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7/14/22

Basic accounting concepts and conventions

 By the end of this study the reader should be able to identify and explain the relevance of accounting concepts, explain the relationship between a business entity and it's owner, explain the relationship between accounting equation and statements of financial position, differentiate between asset, liabilities and owners equity. 


accounting concepts and Conventions


Accounting concepts and conventions 

According concepts and conventions are basic assumptions that underline the preparation of the periodic financial statements of a business entity.  They are rules regulating the manner in which transactions are recorded. They are deemed to be in existence though not actually stated or referred to, the concepts and conventions gives reasons why accounting data are prepared in a typical manner.

We shall now discuss some of the basic accounting concepts and their importance in the preparation of financial statements

Entity accounting concept:

In the strict legal sense, only limited liability companies are regarded as legal entities separate grim their owners .It can acquire assets and incur liabilities.  It can enter into contract on its own and can owe dept. It can sue and be sued. In accounting, however ,all forms of business are regarded as bieng separate form their owners. The asset such as cash contributed by the owner to the business is regarded as the liability of the business to the owner ,which is called capital or owners equity. 

The essence of the entity concept is to distinguish the income and costs of the business from the private income and costs of the proprietor or his drawings from the business. For instance, if the owner of a business draws cash from the business bank account to repair delivery vans, it would be regarded as business expense.  But if he pays his child school fees with the cash, the amount will be treated as drawings of the owner rather than expenses of the business.  The entity concept also gives rise to what is called accounting equation. 

Accounting equation; 

The cash or other asset invested in a business by the owner are liabilities of the business to the owner. Therefore,  assets = capital which a liability to the owner, at the commencement of the bus business .

As the operation progress the owner may obtain goods in credit from suppliers or borrow additional loan from bank to finance the business.  The value of goods supplied and to cash received as loan would increase the assets of the business, while liabilities to third parties would increase.  The accounting equation becomes assets = capital + liabilities .

explanation of some of the terms used in the accounting equation ;

The accounting equation : asset = capital plus liability represents the two sides of statements of financial position; Asset on the other side and capital and liabilities on the other side. The capital and liabilities are claims against the asset. The net worth of the business is the capital.  The net worth is the original capital plus the profits earned during the period less the proprietors drawings during the same period.

Asset; 

Assets are the economic resource of a business that are expected to bring immediate and future benefits to the business . They are classified into non current and current asset. 

non current assets; 

These are the economic resource that aid income generation for more than one accounting period.  They include land and building, motor vehicles ,equipment machinery, furniture etc. 

Current assets; 


These are the economic resource of the business which are easily converted to cash or consumed within an accounting period or operation cycle whichever is longer. Example are cash in hand and at bank ,receivable and other receivable ,prepaid expenses and inventories of goods meant for resale. 

 Liabilities ;

Liabilities are claims against the asset of the business.  Liabilities give rise to payables. Some of the liabilities may arise from the use of the service or goods of another person on credit basis ; some other liabilities may arise from financing the organization therefore loan payables. They are divided into current liability and long term liabilities. 

current liabilities ;

These are the liabilities of the business that are meant to be paid within twelve months. Examples of current liabilities are trade payable and other payable such as outstanding bills on electricity ,salary, wages, taxation, bank overdraft  etc.

non current liabilities; 

These are the liabilities that will take more than one year before repayment is due. They are long term loans. 
We have discussed the accounting entity concept much because it is fundamental to the principle of double entry. We shall now consider the other accounting concepts and conventions.

Money measurement accounting concepts ;

Money serves as the common denominator for measuring the various assets and liabilities of an organization, therefore accounting transactions are expressed in monetary values. The dollar and euro represent unit of value which have the ability to command goods and services in the USA and UK respectively.
Apart from the fact that money serves as a common unit,  accountant also believe that it is stable in value. 

There are some limitations in the use of money as measure of value in accounting which include; 
  • The value of money does not always remain stable particularly in an inflationary economy 
  • Apart from inflation, the time value of money today is greater than the time value of money in any future time ,due to the cost of funds. 
  • There are some activities of an organization that are not recorded because monetary value cannot be attached to them. Example are goods management ,employee ,Morale strength of competition etc. 
Thus, accounting does not provide all the information about a firm,  it provides only economic information that can be express in monetary terms. We may then understand why limited liability companies are required to disclose a lot of non accounting information in their annual reports.

