4 Accounting Principles: Characteristics, Difference between Accounting Concepts and Conventions
Ms. Deepika Gautam
LEARNING OBJECTIVES
This module helps to understand the concept of accounting principles. After studying this module the students may be able to understand the meaning of accounting principles, their characteristics and importance. Further understanding will be enhanced regarding the accounting concepts and conventions, and the difference between them will also be highlighted.
INTRODUCTION
Accounting is the language of business. To make the language convey the same meaning to all people, accountants all over the world have developed certain rules, procedures and conventions, which represent a similar view by the profession of good accounting practices and are referred to as GAAP (Generally Accepted Accounting Principles).
These principles/rules have been developed by different accounting bodies with the main aim to maintain uniformity in the accounting practices and are imposed on companies so that the investors have a maximum level of consistency in the financial statements they use when analysing companies financial records for investment purposes.
Accounting statements are prepared by the organisations in conformity with these principles in order to place more reliance on them. The need for common practices is felt because chaotic environment would prevail in organisations if all the accountants could follow their own practices while recording the transactions.
ACCOUNTING PRINCIPLES
Generally the term “Principle” refers to the fundamental belief or a general truth which once established does not change. AICPA defined the term Principle as “a guide to action, a settled ground or basis of conduct or practice.” Accounting principles can be referred to as the general set of guidelines to establish the standards for sound accounting practices and procedures in reporting the financial statements. These principles are essential to be followed by every company while preparing its financial statements, so that consistency and uniformity is maintained and the usefulness of accounting data is enhanced and it becomes easy for the investors to compare the financial statements of different companies, and make their decision wisely.
Accounting principles have been defined as a body as the body of doctrine, commonly associated with the theory and procedure of accounting, serving as an explanation of current practices being followed and as a guide for the selection of conventions and procedures where alternative exist. In simple words, “Accounting Principles” are those rules of conduct or procedure which are adopted by the accountants universally for recording and reporting of financial data. These principles bring about uniformity, consistency and reliability in the practice of accounting.
According to Robert N Anthony and James S Reece, “Accounting Principles are man-made. Unlike the principles of physics, chemistry and other natural sciences, accounting principles were not deducted from axioms, nor can they be verified by observations and experiment. Instead, they have evolved. Thus, evolutionary process is going on constantly; accounting principles are not eternal truths.”
Accounting principles can be classified into two categories:
(i) Accounting Concepts and
(ii) Accounting Conventions
(These will be discussed later in the module, in brief)
CHARACTERISTICS/FEATURES OF ACCOUNTING PRINCIPLES
The following are the characteristics of accounting principles:
1) Have no authoritativeness/ steadiness as universal principles:
As the accounting principles are man-made so they do not have the steadiness as universal principles like the principles of physics, chemistry, biology and other natural sciences. They simply represent the best possible guidelines set by the accountants to improve the quality and effectiveness of accounting data and maintain consistency in representing the financial statements year after year.
2) Accounting principles are still evolving:
Accounting principles are not in their finished form. Since the principles are influenced by changes in the social, legal, and economic environment, they need to be revised, modified and enhanced continuously, so as to match up with the dynamic environment.
3) Acceptance of principles is dependent on various factors:
How well the accounting principles are accepted depends upon: Relevance, Objectivity and Feasibility.A principle is relevant if it results in information that is useful to those seeking the information, i.e. if the statements provide relevant data.A principle is objective if the accounting information is not influenced by the personal biasness of those furnishing the information.A principle is feasible to the extent that it can be applied without undue complexity or cost.
4) Accounting principles cannot be validated/proved by reference to natural laws:
As in the case of physical sciences these principles cannot be proved with reference to natural laws. They are simply the suggestions based on practical experience, reasons and observations which have been developed by the accountants/authorities engaged in the accounting profession over the years.
5) Accounting principles are not rigid:
Accounting principles are ever changing, they are not rigid, principles can be easily modified as per the accountant’s choice and as per the situations being faced while recording the transactions.
| QUICK REVISION |
|
IMPORTANCE OF ACCOUNTING PRINCIPLES
Accounting principles are very important part of every organisation as following them properly helps an organisation in presenting a true picture of their financial strength. Following are the points of importance of accounting principles:
1) Usefulness of accounting data is enhanced:
Organizations prepare financial accounts in order to make them available to the owners for decision making and to the investors for persuading them to invest in their company. Preparing the statements in accordance with the GAAP (generally accepted accounting principles), enhances the usefulness of the data to the investors, as they can easily without getting confused, compare the data of two or more companies following the same accounting standards.
2) Establishes a greater accountability and transparency:
Preparing a financial report in compliance with GAAP establishes greater accountability and helps in transparent working of the organization, hence presenting a clean and clear picture of its financial performance to the interested users of its accounts.
3) Maintains Consistency:
Accounting principles establish a consistency in the presentation of financial accounts, as similar ways of recording the transactions take place year after year and that allows for more accurate and efficient viewing of company statements and reports.
