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Discipline Courses-I

Semester-I
Paper : Financial Accounting and Auditing
Lesson: Accounting Concepts and Conventions
Lesson Developer: Monika Gupta
College/Department: Moti Lal Nehru college,
University of Delhi

Institute of LifeLong learning, University of Delhi


Accounting Principles: Concepts and Conventions

Lesson: Accounting Principles: Concepts and Conventions


Table of Contents:
1: Learning Outcomes
2: Introduction
3: Generally Accepted Accounting Principles
4: Accounting Concepts
4.1: The Business Entity Concept
4.2: The Money Measurement Concept
4.3: Going Concern Concept
4.4: The Accounting Period Concept
4.5: The Dual Aspect Concept
4.6: The Historical Cost Concept
4.7: The Accrual Concept
4.8: The Revenue Recognition Concept
4.9: The Expense Recognition Concept
4.10: The Matching Period Concept
4.11: The Verifiable Objective Evidence Concept
5: Accounting Conventions
5.1 The Prudence Convention (Conservatism)
5.2 The Convention of Consistency
5.3 The Convention of Materiality
5.4 The Convention of Full Disclosure
6: Concepts Vs. Conventions
Summary
References
Exercises

1. Learning Outcomes:
After you have read this lesson, you should be able to:
• comprehend the concept of accounting principles,
• describe the various accounting concepts,
• appreciate the rationale of following accounting concepts,
• identify the implications of not following accounting concepts,
• describe the various accounting conventions,
• identify the implications of not following accounting conventions,
• appreciate the rationale of following accounting conventions,
• differentiate between accounting concepts and conventions.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

1. Introduction:
Accounting is the language of business and in order that every one uses and understand
the language in the same way, there must be rules and conventions regarding its
construction, expression pronunciation etc.

If every business enterprise is follows its own manner of accounting based on different
notions for the accounting terms like revenue, expense, assets, liabilities, income etc.,
then the records of one enterprise will be inconsistent with that of other enterprise,
which shall lead to confusion and unreliability of accounting information. Accounts
maintained in such biased manner will make to incomparable, such that no meaningful
analysis could be made on them and no inferences would be possible. Some standard
rules or guidelines are therefore necessary for proper reporting of accounting
information. Such set of rules and conventions are called accounting principles. When we
discuss accounting principles, we may recognize broadly two sub sets.

The first one refers to a set of basic postulates, axioms, assumptions that are necessary
conditions in the preparation of accounts. These are so basic that they may be called as
the constitution of financial accounting. Just as constitution is not frequently changed,
these rules are also permanent and do not change with time. For example, every
business entity for which records are prepared is presumed to be functional over a long
period of time. If this were not true, investors would not invest, lenders would not lend,
and suppliers would not supply.

The second sub set includes the principles that govern the detailed practices and
procedures in the preparation of financial statements. For example, on what basis
inventory is to be valued, how should depreciation be determined, what procedures are
to be followed in valuing fixed assets.

These principles have been developed over a long period by accountants, academicians,
regulatory bodies and legislations. The development of accounting principles is a
constant juggling process with the ever-changing needs of society and demands placed
by the ever growing and widening business environment.

3. Generally Accepted Accounting Principles (GAAP)

The term GAAP is used to describe rules developed for preparation and presentation of
financial statements and is also known as concepts, conventions, postulates, principles,
modifying principles etc. They are the basic foundation of accounting structure.
Accounting principles are the basis of preparation of financial statements in every
country. Since they are accepted by all countries, they are referred to ‘Generally
Accepted Accounting Principles’ or simply as ‘GAAPs’.

GAAPs evolved gradually and informally over a period of time but their consolidation,
refinement and further development are now vested in specially constituted rule making
bodies in which broad representation is given to professional accounting bodies,
academicians, regulatory authorities etc. In US, for example, Federal Accounting
Standard Board, makes major pronouncements called Statements of Financial
Accounting Standard (SFACs) from time to time. Similarly Accounting Standard Board in
India, American Institute of Certified Public Accountants (AICPA), International
Accounting Standard Board (IASB) etc. are some professional bodies which have been
set up to issue accounting standard and guidelines.

Value Addition 1: Image


Agencies Involved in Setting Accounting Principles
Click on the link below to view an image that shows the various agencies involved in
setting principles of accounting.
Source:
http://www.bionicturtle.com/images/uploads/WindowsLiveWriterIntroductiontoFinancialS
ta29.png

Due to presence of various agencies, there is need for harmonization of accounting


practices and systems. This role of binding factor responsible for harmonization of
accounting practices and systems is performed by Generally Accepted Accounting
Principles. Public auditors are required to ensure such compliance and report to the
users in case of non-compliance. If GAAPs are observed while preparing financial
statements, it ensures use of a standard language of accounting by all users across
nations.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

However, the observance of GAAPs does not mean absolute rigidity. There is scope for
the accountants to select alternate policies. For example, in the matter of inventory
valuation the accountant may follow FIFO, LIFO, or Weighted Average Method.

The general acceptance of accounting principles depends upon how well these principles
meet or satisfy three attributes namely relevance, objectivity and feasibility. A principle
is said to have relevance if it results in more meaningful and useful information about
the enterprise to the users. It is said to be objective to the extent that accounting
information is free from personal bias of judgments of those who provide it. A principle
is said to be feasible if it can be used without much complexity or cost. It applies to
time, labour and cost of providing accounting information and its accuracy is relation to
probable use and resulting benefits.