The going concern accounting concepts; 

Unless otherwise stated, it is always assumed that a business entity will continue in operation for the foreseeable future.  It is assumed that the enterprise has neither the intention nor the necessities of liquidation or curtailing significantly the scale of operations. 

The going concern concept will help investors ,payable, employees, customers and other stakeholders to determine the extent to which they want to continue to patronize the business.  The going concern concept may be more justified in a limited liability company where death or withdrawal of any member may not affects it's scale of operation .
Asset and liabilities of a going concern enterprise are valued in historical cost basis. When the going concern is in doubt the asset are valued on break up value basis therefore forced scale values. 

Periodic accounting concepts; 

Notwithstanding the going concern assumptions, the operation and performance of a business entity should be subject to periodic review, for instance limited liability companies are required to present their financial statements to members of the company annually. Managememy accounting information is even prepared more frequently.

The periodic review would help to assess management efficiency and the planning and control of future operations. 

prudence concept; 

The prudence concept requires that an accountant should not recognize income until the income has been earned and that losses should be fully written off. The essence of the principle is that profit are not overstated in any accounting period .

The prudence concept is most useful when matters of judgement or estimates are involved. For instance of the credit policy of a business requires a customer to pay for the goods sold to him in 60 days and he has not paid after 120 days,  it may be reasonable to make provision for the entire amount as bad and doubtful debt.
 Another example is when inventories become absolute and it's net realization value will be written off to income statement. 

Failure to write foreseeable losses off the recognition of unrealized income will produce a misleading result which will eventually lead to losses to payables and shareholders. 

substance over form; 

Business transactions are usually governed by legal principles ; nevertheless they are accounted for and presented in accordance with their financial substance and reality ant merely by their legal form. Example are found in ; revenue, and repurchase agreement ,lease contract and consignment of goods. 

The consistency accounting concepts; 

consistency concept requires that when a method had been adopted in treating an item in the financial statements ,the method should be changed but used consistently from time to time . For instance ,there are many methods of depreciating a non current assets; straight line, reducing balance, sum of the digit.  If straight line is chosen to depreciate building in year one, the company should continue to depreciate building straight line basis from year to year.

The essenceof this principles is to make it easy for users of financial statements to compare the results of one period to another. Constant change in method will distorts profits and make comparison difficult. 

Occasionally there may be justification to change from one method to another.  If the change is made, adequate disclosure must be made about the nature of the change and the effect of the change on profits. 

Accrual accounting concepts; 

The accrual accounting concepts started that income should be recognized when they are earned and not when they are received.  Expenses should be recorded when they are incurred and not when they are paid. The application of this concept gives rise to payment and accrued expenses.  A accrued expenses occur when payment has been made for service but benefits have not been derived from them. They give rise to liabilities and assets respectively . Prepared expenses and outstanding receivable are assets while income received in advance and outstanding expenses are liabilities of the business. 

All expenses due but not yet paid should be added to the expenses paid in order to determine the total expenses for the period.  All expenses paid should not be included in the amount to be deducted in the income statement.  All income due and receivable should form part of the income for the period. While all income recieved in advance should be excluded.

Matching accounting concepts; 

This is related to the accrual accounting concepts in a way . The concept holds that for any accounting period ,the earned revenue should be matched with the cost that earned them.  If revenue is differed from one period to another, all element of cost relating to them will be carried forward. 

The concepts is important in measuring the cost if goods sold or services rendered in a period. It is also useful in determining when the cost of an item becomes expensive.  The matching concepts is applied to products where the cost can be related directly to them. It is applied in relation to time period where the cost incured cannot be related to the product. 

For instance if a business man bought 50 pairs of shoe for $5000 and sold 35 pairs for $7000 at the end of a period. The cost of goods sold would be measured on the 35 pairs sold. That is 35/50 x $5000 = $3500. $1500 would be deferred to the next period.

