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Master Key Accounting Concepts and Conventions: Essential Guide for Financial Clarity
You can see that numbers and technical terms are often associated with accounting, making it look very complicated, but for businesses it is a way they use to reveal their financial situation. These transactions are done as per basic principles that govern until they are recorded, organized and generalized. Here the use of the accounting concepts and conventions exists to offer a common foundation for preparing dependable, uniform and similar financial statements. In this blog we are going to discuss about it for your ready reference.
Table of Contents
What are accounting concepts?
Accounting concepts and conventions are the key principles, assumptions, and conditions which help a business entity to record its financial transactions and set up its accounting base. It aids a business in understanding and incorporating a financial transaction into its accounting framework. Therefore, both business owners and accountants need to possess an understanding of these fundamental concepts to promote uniformity and consistency within their accounting operations. This blog will analyze the important accounting ideas before explaining the difference between accounting concepts and conventions and defining some of the accounting concepts.
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Why are Accounting concepts necessary
For understanding the use of financial statements it is imperative that one has knowledge about accounting concepts. These provide a uniform basis for recording, reporting and interpreting financial events and data in an orderly manner which can be beneficial in decision making.
Some of the reasons why accounting concepts are important include:
Stability: Accounting concepts ensure that financial statements are prepared without any change from one period to another. Users have no difficulty in comparing over time and identifying trends.
Comparability: Accounting concepts help in the comparison of financial statements across varying entities. Users can understand what is happening financially in various firms so investors would know whom they should invest their money in.
Transparency: Financial statements must contain all important financial information for businesses as per accounting principles. This makes it possible for a better understanding of company finances hence the chance of dishonest dealings or misuse of money is limited.
Accountability: Financial principles make organizations accountable on their performance regarding money. Companies can be handled properly if they have precise and dependable fiscal data; these morals will guide them rightly while running their affairs.
Here are a few examples of how accounting concepts are applied in real-world scenarios:
- To evaluate a firm’s profitability, investors apply accounting concepts and principles. A company’s income statement may reveal the revenue and profit it has been making during a particular period. Another thing that they might check out from a given balance sheet would be its total debts and total equity.
- Investors may research corporate profit-and-loss account statements to know how much revenue this company has earned and how much net income it makes as well. Furthermore, there is another aspect that would interest them in connection with balance sheets by looking into whether a specific enterprise possesses any debts at all or what kind of shareholders’ equity exists.
Difference between Accounting Concepts and Conventions
| Accounting Concepts | Accounting Conventions |
|---|---|
| The statements (financial) are prepared and presented according to certain guidelines and basic principles known as accounting concepts for example the going concern concept or the accrual concept. | Accounting conventions may involve common norms and regulations that govern this field, like using double-entry accounting or applying historical cost convention. |
| This serve as the foundation for accounting concepts which are then regarded as universal | This tend to be country or region-specific. |
| These concepts provide a basis for reliable and comparable financial statements. | These guarantee consistency and uniformity in accounting practice. |
| These are compulsory for all organizations. | These can be adopted at the discretion of an organization. |
| Transactions are recognized and measured based on accounting concepts. | Accounting conventions determine the way transactions are presented and disclosed. |
| These may change with respect to new developments and shifts in economies. | They are much more stable than their counterparts as they alter rarely. |
| Through them, one is able to attain transparency and fairness in financial statements while carrying out different forms of record keeping. | They only help in keeping records efficiently with simplicity. |
Basic Accounting Concepts
There are numerous ideas that accounting professionals use to give their clients the best services, be it individuals or entities. The commonly used concepts include:
- Revenue: The revenue is the total amount of money a business receives for selling services and products. This means that it is the gross income of a company without reducing any costs.
- Expenses: Expenses are the payments that should be made by a business in order to generate sales. These can include supplies and materials, rent, advertisements, salaries of employees, repairs and taxes. For instance, ingredients may have to be bought regularly from suppliers by restaurant managers for their restaurants to operate. In order to earn profits, a company must ensure that its expenditure is lower than its income.
