Accounting Concepts, Conventions and Principles: Introduction, Meaning, Importance and Its Types

Table of Contents

• Introduction

• Meaning

• Importance

• Types with Examples

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   Introduction

Accounting is the art of recording, classifying, and summarising business transactions in a systematic manner. All businesses are obligated to follow accounting concepts, conventions and principles while preparing accounts. The accounting concepts and principles followed by each business organisation must be uniform so that the financial statements can be interpreted and conclusions drawn.

Each accountant has to prepare the accounts based on the accounting principles and concepts so that the auditors can check and audit the accounts. If a business organisation does not follow the principles and concepts of accounting and the accountant does not adopt the principles and rules of accounting, no one will be in a position to interpret it and it will be difficult for the auditor to check the accounts without knowing the principles applied.

2. Meaning

Accounting concepts and principles help a business with its financial reporting by determining the income, expenses, assets and liabilities. Businesses adopt these principles to make their financial statements so that they are complete, concise and clear. It helps the investors and auditors to analyse and audit the data.

3. Importance

The importance of accounting concepts and principles includes proper information to all, valid and appropriate assumptions, acceptable basis of measurement, uniformity in presenting the accounts and giving reliable financial statements.

1. Types with Examples

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• Business Entity

Business entity means that only business transactions are recorded in the books of account and the proprietor’s personal accounts are not recorded in the books of accounts. The meaning of entity in this concept means that the business unit is separate from its owner. Under this concept trading concern and proprietor are treated as two different entities.

Let’s have an example for better understanding of the concept,

A business owner has rented a building. 50% of the office building is used for the business purpose and 50% is used for residence of the proprietor. The building is rented for $10,000 per month. Now the owner of the business will deduct $5,000 only as drawings from the proprietor’s capital as the building is used for residence as well which are two different entities.

• Cost Concept

The cost concept suggest that the asset purchased by the business will be recorded at the value of the price paid when it was purchased and it will be the base for all further accounting. Now the asset may have different value in the future, like, replacement value, latest value, present value, fixed and current assets at their proper values but we will still use the base price for the asset.

Let’s have an example for better understanding of the concept,

A business has purchased furniture for $1000 and the base price of $1000 has been recorded in the books. Now the said furniture may have different market value in the future or its value will drop to $700 or $600 but the business will not consider the future value or the value at the present moment.

• Money Measurement

Every business has to express their business transactions in a common unit of measurement. This concept means that every transaction is recorded in terms of money. A business in US will record their transactions in dollars ($). This concept says that only monetary items are recorded.

Let’s have an example for better understanding of the concept,

A business has the following assets in their books,

Furniture $1000, Raw materials $4000, Land and Building $30,000 and Cash in hand $60,000. Now the total assets of the business will be recorded by common unit of measurement and will be valued at $95,000 in the books of accounts.

• Consistency Concept

Any business that adopts policy for accounting should use it consistently throughout the business period. The consistency concept means that the policy must no change frequently unless the circumstances demand. However, in terms of adopting new technologies and any new improvement of new techniques is not stopped by the business but it shall be disclosed.

Let’s have an example for better understanding of the concept,

The common policy a business follows is the depreciation. A business charge depreciation on its fixed assets from the beginning till the end of its estimated life.

• Conservatism

The word conservatism here, means playing safe, it encourages the accountant to play safe while recording the accounts. The policy encourages businesses to prevent losses and maintaining their reserves. This will allow the business to show lower income in income statement, overstates the liabilities and understates the assets in balance sheet.

Let’s have an example for better understanding of the concept,

A business has a closing stock of $15,000 at cost price, now the market price for the closing stock is $25,000. Now the business will record the lowest price of $15,000 in books of accounts as it is the lowest of all.

• Going Concern

The going concern means that the business will run and continue for a long time. The more the life a business gives the more the investors will invest in it, suppliers will provide credit and the financial position of the business will be stable.

Let’s have an example for better understanding of the concept,

A new start up in an exhibition will exhibit their services and products to attract investors and clients. When the exhibition is over, the business will start its operations.

• Realization

The realization concepts means that income is recorded only when it is realized, it means either it is earned or received. In a business revenue is recorded when sales are increased or decreased or the services are rendered. If the sales in a business are affected during the accounting period, it will be recognized irrespective of the cash is received or not.

Let’s have an example for better understanding of the concept,

A business has purchased two printers from a manufacturer for $500 each. The business sold one of the printers to a customer for $550 and earned $50 profit. The business recorded the $50 profit in their books of accounts but cannot record the profit for the second printer which is not yet sold. As per the principle of realization, revenue is recorded when realized.

• Accrual

A business will record income when it accrues (earned) and expenses are recorded when they accrue (become payable). Every business will record their expenses and revenues in an accounting period irrespective whether the revenues are received in cash or not, or expenses are paid in cash or not.

Let’s have an example for better understanding of the concept,

A business provided marketing services to an organization in the month of March but received payment in the month of April. Now the business will record the revenue in the month of March regardless of the cash received in that month or not.

• Dual Aspect

Dual aspect also means double entry system. Every business transaction has two affects, a debit and credit. Both aspects will be recorded in the books of accounts. This principle is also considered as the concept of debit and credit. If cash comes in, the account is debited and when the cash goes out the account is credited.

Let’s have an example for better understanding of the concept,

An investor invested $50,000 into the business. In here the business gets the $50,000 in cash in its books in debit side and the investor business credits the $50,000 as the capital in their books.

• Disclosure

The business must disclose all the information to the outside parties and it should be relevant, reliable, comparable and understandable by all the parties. The accounting reports should disclose full and fair information of the business financial position to all the relevant parties. The financial position means balance sheet and income statement in true and accurate form.

Let’s have an example for better understanding of the concept,

A business shows the balance sheet and the income statement to investors and creditors so that they invest and give credit. Now the amount of investment and credit depends on the data presented by the business and the disclosure of the information.

• Materiality

This principle suggests that only those items to be recorded that have monetary value and are relatively important. It means that only those items should be recorded and disclosed in the financial statement which have value on the determination of financial condition. Those items which are not important are left out or merged with other items.

Let’s have an example for better understanding of the concept,

A business has a net sale of $50,000,000 in a year. The business made a loss of $500 which is significantly low and will not be recorded and be left out.

• Revenue Recognition Principle

This principle mainly focuses on the revenue a business earns. It is concerned with the revenue recognized and recorded in the income statement. Revenue is recognized in the period in which it is earned whether received or not received during that period. Revenue is the inflow of cash receivables to the business arising from sales and services rendered.

Let’s have an example for better understanding of the concept,

Sales of goods and services within accounting period. Royalties and dividends

• Matching principle

Expenses incurred in the accounting period should be matched with revenues recognized in that period. This concept follows accrual basis and considers prepaid expenses, outstanding expenses, accrued expenses and unaccrued revenues. Matching does not mean that expenses must be identifiable with revenues.

Let’s have an example for better understanding of the concept,

If revenue is recognized on all goods sold during a period, cost of those goods sold should be charged to that period.