance sheet and profit and loss account of a business should be prepared at regular intervals. This is important for different purposes like calculation of profit and loss, tax calculation, ascertaining financial position, etc. Also, this concept assumes that business indefinite life is divided into two parts. These parts are termed accounting periods. It can be one month, three months, six months, etc. Usually, one year is considered as one accounting period which may be a calendar year or financial year.

The year that begins on January 1 and ends on January 31 is termed as calendar year whereas the year that begins on April 1 and ends on March 31 is termed as financial year.

Realization Concept

The term realization concept states that revenue earned from any business transaction should be included in the accounting records only when it is realized. The term realization implies the creation of a legal right to receive money. Hence, it should be noted that selling goods is considered as realization whereas receiving order is not considered as realization.

In other words, the revenue concept states that revenue is realized when cash is received or the right to receive cash on the sale of goods or services or both have been created.

Matching Concepts

The Matching concept states that revenue and expenses incurred to earn the revenue must belong to the same accounting period. Hence, once revenue is realized, the next step is to assign the relevant accounting period. For example, if you pay a commission to a salesperson for the sale that you record in March. The commission should also be recorded in the same month.

The matching concept implies that all the revenue earned during an accounting year whether received or not during that year or all the expenses incurred whether paid or not during that year should be considered while determining the profit and loss of the business for that year. This enables the investors or shareholders to know the exact profit and loss of the business.

What are Accounting Conventions?

Accounting conventions are certain restrictions for the business transactions that are complicated and are unclear. Although accounting conventions are not generally or legally binding, these generally accepted principles maintain consistency in financial statements. While standardized financial reporting processes, the accounting conventions consider comparison, full disclosure of transaction, relevance, and application in financial statements.

Four important types of accounting conventions are:

Conservatism: It tells the accountants to err on the side of caution when providing the estimates for the assets and liabilities, which means that when there are two values of a transaction available, then the always lower one should be referred to.

Consistency: A company is forced to apply the similar accounting principles across the different accounting cycles. Once this chooses a method it is urged to stick with it in the future also, unless it finds a good reason to perform it in another way. In the absence of these accounting conventions, the ability of investors to compare and assess how the company performs becomes more challenging.

Full Disclosure: Information that is considered potentially significant and relevant is to be completely disclosed, regardless of whether it is detrimental to the company.

Materiality: Similar to full disclosure, this convention also bound organizations to put down their cards on the table, meaning they need to totally disclose all the material facts about the company. The aim behind this materiality convention is that any information that could influence the person’s decision by considering the financial statement must be included.

Accounting Principles

Accounting principles are a set of guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while presenting or recording financial transactions in the books of account. This enables companies to present a true and fair view of the financial statements.

Here is the list of the top 6 accounting principles that companies follow quite often:

Accrual Principle

Consistency Principle

Conservatism Principle

Going Concern Principle

Matching Principle

Full Disclosure Principle

FAQs on Accounting Concepts

1. What is an Accounting System?

An accounting system is a set of accounting processes, integrated procedures, and controls. The primary motive of the accounting system is to keep up the records of business transactions, compile those transactions into an aggregated form, and draw up a report that can be used by decision authorities to audit, evaluate, and enhance the business operations. There are two types of accounting systems namely single entry system and a double-entry system.

2. What are Expenses?

An expense is the cost of operations that a company incurs to generate its revenue. A popular saying goes, “it costs money to make money.” Expenses include payments to the suppliers, employee wages, factory leases, and equipment or asset depreciation. Examples of Expenses are - Cost of goods sold, Sales commissions expense, Delivery expense, rent expense, Advertising expense, etc.

3. What are Accounting Standards?

Accounting standard refers to the set of rules, guidelines, and principles framed by the regulatory body or the government that act as a framework for accounting policies and practices. In the United States, the Generally Accepted Accounting Principle, also known as GAAP, is an accounting standard that must be followed while presenting and preparing financial statements. Generally,accounting standards are established to ensure transparency of accounting professionals and consistency in accounting principles followed by organizations. All countries have their own accounting standards framed by the regulatory body or the government. However, these standards may vary from one country to another.