The accounting principles are classified into two categories as shown in the figure below.

Figure 1: Accounting Principles

Value Addition 2: Surf and Learn


Accounting Concepts and Conventions
Click on the link below to read about the accounting concepts, conventions and
standards as subsets of GAAP.
Source: http://www.expertsmind.com/learning/accounting-principles-assignment-help-
7342872306.aspx

4. Accounting Concepts
An accounting concept is nothing but a basic assumption about the environment in
which the business operates and accounting functions. It is an assumption that is well
recognized and accepted by the accounting professionals. It therefore gains acceptability
among the entire accounting people. However, it is not a fact. It is the building block on
which the entire accounting structure rests. They are general in nature and present a
philosophy with regard to the manner business transactions must be recorded.

4.1 The Business Entity/Separate Entity Concept

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

The entity postulate assumes that both business and businessman are different for
accounting purposes. Thus, for accounting purposes the business is considered as a unit
or an entity that is separate from all the people that are related to it or transact with it
either directly or indirectly. This is an important concept as it justifies considering every
transaction from the business point of view for recording purposes. For example, capital
introduced by the owner of the business into the business increases the assets as well as
owings of the business to the owner. Although the business belongs to the owner, and
the total of his personal and business worth in terms of net assets owned by him
remains the same, yet he is able to analyse the growth of the business by recording
them separately. So, when the owner introduces his personal assets in the business,
they are recorded as business assets separately in the books of the business, and not in
the name of the owner. However, if the owner uses some of the business assets for his
personal use, say payment of his personal electricity bill from office cash, it is treated as
drawings made by him from the business. In this way this concept enables the
accountants to distinguish between personal and business transactions.

Figure 2: Separate Entity Concept

Value Addition 3: Surf and Learn


Separate Entity Concept
Click on the link below to view an image that describes that the business entity is
separate from the people who provide funds and other resources. It obtains funds and
resources from such people and as a separate entity employ such funds and put
resources to use. It enters into several contracts as a separate entity.
Source: http://2.bp.blogspot.com/-u-
EpPJzPTvQ/Th5ZhDS5PnI/AAAAAAAAAPQ/dnPzZ9428ZA/s1600/accounting-entity-
assumption.jpg

Accounting entity concept is applicable to all types or forms or sizes of business


enterprise namely, a sole proprietary firm, a partnership firm or a company. However,
separate existence of business from that of the owner is recognised by law only is case
of corporate form of enterprise. In case of non-corporate form of business enterprises,
business exists as a separate entity only for accounting purposes and not for legal
purposes. In the eyes of law, business and owner are one and he/she is personally liable
for the business claims. Hence, in legal sense, owner and business may not be different
for some form of business enterprises but in accounting sense, owner and business are
always regarded as separate. Thus in business records, only the assets and liabilities
created out of transactions pertaining to business are recorded and personal
transactions of the owner are excluded. For example, rent paid Rs. 8000 for a building,
half of which is used for residential purpose and half for business, is paid from the
business account. It will be recorded as reduction is business cash by Rs. 8,000.
Rs.4000 as expense (rent) in the books of business entity and Rs.4000 as reduction in
capital on the ground that the money paid for personal purpose is withdrawn by the
owner as drawings.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

Value Addition 4: Did You Know?


Impact of Separate Entity Concept
· Only the business transactions are recorded and reported, not the
personal transactions of the owner.
· The personal assets and liabilities of the owner are not taken into
account while considering the assets and liabilities of the business.
· The capital of the business is considered as a liability of the business
to its owner.
· Income or profit is the property of the business unless distributed to the
owners.
· The entity concept may be applied to the whole enterprise or one unit or even
to the part of the business enterprise.
Source: Shukla, M.C., T.S. Grewal and S.C. Gupta, “Advanced Accounts”, Vol-I,
S. Chand & Co., New Delhi.

4.2 The Money Measurement Concept

Money is considered as a common basis for recording business transactions. According


to this concept, such transactions alone can be recorded in the books of account that
can be measured in terms of money. In the absence of common measuring unit (i.e.
money) it is not possible to add or subtract various business events.

For example a business enterprise has following assets and liabilities:


(i) A three-storey building constructed on a 1000 square meter plot;
(ii) 500 units of raw material;
(iii) 1000 units of a product held for resale;
(iv) 5 machines;
(v) Rs.10,000 cash;
(vi) Rs. 15,000 payable to the bank on account of loan;
(vii) Amount payable to supplier for 400 units of a product supplied on a credit basis.

These various items cannot be added together to determine the total assets and total
liabilities. The problem which is generally referred to as apples and oranges problem
may be resolved by expressing the aforesaid items in some common unit say money
rather than in any other physical unit.

