Concepts, Principles, And Conventions An Overview

In this tutorial, we will learn about concepts, principles, and conventions an overview of the world’s accountancy bodies may change any gathering to improve the quality of accounting information.

They are the theoretical base for accounting. The following areas widely accepted accounting concepts:

Entity Concept:

It states that a business enterprise is a separate identity apart from its owner. Accountants should treat books of accounts of the business distinct from the personal papers of reports as the owner. Therefore, the business transactions are recorded in the writings of business, not in the owner’s books.

Because of the concept of the amount invested by the proprietor in the company, i.e., the capital is treated as a liability, and the business has to give an interest to the owner. The owner or proprietor invested the money, which is also the risk capital he claims about the business’s profit.

Money Measurement Concept:

It states that only those transactions that package under monetary terms are to be recorded in the books of accounts. The financial value, this concept requires that those transactions alone are capable of being measured in terms of money. Sales and events which cannot be expressed in terms of payment are to be left out.

For example, the enterprise’s employees are undoubtedly the assets of the firm, but they cannot be shown in the balance sheet as they cannot be expressed in terms of money. The measuring unit of money is taken as the currency of the ruling country in which accounts are prepared, i.e., the country’s ruling currency provides a common denomination for the material objects. Now the question arises if the transactions happen across the country’s international borders, then the sales will be recorded in the ruling currency of the foreign country or the country?

The concept ignores that money is an inelastic yardstick for measurement based on the implicit assumption that the purchasing power of the money is not sufficient importance as to require adjustment.

Periodicity concept:

This is also called the idea of a definite accounting period. But another idea going concern concept an indefinite life of the entity is assumed. For business, it causes inconvenience in measuring performance achieved by the object in the ordinary course of business. For example, if a textile mill lasts for 100 years, it is not desirable to measure its performances as well as financial position only at the end of its life.

Therefore a small but workable fraction of time is chosen out of the infinite life. Generally, that workable fraction of time is one year. However, some organizations also take nine months or 15 months for performance appraisal of financial position. In India, we follow from 1st April to 31st March of the immediately following year.

The concept helps to differentiate between capital and revenue expenditure, differentiate between long-term liabilities and short-term liabilities. Thus, the periodicity concept facilitates in:

You are comparing financial statements of different periods.

We uniform and consistent accounting treatment for ascertaining the profit and financial position of the firm.

They are matching periodic revenues with the expenses for getting reliable results for business operations.

Accrual Concept:

The accrual concept, the effects of transactions, and other events recognized when they occur and not as cash or cash equivalent are received or paid. They are recorded in the accounting records and reported in financial statements of the periods to which they relate.

Financial statements are prepared on the accrual basis to inform users not only about the past events that took place in the fiscal year but also the future obligations cash soon or cash is received in the future.

To understand the concept better, let us give you some examples.

XYZ CO. sold $15000 worth goods to ABC Co. on 1st April 2016. But ABC Co. made the payment a week later.

But in the books, XYZ Co. sales are to be recorded on 1st April, not when they received payment. It happened due to the Accrual Concept.

Accrual means recognizing revenue and costs as they earned or incurred and not as money is received or paid. The accrual concept relates to the measurement of income identifying assets and liabilities.

According to the Accrual concept: Revenue- Expenses= Profit or

Cash received in the ordinary course of business- Cash paid in the ordinary course of business = Profit

Matching Concept:

The concept talks about that all the revenue incurred in the specific period must be matched with the expenses of that time only.

It concentrates on actual inflow and outflow, which leads to adjustments of certain items like prepaid and outstanding salaries, rent, insurance, and unearned and accrued incomes.

Not every expense needs to identify its revenue or income. Some costs are directly related to the tax, and some are time-bound. E.g., selling expenses are directly related to sales, but rent and salaries were recorded on an accrual basis.

Going Concern Concept:

The financial statements are prepared with the assumption that the business will last foreseeable future. Hence it is assumed that the company doesn’t have the intention to liquidate. Traditionally, accountants follow historical costs in the majority of cases.