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MP Taps and Fittings Enterprise*

Case Preview

Mp taps and fittings enterprise.

Mr. Manohar Prakash could not believe his luck. Just when he thought that the difficult days were over and the situation was under control, news came about accident of his accountant Mr. Arun Chandra. He was also informed that all the books of accounts were destroyed in the same accident. It was March 2016 now, the financial year closing time, the time to prepare the final accounts. What was to be done now …?

Manohar Prakash (Manohar) and Arun Chandra (Arun) worked in SriRam Faucet Ltd., Okhla, Delhi, as Chief Marketing Manager and Senior Accounts Officer respectively. SriRam Faucet Ltd. used to manufacture taps and faucets and supply them to the construction companies like DLF, Parshwanath, Ansals, Amrapali, Unitech, etc. The business was good and the salary (INR40,000 per month) was adequate for Manohar. However, he always felt that he could earn more with little more efforts. As a Chief Marketing Manager, he used to interact a lot with the purchase heads, production heads, and CEOs of these construction companies. He had realized during these interactions that the home buyers always looked for variety as well as better features from the taps and faucets they bought and were ready to pay more for better utility products. He could see the supply gap on these lines and understood that the market needed more players who could cater to these needs........

Preparing for the Set-up

Armed with these information, Manohar went ahead to acquire infrastructure. He rented a building to serve as his factory cum office in Patparganj, Delhi, belonging to his friend Nixit Arnold (Nexit) who waived off the security deposit of INR 50,000 for him. Nixit let out his homeat a discounted rent of INR15,000 per month only (which otherwise would have amounted to at least INR20,000 per month)but with a condition in the rental agreement that if the ROI of the faucet business is more than 20% after first year, the rent would be revised upward by 20% in the second year and by 10% thereafter every year. Mahonar agreed and promised to send him the copy of his Profit and Loss account at the year end.............

Beginning of the Operations

The operations in the factory started in the last week of April after an order of 250 ‘wall-mounted kitchen faucets with spray/stream/foam selector options’ was received from Amrapali builders for one of their semi-luxury residential project in Noida Extension. Mahonar made sure that the quality of the faucets was the best and also that the delivery was as per schedule on May 15 th 2015. He believed that a good word of mouth would ensure regular flow of orders from other customers as well...............

Issues and Challenges

However, things after the initial euphoria were not as rosy as Manohar thought. There were no orders. For the entire duration between mid-May to mid-June, he kept on knocking the doors of those construction companies for procuring sales orders. But there were hardly any requisitions from those builders mostly due to the logjam of Farmers - Greater Noida Urban development authority in the area where maximum residential projects were coming up..............

The Turnaround

Aditya did not disappoint him. Mid-July onwards, Manohar saw a steady flow of orders from builders across the city as well as outside of which only sales worth INR600,000 was through Manohar’s efforts and old contacts. So much so that he had to hire 5 additional workers in his factory from September 1 st 2015 onwards at a wage rate of INR6,000 per month to ensure timely deliveries.............

The Data Loss

This was the last official conversation he had with Arun. After coming back from his vacation, Arun worked doubly hard to complete the pending accounting work for preparing final accounts. He used to take the journal books and ledger to his house after office for checking the work done by office manager in his absence and used to bring them back to the office the next day...........

Reports Available

This was a big setback for Manohar. There were no books of accounts to refer to, though he had a report prepared by Arun as a summary of major expenses paid (except salary, wages and rent) and of incomes through sales till December 31 st 2015 on cash as well as credit basis (Exhibit III)..........

Assignment Questions

I. Clarify all the doubts (as mentioned above) divulged by Manohar by citing relevant accounting principles.

a) How should he treat the sale which was on approval basis? No approval was received till March 31st 2016, although his sales manager had assured him that the customer had liked the product and was keeping it. b) How should he treat the rumor of his customer going into bankruptcy? c) Should he include the sales order of INR210,000 from BPTP builder in his P/L account? d) Before starting his business, Manohar had paid for information about types of faucets and their customization work. Could he show this in his final accounts? And in what way? e) ........................

