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Introduction

In drawing up accounting statements, whether they are external "financial accounts" or internally-the concept of a "true and fair view". The true and fair view is applied in ensuring and assessingwhether focused "management accounts", a clear objective has to be that the accounts fairlyreflect the true "substance" of the business and the results of its operation.The theory of

accounting has, therefore, developed accounts do indeed portray accurately the business'activities.To support the application of the "true and fair view", accounting has adopted certainconcepts and conventions which help to ensure that accounting information is presentedaccurately and consistently

Accounting concepts and conventions as used in accountancy are the rules and guidelines by

that the accountant lives. All formal accounting statements should be created, preserved and

presented according to the concepts and conventionthat follow.

y Going concern concepty Accruals or matching concepty Consistency concepty Prudence concept

Accounting Concepts

Going concern

This concept is the underlying assumption that any accountant makes when he prepares a set of

accounts. That the business under consideration will remain in existence for the foreseeable

future. In addition to being an old concept of accounting, it is now, for example, part of UK statute

law: reference to it can be found in the Companies Act 1985. Without this concept, accountswould have to be drawn up on the 'winding up' basis. That is, on what the business is likely to be

worth if it is sold piecemeal at the date of the accounts. The winding up value would almost

certainly be different from the going concern value shown. Such circumstances as the state of the

market and the availability of finance are important considerations here.

Accruals

Otherwise known as the matching principle. The purpose of this concept is to make sure that all

revenues and costs are recorded in the appropriate statement at the appropriate time. Thus, when

a profit statement is compiled, the cost of goods sold relevant to those sales should be recorded

accurately and in full in that statement. Costs concerning a future period must be carried forward

as a prepayment for that period and not charged in the current profit statement. For example,

payments made in advance such as the prepayment of rent would be treated in this way. Similarly,

expenses paid in arrears must, although paid after the period to that they relate, also be shown in

the current period's profit statement: by means of an accruals adjustment.

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Consistency

Because the methods employed in treating certain items within the accounting records may be

varied from time to time, the concept of consistency has come to be applied more and more

rigidly. For example, because there can be no single rate of depreciation chargeable on all fixed

assets, every business has potentially a lot of discretion over the precise rate it chooses to use.

However, if it wishes, a business may vary the rates at which it charges depreciation and alter the

profits it reports at the same time. Consider the effects on profit of charging depreciation at 15%

this year on 10,000 worth of fixed assets and then charging depreciation at 10% next year on the

same 10,000 worth of fixed assets. This year you would charge 1,500 against profits and next

year it would be only 1,000, using the straight line method of providing for depreciation.

Because of these sorts of effects, it is now accepted practice that when a company chooses to

treat items such as depreciation in a particular way in the accounts it should go on using that

method year after year. If it is NECESSARY to change the method being employed or the rates

being charged then an explanation of the change and the effects it is having on the results must

be shown as a note to the accounts being presented.

Prudence

Otherwise known as conservatism. It is this concept more than any other that has given rise to the

idea that accountants are pessimistic boring people!! Basically the concept says that whenever

there are alternative procedures or values, the accountant will choose the one that results in a

lower profit, a lower asset value and a higher liability value. The concept is summarised by the

well known phrase 'anticipate no profit and provide for all possible losses'. Thus, undue optimism

can never be part of the make up of an accountant! The danger is that if an optimistic view of

profits is given then dividends may be paid out of profits that have not been earned.

Objectivity

The objectivity concept requires an accountant to draw up any accounts, and further analysis,

only on the basis of objective and factual information. Thus, this concept attempts to ensure that

if, for example, 100 accountants were to draw up a set of accounts for one business, there would

be 100 identical accounting statements prepared. Everyone would be obtaining and using only

facts. The problem here is that there are many aspects of accounting ensuring that objectivity

cannot be universally applicable in the preparation of accounts. For example, with fixed assets:

the cost of a van must be known at its purchase: say 30,000. However, how long will this van be

in service? I say five years, my colleague could say 10 years. If I prepare the accounts using the

straight line method of depreciation calculation, I would provide 30,000 5 = 6,000 each year for

depreciation; my colleague would charge 30,000 10 = 3,000 each year for depreciation; and

both of us could be correct! The problem is that with an issue such as depreciation we are not

always able to be objective.

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Duality

This is the very foundation of the universally applicable double entry book keeping system and it

stems from the fact that every transaction has a double (or dual) effect on the position of a

business as recorded in the accounts. For example, when an asset is bought, another asset cash

(or bank) is also and simultaneously decreased OR a liability such as creditors is also and

simultaneously increased. Similarly, when a sale is made the asset of stock is reduced as goods

leave the business and the asset of cash is increased (or the asset of debtors is increased) as

cash comes into the business (or a promise to pay is made and accepted). Every financial

transaction behaves in this dual way.

