Unit 2: Accounting Concepts, Principles and Conventions - Comprehensive Study Notes

2.1 Introduction

• After studying this unit, you would be able to:

  • Grasp the basic accounting concepts, principles and conventions and observe their implications while recording transactions and events.

  • Identify the three fundamental accounting assumptions: Going Concern, Consistency, Accrual.

  • Understand the qualitative characteristics that will help to develop the skill in course of time to prepare financial statements.

• The theoretical framework introduces the backbone of accounting: GAAPs (Generally Accepted Accounting Principles) including concepts, conventions, postulates, principles, etc., used to standardize and guide financial reporting.

• Globally, IFRS provides a framework, but nations may apply their own GAAPs with related conceptual frameworks (e.g., India uses AS or Ind‑AS).

• GAAPs form the theory base of accounting; standards issued by regulatory authorities standardize policies for specific circumstances.

• Key aim: Unity of understanding and approach in practice and presentation of financial statements.

2.2 Accounting Concepts

• Accounting concepts define the assumptions on which financial statements are prepared.

• A concept is an idea or notion with universal application; accounting concepts provide a unifying structure and internal logic.

• Unlike physical sciences, accounting concepts emerge from broad consensus among practitioners.

• These concepts lay the foundation for forming accounting principles.

2.3 Accounting Principles

• A body of doctrines associated with the theory and procedures of accounting, guiding current practices and selection of conventions when alternatives exist.

• Principles must satisfy:

  • 1. Based on real assumptions.

  • 2. Simple, understandable and explanatory.

  • 3. Followed consistently.

  • 4. Should reflect future predictions.

  • 5. Informational for users.

2.4 Accounting Conventions

• Conventions emerge from long-standing accounting practices adopted by organizations.

• They are derived by usage and practice and may change to improve information quality; they need not have universal application.

• In study materials, the terms accounting concepts, accounting principles and accounting conventions are used interchangeably to mean basic agreed points of accounting theory and practice.

2.5 Concepts, Principles and Conventions – An Overview

• Widely accepted accounting concepts include:

  • (a) Entity concept

  • (b) Money measurement concept

  • (c) Periodicity concept

  • (d) Accrual concept

  • (e) Matching concept

  • (f) Going Concern concept

  • (g) Cost concept

  • (h) Realisation Concept

  • (i) Dual aspect concept

  • (j) Conservatism

  • (k) Consistency

  • (l) Materiality

2.5.1 (a) Entity Concept

• An enterprise is a separate identity apart from its owner; treat business as distinct from owner.

• Distinguish business transactions from owner’s personal transactions.

• Applies to sole proprietorships, partnerships, and corporations.

• Helps determine how much is due to the owner as capital and share of profits.

• If the owner withdraws funds for personal use, it alters the owner’s capital, not business expenses.

• Example 1 (Mr. X):

  • Initial: Capital ₹7,00,000; Machinery ₹5,00,000; Cash ₹2,00,000.

  • If Mr. X spends ₹5,000 from business funds for family expenses, it is charged to capital (drawings), not a business expense:

  • Revised: Liability: Capital ₹7,00,000; Drawings ₹5,000; Assets: Machinery ₹5,00,000; Cash ₹1,95,000.

• This concept also ensures the enterprise owes the owner capital and the owner has a claim on profits.

2.5.2 (b) Money Measurement Concept

• Only transactions that can be measured in monetary terms are recorded.

• Money is the medium of exchange and standard of economic value; non-monetary items are not recorded.

• Example: A factory’s land, office building, computers, machines are recorded in monetary terms (e.g., factory price, land cost, etc.).

• Limitations:

  • Some assets (e.g., employees) cannot be reliably measured in monetary terms and are not recorded.

  • Across borders, multiple currencies may complicate measurement; transactions are recorded in a uniform monetary unit (e.g., one currency).

• Implications:

  • Money measurement provides flexibility in measurement and interpretation, but assumes money’s purchasing power is stable, which is not always true.

• Basic relation: monetary unit acts as a common denomination for values.

• Concept anchors subsequent procedural concepts (e.g., accrual, matching).

2.5.3 (c) Periodicity Concept

• Also called the definite accounting period concept.

• Even if a business is assumed to have an indefinite life (Going Concern), performance and financial position are measured in finite periods.

• Typically one year (though periods may be 6, 9, 15 months, etc.).

• Accounts are prepared after each period, not only at the end of life of the entity.

• This concept makes accrual meaningful and supports performance appraisal by period.

• Benefits: enables comparing financial statements across periods; supports uniform and consistent treatment; aids in matching revenues with expenses.

2.5.4 (d) Accrual Concept

• Transactions and events are recognized on mercantile basis (when they occur), not when cash is received or paid.

• Financial statements reflect the periods to which they relate.