Limitations
Money measurement postulate suffers from the following drawbacks:
(i) Accounting is limited to the production of information expressed in terms of a
monetary unit; it dose not record and communicate other relevant but non monetary
information. Hence even those transactions that affect the results of the business
considerably, but cannot be measured in monetary terms, are not recorded in the books
of accounts. For example, the state of chairman’s health, the attitude of the employees,
or the relative advantages of competitive products etc. are not recorded or
communicated how so ever important they are to the working of business enterprise.
(ii) According to this concept, a transaction is recorded at its money value on the date
of occurrence and the subsequent changes in the money values are conveniently
ignored. For example, a building purchased for Rs.1,00,000 in 1975 and another
purchased for the same amount in 1990 are recorded at the same price although the
one purchased in 1975 may be worth many times more than the value recorded in the
books due to rise in the value of land and building. Thus, this concept assumes the same
value for money at all times. But money does not have constant value forever like other
units of physical measure.
(iii) Financial statements are prepared from the transactions entered in the books of
accounts. Thus, facts of business which are not derived from or related to transaction
are not recorded in the books of account. It is because of this reason why only
purchased goodwill is recorded in the balance sheet whereas goodwill generated within
the business because of successful business activities, efficient management etc is
simply ignored.

Value Addition 4: Surf and Learn


Money Measurement Concept
Click on the link below to read more on the recognition criterion and application of the
concept.
Source: http://accounting-simplified.com/financial/concepts-and-principles/money-
measurement.html

4.3 Going Concern Concept

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

As the name suggests, going concern refers to the assumption that the life of business
will be fairly large. It suggests that the business is run with the objective of continuing it
for long number of years, and it not intended to be closed in near future. It assumes
that the business has an unlimited life, extending to an indefinite period until it is
liquidated. It is important for the interested parties to know that the business is run for
a long period of time, so that they are induced to enter into various contracts with the
enterprise. Such an assumption is made by every interested party, even if the life of
business cannot be known with certainty. However, an enterprise is not considered to be
a going concern if there is a clear evidence or specific information about its end. For
example, when the venture is for specific purpose such as setting up of a stall in an
exhibition or fair, the business comes to an end on the completion of fair or exhibition.

Some of the reasons for adopting going concern concept are discussed under:
(i) It provides a sound basis for proper income or profit measurement. Therefore, items
which provide benefits for a longer period of time are recorded as fixed assets rather
than expense because of going concern concept. Further, the assets are recorded at
historical cost rather than at a value which it will fetch if it is to be sold. As a result,
depreciation on fixed assts is charged on the basis of expected life of the asset. For
example a machine is acquired for Rs. 10,000. It is recorded as reduction of one asset
i.e. cash and increase in another i.e. machinery. It is expected that the machine will
have commercially useful life of 10 years after which it will be worthless. Accounting
records the loss of value of Rs. 10,000 every year as depreciation for 10 years. This
shows that the business at least has minimum life of 10 years.
(ii) This concept assures the investors that the business enterprise will continue to
function in the expected manner in order to achieve the predetermined goals including
fair returns to the investors.
(iii) The going concern concept facilitates the classification of assets and liabilities into
long term and short term.

Value Addition 5: Image


Implications of Going Concern Concept
Click on the link below to view an image that describes the implications of the above
concept in relation to conduct of business operations, allocation of costs and revenues to
different accounting periods, and recording of assets.
Source: http://img.scoop.it/raVrznD6npviz-
FLFGjGQDl72eJkfbmt4t8yenImKBXEejxNn4ZJNZ2ss5Ku7Cxt

4.4 The Time Period/Accounting Period Concept

As per going concern concept, the business is assumed to have indefinite life. But the
proprietor of the business cannot wait for such a long period for the determination of
income. Such a measurement of income at the end of the life of business would render
useless information as well as it will be too late to take corrective steps at that time.
Therefore, accountants choose some convenient period of time to measure the income
or to know the results of business transaction known as accounting period.
Thus, accounting period refers to span of time at the end of which financial statements
are prepared to represent the results of the operations of the business during the
relevant period and financial position at the end of that relevant period. The accounting
period vary in time intervals such as month, quarter, and year. However the year is the
most common accounting period as a result of established business practices traditions
and government requirements. The Companies Act 1956 also requires annual reports to
be submitted to shareholders and Income Tax Law requires determination of taxable
income on an annual basis. The more useful accounting period is calendar year i.e. from
January 1 to December 31. For tax purposes in India, the customary accounting period
is twelve months beginning from April 1 and ending on March 31.

Figure 3: Implications of Accounting Period Concept

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

However this accounting period concept has the following consequences:


(i) Much efforts are needed to prepare financial statements every year;
(ii) Sometimes arbitrary allocations have to be made in respect of depreciation,
provision for doubtful debts etc.

4.5 The Duality or Dual Aspect Concept

Financial accounting is transaction based. Of course, we consider only those transactions


and events which involve financial element. In every type of business there are
numerous transactions. For example, purchase of goods from several suppliers, sale to
various customers for cash or on credit, payment to suppliers, collection from
customers, payment of salaries and wages, payment of rent and taxes etc. In each of
the above transactions, there are two aspects to be recorded from the point of view of
entity. For example – if there is sale of goods – it involves two aspects, one is the
delivery of goods and other is the receipt of cash (in case of cash sale) or the
acknowledgement of the debt from the customer (in case of credit sale). The recognition
of two aspects for every transaction is known as dual aspect analysis. The method of
recording transactions on the basis of the concept of duality is known as ‘Double Entry
Book Keeping’. Every transaction is recorded under the following heads under this
double entry system of book keeping, while holding the following equation true at all
times:
Assets = Liabilities + Capital

In accounting terminology, resources are referred to as assets, obligations towards the


owners is referred to as capital, and obligations towards the outsiders is referred to as
liabilities The total of assets and the total of obligations to owners and outsiders must
agree.