The essential differentiation between goods and assets is that assets are purchased to increase the business’s productivity and remain in the market for the period, not less than five years. In contrast, products are sent or manufactured for selling purposes.

Cost Concept:

This concept says that the valuation of assets is to be done based on historical cost or acquisition cost, i.e., the price at which the asset is purchased. For example, XYZ Co. purchased machinery for 1, 00,000 (INR) on 1st April 2015, but on 31st March 2016, the machinery’s market value was 2, 00,000. But due to the Cost Concept, the balance sheet will reflect the mechanism at 1, 00,000 as it is the historical cost or the acquisition cost.

However, the cost concept creates a lot of distortion, too, as outlined below:

When prices go up in an inflationary situation, prices of all commodities go up on average, and acquisition cost loses relevance.

For example, land purchased on 1.1.1996 for 2000(INR) may cost 1, 00,000(INR) on 1.1.2016.

Actual cost based accountants may lose comparability. Suppose Mr. X invested 10,000 (INR) in Plant A, which produced 5,000(INR) cash inflow, and Mr. Y invested 5,00,000(INR) and got a cash inflow of 50,000(INR) during the year. Who is more efficient? Since the assets were recorded at historical cost, the results are comparable. It is a collar to point

The most valuable assets are the human resources, but they do not have acquisition cost. The cost concept fails to recognize such assets, although it is an essential asset of any organization.

Realization Concept:

Any change in an asset will be recorded when the business realizes it. When the asset is recorded at the historical cost of 5, 00,000 (INR), and even its current prices are 15, 00,000(INR), such change is not counted unless there is undoubted that such change will materialize.

However, accountants follow a more conservative path. They add all the probable losses but do not count the future losses.

They can decrease the value of an asset if they anticipate a future decrease, but if any future increase, they ignore it. Economists consider such a concept creates value distortion. Nowadays, the revaluation of assets has become widely popular. Accountants adjust such a change in value through the creation of revaluation reserve or capital reserve.

Dual-Aspect Concept:

The concept is the core of the double-entry book-keeping. Every transaction or event has two aspects:

It increases one asset decreases another asset.
It raises an asset simultaneously increases liability.
It reduces one asset, increases another asset.
It falls one asset, declines a liability.

Alternatively:

It increases one liability, decreases other burdens.
It raises a debt, increases an asset.
It reduces liability, increases additional difficulties.
It declines liability, decreases an asset.

For example, a new machine is purchased paying 5,000(INR) than on the one hand; it increases the industry; on the other hand, it reduces the cash of the company.

This concept can be explained algebraically,

Equity(E) + Liabilities(L)= Assets(A)

Equity(E)= Assets(A)-Liabilities(L)

Equity(E)+Long Term Liabilities+ Current Liabilities = Fixed Assets +Current Assets

Equity(E) + Long term Liabilities = Fixed Assets + (Current Assets – Current liabilities)

Equity(E)=Fixed Assets+ Working Capital- Long term Liabilities

Whatever is received as funds are either expended- Debited to Profit & Loss Account

Or Lost- Losses to have been transferred to a capital account.

Or saved – Shown on the assets side of the Balance sheet.

Therefore, Capital + Income/Profit + Liabilities = Expenses +Net loss + Assets

Capital + Income – Expenses + Net Profits= Assets-Liabilities

Since the net profit/ loss is transferred to equity, the net effect is

Equity + Liabilities = Assets.

Conservatism:

It states that the accountant should not anticipate income and should provide for all possible losses. If an accountant should choose the method that leads to a lesser amount when there are many alternative values of an asset, due to this concept, we have the golden value cost or net realizable value, whichever is lower.

For this concept, the financial statement has the following qualitative characteristics.

Prudence, i.e., judgment about the future possible losses to have been guarded as well as uncertain gains.
Neutrality, i.e., financial statements, are to be made with an unbiased outlook.
Faithful representation of alternative values.

Consistency:

In financial statements, comparable accounting policies are followed consistently from one fiscal year to another; change in accounting policy is made only in certain exceptional circumstances.

