Accounting Concepts And Convention
Accounting concepts are broad working rules adopted by the accounting profession as guides for recording and reporting the affairs and activities of corporate organizations. In this article, I summarised the basic concepts which are to be observed at the reporting stage. i.e., at the time of preparing the final accounts.
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Lists of Concepts
Accounting Concepts that are applied in the preparation of financial statements are listed below:
- Going Concern Concept.
- Accounting Period (Periodicity) Concept
- Matching Concept
- Conservatism (or Prudence) Concept
- Consistency Concept
- Full Disclosure Concept
- Materiality Concept
Summary of financial statements is prepared at the end of an accounting period in the form of a Profit and Loss Account and Balance Sheet to ascertain the profit or loss and the financial position of the business. These are called final accounts.
There are seven accounting concepts that are to be observed while preparing the final accounts.
The going concern concept implies that a firm is a continuing unit. Hence, expenditure on long-term assets could be spread over a number of years.
According to the Matching Concept, appropriate costs have to be matched against the appropriate revenues for the accounting period.
The concept of Prudence implies that while calculating the profit of an accounting period, all possible losses should be taken into account while only those incomes should be included which have actually arisen and not just expected.
According to the consistency concept, the accounting methods followed from period to period should be the same so as to ensure meaningful comparisons.
The full disclosure and the materiality concepts signify that the financial statements should disclose all material information so that the users can draw rational conclusions about the enterprise.
There are two bases of accounting viz. cash basis and accrual basis. The accrual basis is considered more logical because it takes into account all expenses incurred (whether paid or not) and all incomes earned (whether received or not) during the accounting period and thus ensures correct ascertainment of profit or loss.
It is also important to distinguish between capital and revenue expenditure, otherwise, the ascertainment of profit or loss and the financial position of the business will be incorrect.
Bases of Accounting
The accounts are prepared by the business either on a cash basis or on an accrual basis. In the cash basis system, accounting entries are made on the basis of cash received or cash paid. In other words, no entry is made when an income is earned or an expense is incurred. It will be recorded in books only when the amount involved is actually received or paid. Thus, the incomes earned but not yet received (accrued income) or the expenses incurred but not yet paid (accrued expenses) are completely ignored while preparing the final accounts.
For example, Rent for the month of December 2017 paid in January 2018 will be taken to the
Profit and Loss Account of 2018 even though the expenditure relates to 2017. This leads to the incorrect ascertainment of profit or loss of the business, but it is not true of the accounts maintained on an accrual basis.
Under the Accrual System, the financial effect of transactions is recorded in the books as and when they occur and not when the amount involved is received or paid by the business. This system attempts to relate the revenues and expenses to the accounting period during which they are actually earned or incurred. Thus, rent for the month of December 2017 paid in January 2018 will be taken into the Profit and Loss Account of 2017 and not of 2018. This is more logical because the benefit is enjoyed in the year 2017 and not in 2018.
The main difference between the accrual basis of accounting and cash basis of accounting is the timing of recognition of revenues, gains, expenses, and losses. The objective of accrual accounting is to account for the effect of transactions and events to the extent their financial effect is recognizable and measurable in the periods in which they occur.
The adjustments made in the final accounts in respect of outstanding expenses, prepaid expenses, income received in advance and income earned but not yet received are in fact based on accrual accounting.