4) Makes the accounts universally understandable:
GAAP are the general guidelines which frames a common set of procedures and rules to be followed in order to maintain the accounts, hence it converts the accounts in a common language universally understandable and acceptable by all the investors.
5) Provides Relevant Data:
An accountant while preparing the accounts follow the Accounting principles and ensures that only relevant data is presented in the books of accounts that may assist the interested users to form, confirm or maybe revise a view- usually in context of making a decision.
6) Guidelines to Accountants:
Accounting principles provides guidelines to the accountants in preparing and presenting financial statements in different situations. Thus the scope of personal choice and biasness is reduced to the minimum.
7) Increases Reliability:
The financial accounts if prepared as per the principles and standards laid down by AICPA, the information so presented is deemed to be accurate, reliable and complete in all aspects. It means that the investors can easily rely on the information so presented before making any decisions.
CLASSIFICATION OF ACCOUNTING PRINCIPLES
Traditionally, accounting principles were classified into two categories:
The International Accounting Standards (IAS-I) has classified the accounting principles into:
(A) Fundamental Accounting assumptions (Concepts)
(B) Accounting Policies (Conventions)
ACCOUNTING CONCEPTS
The business affairs need to be communicated to the interested parties as well as to the owners of the business, through accounting information which has to be suitably recorded, classified, summarized and presented. Accountants make sure that they use simple and understandable language. If the language is to be understood by all, it must contain certain concepts which are universally accepted and understandable.
In general terms, concepts refers to the postulates i.e., basic assumptions or conditions upon which the science of accounting is based, or the rules that should be followed in preparation of all accounts and financial statements. These can also be described as a set of principles that ensures that accounting information is presented in a true and fair manner. There are a number of concepts that have been established as standard accounting principles. These concepts are created by professional organisations and may also be backed by governing bodies and law.
There are various accounting concepts that are followed by the accountants while maintaining the financial statements:
1) Business Entity Concept
2) Money Measurement Concept
3) Going Concern
4) Cost Concept
5) Dual Aspect Concept
6) Accounting Period Concept
7) Matching Concept
8) Realization Concept
9) Objective Evidence Concept
10) Accrual Concept
These concepts are discussed in brief as under:
Business Entity Concept: the concept implies that, for the purpose of accounting the business firm is regarded as separate and distinct legal entity from its owners, creditors, employees, customers etc. The concept of separate legal entity suggests that the affairs of the business must not be mixed up with the personal affairs of the owner.
Money Measurement Concept: this is one of the basic concept which states that only those transactions will be recorded in the books of accounts that are capable of being measured in terms of money. And those that cannot be expressed in monetary terms, will not be recorded in the books.
Going Concern Concept: this concept is based on the premise that business will continue for an indefinite period of time and it would not be wound up or terminated in the near future. It will go on continuously. Under this concept pre-paid expenses are recognised as assets since the benefits will be utilized in future when the business entity will continue.
Cost Concept: this concept explains that assets acquired by the business are generally recorded at their historical cost ie the price which is paid for acquiring the asset. The fixed assets recorded at cost price at the time of purchase are reduced every year by its depreciation amount.
Dual Aspect Concept: this is the most distinctive and fundamental concept of accounting. This states that there are two aspects. The first is the assets of the business and second is equities. And that both aspects of the transaction should be recorded to have a complete record of each business transaction. And each debit should have a credit with same amount.
Accounting Period Concept: accounting is based on the assumption that business will continue for a long period of time. However to know the results of the business operations and financial position of the firm, time is divided into different segments referred to as accounting periods. It may be financial year or calendar year.
Matching Concept: this concept states that the expenses incurred in an accounting period should be matched with the revenues during that period. It follows from this that the revenue and expenses (incurred to earn these revenues) must belong to the same accounting period.
Realization Concept: this concept implies that revenue is deemed to be earned when it is realised. Example: Revenue is generally deemed to be realised when goods are shipped or delivered to the customer and not when sale order is received or when a contract is signed.
Objective Evidence Concept: this concept states that only those transactions can be recorded in the books of accounts, which are supported by some physical proof or evidence, like a voucher in case of an asset purchase.
Accrual Concept: according to this concept revenues and expenses are recognised in the period in which activities that cause those revenues and expenses occurs. This concept is also known as matching cost and revenue. It simply means that all the revenue incomes earned and accrued during the year are recorded, similarly all revenue expenses due and accrued during the year are recorded.
| QUICK REVISION |
|
ACCOUNTING CONVENTIONS
The term “Convention” means circumstances or traditions which guide the accountants while preparing the accounting statements. It refers to a statement or rule of practice which by common consent, express or implied, is employed in the solution of a given class of problem. In simple terms, these are the practices that are generally accepted by organisations to be the norm and cover a wide range of issues including how to handle situations ethically, what measures to take when faced with specific issues, how to report and disclose a certain sensitive information etc. Example: Debit on the left hand side and Credit on the right hand side is an example of convention. Basically, conventions are the guidelines which guide the accountants while preparing the accounting statements.
