Accounting principles form the fundamental norms and assumptions that serve as the foundation for accounting systems. Universally embraced by accountants, these principles ensure uniformity and consistency in accounting methods and processes. They collectively constitute the Generally Accepted Accounting Principles (GAAP).
Accounting principles establish the fundamental structure for preparing accounting records and reports. National and international regulatory bodies have introduced accounting standards to ensure consistency in accounting procedures and outcomes. These standards, along with Generally Accepted Accounting Principles (GAAPs), form the theoretical foundation of accounting. Accounting principles encompass both concepts and conventions: concepts serve as fundamental assumptions, while conventions offer guidelines derived from practical applications or established practices.
Accounting concepts form the fundamental assumptions and foundations of accounting. They stem from widespread consensus and represent universally accepted notions or abstractions. These concepts serve as the cohesive framework for the accounting process and the creation of accounting reports.
Convention, in essence, embodies traditions or customary practices. In accounting, conventions represent the guiding principles followed in preparing financial statements. Recognized by regulatory bodies in accountancy, these conventions serve a crucial role in enhancing the realism, reliability, and overall usefulness of financial statements for all involved stakeholders.
Outlined below are the significant concepts and conventions essential to accounting:
(i) Business entity concept- This principle suggests that a business entity is seen as distinct from its owner or owners, who provide capital to it. Following this principle, accounts are formulated from the perspective of the business rather than the owner’s viewpoint. Consequently, the business is indebted to the owner for the contributed capital. Under this principle, only transactions related to the business are documented in the accounting records. The personal dealings of the owners remain unrecorded. However, any interactions between the owners and the business, such as capital infusion or withdrawals for personal use, are documented in the books. Essentially, this notion highlights that the business possesses assets and carries liabilities in its own right.
(ii) Money measurement concept- This concept operates on the premise that only transactions quantifiable in monetary value find their place in the accounts. Money acts as the intermediary for recording exchanges and making transactions measurable, and the national currency sets the standard for accounting. Transactions devoid of monetary involvement remain unaccounted for in the financial records. Instances like workplace conditions, employee strikes, or managerial efficiency, being immeasurable in monetary terms, remain excluded from the books. This approach aids in grasping the business’s status quo, using money as the universal metric to record diverse aspects of the business. For instance, while a business may possess 5 computers, 2 tables, and 3 chairs, these assets lack informative value until expressed monetarily—such as $1,00,000 for computers, $10,000 for tables, and $1,500 for chairs.
(iii) Going concern concept- The fundamental premise in business is the assumption of its continuity and ongoing operations in the foreseeable future. This principle, known as the ‘going concern’ concept, significantly shapes accounting methodologies regarding the assessment of asset and liability values, the handling of fixed asset depreciation, the treatment of outstanding and prepaid expenses, as well as accrued and unearned revenues. As an illustration, assets are typically appraised based on historical costs, disregarding any short-term fluctuations in their value.
(iv) Cost concept- Assets are initially documented in financial records based on historical cost—the original purchase expense. This acquisition cost serves as the fundamental reference point for all subsequent accounting activities. However, this doesn’t imply that assets will perpetually appear at their purchase price. While they are initially registered at cost upon acquisition, their book value undergoes systematic reduction through depreciation. Nevertheless, the concept of cost encounters several limitations: a) During periods of inflation, when prices surge, valuing assets at historical cost might not accurately reflect the actual status of the business. b) Comparability between business units established at different times becomes challenging when assets are documented based on historical values. c) Assets lacking an explicit acquisition cost, like human resources, aren’t acknowledged under this concept.
(v) Dual aspect concept- This concept operates on the principle that each transaction or event has a dual effect. For instance, when Arun initiates a business with a cash infusion of $ 5,00,000, it results in a twofold impact: the business receives $ 5,00,000 in cash, but simultaneously incurs a liability, obligating the business to reimburse Arun the same amount. This principle highlights the correlation between debit and credit, forming the foundation of the double-entry bookkeeping system. Out of this concept emerges the fundamental accounting equation: Capital + Liabilities = Assets.