Exhibit I: Types of Faucets

Exhibit II: Additional Customization Required

Exhibit III: Summary Report of Incomes and Expenses Paid

Teaching Note Preview

Preparation of final accounts i.e., Trading and Profit & Loss (P/L) account, Cash Flow Statement and Balance Sheet is the basic requirement for all the business entities. While the format for preparing these final accounts has been specified as per schedule VI of the Companies Act 2013 for the public limited companies, the same is not mandatory for sole proprietors. However, the sole proprietors have to still prepare these financial statements, i.e., P/L account, Balance Sheet and Cash Flow statement at the end of each financial year for various purposes like calculating their tax liability and filing tax returns, applying for business loan, making capital expenditure decisions etc., apart from determining their business profitability and financial position.

The recording of business transactions and preparation of final accounts are based on Generally Accepted Accounting Principles (GAAP), accounting standards issued by Institute of Chartered Accountants of India (ICAI). These principles are rule of actions adopted by the accountants universally while recording accounting transactions which comprise of concepts and conventions. While the accounting concepts are basic assumptions on which accounting is based, the conventions are customs or traditions which guide the accountant while preparing financial statements.

Taking the above into consideration, the case describes the various situations and transactions where the recording of business transactions would be done using the various accounting concepts and conventions practiced by accountants in India as well as abroad.

It begins with a brief history about the formation of sole proprietorship business entity ‘MP Taps and Fittings Enterprise’ and then talks about various business activities and transactions during the year. Through this, the case tries to bring to the light the importance of recording the business transactions and treatment of the adjustment entries while preparing the financial statements.

Prerequisite Conceptual Understandings (PCUs)

• S N Maheshwari & S K Maheshwari, “An Introduction to Accountancy” • Asish K Bhattacharyya, “Indian Accounting Standards: Practices, Comparisons, and Interpretations” • http://www.icai.org/post.html?post_id=8660/Accounting Conventions and Standards, September 1 st 2014 (accessed date: March 12 th 2015) • http://www.yourarticlelibrary.com/accounting/final-accounts/types-of-adjustments-entries-in-finalaccounts/61564/

Case Positioning and Setting

MBA program – Financial Accounting course – To discuss various issues pertaining to the treatment of business transactions and preparation of final accounts

Expected Learning Outcomes

• Understand the application of accounting principles in recording of financial transactions • Analyze the treatment of adjustment entries in the preparation of final accounts • Understand the concept of Return On Investment (ROI) and its importance • Discuss the concept of providing for future losses or cash requirements • Analyze the differences between book profit and cash profit

Teaching Strategy

It would include questioning students in a way that helps them evaluate the concepts behind the statements and questions. Students would use domain knowledge and apply concepts relevant to the case to solve the stated problems.........

The caselet highlights the importance of applying the accounting concepts and conventions mandated by Institute of Chartered Accountants of India (ICAI) for preparation of final accounts by the business enterprises. It begins with a brief history about the formation of sole proprietorship business entity ‘MP Taps and Fittings Enterprise’ and then talks about various business activities and transactions during the year. Through this, the case tries to bring to the light the importance of recording the business transactions and treatment of the adjustment entries while preparing the financial statements. It also describes the various situations where the recording of business transaction would be done using different accounting concepts and conventions practiced by accountants in India as well as abroad.