This equation holds good at any point of time because of double entry system of book
keeping. In double entry system for every transaction two entries are made one entry
consists of debit to one or more accounts and another entry consists of credit to one or
more accounts. However the total amount debited always equals the total amount
credited.

For example, when Rs. 50,000 cash is contributed by the owner who starts a business
then this fact is recorded at two places: assets account and capital account. This can be
shown in the form of an equation as under:
Assets = Liabilities + Capital
Cash = Capital
Rs.50,000 = Rs.50,000

Further if the proprietor takes a loan of Rs 20,000 from a bank then the dual aspect of
this transaction affects the equation as under:
Assets = Liabilities + Capital
Cash = Bank loan + Capital
Rs.70000 = Rs.20,000 + Rs.50,000

Purchase of furniture for Rs. 25000 for cash and machinery for Rs. 50000 on credit, the
dual aspect is:
Assets =Liabilities + Capital
Cash +Furniture + Machinery = Loan + Creditors for machinery + Capital
45,000 + 25,000 + 50,000 = 20,000 + 50,000 + 50,000.

Similarly payment of salaries of Rs. 10,000 decreases cash by Rs.10,000 and at the
same time results in reduction in capital. The resulting equation will be:
Assets = Liabilities + Capital

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

Cash + Furniture + Machinery = Loan + Creditors for machinery + Capital


35000 + 25000 + 50000 = 20000 + 50000 + 40000

Thus assets must always be equal to the obligations i.e. liabilities and capital

Value Addition 6: Example


Dual Concept
Click on the link below to read about the above concept and understand the duality in a
few cited examples.
Source: http://accounting-simplified.com/financial/concepts-and-principles/duality.html

4.6 The Cost or Historical Cost Concept

The cost concept requires that the assets should be recorded at the exchange price or
acquisition cost. Since the original or acquisition cost relates to past, it is also referred to
as historical cost. Historical cost is recognised as the appropriate valuation basis for
recognition of all goods and services, expenses cost and equities. For the purposes of
recording in accounting, all business transactions are measured in terms of actual prices
at the time of occurrence of the transaction.

For example if a business entity purchases a machine for Rs. 5,00,000 from a builder
friend. The actual worth of the machinery is Rs. 6,00,000. This asset would be recorded
in the books at Rs 5,00,000 not at Rs. 6,00,000 because for the business entity actual
cost of the asset is Rs 5,00,000 i.e. the price paid for it. The basis for all future
transactions relating to this building would be its cost i.e. Rs. 5,00,000. For example, the
depreciation will be charged at Rs. 5,00,000 not at Rs. 6,00,000.
Further historical cost is considered more relevant than any other value of asset i.e.
market value. The identification of the market value involves following problems:

(i) One has to make a choice about the value prevailing in the market. At the same point
of time two different market values exist in any market: the one at which the asset can
be sold and one at which the asset can be purchased.
(ii) The accountant has to keep a record of changes in market price of the asset as the
market keeps on fluctuating. Suppose there are 50 dealers in the market dealing in sale
or purchase of a particular asset. There may be 100 different values (50 sale values and
50 purchase values) of that asset. Now the question is which value in the most
appropriate.
(iii) Moreover it is not always feasible to keep track of the market to determine the
correct value.

Thus, the justification for recording fixed assets at historical cost is that the historical
cost is most objective reliable, definite and it is also free from personal bias.

However this concept suffers from the following limitations:


(i) Items which do not carry any cost are ignored in accounting. Thus goodwill aroused
on account of favourable location, brand name, knowledge, technological skill built inside
the enterprise, are not recorded in the books of account.
(ii) The actual information required by the management, investors, creditors etc. may
be current value and not the historical costs.
(iii) During inflation, if the depreciation based on historical cost of earlier year is charged
against revenue at current prices, then income figure may be distorted.

4.7 The Accrual Concept

According to this concept, revenues are recognized when they are realized rather than at
the time of their receipt. Similarly, expenses are recognized at the time of their
incurrence rather than considering them at the time of their payment. According to
Financial Accounting Standards Board (US), “Accrual accounting attempts to record the
financial effects on an enterprise of transactions and other events and circumstances
that have cash consequences for the enterprise in the periods in which such
transactions, events and circumstances occur rather than only in the period in which
cash is received or paid by the enterprise”. The accrual concept assumes that the
payment for various routine activities of the business for labour, materials, production
and administrative expenditures do not coincide with the incurrence of such
expenditures. They may be paid in advance of the period to which they relate, or they
may be paid in some subsequent period. Similarly, revenues earned may be received in
advance or may be received at a later date.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

The accrual concept makes the distinction between the receipts of cash and the right to
receive cash. Similarly, there is a difference between the payment of cash and the
obligation to pay cash. Thus accrual basis provides more appropriate information about
the performance of business enterprise as compared to cash basis. Under the cash
system of accounting, revenue recognition does not take place until cash is received and
costs are recorded only after they are paid. There is hybrid system of accounting also
which combines the features of cash and accrual system. While accrual basis is followed
for expenses and cash basis is for revenue. The companies Act, 1956 under section 209
(3) (a) requires pursuance of accrual basis of accounting as a precondition to the truth &
fairness of the financial statements.