• Revenue is the gross inflow of cash, receivables, and other consideration from ordinary activities (sales, services, use of resources yielding interest, royalties, dividends).

• Examples:

  • Example 1: Cloth merchandising: Invest ₹50,000; buy merchandise ₹50,000; sell for ₹60,000; cash received ₹50,000; receivables ₹10,000; revenue ₹60,000.

  • Example 2: Electricity utility: Spends ₹16,00,000 on fuel and wages; bills customers ₹20,00,000; revenue ₹20,00,000.

  • Example 3: Mr. A invests ₹1,00,000; machine costs ₹1,00,000; rents machine for ₹20,000 annually to Mr. B; ₹20,000 is revenue.

• Accrual concept underpins the structure of present-day accounting.

• Timing of revenue and expense bookings can differ from cash flows; four outcomes:

  • (i) Cash received before revenue is booked → liability created when cash is received in advance.

  • (ii) Cash received after revenue is booked → asset created (Trade receivables).

  • (iii) Cash paid before expense is booked → asset created (Trade advances).

  • (iv) Cash paid after expense is booked → liability created (Trade payables).

• Revenue − Expenses = Profit (under accrual). Cash basis alternative: Cash receipts − Cash payments = Profit.

2.5.5 (e) Matching Concept

• Expenses must be matched with the revenues they help generate in the same period.

• Based on accrual, not cash movements; requires adjustments for prepaid and outstanding expenses, unearned or accrued incomes.

• Not every expense needs to be matched with every income; some expenses relate to specific revenues.

• Example (P.K.’s cloth business):

  • 10,000 garments @ ₹100 each bought; 8,000 sold @ ₹150 each in 12 months (Jan 1 to Dec 31).

  • Rent: ₹3,000 per month for 11 months.

  • Purchases from suppliers: ₹8,00,000; Receipts from customers: ₹10,00,000.

  • Calculations illustrate accrual and periodicity in reporting: revenue recognized is from 8,000 units (₹12,00,000); expenses include cost of goods sold for 8,000 units (₹8,00,000) and rent (₹36,000).

  • Asset adjustments: Inventory (2,000 pcs × ₹100) ₹2,00,000; Trade receivables ₹2,00,000; Cash balance ₹1,67,000.

  • Liabilities: Trade payables ₹2,00,000; Expenses payables ₹3,000.

  • Capital (Profit): ₹3,64,000; Computed as: Revenue − Expenses (after matching) = Profit.

• It shows that accrual and periodicity concepts, together with matching, determine income measurement and assets/liabilities recognition.

2.5.6 (f) Going Concern Concept

• Financial statements are prepared assuming the enterprise will continue operation in the foreseeable future.

• If there is an intention or need to liquidate or curtail operations, financial statements may need to be prepared on a different basis, with disclosures.

• Going concern affects asset valuation, as assets are valued for their future benefit rather than immediate sale.

• Example: During a pandemic, many businesses faced shutdowns; disclosure is required if going concern is in doubt.

2.5.7 (g) Cost Concept

• Asset value is determined on the basis of historical cost (acquisition cost) due to objectivity.

• Pros: highly objective and free from bias.

• Cons and distortions:

  • Inflation erodes relevance; replacement cost may differ greatly from historical cost.

  • Historical cost may reduce comparability across time and different assets with different purchase dates.

  • Some assets (e.g., human assets) may not have a clear acquisition cost.

• Difficulties in measurement and comparability may lead to departures from the cost concept in certain circumstances (e.g., selective adoption of other bases). Real value may be captured through other concepts (e.g., revaluation in cost/conservatism discussions).

2.5.8 (h) Realisation Concept

• Changes in asset values are recorded only when materialized.

• Conservative approach: recognize losses but not untill they are realized gains.

• Economists critique realisation for potentially distorting value.

• Example: Mr. X buys land for ₹2,000 in 1995; current market value ₹1,02,000 (2022). Should reflect realisable value if appropriate (revaluation may be used with reserve). Historically, a purely cost-based approach would present lesser asset values; modern practice may adjust via revaluation reserves when the increase is permanent.

2.5.9 (i) Dual Aspect Concept

• Core of double-entry bookkeeping: every transaction has two aspects.

• The possible dual effects include:

  • (1) Increase one asset and decrease another asset;

  • (2) Increase an asset and increase a liability;

  • (3) Decrease one asset and increase another asset;

  • (4) Decrease one asset and decrease a liability;

  • (5) Increase one liability and decrease another liability;

  • (6) Increase a liability and increase an asset;

  • (7) Decrease a liability and increase another liability;

  • (8) Decrease a liability and decrease an asset.

• Illustrative balance sheet movements:

  • (a) Purchase of new machine for ₹50,000 in cash → Asset ↑ Machine, Asset ↓ Cash.