- Assets: Assets are things owned by an organization that provide economic benefits. Assets can be calculated by adding liabilities to equity. There are two types of assets which include:
- Current or liquid: These involve resources used up within one year e.g. cash at bank and cash in hand, receivables and prepaid expenses.
- Non-current or fixed: These items are long-term in nature because they generate benefits over more than one year; land & buildings, equipment like machinery including patents
- Liabilities: Liabilities refer to economic obligations or what a corporate owes other enterprises like creditors or lenders. Just as with assets, these can also be categorized into current and non-current liabilities. The differences between these are:
- Current: These refer to amounts payable within the next 12 months such as trade payables/creditors (accounts payable), short term borrowings (loans) by credit institutions/tax revenue authorities respectively.
- Non-current: liabilities are not due within the year, and these include long-term bonds, mortgages and deferred tax obligations payable in future.
- Capital: Capital encompasses all things that add value to an owner of a business, such as assets, machinery, property, stocks and patents. Capital is a term that usually refers to investments generating wealth for a business although cash can also be considered capital. Here are some types of capital:
- Working: Working capital can be found by subtracting current liabilities from current assets. Working capital includes liquid assets or cash that a company utilizes for daily operations and short-term payments like payment of debts and accounts payable which fall due within the financial year.
- Equity: Equity is an owner’s claim or stake in a business or any asset that he owns meaning money shareholders invest in the company. This equity is what shareholders get if they sell off all their assets including inventory and other current assets, pay off any debts then use the remaining funds to settle claims.
- Debt: Debt capital can be obtained by businesses when they borrow loans or bonds from banks, private organizations or government agencies. As it provides substantial funds at once, debt capital may serve as the means for expanding the business into its future.
- Financial Statements: The documents which show the movement of funds by an individual or organization are termed as financial statements. Here are several types of financial statements and their definitions:
- Income statement: Also known as profit and loss account, it refers to a document that explains a company’s financial performance by reflecting on its revenues, costs, and expenses over a given period.
- Balance sheet: This is an accounting document that shows the assets, liabilities, and owners’ equity position of a business entity at a particular point in time.
- Statement of cash flows: These financial statements indicate how much money a business generated during any given period and how much cash left the organization.
Accounting Concepts with Examples
Accounting concepts form the basis of ideas, assumptions, and conditions that support the accounting process. These types of accounting concepts create a structure to record, report, and interpret financial transactions and data.
Accounting concepts make sure financial statements follow a consistent and uniform approach, which boosts their reliability and usefulness in making decisions.
Companies and their stakeholders need these concepts to monitor their financial results, make smart business choices, and follow financial reporting rules.
Stakeholders, like investors, lenders, and government bodies, use accounting concepts to evaluate the financial well-being of businesses and to make smart investment and lending decisions.
Some of the most important types of accounting concepts include:
Business Entity Concept
This concept is also called Separate Entity Concept. According to this concept, a business is viewed as an independent legal entity distinct from its owners. Therefore, the company’s financial records are separated from the personal finance of its owner. In other words, the company has its own assets, debts, and ownership claims that are not affected by the private property of the owner.
He buys flour for INR 5000 for his business. This will be recorded as bakery ‘A’ expense, not a personal expense for Sanjay.
Sanjay sells bread for INR 9000. This will be recorded as bakery ‘A’ income, not personal income of Sanjay.
Sanjay takes INR 2000 from the bakery ‘A’ for his personal use. This will be recorded as a withdrawal, not a bakery expense. So Sanjay and his bakery is treated as a separate entity as per accounting records.
Going Concern Concept
This concept presumes that a company will keep running for the foreseeable future. Thus, accountants should register assets and liabilities at their initial price, instead of their fair market value. The significance of the Going Concern Concept lies in the fact that it enables accountants to draw up financial statements that represent the true worth of a company as an entity.