It is applied when alternative methods of accounting are equally acceptable. For example, a company follows a straight-line method when specific other ways of depreciation are available and widely accessible. Changing the plan is a long process, and the accountant has to make many adjustments.

There is no hard and fast rule that an enterprise cannot change its accounting policy but under certain circumstances, only to bring the books of accounts following the issued accounting standards to comply with the provision law when under changed conditions, that the new method will reflect a more accurate and fair picture in the financial statement.

Materiality:

It permits other concepts to be ignored if the effect is not considered material. According to it, all items which have a significant impact on the financial statement should be disclosed. Any insignificant item which will only increase the accountant’s work but will not be relevant to the users’ need should not be published in the financial statements.

For example, depreciation on small items says calculators or stationary is taken as 100% in the year of purchase though used by the company for more than a year. They are very small or nominal to be written in the balance sheet.

Accountancy

In this tutorial, we will learn about accountancy is the practice of recording, classifying, and reporting on business transactions for a business.

Every individual performs some economic activity for survival. A salaried person gets his salary, daily-waged labor gets his wages, and a businessman gets profit as his remuneration or reward for their hard work. The compensation earned by them is used to buy daily necessities such as food, clothing, residence, education, etc. Not necessarily the economic activities are done for individual benefit; they are also performed for social benefits, i.e., the benefit of the public. All financial activities are done through transactions & events.

To explain the concept better, let us take an example. Ram invests 1, 00,000 (INR), and goods worth of 100,000(INR) in a stationary business. On 1st January 2016, he purchased goods of 50,000 (INR), and during the month, he made a sale of 1, 50,000(INR). They pay the shop rent, electricity bills, and salaries to support staff cumulatively 15,000(INR). He finds out that stock worth 50,000(INR) is still left at the inventory.

During the year, the Ram carried out few transactions such as investment in the business, purchase of goods, etc. and encountered some events such as Opening stock, Closing stock, and Surplus, i.e., Profit.

Goods sold + Goods in hand – Goods purchased – Shop rent paid – Electricity bill – Salaries = Surplus

150000+ 50000 – 50000 -50000 -15000= 85000

85000(INR), which is the surplus, is the result of the transactions made in the year.

So, every business, even individuals, record all their transactions to have adequate information about the economic activity as an aid to decision making. Accounting has developed to serve this purpose, which helps to create useful information that makes the business transparent and helps make an effective decision-making process.

An accounting has universal application for recording transactions and presenting suitable information to aid decision making regarding any economic activity ranging from family functions to national government. But here in after we should talk about business activities. Nevertheless, it will give adequate knowledge to think coherently of accounting as a field of study for universal application.

Accounting is closely related to the development of the business world. Thus, to understand accounting as a field of study for universal application. Accounting aims to meet the information needs of the rational and sound decision-makers and, therefore, the language of business.

Meaning of Accounting.

The Committee on Terminology set up by the American Institute of Certified Public Accountants formulated the following definition of accounting in 1961:

“Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are part, in part of at least, of a financial character and interpreting the result thereof.”

As per definition, we can say that.

Accounting is an art—only a technique of record keeping. The process of accounting starts by identifying and classifying events and transactions and then recording in the necessary books of accounts.
Every sound accounting system includes summarization ready for reference. Primarily, the transactions recorded in Journal then they are transferred to Ledger.
The deals must be classified in monetary terms, i.e., and they’re to be measured in the nations ruling currency, e.g., Rupee in India, Dollar in the U.S.A, Pound Sterling in the U.K.
Finally, accounting used for interpreting the results for determining the financial position of the organization or for the estimation of the profit earned or loss suffered.

However, the above definition does not reflect the present-day accounting function. Nowadays, the concept of accounting is way broader than that is described in the high definition.

According to the above definition, the role of accounting ends after interpreting the result of the financial transactions but in the present world with the diversification of management and ownership has increased the workspace or say the scope of accounting in the following ways:

The importance of communicating the results has become very necessary and even mandatory in some cases.
Globalization of economy.
Expansion of the society and the industries.