  • (b) Purchase of machine for ₹50,000 on credit → Asset ↑ Machine, Liability ↑ Creditors.

  • (c) Cash payment of ₹50,000 to repay bank loan → Asset ↓ Cash, Liability ↓ Bank Loan.

  • (d) Raised bank loan of ₹50,000 to pay off other loan → Asset ↑ Cash (via loan) and Liability ↑ Bank Loan; Liability ↓ Other Loan.

• Conclusion: The fundamental accounting equation must hold after every transaction.

• Basic accounting equation forms:

  • Equity (E) + Liabilities (L) = Assets (A)

  • Equity (E) + Long Term Liabilities (LTL) + Current Liabilities (CL) = Fixed Assets (FA) + Current Assets (CA)

  • Equity (E) + Long Term Liabilities (LTL) = Fixed Assets (FA) + (Current Assets – Current Liabilities)

  • Equity = Fixed Assets + Working Capital – Long Term Liabilities

2.5.10 (j) Conservatism

• Conservatism states not to anticipate future income but to provide for all possible losses.

• When alternative values exist for an asset, choose the lesser value.

• The Realisation Concept aligns with conservatism by recognizing gains only when realized; conservatism provides a check against overstating income or assets.

• Qualitative characteristics connected to conservatism include prudence, neutrality, and faithful representation.

• Qualitative implications for investors: avoid overstating profits to lure investments; reveal potential losses early when prudent.

• Example: If computers bought for ₹20,000 each are expected to sell at ₹25,000 but market falls to ₹17,000, conservatism would require recognizing the loss of ₹3,000 per computer until realized.

• Some authors critique conservatism as potentially leading to income understatement and advocate for more balanced approaches; conservatism interacts with other concepts such as realisation.

2.5.11 (k) Consistency

• To achieve comparability over time, accounting policies should be followed consistently from one period to another.

• Changes in policy happen only in exceptional circumstances (e.g., to comply with Accounting Standards, legal requirements, or when a new method better reflects true and fair view).

• Consistency does not imply inflexibility to adopt improved methods; it emphasizes stable reporting unless justified.

• Example: Depreciation methods (e.g., Written Down Value vs. Straight Line) or inventory valuation methods should be applied consistently unless there is a reason to change.

2.5.12 (l) Materiality

• Materiality allows ignoring insignificant items if their omission does not affect decision-making.

• The threshold for materiality depends on the size and nature of the business, the information level of the users, etc.

• Examples:

  • Stationery purchases may be expensed in full in the year of purchase due to materiality.

  • Depreciation on small items (books, calculators) may be charged 100% in the year of purchase if immaterial.

2.6 Fundamental Accounting Assumptions

• There are three fundamental accounting assumptions:

  • (i) Going Concern

  • (ii) Consistency

  • (iii) Accrual

• If nothing is stated about these assumptions in financial statements, it is assumed they have been followed; if not, disclosure is required.

2.7 Financial Statements

• The aim of accounting is to keep systematic records to ascertain financial performance and financial position and to communicate relevant financial information to interested users.

• Financial statements are the basic means of public communication of financial information and include balance sheet, income statement (profit and loss account), cash flow statement, etc., prepared under the discussed concepts, principles, and conventions.

2.7.1 Qualitative Characteristics of Financial Statements

• Qualitative characteristics are attributes that make financial information useful. The four principal characteristics are:

  • Understandability: Information should be readily understandable by users who have reasonable knowledge of business and accounting. Complex information should not be excluded merely because it is difficult.

  • Relevance: Information must influence economic decisions; it should help in predicting and confirming past or future events. Its predictive and confirmatory roles are interrelated. For predictive value, information should be presented in a way that enhances decision-making; unusual items should be separately disclosed to aid prediction.

  • Reliability: Information must be free from material error and bias and faithfully represent the underlying transactions.

  • Comparability: Users should be able to compare financial statements over time and across enterprises; measurement and display of effects of similar transactions should be consistent.

• Additional related qualitative aspects include:

  • Materiality: the relevance threshold; information that could influence decisions should be disclosed; immaterial items may be omitted or handled differently.

  • Faithful Representation: information should faithfully represent the economic phenomena it purports to represent; good accounting practice may require disclosures of uncertainty and risk.

  • Substance over Form: accounting should reflect the economic reality rather than just the legal form of transactions.

  • Neutrality: information should be free from bias.

  • Prudence: cautious estimation in the face of uncertainty; avoid overstating assets or income and avoid understating liabilities or expenses; do not create hidden reserves or manipulate provisions.

  • Full, Fair and Adequate Disclosure: financial statements should disclose all reliable and relevant information; formats (like footnotes) may be used to provide necessary disclosures; statements should present a true and fair view.