The accounting conventions can be classified into:
1) Consistency
2) Full Disclosure
3) Conservatism
4) Materiality
These conventions are discussed in brief as under:
Consistency: this convention emphasis that there should be consistency in the accounting practices followed by a business organization. The rationale behind this convention is that if there are frequent changes in accounting policies of a firm it would make balance sheet and income statement irrelevant for the users (both internal and external).
Full Disclosure: this convention states that a business enterprise should provide all relevant material information to external users for the purpose of sound economic decisions by preparing a fully transparent report. This implies that no information of use or of interest to the average investors will be omitted or concealed, whether intentionally or not.
Conservatism: it takes into consideration all prospective losses but leaves all prospective profits. Financial statements are usually down up on a conservative basis. It is a way of playing a safe and sound game. This convention means that accounting policies should be such which would guard against risk and loss, however it should not create secret or hidden reserves. Basically it means anticipating the losses and not the profits by wearing a risk proof jacket.
Materiality: as per this convention only such transactions and events are recorded which are material or significant from business point of view and should ignore events which are materially insignificant. For Example: Purchase of stationary for Rs 100 can be treated as an expense for that period rather than as an asset.
| QUICK REVISION
|
|
DIFFERENCE BETWEEN ACCOUNTING CONCEPTS AND CONVENTIONS
At the end of the financial year, financial statements are prepared by firms for a number of purposes, which include summarizing all activities and transactions, review the firm’s financial position, evaluate performance and to make comparisons between previous years. The financial statements prepared must be consistent, complete and comparable and must also offer a true and a fair view of the firm’s workings. In order to make sure that these standards of accuracy, fairness and consistency are met, a number of accounting concepts and conventions have been developed. Accounting concepts and conventions are significant to the development of accounting theory in two ways. First, they are themselves part of an important process for developing the accounting principles. Second, they reflect the influence of the social, economic, historical and legal forces which shape the psychology of accounting in a given environment. Also both concepts and conventions aim to offer a more realistic and true view of the firm’s financial statements. Despite of some similarities there are a number of differences between them:
The main point of difference between accounting concepts and conventions is that accounting concepts are officially recorded, whereas accounting conventions are not recorded officially and are followed as generally accepted guidelines.
Accounting concepts have been established by professional organisations/committees and are standard principles that must be followed while preparing financial accounts. Whereas, conventions are the generally accepted practices that can change and are updated over time, depending on the changes in the financial reporting arena.
In case of the accounting concepts, one has to follow all the concepts, there is no choice to leave any, it is a legal binding to follow all. Whereas, in case of accounting conventions, there is a choice to select a particular convention and leave one.
SUMMARY
Accounting is primarily concerned with recording and reporting of financial information for the use of those who have some interest in the business enterprise such as investors, shareholders, debenture holders, creditors, employees, government and so on. The financial information is the only source which can be used to ascertain the accounting information to internal as well as external users. It is the only source of communication with the outside world.
In order to maintain consistency in the reporting practices a need was felt to establish a set of common principles or standards (known as GAAP), which are imposed on the companies so as to avoid the chaotic environment in the accounting world. The financial statements are prepared keeping in mind these set principles and hence presented in a fair, uniform and understandable manner.
Accounting principles are considered as the settled ground or the general guidelines framed for the companies to follow while preparing their financial statements. These principles are not in their final and rigid form but still evolving from time to time as they need to be revised and modified keeping in mind the ever changing legal, social and economic environment. The accounting principles are classified into two heads- (1) Accounting Concepts: In general terms, concepts refer to the postulates i.e., basic assumptions or conditions upon which the science of accounting is based, or the rules that should be followed by those preparing the accounts, in preparation of all accounts and financial statements. Some of the important concepts are business entity, going concern, money measurement, dual aspect, matching, accounting period and cost concept. (2) Accounting conventions: The term “Convention” means circumstances or traditions which guide the accountants while preparing the accounting statements. Main conventions are consistency, conservatism, full disclosure and materiality.
The main point of difference between accounting concepts and conventions is that accounting concepts are officially recorded, whereas accounting conventions are not recorded officially and are followed as generally accepted guidelines.
Another difference is that accounting concepts have been established by professional organisations and are standard principles that must be followed when preparing financial accounts. Whereas, conventions are the generally accepted practices that can change and are updated over time, depending on the changes in the financial reporting arena.
Every organisation tries to furnish its accounts in such a manner that the clear and biasfree image of it is disclosed to the outsiders and also that uniformity is maintained throughout the recording process, and to fulfil these purposes organisations follow the accounting principles and present their accounts in every accounting year.
Few suggested readings to learn more:
1) Sehgal & D. Sehgal,“Advanced Accounting(Financial Accounting)”Taxmann Publications,New Delhi.
2) Arun Jha, “Student’s guide to Auditing and Assurance”Taxmann Publications Pvt Ltd,New Delhi.
3) R.Monga, “Financial Accounting- Concepts & Applications”Mayoor Paperbacks,Noida.
4) L. Gupta & V.K. Gupta, “Financial Accounting”Sultan Chand & Sons, New Delhi.
| you can view video on Accounting Principles: Characteristics, Difference between Accounting Concepts and Conventions | |