The definition is given by the American Accounting Association (AAA) in 1966 which states

The process of identifying, measuring, and communicating economic information will permit informed judgments and decisions by the accounts. In summarizing, analyzing, and interpreting the financial transactions and delivering the information’s results.

Sub-Fields Of Accounting

In this tutorial, we will learn about sub-fields of accounting is a system meant for measuring business activities, processing of information into reports, and making the findings available to decision-makers.

Accounting is a fairly broad term and encompasses many meanings and types of recording and analyzing activities. These various types of accounting are known as sub-fields of accounting.

The various sub-fields of accounting are:

Financial Accounting:

It covers the preparation and interpretation of financial statements and communication to users of accounts. It is historical as it records transactions which already been occurred. The final step is to prepare a profit and loss account and balance sheet. It fundamentally helps determine the net result of an accounting period and the financial position on the given date.

Financial accounting primarily concerns itself with the preparation and interpretation of financial statements and accounts of a company. It is mainly aimed at providing external users with the financial information that they require. The process begins with bookkeeping.

Management Accounting:

May concerned with internal reporting to the managers of a business unit. To discharge functions of planning, controlling, and decision making, the management needs a variety of information. An essential component of the management accounting is cost accounting which deals with cost ascertainment and cost control. The different ways of grouping information and preparing reports as desired by managers for discharging their functions referred to as management accounting.

In management accounting, the information grouped and organized in a way desired by the managers who are the users of this information. So such reports, budgets, memos make the information easier to understand and analyze for the managers. Thus they can plan their managerial activities accordingly and make better and smarter decisions as well.

Cost Accounting:

Institute of Cost and Management Accountants of England defines cost accounting as:

“ The process of accounting for cost which begins with the recording of income and expenditure or the bases on which it is calculated and ends with the preparation of periodical statements and reports for ascertaining and controlling costs.”

Cost accounting deals with all three aspects of cost ascertainment, the controlling of cost, and eventually, cost reduction. It will help the management avoid wastage, determine the selling price of a product/ service, calculate the break-even point, and overall better decision making functions. Cost accounting is also essential for budgeting and implementing budgetary control for the organization.

Social Responsibility Accounting:

The social responsibility accounting is concerned with accounting for social costs incurred by the enterprise and social benefits created. The demand for social responsibility accounting stems from increasing social awareness about the undesirable by-products of economic activities.

It is associated with determining the social costs of the company and the social benefits it contributed. It is one of the ways a company can inform the general public about the welfare activities the company does and the benefits of such actions to society. It attempts to express in quantitative terms the gain/welfare the company’s social program is causing to the community in general.

Human Resource Accounting:

Humans who are the most valuable assets in an enterprise are also accounts. Accounting is an attempt to identify, quantify, and report investments made in an organization’s human resources. It is an attempt to identify the quantity and report investments made in human resources of an organization that is not presently accounted for under conventional accounting practice.

One of the main objectives of human resource accounting is to determine the cost of recruiting, developing, training, and maintaining human resources. It can even provide for the appreciation or the depreciation of human resources. It will allow management to monitor the effectiveness and efficiency of their employees. And now that the information is available, they can make better decisions regarding their human resources.

Limitations Of Accounting

In this tutorial, we will learn about the limitations of accounting as a language that has its limitations. The assumptions on which accounting is based are sometimes are the limitations of the accounting.

There are certain misconceptions regarding financial statements. A common man presumes that an income statement shows the correct income or loss of the enterprise and that a balance sheet depicts the enterprise’s fair and accurate financial position. Accounting as a language has its limitations. The assumptions on which accounting is based are sometimes are the limitations of the accounting.

It is well established that accounting, especially financial accounting, is of absolute importance. Whether it is the management of the company or other external stakeholders, they depend on these financial statements for their dose of information about a firm’s financial transactions and position. However, accounting is not a perfect science yet.

Whereas the truth is that accounting is not a perfect science or art or language yet. It has been evolving for so many years and continues to grow. The limitations of accounting must be studied to understand it better.