4.8 The Revenue Recognition Concept

Business enterprises utilise resources to earn revenue by sale of goods or rendering of


services. According to AS -9 issued by ICAI, “Revenue is the gross inflow of cash
receivables or other considerations arising in the course of an enterprise from the sale of
goods, from the rendering of services and from holding of assets. Revenue is measured
by the changes made to customers or clients for goods supplied and services rendered
to them and by the changes and rewards arising from the provision of assets. It
excludes amounts collected on behalf of third parties such as certain taxes.”

Thus revenue is considered as being realized or earned on the date when the sale
process is complete and transfer of title or ownership takes place. Suppose a business
enterprise manufactures a machine in the year 2005, receives an order from a customer
in 2006 and delivers the machine in the year 2007 when it is accepted by the customer,
however the payment is received in the year 2008. The cost of the machine is Rs.15Lacs
and it has been sold for Rs. 20Lacs. The problem is in which year’s Profit & Loss
Account, this profit of Rs 5Lacs be recorded. This would depend upon the timing of
revenue recognition and in this case, it will be recorded in the year 2007, the promise of
the customer to pay is sufficient.

However there are certain exceptional cases when following alternatives are used:
1. Production basis:
(i) In case of long term contracts, profit accrues over the period of contract and does not
occur immediately on the completion of contract. Therefore, the contractor may elect to
take up revenue as earned on the basis of percentage of work completed during a
particular accounting period
(ii) Products can be marketed easily at as objectively determined price. For example, in
case of gold, as marketing of the product is not a problem and the price is an objective
measurement, revenue is recognised in the period in which gold is mined.
2. Cash basis:
In case of doubt about the collection of the amount, revenue is considered as realised
only when the cash is received. Generally doctors, lawyers, chartered accountants and
other professionals record revenue when the amount is actually received. For example, a
chartered accountant files return @ Rs. 500 per return for 200 clients. At the end of the
year he receives money from 150 clients, the revenue would be recorded as
(Rs.500×150) Rs.75,000 on cash basis.
3. Time basis:
In certain cases, the revenue is treated as realised on the basis of time. For example,
the full interest on cumulative fixed deposits for more than one year would be received
only at the time of maturity. But proportionate interest though accrued but not payable
is credited in the profit & loss account as realised every year.

Value Addition 7: Image


Revenue Recognition Concept
Click on the link below to view an image that depicts a production activity, an exchange
between a salesman and customer and an accountant doing his work. The revenue
recognition concept applies to all such transactions and enables correct recording of
revenue pertaining to specific periods.
Source: http://www.principlesofaccounting.com/chapter3/revenuerecognition.png

4.9 The Expense Recognition Concept

Expense or expenditure refers to any outlay of cash that is made for the purpose of
generating revenue in an accounting period. Expense decreases owner’s equity. It
connotes resources consumed to produce and sell goods and or to render services. Thus,
recognition of expense is also very important as the recognition of revenue to obtain
information about income.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

According to American Accounting Association, “Expense is given recognition in the


period in which there is (a) a direct identification or association with the revenue of
periods as in case of merchandise delivered to the customer (b) an indirect association
with the revenue of the period as in case of office salaries or rent or (c) a measurable
expiration of asset cost even though not associated with the production of revenue for
the current period as is case of loss from fire or flood.”

There are basically four principles of recognising expenses to be used for income
determination. These are explained as under:
(1) Principle of associating cause and effects - Certain costs expire in a particular
accounting period since they can be directly associated with the revenue realized during
that period i.e. commission on sales, carriage on sale, rent etc.
(2) Principle of systematic and rational allocation - Certain costs produce revenue
but can not be associated directly with specific revenue. In such a case, this principle
requires that the cost should be allocated in a systematic and rational manner among
accounting period in which they help earn revenue. For example, depreciation expense
for plant and machinery.
(3) Immediate recognition principle - It applies to costs that provide no clear future
benefits. These costs are recognised as expense during the period in which they are
incurred. For example, most of selling and administration expenses.
(4) Lost Cost - It includes those expired cost that have not resulted in the production
of revenue. For example, loss on sale of marketable securities, destruction of plant by
fire etc.

Value Addition 8: Image


Expense Recognition Concept
Click on the link below to view an image that depicts the recognition of an amount paid
for an expense for three months i.e. June, July and August at the beginning of the
month of June for different periods, such that there is a prepaid amount of Rs. 300 at
the beginning of June, Rs. 200 at the beginning of July and Rs. 100 at the beginning of
August. It becomes nil at the end of the month of August.
Source: http://www.principlesofaccounting.com/chapter3/prepaidexpense.png

4.10 The Matching Period Concept

The matching principle in financial accounting is the process of matching


accomplishments or revenues with efforts or expenses to a particular period for which
the income is being determined. This concept emphasizes which items of costs are
expenses in a given accounting period. Costs are reported as expenses in the accounting
period in which the revenues associated with those costs are reported. For example,
when the sales value of some goods is reported as revenue in a year, then the cost of
those goods would be reported as an expense in the same year.

