CHAPTER 2

Accounting Concepts,
Conventions & Principles
NEED AND MEANING OF ACCOUNTING PRINCIPLES

• A uniform set of rules and guidelines must be necessary for

any accountant to prepare the financial statements of an
enterprise.
– If there are no standardized set of rules, then each accountant
for each enterprise will prepare the financial statements in their
own way which will result in unreliable, inconsistent and biased
accounting information.
• Keeping in view of this, the accountants have developed
certain rules and guidelines to be followed by each
enterprise.
– These rules and guidelines are the outcome of constant hard
work of accounting professionals over the years.
• Generally, such set of rules and guidelines are known as accounting
principles.
• The AICPA (American Institute of Certified
Public Accountants) defines principles as
“Principles of accounting are the general laws
or rules adopted or proposed as a guide to
action, a settled ground or basis of conduct
or practice.” Accounting principles are
adopted based on their general acceptability
rather than universal acceptability and thus
are popularly known as “Generally Accepted
Accounting Principles” (GAAP).
 Meaning of GAAP
• GAAP may be defined as “those rules of action or conduct, which
are derived from experience and practice and when they prove
useful, they become accepted as principles of accounting.”
• GAAP is a technical accounting term, which describes the basic rules, concepts,
conventions and procedures that represent the accepted accounting principles at
a particular time.
• According to the American Institute of Central Public Accountants
(AICPA), the principles which have substantial authoritative
support become a part of the generally accepted accounting
principles.
– It further stated that, “ generally accepted accounting principles
incorporate the consensus at any time as to which economic resources
and obligations should be recorded as assets and liabilities, which
changes in them should be recorded, how the recorded assets and
liabilities and changes in them should be measured, what information
should be disclosed and how it should be disclosed and which financial
statements should be prepared.”
• GAAP include accounting principles as well as procedures for applying these
 BASIC ACCOUNTING CONCEPTS

• An accounting concept is a basic assumption

on which the accounting system functions.
– For example, it is a recognized presumption that
business in an accounting entity, separate from its
owners, is a sole proprietorship, or partnership
firm or limited companies (private as well as
public).
• Accounting concept is not subject to any proof
because it is only an opinion based on the
assumption. Despite the fact that accounting concept is
not a fact, its role in the preparation of financial
statements or any accounting process is well recognized
by the accountants.
 Accounting Concepts
• Entity or business entity or accounting entity
concept
• Money measurement concept
• Going concern concept
• Accounting period concept
• Cost concept
• Realization concept
• Accrual concept
• Matching concept
 Separate Entity Concept
• Also known as business entity concept
• For accounting purposes, the business is treated as a
unit or entity, apart from its owners.
• As per the business as an entity concept, even the
proprietor (owner) of business enterprise is observed
as a creditor to the extent of his capital
contributions.
– It is important to note that, in some form of organizations,
accounting entity is not necessarily a separate legal entity.
• Take the case of sole proprietorship, where a sole trader cannot
separate his business assets and liabilities from those of his
personal assets and liabilities. Legally speaking, a sole trader’s
liability is “unlimited,” which means his business liability can be
met with his personal assets.
Thus, the “entity concept” implies that
(i) Personal transactions of the owners are not at
all recorded. Only business transactions are to
be recorded.
(ii) Net result (profit/loss) is related to the
business.
(iii)The capital is treated as a liability of the
business, which it has to owe to its owners.
(iv)This concept may be applied to the whole
enterprise as one single unit or to different
departments of the enterprise.
 Money Measurement Concept
• According to this concept, transactions, which cannot
be expressed in terms of money, are not recorded in
the books of account.
• This concept suffers from a serious limitation. According
to this concept, a transaction is recorded at its money
value on the date of the transaction. It fails to recognize
the frequent changes in the money value. For example,
a land (measuring 1,000 sq. mtrs.) was purchased for
`1,00,000 in 2000 and another transaction of purchase
of a land (same extent, same location) for `2,00,000 in
2020 were recorded at `1,00,000 and `2,00,000
respectively. However, purchasing power of birr is not
same in both these years.
• Another drawback in the usage of this concept
is that it does not take into consideration of
nonmonetary transactions. It ignores all the
other facts and events that affect the
enterprises. For example, quality of the
products marketed, working conditions of
employees, sales policy and such facts and
events, which cannot be recorded in terms of
money, are ignored.
 Going Concern Concept

• This going concern concept assumes that the

enterprise will continue to exist for a long
number of years (indefinite) in future. the
enterprise is normally viewed as a going
concern, that is, as continuing in operation for
the foreseeable future.
 Periodicity Concept (Accounting Period Concept)