Following are certain instances:

The factors which may be relevant in assessing the worth of the enterprise don’t find a place in the accounts, as they cannot measure in terms of money such as employee skills, loyalty towards work, etc.
The balance sheet shows the business’s position on the day of its preparation and not on the future date, while users of accounts (external or internal) are interested shortly.
With the emergence of AS 11, AS 26, AS 28, etc., market/fair value of assets is considered, but still, there remains some bias as accounting ignores changes in the number of assets like inflation, etc.
There are incidences where accounting principles conflict.
The accountant tries a lot so that the accounts are not affected by his judgment, e.g., provision of doubtful debts, methods of depreciation, etc.
The usage of different policies manipulates the profitability of the enterprise.
The financial information revealed by them is neither complete nor exact. The financial position or the ultimate gain or loss can be known when the business is closed down.
Qualitative factors such as the reputation and image of the management with the public, cordial industrial relations and efficiency of workers, customer satisfaction, competitive strength, etc., which cannot express in monetary terms, are not considered by the financial accounting.
The financial statements are compiled based on the account such factors as the decrease in money value, or increase in the price level changes. Since these statements deal with past data, not with the future, decision-making is of little importance.
The value of fixed assets in the balance sheet is shown based on the going concern concept. That the value put on an asset rarely represents the amount of cash, which would realize on liquidation. Similarly, the income statement prepared based on conservatism’s convention fails to disclose real income, for it includes probable losses and ignores likely income.

Bookkeeping

In this tutorial, we will learn about bookkeeping is an activity concerned with the recording of financial data regarding business operations.

It involves the estimation of profit earned by the firm. It only covers the procedural record of transactions in monetary terms in a meaningful and orderly manner—bookkeeping procedures governed by the end product, the financial statements. Here in India, financial statements mean Profit and Loss Account and Balance Sheet.

It’s a clerical job, whereas accounting has managerial. A bookkeeper is only responsible for keeping all business records of a minor segment, such as the position of customer’s accounts. The primary purpose of bookkeeping was to find the correct amount of income and expenditure under each head.

Bookkeeping is the work of a bookkeeper, who records the day-to-day financial transactions of a business. They usually write the daybooks and document each financial transaction, whether cash or credit, into the correct day-book- that is, petty cash book, suppliers ledger, customer ledger, etc.- and the general ledger. After that, an accountant can create financial reports from the information recorded by the bookkeeper.

Treated proclamations and expense reports are all a player in accounting. Bookkeepers don’t share their perspective. Others consider accounting to be constrained to recording exchanges in diaries term accounting implies distinctive things to various individuals:

A few people feel that accounting is the same as bookkeeping. They expect that staying with as books and setting up its money into books and after that posting the sums into records. After the amounts posted, the accounting has finished, and a bookkeeper with a professional education assumes control. The bookkeeper will make conforming sections and afterward set up the money related proclamations and different reports.

At the moderate size and more prominent companies, the term accounting may be truant. Regularly, organizations have bookkeeping offices staffed with the representatives who process creditor liabilities, records of sales, finance, and so on. One or more bookkeepers will administer the bookkeeping representatives.

The distinction between Accounting and Bookkeeping

Some people mistake bookkeeping and accounting to be synonymous terms, but there are very different from each. Accounting is a broad subject, and auditing is a small part of it. Bookkeeping is the recording phase, while accounting is concerned with summarizing steps interpreting the results.

The following Bullet points will help you to distinguish between Bookkeeping and Accounting.

It is a process concerned with recording transactions, whereas, accounting is a process concerned with summarizing the recording transactions.
It constitutes a base for accounting, whereas accounting is considered as a language of the business.
It does not consider financial statements, whereas, In Accounting, financial statements are prepared based on bookkeeping.
It doesn’t help to take managerial decisions whereas accounting helps the management to make all the administrative decisions
There is no sub-field of bookkeeping. Whereas, there are several sub-fields like financial accounting, management accounting, etc.
It does not help to ascertain the firm’s financial position, whereas its main objective is to determine the economic situation.