Entity

Otherwise known as the 'accounting entity' concept. The idea here is that the financial

transactions of one individual or a group of individuals must be kept separate from any unrelated

financial transactions of those same individuals or group. The best example here concerns that of

the sole trader or one man business: in this situation you may have the sole trader taking money

by way of 'drawings': money for his own personal use. Despite it being his business and

apparently his money, there are still two aspects to the transaction: the business is 'giving' money

and the individual is 'receiving' money. So, the affairs of the individuals behind a business must

be kept separate from the affairs of the business itself.

Co$t

This concept is based on the notion that only the costs paid to acquire an asset are relevant and

thus should be the only costs to be shown in the accounts. For example, fixed assets are shown

on the balance sheet at the price paid to acquire them; that is, their historic cost less depreciationwritten off to date.

There is a problem in this area. That is the one of value. The accountant will rarely talk of value in

this context since the use of such a term implies personal bias. After all, the value of an asset as

far as I am concerned may be different to the value of the same asset as far as you may be

concerned. The application of the cost concept ensures that subjective judgements play no part in

the drawing up of accounting statements.

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Accounting Concepts

(1) Materiality

It refers to the relative importance of an item or event. Those who make accounting decisions

continually confront the need to make judgments regarding materiality. Is this item large enoughfor users of the information to be influenced by it? The essence of the materiality concept is : theomission or misstatement of an item is material if, in the light of surrounding circumstances, themagnitude of the item is such that it is probable that the judgment of a reasonable person relyingon the report would have been changed or influenced by the inclusion or correction of the item.

(2) Accounting period

Though accounting practice believes in continuing entity concept i.e. life of the business isperpetual but still it has to report the 'results of the activity undertaken in specific period(normally one year). Thus accounting attempts to present the gains or losses earned or sufferedby the business during the period under review. Normally, it is the calendar year (1st January to31st December) but in other cases it may be financial year (1st April to 31st March) or any other

period depending upon the convenience of the business or as per the business practices incountry concerned.

Due to this concept it is necessary to take into account during the accounting period, all items ofrevenue and expenses accruing on the date of the accounting year. The problem confronting thisconcept is that proper allocation should be made between capital and revenue expenditure.Otherwise the results disclosed by the financial statements will be affected.

(3) Realization

This concept emphasizes that profit should be considered only when realized. The question is atwhat stage profit should be deemed to have accrued? Whether at the time of receiving the orderor at the time of execution of the order or at the time of receiving the cash. For answering this

question the accounting is in conformity with the law (Sales ofGoods Act) and recognizes theprinciple of law i.e. the revenue is earned only when the goods are transferred. It means that profitis deemed to have accrued when 'property in goods passes to the buyer' viz. when sales areaffected.

(4) Matching

Though the business is a continuous affair yet its continuity is artificially split into severalaccounting years for determining its periodic results. This profit is the measure of the economicperformance of a concern and as such it increases proprietor's equity. Since profit is an excess ofrevenue over expenditure it becomes necessary to bring together all revenues and expensesrelating to the period under review. The realization and accrual concepts are essentially derivedfrom the need of matching expenses with revenues earned during the accounting period. The

earnings and expenses shown in an income statement must both refer to the same goodstransferred or services rendered during the accounting period. The matching concept requiresthat expenses should be matched to the revenues of the appropriate accounting period. So wemust determine the revenue earned during a particular accounting period and the expensesincurred to earn these revenues.

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(5) Entity

According to this concept, the task of measuring income and wealth is undertaken by accounting,for an identifiable Unit or Entity: The unit or entity so identified is treated different and distinctfrom its owners or contributors. In law the distinction between owners and the business is drawnonly in the case of joint stock companies but in accounting this distinction is made in the case of

sole proprietor and partnership firm as well. For example, goods used from the stock of thebusiness for business purposes are treated as a business expenditure but similar goods used bythe proprietor i.e. owner for his personal use are treated as his drawings. Such distinctionbetween the owner and the business unit has helped accounting in reporting profitability moreobjectively and fairly. It has also led to the development of "responsibility accounting" whichenables us to find out the profitability of even the different sub-units of the main business.

(6) Stable Monetary Unit

Accounting presumes that the purchasing power of monetary unit, say Rupee, remains the samethroughout. For example, the intrinsic worth of one Rupee is same and equal in the year 1,800 and2,000 thus ignoring the effect of rising or falling purchasing power of monetary unit due todeflation or inflation. In spite of the fact that the assumption is unreal and the practice of ignoring

changes in the value of money is now being extensively questioned, still the alternativessuggested to incorporate the changing value of money in accounting statements viz., currentpurchasing power method (CPP) and current cost accounting method (CCA) are in evolutionarystage. Therefore, for the time being we have to be content with the 'stable monetary unit' concept.