Matching concept needs to be fulfilled only after accrual concept has been completed by
the accountant. First, revenues are measured in accordance with the accrual concept
and then costs are associated with these revenues.

The following two aspects of matching principle must be carefully considered:


(i) The revenues of a particular accounting period should be related to expenses
directly associated in obtaining the revenues. The association between them must be
direct e.g. association of sales revenue and cost of goods sold.
(ii) If revenue is deferred i.e. it is regarded as not yet earned, all elements of expenses
related to such defined revenue must also be deferred & vice- versa. For example, an
advertisement expense of Rs. 50,000 which will provide benefits for 5 years should be
treated as the expense of 5 years and 1/5 of the total expense must be charged equally
against the revenue of 5 years.

Drawbacks:
The matching concept when practiced may require expert judgment of the accountant
and thus, it may create certain problems, which are as under:
(i) The matching concept requires allocating the cost of fixed asset to different
accounting periods in accordance with the use of the asset for production purposes i.e.
in proportion to the revenue generated by them in different accounting periods. This is
not an easy task.
(ii) In case of joint costs also some arbitrary measures are used to allocate the cost
over two or more different products.
(iii) Estimates for doubtful debts & discounts etc. should be done carefully for proper
matching of costs.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

(iv) Unexpected & non-trading revenues where there is no corresponding expense may
distort the income determination. For example, gains on the sale of fixed assets, interest
on investment etc.

Value Addition 10: Image


Accruals and Deferrals
Click on the link below to view an image that describes the fact the revenues and
expenses must be matched and appropriated to the concerned accounting period.
Source:
http://img.scoop.it/fDcrZX7DaL6KWbCNBZNEPTl72eJkfbmt4t8yenImKBVaiQDB_Rd1H6k
muBWtceBJ

4.11 The Verifiable Objective Evidence Concept

For all business transactions, it is very much needed that all accounting records are
objective. The term objective refers to being free from bias or free from subjectivity. For
this purpose, all accounting transactions should be
supported by documentary evidences. For example, receipts for payments made. These
supporting documents form the basis for making
entries in the books of account and for their verification by auditors
afterwards. If accounting records are based on documentary evidences which are
capable of verification, then these are universally acceptable.

5. Accounting Conventions
An accounting convention may be called as a rule, an accepted method, a procedure, or
a statement of practice, which is followed over a period of time. They have arisen more
out of the application of various concepts to create useful information from the
standpoints of various stake holders. For example, it is an accepted practice by general
agreement among the accountants to ‘anticipate no gains but provide for all losses’,
which shall be explained later in the lesson. The following figure depicts the various
accounting conventions.

Figure 4: Accounting Conventions Facilitate Preparation of Financial Statements

5.1 The Prudence Convention (Conservatism)

Every business enterprise wants to play safe in the world of uncertainty. These are
following two principal rules that are related to the convention of prudence:
(i) The accountant should not anticipate profits and should provide for all losses;
(ii) When is doubt, the accountant must prefer that method of accounting which will not
lead to any overestimation of assets and/or income.
(iii) When applied to business income, this convention results in the recognition of all
losses that have occurred or liable to occur and to admit the gains only when they
have been realised.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

Thus, the convention advocates: Don’t count on the eggs which are not hatched
(ignore anticipated incomes) but provide for an umbrella for the rainy day (do
not ignore likely expenses).

The convention of prudence is applied in the following cases:


(a) When there is an uncertainty inherent in the activity e.g. uncertainty as to the
useful life of an asset, realisation of income, estimated liability.
(b) When the judgment is made on the basis of estimates and there is a doubt as to
which estimate is correct, most conservative should be selected.
(c) When there are two equally acceptable methods, the more conservative should be
selected.
(d) When there is possibility of occurrence of a loss or profit, losses should be
considered and profits will be overlooked.

The convention has its effects both on income statement as well as on the balance
sheet. In the income statement it results in lower net income than would otherwise be
the case. In balance sheet, this approach results in understatements of assets and
capital and overstatements of liabilities and provisions.

Application of the convention of conservatism in accounting leads to the following:


(i) Providing for doubtful debts and for discount on debtors;
(ii) Valuing the stock in hand at lower of cost or market value;
(iii) Creating investment fluctuation reserve;
(iv) Showing joint life policy at surrender value as against the amount paid;
(v) Not providing for discount on creditors;
(vi) Amortizing intangible assets like goodwill, patents etc;
(vii) Provide for loss on the issue of debentures when they are issued at par but
redeemable at premium.
(viii) Treat small amount of capital expenditure items like crockery etc, as expense.
This convention has been criticised as inherently inconsistent and fails to disclose the
correct picture. For example sometimes the income is deliberately understated as a
result of excessive depreciation charge, creation of unwanted provisions etc. It could
result in the creation of secret reserves which is against the convention. However the
defendants maintain that convention of conservatism has less severe effects than
overstating net income and overvaluing the assets. Therefore, it must be emphasized
that deliberate attempts to understate the items must be discouraged.