To understand the application of accounting principles in recording of financial transactions
To analyze the treatment of adjustment entries in the preparation of final accounts
To understand the concept of Return On Investment (ROI) and its importance
To discuss the concept of providing for future losses or cash requirements

Case Positioning and Setting MBA program – Financial Accounting course – To discuss various issues pertaining to the treatment of business transactions, understand the applicability of accounting principles and preparation of final accounts

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Case Study Preview	Mr. Manohar Prakash could not believe his luck. Just when he thought that the difficult days were over and the situation was under control, news came about accident of his accountant Mr. Arun Chandra. He was also informed that all the books of accounts were destroyed in the same accident. It was March 2016 now, the financial year closing time, the time to prepare the final accounts. What was to be done now …? Manohar Prakash (Manohar) and Arun Chandra (Arun) worked in SriRam Faucet Ltd., Okhla, Delhi, as Chief Marketing Manager and Senior Accounts Officer respectively. SriRam Faucet Ltd. used to manufacture taps and faucets and supply them to the construction companies like DLF, Parshwanath, Ansals, Amrapali, Unitech, etc. The business was good and the salary (INR40,000 per month) was adequate for Manohar. However, he always felt that he could earn more with little more efforts. As a Chief Marketing Manager, he used to interact a lot with the purchase heads, production heads, and CEOs of these construction companies. He had realized during these interactions that the home buyers always looked for variety as well as better features from the taps and faucets they bought and were ready to pay more for better utility products. He could see the supply gap on these lines and understood that the market needed more players who could cater to these needs........ Armed with these information, Manohar went ahead to acquire infrastructure. He rented a building to serve as his factory cum office in Patparganj, Delhi, belonging to his friend Nixit Arnold (Nexit) who waived off the security deposit of INR 50,000 for him. Nixit let out his homeat a discounted rent of INR15,000 per month only (which otherwise would have amounted to at least INR20,000 per month)but with a condition in the rental agreement that if the ROI of the faucet business is more than 20% after first year, the rent would be revised upward by 20% in the second year and by 10% thereafter every year. Mahonar agreed and promised to send him the copy of his Profit and Loss account at the year end............. The operations in the factory started in the last week of April after an order of 250 ‘wall-mounted kitchen faucets with spray/stream/foam selector options’ was received from Amrapali builders for one of their semi-luxury residential project in Noida Extension. Mahonar made sure that the quality of the faucets was the best and also that the delivery was as per schedule on May 15 2015. He believed that a good word of mouth would ensure regular flow of orders from other customers as well............... However, things after the initial euphoria were not as rosy as Manohar thought. There were no orders. For the entire duration between mid-May to mid-June, he kept on knocking the doors of those construction companies for procuring sales orders. But there were hardly any requisitions from those builders mostly due to the logjam of Farmers - Greater Noida Urban development authority in the area where maximum residential projects were coming up.............. Aditya did not disappoint him. Mid-July onwards, Manohar saw a steady flow of orders from builders across the city as well as outside of which only sales worth INR600,000 was through Manohar’s efforts and old contacts. So much so that he had to hire 5 additional workers in his factory from September 1 2015 onwards at a wage rate of INR6,000 per month to ensure timely deliveries............. This was the last official conversation he had with Arun. After coming back from his vacation, Arun worked doubly hard to complete the pending accounting work for preparing final accounts. He used to take the journal books and ledger to his house after office for checking the work done by office manager in his absence and used to bring them back to the office the next day........... This was a big setback for Manohar. There were no books of accounts to refer to, though he had a report prepared by Arun as a summary of major expenses paid (except salary, wages and rent) and of incomes through sales till December 31 2015 on cash as well as credit basis (Exhibit III).......... I. Clarify all the doubts (as mentioned above) divulged by Manohar by citing relevant accounting principles. a) How should he treat the sale which was on approval basis? No approval was received till March 31st 2016, although his sales manager had assured him that the customer had liked the product and was keeping it. b) How should he treat the rumor of his customer going into bankruptcy? c) Should he include the sales order of INR210,000 from BPTP builder in his P/L account? d) Before starting his business, Manohar had paid for information about types of faucets and their customization work. Could he show this in his final accounts? And in what way? e) ........................ Exhibit I: Types of Faucets Exhibit II: Additional Customization Required Exhibit III: Summary Report of Incomes and Expenses Paid

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3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

Accounting Principles, Assumptions, and Concepts

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1.7 Accounting Principles, Concepts and Assumptions

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