Money Measurement Concept
As per the monetary measurement concept, only those transactions that can be measured in terms of money should be recorded in account books. This method facilitates quantification and comparison, enabling financial statements to contain pertinent and comparable information for making decisions concerning the business.
Using the money measurement principle only financial transactions should be recorded in accounting. This approach helps in quantifying and comparing, making financial statements meaningful and able to compare in case they are to be used in the decision making process.
Accrual Basis of Accounting Concept
Accrual is defined as a sum of money that becomes due, especially an amount that is still unpaid or has not been received at the end of an accounting period. This means that transactions are acknowledged as soon as they become due, that is, no matter whether cash was exchanged or not. On the other hand, accrual entails recording an expense which has been incurred and whose payment has not been done yet whether cash has been paid or not.
Under ‘Accrual Basis of Accounting’ concept, Company ‘A’. will pass the journal entry of INR 20,000 as accounts receivable in March 2024 because the service was provided in the month of March, even though the cash is received in April 2024.
Matching Concept
The matching principle states that income earned from the sale of goods or services and costs incurred in generating such income must be recorded in the same accounting period. Therefore as soon as income is received, it should immediately be assigned to the respective accounting period through accruals. When revenue exceeds expenses the term used is “profit”. When the expenses exceed revenue, the term used is loss. This enables the investors or shareholders to know the exact profit and loss of the business.
The revenue from selling of the 50 units OF LED TV and the retail cost related to those units should be recorded in the same accounting period i.e. April 2024 to accurately match the expenses with the revenues they generated.
Dual Aspect Concept
‘Dual aspect’ concept is the foundation of accounting, or its basic principle. This is the basis for recording business transactions in books of accounts. This concept assumes that every transaction has a dual effect, that is, it affects two accounts on opposite sides. Thus, the transaction should be recorded at two places. This implies that both aspects of each transaction must be recorded in the books of accounts. In short, every transaction has two effects, equal in amount but opposite in nature.
Hence the dual aspect concept is commonly expressed as: Assets = Liabilities + Equity Capital
The Machinery Account (an asset) is debited with INR 30,000.
The Cash account (another asset) is credited by INR 30,000.
Materiality Concept
According to the ‘Materiality Concept’, all vital information that may change user preferences of financial statements must be included in the records and reports. An important thing must always be revealed but a less significant aspect can either be simplified or disregarded due to its overall effect on financial status.
Typically, materiality is assessed using size or characteristics attached to an item against the entire financial statements of an enterprise. For instance, certain aspects could be substantial to one firm whereas they are marginal for another depending on factors such as size, nature and financial condition.
In other case, Company ‘B’ can omit to record a petty cash expense of INR 100 where its total assets is INR 100 crore as the INR 100 is an insignificant amount compared to the overall financial position.
Conclusion
The foundation of trustworthy and uniform financial reports lies in accounting principles and practices. They are the guidelines that make sure that financial statements are correct, comparable and useful to partners or shareholders. Following principles such as ‘Matching’ Concept or ‘Dual Aspect’ concept can make it possible for accountants to prepare accounts that can represent companies’ actual financial position.
Besides, Materiality and Prudence help ascertain whether financial data is relevant or not, protecting against misleading information and over optimism. These concepts and conventions become more important with the increase in complexity of businesses as they serve to safeguard integrity of financial reporting while enabling better decision-making.
Understanding these Accounting Concepts and Conventions is most important for anybody involved in finance because this ensures that clients’ stories are true as far as numbers are concerned.
Profession: Tax Consultant & Financial Planner
Organization: Master Trainer (CA) at “ICA Edu Skills Pvt. Ltd".
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Author of Book: “10+2 Accountancy”
Mr. Sanjiv Kumar Giri is having more than 15 years of experience in the field of Direct Taxes, GST, and Accounts & Finance.
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