• The net income of the business, really speaking, can be

measured correctly by computing the assets of the
business existing at the time of its commencement with
those existing at the time of its liquidation (winding up).
– As per the going concern concept, the life of the business is
indefinite.
• In that case, one has to wait for a very long period to know the results
of his business. The preparing and reporting of the net results of the
business at the end of the life is not at all useful to its users. Not even
corrective measures can be taken by the owners after liquidation takes
place.
• Each and every user of financial statements are much
interested to know “how things are going” at frequent
intervals. Hence, the accounting professionals have
developed this concept – the periodicity concept.
 Cost Concept

• According to the cost concept, the asset is

recorded at the price paid to acquire it, that is,
at cost (not market value) and this cost is the
basis for all subsequent accounting for the
asset.
– This is also called as historical cost because the
acquisition cost, which is taken as a basis, relates to
the past. In case, if nothing is paid for acquiring the
asset as per this concept, it will not be recorded in
the books of accounts as an asset.
 Realization Concept

• According to the concept, revenue is realized

when a transaction has been entered into
and the obligation to receive the amount has
been established. Therefore, revenue is
realized at the point of sale (when the
ownership is passed to customer) or in the
period in which the services are rendered
 Accrual Concept

• In accrual system of accounting, revenue is recognized

when it is realized, that means when sale is complete or
services are rendered, whether cash is received or not is
immaterial. Similarly, costs (expenses) are recognized
when they are incurred and not when paid. The date of
transaction (sale/ service/cost) is taken for accounting
process and not the date of actual receipt of revenue or
the date of actual payment for cost. For example, sales
made on 2010 Mar 31 will be recorded in the year 2009–
10 even when money is received in April 2010.
 Matching Concept
• After revenue recognition, all costs (expenses) that were
incurred to earn the revenue of the period will be charged
against that revenue earning during that accounting
period to determine the net income of the business
enterprises.
• To put it in simple terms, matching revenues against the
related expenses is termed as matching concept.
– The revenues and expenses shown in a Profit and Loss Account
must belong to the accounting period for which it is prepared.
– Because of this, sometimes the accrual concept is also called the
matching concept.
• The revenue earned during an accounting period and costs
incurred during the same accounting period is computed
– Profit = Sum of Revenues minus Sum of Expenses (Costs
Incurred)
• Dual aspect concept: For every credit, a
corresponding debit is made. The recording of
a transaction is complete only with this dual
aspect.
 Accounting concepts….cont
• Business entity concept: A business and its
owner should be treated separately as far as
their financial transactions are concerned.
• Money measurement concept: Only business
transactions that can be expressed in terms of
money are recorded in accounting, though
records of other types of transactions may be
kept separately.
• Dual aspect concept: For every credit, a corresponding
debit is made. The recording of a transaction is
complete only with this dual aspect.
• Going concern concept: a business is expected to
continue for a fairly long time and carry out its
commitments and obligations.
• Cost concept: The fixed assets of a business are
recorded on the basis of their original cost in the first
year of accounting. Subsequently, these assets are
recorded minus depreciation.
• Accounting period concept(periodicity): Each business
chooses a specific time period to complete a cycle of
the accounting process—for example, monthly,
quarterly, or annually—as per a fiscal or a calendar year.
• Matching concept: This principle dictates that
for every entry of revenue recorded in a given
accounting period, an equal expense entry has
to be recorded for correctly calculating profit
or loss in a given period.
• Realization concept: According to this
concept, profit is recognized only when it is
earned. An advance or fee paid is not
considered a profit until the goods or services
have been delivered to the buyer.
 BASIC ACCOUNTING CONVENTIONS
• Definition: An accounting convention is defined
as, “a rule of practice, which has been sanctioned
by general custom or usage. They are lamp posts
to procedures employed in the collection,
measurement and reporting of financial data.”
• Accounting conventions has come into existence
by common accounting practices. They are
adopted by common consents.
– It may also be said that an accounting convention is a
common procedure which is adopted by common
agreement.
 Accounting Conventions

There are four main conventions in practice in

accounting:
 Conservatism;
 Consistency;
 Full disclosure; and
 Materiality.
 Convention of Conservatism
• Conservatism is the convention by which,
when two values of a transaction are
available, the lower-value transaction is
recorded. By this convention, profit should
never be overestimated, and there should
always be a provision for losses.
Examples of convention of conservatism