(vi) Periodicity concept- This principle involves compiling financial records for a specific timeframe. Proprietors, investors, creditors, employees, and the government all have a stake in understanding a business’s performance over time. To facilitate this, a specific duration—often a year—is chosen to assess performance. Consequently, financial statements are generated at the conclusion of each accounting period, not at the end of a business’s existence. This practice aids in distributing income to owners and enables the comparison and evaluation of performance across various periods.
(vii) Matching concept- This concept aligns revenues earned within an accounting period with the expenses incurred during the same duration to generate those revenues. It hinges on the accrual and periodicity principles. Periodicity establishes the timeframe for assessing performance and determining financial standing. Only expenses pertinent to the accounting period are considered, excluding those paid outside of this timeframe. Adjustments, such as accounting for outstanding and prepaid expenses, accrued and unearned revenues, depreciation of fixed assets, and provisions for bad debt, are made based on this concept. By doing so, it ensures a correlation between the revenues earned and the expenses incurred within the same accounting period, preceding any profit or loss sharing.
(viii) Realisation concept- The concept of realization dictates that changes in an asset’s value should only be recognized by a business when they are actually realized. If assets are initially recorded at historical value, any alteration in their worth is to be acknowledged solely upon realization.
(ix) Objective evidence concept- The principle of objective evidence in accounting mandates that all recorded transactions must be supported by concrete proof. This evidence comprises documents such as cash receipts, invoices, and similar paperwork. Adhering to this principle guarantees the credibility, precision, and trustworthiness of the financial entries made in the accounting records.
(x) Accrual concept- According to the accrual concept, transactions are recorded based on when they occur, not solely when cash is exchanged. Revenue is acknowledged when earned, and expenses are noted when incurred, regardless of cash flow. This means that all revenue and expenses pertinent to the accounting period are considered, regardless of whether cash has been received or paid. For instance, a sale made on credit is recognized as revenue even if the payment hasn’t been received immediately. Similarly, if rent for March 2018 remains unpaid by the end of the accounting period, say from April 1, 2017, to March 31, 2018, it’s still recorded as an expense for the 2017-2018 accounting year because it became due within that period.
(xi) Convention of consistency- The consistency convention dictates the need for maintaining uniformity in accounting practices across consecutive periods. Comparable outcomes between different years are achievable only when consistent accounting policies are adhered to annually. For instance, if a company has employed the straight-line depreciation method since acquiring or building an asset, it should persist without alteration. Nonetheless, this guideline doesn’t preclude the possibility of making changes.
Accounting policy changes may be implemented under these conditions: (a) Adherence to legal requirements (b) Compliance with issued accounting standards (c) Ensuring an accurate representation of the business’s current state.
(xii) Convention of full disclosure- The preparation of accounts necessitates honesty and the full disclosure of all significant information within the accounting statements. This practice holds significance as management typically differs from ownership in the majority of organizations. Therefore, the disclosure must be comprehensive, impartial, and sufficient to enable users of financial statements to accurately evaluate the business unit’s financial position and performance.
(xiii) Convention of materiality- In accordance with this convention, financial statements are required to reveal all significant items that could impact the decisions made by those relying on them. Consequently, any non-significant item that doesn’t hold relevance for users need not be included in the financial statements. This principle essentially serves as an exemption to the overarching full disclosure principle. The concept of materiality is subjective, contingent upon factors such as transaction amount, business size, information nature, decision-maker requisites, and more. What’s considered material to one person might be deemed immaterial to another.
(xiv) Convention of conservatism or prudence- It’s a policy emphasizing caution and risk mitigation. When recording business transactions, the approach involves expecting no income but preparing for all potential losses. For instance, if the closing stock in a factory holds a cost price of $ 35,000 and a realizable price of $ 25,000, the books will reflect the lower value, which is $ 25,000. This aligns with the realization concept, which dictates that any increase in value isn’t recognized until it’s actualized. The conservatism convention goes a step further—unrealized gains aren’t anticipated, but provisions can be set aside for potential losses.