Some cost that cannot be related to specific transactions are depreciation ,electricity bill, insurance cost etc.  When matching concepts is properly applied profits are either overstated or understated.

Materiality accounting concepts; 

This principle of materiality holds that financial statements should separately disclose items which are significant enough to affect evaluation or decisions. It refers to the relative importance of an item ; therefore some level of judgement may be required in determining what is material to an organization; as what is material to a sole trader may be immaterial to a company .

In any event the amount of the item would affect materiality.  For instance, stapler, perforator, waste basket, are expected to be used for more than one period,  so that their cost should be measured over the period of use.  However, because of the significant amount involved,  the concept of materiality permits the immediate write off of these costs as expenses. The nature of an item and type of a business entity will also affect materiality. 

Historical cost accounting concepts; 

The basis for initially recognition of an sets acquisition, service rendered or received and a expenses incurred is cost. The concept also holds that after acquisition cost values are retained through out the accounting process except to allocate a portion of the original cost to expense as the assets expire. The justification for the historical cost principle is it's objectivity ; that is, the cost can be traced to source documents and that other measures of value would be based on the subjective judgement of Management.

The main criticism against the historical cost concept is that with the passage of time, cost would no more represent the fair value of an asset.  For instance,  the value of  a building contracted ten years ago might have appreciated considerably over the period.  In periods of inflation, the use of historical cost instead of fair values,  normally leads to the recognition of holding gain because cost would significantly understate the value of the resources being consumed.  Recognizing holding gain may lead to distribution of the profit that would have been retained in the business for further expansion. 

Objectivity accounting concepts; 

Objectivity concept holds that financial statements should not be influenced by personal bais of management .The use of historical cost for asset valuation is an attempt to be objective, because it can be backed up by voucher ,invoice, cheques, bill etc. 

A change in the value of an asset should be recognized when it can be measured in objective terms. 

Objectivityis useful in accounting in the following ways; 
  • Auditing is made possible 
  • Accounting data are standardized 
  • Fraud and falsification of accounts are minimized
  • Data is available for independent party to cross check. 
in spite of the goals of objectivity concept some personal opinion and judgment are brought into accounting information in few instance, estimates are required to determine the useful life of a non current asset ,the net realizable value of inventories or the amount to be provided for bad and doubtful Sept's. 

However ,figures built into financial statements should rely as little as possible on estimates of subjectivity.
  
fairness ; This is an extension of the objectivity principle. In view of the fact that the are many users of accounting information, all having differing need, the fairness principle requires that accounting reports should be prepared not to favour any group or segment of society. 

Realisation accounting concepts; 

Under accrual accounting concept ,revenue should be recorded when it is earned.  The realization concept is concerned with determining when revenue is earned.
The realization concept holds that revenue should be recognized at the time goods are sold and servies are rendered; that is the point at which the customer had incurred liability.

Before revenue can be realised and recorded, it must have met the following two conditions .
  1. The revenue is capable of objective measurement
  2. The value of asset received or receivable is reasonably certain 
The realization concept may be difficult to apply in hire purchase transactions, lease, transactions ,contract jobs, advertisement agencies etc. 

In summary we have discussed the basic accounting concepts and conventions including entity, going concern, historical cost, periodicity, monetary measurements, realization ,matching, consistency, prudence, materiality, accrual, substance over form and fairness accounting concepts and conventions. 


There are many accounting concepts and conventions that businesses use to maintain financial accuracy and accountability. Some of the most common and important accounting concepts and conventions include:

1. The accrual basis of accounting: This accounting concept dictates that businesses must record revenue and expenses when they are earned or incurred, regardless of when the actual cash is exchanged. This provides a more accurate picture of a business's financial status.

2. The matching principle: This accounting convention requires businesses to match expenses with the revenue they generate in the same accounting period. This helps to provide a more accurate picture of profitability.

3. The going concern principle: This accounting concept assumes that businesses will continue to operate for the foreseeable future. This assumption allows businesses to account for long-term assets and liabilities.

4. The conservatism principle: This accounting convention dictates that businesses should err on the side of caution when recording revenue and expenses. This principle helps to prevent businesses from overstating their financial performance.



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