• Making provision for Doubtful Debts in anticipation of actual

Bad Debts.
• Valuing the Stock-in-hand at market price or cost price,
whichever is lower.
• Charging of small amount of capital expenditure like crockery
to Revenue Expenses.
• Applying Written-Down-Value (WDV) Method of depreciation
as against Straight-Line Method. (WDV method is
conservative approach.)
• Never providing discount on Creditors.
 Convention of Consistency
• Consistency prescribes the use of the same
accounting principles from one period of an
accounting cycle to the next, so that the same
standards are applied to calculate profit and loss.
– For example, there are several methods of valuation
of inventories like First-In-First-Out (FIFO) Method,
Last-In-First-Out (LIFO) Method, Weighted Average
Method and so on. If one method is followed in one
accounting year, say FIFO, in subsequent years also
the same FIFO Method has to be followed for valuing
the inventories. If there is any change in the method,
it will affect the financial statements to a great extent
 Convention of Materiality
• According to this convention, only those
transactions which are material and important for
decision making by people who may be interested
in the financial position of the business should be
recorded. Recording of immaterial and
insignificant items may be avoided.
– It has to be observed that an item which is material for
one enterprise may be immaterial for another
enterprise.
• For example, for a manufacturing firm items such as pencils
and eraser may be immaterial expenses. However, for a firm
trading in stationery, they are most important items of
stock.
 Convention of Disclosure
• The convention of full disclosure implies that
every financial statement should fully disclose
“all pertinent information that has a bearing on
the figures in the statements and that will make
possible a reasonable interpretation of their
meaning.”
– It should be important to note that no information
of substance or interest to users especially investors
will be concealed in presenting financial statements.
• Take for example, if the Balance Sheet shows Debtors at
`1,00,000, it is important to know how much Bad Debts
are there and what percentage of provision is made for
the Doubtful Debts and the like
MEANING AND DEFINITION OF ACCOUNTING STANDARDS

• Accounting Standards are written statements of accounting

rules and guidelines to prepare financial statements.
– It may also be said that Accounting Standards are codified forms
of GAAP.
• Accounting Standards consists of detailed rules to be adopted for the
treatment of various items in accounting process so as to attain
uniformity and consistency in internal and external reporting process.
• Accounting Standards are written policy document issued
by expert accounting body, a regulatory body or
government, providing code of conduct for the accountants
on how to recognize, measure, present, and disclose
financial transactions in the financial statements.
 Objectives of Accounting Standards
• To provide information: The main objective of Accounting
Standards is to provide information to the users. It sets
the standards on which accounts have to be prepared.
• To harmonize different accounting processes: Accounting
Standards are evolved to bridge the gap between various
accounting procedure to harmonize the different
accounting processes.
• To enhance the credibility of contents: Accounting
Standards enhance the credibility and comparability of
the financial statements.
Development of Accounting Standards
• Due to the increase in malpractices in accounting, and
increase in failure of business entities, there was a
great demand for standardized accounting practices.
• The result is the formation of “ Accountants
International Study Group (AISG)” – an international
body in 1967.
• Again in 1973, International Accounting Standards
Committee (IASC) begun to function in London, UK.
• On 1972, Financial Accounting Standard Board (FASB)
was established in USA. IASC is now renamed as
International Accounting Standard Board and IAS is
called as International Financial Reporting Standards
(IFRS).
 IFRS

• On 2001 Apr 01, International Accounting

Standard Board (IASB) took over the
responsibility for setting International
Accounting Standards (IAS) from International
Accounting Standard Committee (IASC). Now
IASB issues accounting standards in the name
of International Financial Reporting Standards
(IFRS)
 Importance of IFRS

(i) Standardization: If most of the countries are adopting IFRS, it

would enable to standardize financial statements and assures
better quality globally.
(ii) Level of Confidence: The key benefit is a common
accounting system that is perceived as stable, transparent
and fair to investors. It gives a better understanding to the
financial statements and assesses the investment
opportunities other than home country. They will be required
to invest less time, money and efforts and can confidently
compare opportunities.
(iii) Mergers and Takeover Activity: Cross-broader mergers and
acquisitions get a boost by making it easier for the parties
involved, as no redrawing of financial statements will be
required.
(iv)Easy for Regulators: IFRS are beneficial to regulators too,
as they will be required to understand less number of
accounting reporting standards used by different countries.
The complexity of their work gets reduced.
(v) Opportunity for Accounting Professionals: Convergence
with IFRS also benefits the accounting professionals, as they
are able to sell their services as experts in different parts of
the world. It gives them more opportunities and income.
(vi) Easy Capital Raising: IFRS also benefit the companies who
wish to raise capital abroad. Standardized reporting permits
the international capital to flow more freely and easily.
END of Chapter 2