WORKSHEET 4- BASIC CONCEPTS OF ACCOUNTING (CLASS 11)

 UNIT 1 ACCOUNTING FOR MANAGEMENT 

ACCOUNTING CONCEPTS AND CONVENTIONS WITH EXAMPLES[ 6 MARKS]

Difference Between Accounting Concept and Convention. ... Accounting concepts are the fundamental accounting assumptions that act as a foundation for recording business transactions and preparation of final accounts. On the other extreme, accounting conventions are the methods and procedures which have universal acceptance 

 

ELEVEN KEY ACCOUNTING CONCEPTS 

1.     Entity 

Accounts are kept for entities and not the people who own or run the company. Even in proprietorships and partnerships, the accounts for the business must be kept separate from those of the owner(s). This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business 

2.     Money-Measurement

For an accounting record to be made it must be able to be expressed in terms of money and money’s worth. For this reason, financial statements show only a limited picture of the business. Consider a situation where there is a labor strike pending or the business owner’s health is failing; these situations have a huge impact on the operations and financial security of the company but this information is not reflected in the financial statements. 

3.     Going Concern 

Accounting assumes that an entity will continue to operate indefinitely. This concept implies that financial statements do not represent a company’s worth if its assets were to be liquidated, but rather that the assets will be used in future operations. This concept also allows businesses to spread (amortize) the cost of an asset over its expected useful life. 

4.     Cost 

An asset (something that is owned by the company) is entered into the accounting records at the price paid to acquire it. Because the “worth” of an asset changes over time it would be impossible to accurately record the market value for the assets of a company. The cost concept does recognize that assets generally depreciate in value and so accounting practice removes the depreciation amount from the original cost, shows the value as a net amount, and records the difference as a cost of operations (depreciation expense.) Look at the following example: 

 

Truck $10,000 purchase price of the truck Less depreciation $ 1,000 amount deducted as a depreciation expense Net Truck: $ 9,000 net book-value of the truck 

The $9000 simply represents the book value of the truck after depreciation has been accounted for. This figure says nothing about other aspects that affect the value of an item and is not considered a market price. 

5.     Dual Aspect 

This concept is the basis of the fundamental accounting equation: 

Assets = Liabilities + Equity 

1.     Assets are what the company owns. 

2.     Liabilities are what the company owes to creditors against those assets 

3.     Equity is the difference between the two and represents what the company owes to its investors/owners. 

All accounting transactions must keep this equation balanced so when there is an increase on one side there must be an equal increase on the other side or an equal decrease on the same side. 

6.     Objectivity

The objectivity concept states that accounting will be recorded on the basis of objective evidence (invoices, receipts, bank statement, etc...). This means that accounting records will initiate from a source document and that the information recorded is based on fact and not personal opinion. 

7.     Time Period 

This concept defines a specific interval of time for which an entity’s reports are prepared. This can be a fiscal year (Mar 1 – Feb 28), natural year (Jan 1 – Dec 31), or any other meaningful period such as a quarter or a month. 

8.     Conservatism

This requires understating rather than overstating revenue (income) and expense amounts that have a degree of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize expenses as soon as they are reasonably possible. The reasons for accounting in this manner are so that financial statements do not overstate the company’s financial position. Accounting chooses to err on the side of caution and protect investors from inflated or overly positive results. 

9.     Realization

Revenues are recognized when they are earned or realized. Realization is assumed to occur when the seller receives cash or a claim to cash (receivable) in exchange for goods or services. This concept is related to conservatism in that revenue (income) is only recorded when it actually occurs and not at the point in time when a contract is awarded. For instance, if a company is awarded a contract to build an office building the revenue from that project would not be recorded in one lump sum but rather it would be divided over time according to the work that is actually being done. 

10.  Matching 

To avoid overstatement of income in any one period, the matching principle requires that revenues and related expenses be recorded in the same accounting period. If you bill $20,000 of services in a month, in order to accurately represent the income for the month you must report the expenses you incurred while generating that income in the same month. 

11.  Consistency

Once an entity decides on one method of reporting (i.e. method of accounting for inventory) it must use that same method for all subsequent events. This ensures that differences in financial position between reporting periods are a result of changes in the operations and not to changes in the way items are accounted for. 

12.  Materiality

Accounting practice only records events that are significant enough to justify the usefulness of the information. Technically, each time a sheet of paper is used, the asset “Office supplies” is decreased by a very small amount but that transaction is not worth accounting for. By understanding and applying these principles you will be able to read, prepare, and compare financial statements with clarity and accuracy. The bottom-line is that the ethical practice of accounting mandates reporting income as accurately as possible and when there is uncertainty, choosing to err on the side of caution. 

KEY TAKEAWAYS OF ACCOUNTING CONVENTIONS.

·       Accounting conventions are guidelines used to help companies determine how to record business transactions not yet fully covered by accounting standards.

·       They are generally accepted by accounting bodies but are not legally binding.

·       If an oversight organization sets forth a guideline that addresses the same topic as the accounting convention, the accounting convention is no longer applicable.

·       There are four widely recognized accounting conventions: Conservatism, consistency, full disclosure and materiality. 

Accounting Convention Methods 

There are four main accounting conventions designed to assist accountants:

CONSEVATISIM  Playing it safe is both an ACCOUNTING PRINICIPLE  and  CONVENTION. It tells accountants to err on the side of caution when providing estimates for asses and liabilities.  That means that when two values of a transaction are available, the lower one should be favored. The general concept is to factor in the worst-case scenario of a firm’s financial future.

·       Consistency: A company should apply the same accounting principles across different accounting cycles.. Once it chooses a method it is urged to stick with it in the future, unless it has a good reason to do otherwise. Without this convention, investors ability to compare and assess how the company performs from one period to the next is made much more challenging.

·       FULL DISCLOSURE: Information considered potentially important and relevant must be revealed, regardless of whether it is detrimental to the company.

·       Materiality: Like full disclosure, this convention urges companies to lay all their cards on the table. If an item or event is material, in other words important, it should be disclosed. The idea here is that any information that could influence the decision of a person looking at the financial statement must be included.

Examples of Accounting Conventions 

Accounting conservatism may be applied to inventory valuation  When determining the reporting value for inventory, conservatism dictates the lower historical cost  or replacement cost is the monetary value.

Adjustments to line items are not made for inflation or market value.  This means book value  can sometimes be less than market value. For example, if a building costs $50,000 when it is purchased, it should remain on the books at $50,000, regardless of whether it is worth more now.

Estimations such as uncollectable accounts  receivables  (AR) and casuality losses  also use the conservatism convention. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles. However, if a litigation claim is expected to be lost, an estimated economic impact is required in the notes to financial statement.  Contingent liability  such as royalty payments or unearned revenue are to be disclosed, too.

What Is a Contingent Liability? 

A contingent liability is a liability that may occur depending on the outcome of an uncertain future event. A contingent liability is recorded if the contingency is likely and the amount of the liability can be reasonably estimated. The liability may be disclosed in a footnote on the financial statements unless both conditions are not met.

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