5.2 The Convention of Consistency

Uniformity in accounting methods and practices over a period of time is necessary in


order to enable the management to analyze the records and draw correct inferences
about the working of the enterprise. The comparison of financial statements of one
accounting period with that of the other cannot be made unless they are prepared on
the basis of consistent methods. For example, if the income statement for the current
year shows higher earnings than the preceding year, the user is entitled to assume that
the business operations have been more profitable provided there is no change in the
accounting procedure adopted by the enterprise. The rationale for this convention is that
frequent changes in accounting treatment would make the income statement and
balance sheet unreliable to end users; there are many examples in which a change in
accounting method may bring different results. For instance, different methods of
charging depreciation will result in different amounts of depreciation to be written off the
fixed assets over the useful life of the asset. A change of method of charging
depreciation will affect the depreciation amount and consequently the net profits of the
enterprise. The figures of net profit do not become comparable in that case. If there is
inconsistency in the record keeping, it may bring about considerable influence on the
income reported as well as the value of assets in the balance sheet.

Eric L. Kohler has discussed three types of consistencies:


(i) Vertical consistency: This consistency is maintained within the interrelated
financial statements of the same date. For example, when an asset has been
depreciated on one basis for income statement and on another basis for balance sheet.
This is called vertical inconsistency.
(ii) Horizontal consistency: This consistency is found between financial statements
from period to period. Thus, it enables the comparison of performance of an organisation
in one year with its performance in another year.
(iii) Third dimensional consistency: This facilitates the comparison of the
performance of one organisation with the performance of other organisation in the same
industry on the same date.
The convention does not mean that a particular method of accounting once adopted can
never be changed. The method can be changed provided such a change is desirable and

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Accounting Principles: Concepts and Conventions

provides more useful and better information to the users. But it should be fully disclosed
in the financial statements along with its effects in terms of rupee amounts on the
reported income and financial position of the year in which such change is made.

5.3 The Convention of Materiality

In order to make financial statements more meaningful and to minimize costs, the
accountant should report only the information which is material. Thus, accounting should
focus on material facts and resources should not be wasted in recording and analysing
immaterial and insignificant facts. Materiality is an implicit guide for the accountant in
deciding what should be disclosed in the financial statements. However, it is difficult to
define the term materiality. Most definitions of materiality stress the role of accountants’
judgment in interpreting what is and what is not material at the same time stressing its
importance. According to American Accounting Association (AAA), “an item should be
regarded as material if there is reason to believe that knowledge of it would influence
the decision of informed investor.”
Therefore, the essence of materiality has relative importance for use in decision making.

For example, the business clubs many expenses, the amounts of which are negligible
and report them as one item under the heading ‘miscellaneous expenses’. Materiality of
information: An item may be important from the point of view of one user while it may
be insignificant for other users. For example, the investors would be interested to know
the current value of land & building while the banker may not attach any importance to
it while advancing loans.

The accountant does not attempt to record the amounts of those items which are so
insignificant that the work of recording involves more costs than benefits. Suppose a
business enterprise wants to keep an account of the number of pages or the pens used
in order to determine the stationery expenses. This might appear a sound accounting
practice but the cost of such an effort would be much more than the benefits arrived.
Therefore, pencils, pens, papers etc. are treated as expense when they are acquired
although technically they are the assets of the business.

Some of the examples of material financial information to be disclosed are likely fall in
the value of stocks, loss of market due to competition, increase in wages etc. Materiality
concept limits the unnecessary disclosure in the financial statements making them less
bulky and more worth reading. A separate disclosure may be made if an item is
material. The Companies Act 1956 requires that if an item of expense exceeds 1% of
total revenue it should be separately disclosed.

5.4 The Convention of Full Disclosure

Under this convention, it is required that the accounts must be honestly prepared and all
material information must be disclosed there in. Accountants are unanimous that there
should be a full, fair and adequate disclosure. Full disclosure means complete and
comprehensive presentation of information i.e. nothing is omitted. Fair disclosure means
that accounting principles have been applied in a fair manner so as to report the true
and fair view of the results of the business. Adequate disclosure means that anything
which influences the decision of the user must always be reported. Thus, disclosure
should not be taken to imply that every small piece of information must find place in the
financial statements, rather provides that there must be adequate disclosure of material
information to the interested parties that is required by them and will influence their
decision making. For example a firm is depreciating its assets on straight line basis for
last two years. It changes the method to written down value method with retrospective
effect. The firm must disclose this fact as a part of accounting policies as ‘Notes to
accounts’ forming part of financial statements. Similarly contingent liabilities and market
value of investments are also shown as notes to financial statements.

The concept of disclosure also applies to events occurring after the balance sheet date
and the date on which the financial statements are authorised for issue. Such events
include bad debts, destruction of plant and equipment due to natural calamites etc. Such
events are likely to have a substantial influence on the earning and financial position of
the enterprise.

To ensure proper disclosure of all significant information, the Indian Companies Act 1956
has prescribed the format of balance sheet and a performa of profit and loss account.

6. Concepts Vs. Conventions

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

The above discussed terms viz. principles, postulates, concepts and conventions are
widely used but with no general agreement as to their precise meanings. In fact there is
no effective difference between these various terms. Often what is referred to as
postulates by some writers are called as concepts or principles by the other writers and
vice-versa. Thus, as such there is no distinction between postulates, concepts and
principles. However, from a theoretical point of view, we will attempt to make some
differences between concepts and conventions. Following are the main points of
distinction between the two:
1. A concept is a theoretical idea forming a set of practices while a convention
is a method accepted by general agreement.
2. Concepts precede conventions. Thus, conventions depend on concepts and
not vice- versa.
3. These is no chance of personal judgment or individual bias in the adoption of
accounting concepts, But in following the conventions, individual bias or personal
judgment play a crucial role.
4. Accounting concepts are established by accounting bodies while accounting
conventions are established by common accounting practices.