(7) Cost

This concept is closely related to the going concern concept. According to this, an asset isordinarily recorded in the books at the price at which it was acquired i.e. at its cost price. This'cost' serves the basis for the accounting of this asset during the subsequent period. This' cost'should not be confused with 'value'.

It must be remembered that as the real worth of the assets changes from time to time, it does not

mean that the value of such an assets is wrongly recorded in the books. The book value of theassets as recorded do not reflect their real value. They do not signify that the values noted thereinare the values for which they can be sold. Though the assets are recorded in the books at cost, incourse of time, they become reduced in value on account of depreciation charges. In certaincases, only the assets like 'goodwill' when paid for will appear in the books at cost and whennothing is paid for, it will not appear even though this asset exists on name and fame created by aconcern.

Therefore, the values attached to the assets in the balance sheet and the net income as shown inthe Profit and Loss account cannot be said to reflect the correct measurement of the financialposition of an undertaking, as they do not have any relation to the market value of the assets ortheir replacement values. This idea that the transactions should be recorded at cost rather than ata subjective or arbitrary value is known as Cost Concept. With the passage of time, the market

value of fixed assets like land and buildings vary greatly from their cost.

These changes or variations in the value are generally ignored by the accountants and theycontinue to value them in the balance sheet at historical cost. The principle of valuing the fixedassets at their cost and not at market value is the underlying principle in cost concept. Accordingto them, the current values alone will fairly represent the cost to the entity.

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The cost principle is based on the principle of objectivity. The supporters of this method argue solong as the users of the financial statements have confidence in the statements, there is nonecessity to change this method.

(8) Conservatism

This concept emphasizes that profit should never be overstated or anticipated. Traditionally,accounting follows the rule "anticipate no profit and provide for all possible losses. For example,the closing stock is valued at cost price or market price, whichever is lower. The effect of theabove is that in case market price has come down then provide for the 'anticipated loss' but if themarket price has gone up then ignore the 'anticipated profits'.

Critics point out that conservation to an excess degree will result in the creation of secret reserve.This will be quite contrary to the doctrine of disclosure. However, conservatism to a reasonabledegree may not come in for criticism.

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Key Characteristics ofAccounting InformationThere is general agreement that, before it can be regarded as useful in satisfying the needs ofvarious user groups, accounting information should satisfy the following criteria:

Criteria What it means for the preparation of accounting information

Understandability This implies the expression, with clarity, of accounting information in such away that it will be understandable to users - who are generally assumed to havea reasonable knowledge of business and economic activities

Relevance This implies that, to be useful, accounting information must assist a user to

form, confirm or maybe revise a view - usually in the context of making adecision (e.g. should I invest, should I lend money to this business? Should Iwork for this business?). The convention of relevance emphasizes the fact thatonly such information should be made available by accounting as is relevantand useful for achieving its objectives. For example, business is interested inknowing as to what has been total labor cost? It is not interested in knowinghow much employees spend and what they save

Consistency This implies consistent treatment of similar items and application of accountingpolicies

Comparability This implies the ability for users to be able to compare similar companies in thesame industry group and to make comparisons of performance over time. Muchof the work that goes into setting accounting standards is based around the

need for comparability.

Reliability This implies that the accounting information that is presented is truthful,accurate, complete (nothing significant missed out) and capable of beingverified (e.g. by a potential investor).

Objectivity This implies that accounting information is prepared and reported in a "neutral"way. In other words, it is not biased towards a particular user group or vestedinterest.The convention of objectivity emphasizes that accounting informationshould be measured and expressed by the standards which are commonlyacceptable. For example, stock of goods lying unsold at the end of the yearshould be valued as its cost price not at a higher price even if it is likely to be

sold at higher price in future. Reason is that no one can be sure about the pricewhich will prevail in future

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Conclusions

These, then, are the basic concepts and conventions on which the accountant bases all of his

accounting work. We can see evidence of such work in the published annual reports and

accounts that all publicly quoted companies are required to prepare and publish. The concepts

and conventions also apply to the millions of businesses world wide that do not publish their

accounts.

When we look at the work of an accountant we can see evidence that he has followed these

concepts and conventions: we will see accrued expenses, we will see that there is a statement to

the effect that the accounts have been drawn up on the basis of the going concern concept and

so on.

There are problems with these concepts and conventions, however, in that some of them conflict

with each other. For example, money measurement and materiality can conflict, consistency and

materiality can conflict. Have a look at the next page Conflicts in accounting concepts to explore

some of these issues in more detail.