Summary:
• Accounting Principles refer to the set of basic postulates, axioms, assumptions
that are necessary conditions in the preparation of accounts.
• GAAP describes rules developed for preparation and presentation of financial
statements that are known as concepts, conventions, postulates, principles.
• An accounting concept is nothing but a basic assumption about the environment
in which the business operates and accounting functions. It is the building block
on which the entire accounting structure rests.
• The different accounting concepts are: the business entity concept, the money
measurement concept, going concern concept, the accounting period concept,
the dual aspect concept, the historical cost concept, the accrual concept, the
revenue recognition concept, the expense recognition concept, the matching
period concept, and the verifiable objective evidence concept.
• An accounting convention is a rule or an accepted method or procedure or a
statement of practice that is adopted either by general agreement or by common
consent that may be expressed or implied.
• The different accounting conventions that are used in preparing financial
statements are the prudence convention or the convention of conservatism, the
convention of consistency, the convention of materiality, and the convention of
full disclosure.

Exercises:
1. Explain the following accounting concepts:
(a) The Business Entity Concept.
(b) The Money Measurement Concept.
(c) The Going Concern Concept
(d) The Duality/ Dual Aspect Concept.
2. Explain the meaning and significance of the following:
(a) The Convention of Materiality
(b) The Convention of Full Disclosure
(c) The Historical Cost Concept.
(d) The Convention of Consistency.
1. Accountants frequently refer to a procedure as being conservative Explain what is
meant by ‘Conservative Accounting Procedures’. State some of the applications of
the concept of conservatism.
2. What are accounting principles? What is their necessity?
3. What do you understand by Periodicity Concept?
4. Unless and until there in evidence to the contrary an enterprise must be
considered as continuing largely in its present form and with its present purpose.
Elaborate the accounting principle involved.
5. What is money measurement concept? What limitation does the concept put on
the use of accounting?
6. Why are accounting concepts and conventions required? How do you distinguish
between accounting concepts and conventions?
7. It is not important to know when cash is received and when payment is made.
Comment on the statement with suitable examples.
8. 10. Many important events that influence the prospects for the entity are not
recorded in the financial records. Comment and give examples.
11. What is meant by ‘Generally Accepted Accounting Principles’?
12. Comment in brief on any two of the following naming the principles on which these
statements are based:
(i) Balance Sheet is not a value statement.

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Institute of Lifelong Learning, University of Delhi
Accounting Principles: Concepts and Conventions

(ii) Advance received from a supplier is not taken as income or sales.


(iii) Caliber or quality of management team is not directly disclosed in the balance sheet.
13. Mr. Ram, the Managing Director of PVC Co. purchased a new truck for delivery
service. PVC Co. is organised as a company with Mr.Kishan as the sole shareholder. The
truck was purchased for Rs.10,00,000 cash from Avon Ltd. According to business entity
concept which of the entities (Ram, PVC Co., Kishan or Avon Ltd.) should record this
transaction in their books?
14. Would as accountant record the personal assets and liabilities of the owners in the
books of accounts of the business? Explain.
15. Explain the significance of accrual concept.

References:
1. Work Cited and Suggested Readings:
Anthony, R.N., and J.S. Reece, “Accounting Principles”, Richard D Irwin. Inc.
Monga, J.R., “Financial Accounting: Concepts and Applications”, Mayoor Paper Backs,
New Delhi.
Shukla, M.C., T.S. Grewal and S.C. Gupta, “Advanced Accounts”, Vol-I, S. Chand & Co.,
New Delhi.
Gupta, R.L., and M. Radhaswamy, “Advanced Accountancy”, Vol-I, Sultan Chand & Sons,
New Delhi.
Maheshwari, S.N. and S.K. Maheshwari, “Financial Accounting”, Vikas Publishing House,
New Delhi.
Sehgal, Ashok, and Deepak Sehgal, “Advanced Accounting”, Part-I, Taxmann Applied
Services, New Delhi.
Tulsian, P.C., “Advanced Accounting”, Tata Mc Graw Hill, New Delhi.
Jain, S.P., and K.L. Narang, “Financial Accounting”, Kalyani Publishers, New Delhi.
Gupta, Nirmal, “Financial Accounting” Sahitya Bhawan, Agra.
“Compendium of Statements and Standards of Accounting”, The Institute of Chartered
Accountants of India, New Delhi.

2. Web Links:

• http://www.principlesofaccounting.com/
• http://www.pondiuni.edu.in/dde/downloads/h1030.pdf
• http://bookboon.com/in/student/accounting/the-accounting-cycle
• Visit the link http://www.slideshare.net/AmitTripathy/accounting-concept to read
more about accounting concepts.
• Visit the link http://accounting-simplified.com/financial-accounting/accounting-
concepts-and-principles/accrual-concept.html to read on accrual concept.

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Institute of Lifelong Learning, University of Delhi