  • Completeness: information should be complete within materiality and cost constraints; omissions can mislead.

2.7.2 Summary of Qualitative Characteristics

• Understandability, Relevance, Reliability, Comparability, Materiality, Faithful Representation, Substance over Form, Neutrality, Prudence, Full, Fair and Adequate Disclosure, Completeness.

Summary (condensed)

• Accounting concepts define assumptions; widely accepted concepts include entity, money measurement, periodicity, accrual, matching, going concern, cost, realisation, dual aspect, conservatism, materiality.

• Accounting principles guide current practices and when alternatives exist.

• Accounting conventions arise from long-standing practices and may be updated for quality.

• Three fundamental accounting assumptions: Going Concern, Consistency, Accrual.

• Qualitative characteristics (Understandability, Relevance, Reliability, Comparability, Materiality, Faithful Representation, Substance over Form, Neutrality, Prudence, Full and Adequate Disclosure, Completeness) determine usefulness of financial statements.

Test Your Knowledge (True/False statements)

• 1) The concept that keeps business affairs free from owner’s personal influence is matching concept. [False]

• 2) Entity concept means the enterprise is liable to the owner for capital investment. [True]

• 3) Accrual means recognition when money is received or paid, not when revenue/costs are earned/incurred. [False]

• 4) Realisation concept states no change should be counted unless it has materialised. [True]

• 5) Consistency implies non-flexibility to introduce improvements. [False]

• 6) Materiality depends only on amount, not the size or nature of the business. [False]

• 7) Cash basis of accounting records revenues/costs/ assets/liabilities in the period of cash receipts/payment. [True/False: the statement as written is false; cash basis is as stated in the True/False key—this item in the source says False; the cash basis statement here is that it is the method of recording transactions in the period in which cash is received or paid, so the given phrasing may be ambiguous; the provided material marks it as False.]

Multiple Choice Questions (selected)

• (i) All the following items are classified as fundamental accounting assumptions except:

  • (a) Consistency

  • (b) Business entity

  • (c) Going concern

• (ii) Two primary qualitative characteristics of financial statements are:

  • (a) Understandability and materiality

  • (b) Relevance and reliability

  • (c) Neutrality and understandability

• (iii) Kanika Enterprises follows the written down value method of depreciation year after year due to:

  • (a) Comparability

  • (b) Convenience

  • (c) Consistency

• (iv) A purchased a car for ₹5,00,000, down payment ₹1,00,000 and bill ₹4,00,000 due in 60 days. As a result:

  • (a) Total assets increased by ₹5,00,000

  • (b) Total liabilities increased by ₹4,00,000

  • (c) Total assets increased by ₹4,00,000 with corresponding increase in liabilities by ₹4,00,000

• (v) Mohan purchased goods ₹15,00,000 and sold 4/5th for ₹18,00,000 with expenses ₹2,50,000. Net profit reported ₹3,50,000. Which concept was followed?

  • (a) Entity

  • (b) Periodicity

  • (c) Matching

• (vi) A businessman purchased goods for ₹25,00,000 and sold 80% in year; closing inventory market value ₹4,00,000. Valued at cost. Violated concept of:

  • (a) Money measurement

  • (b) Conservatism

  • (c) Cost

• (vii) Capital brought in by the proprietor is:

  • (a) Increase in asset and increase in liability

  • (b) Increase in liability and decrease in asset

  • (c) Increase in asset and decrease in liability

• (viii) During the life of an entity, accounting provides financial statements in accordance with which basic accounting concept?

  • (a) Conservatism

  • (b) Matching

  • (c) Accounting period

• (ix) A concept that a business enterprise will not be liquidated in the near future is known as:

  • (a) Going concern

  • (b) Economic entity

  • (c) Monetary unit

Answers/Hints (selected)

• True/False answers align with the provided answer key in the transcript.

• Selected explanations align with the illustrative examples and definitions given in the unit.

Illustrative Calculations and Examples (key extracts)

• Entity concept example: capital and asset relationship and effects of owner withdrawals on capital and business assets.

• Money measurement example: currency conversion example across borders (e.g., 1 Euro = ₹71; total revenue calculation in uniform currency).

• Periodicity example: choosing a 12-month year for reporting; rationale for accrual terms.

• Accrual examples:

  • Revenue recognition and receivables in the cloth merchandising and electricity business examples.

  • Asset and liability recognition for future cash inflows/outflows.

• Matching example (P.K.’s garment business) demonstrates the alignment of revenue with its related expenses within a period.

• Dual aspect examples demonstrate the accounting equation in action with four variations of transactions (cash purchase, credit purchase, loan repayments, new loan).

• Illustration 1: Develop the accounting equation from given data for two-year comparison; compute profit for the year by changing equity and liabilities and reconciling assets.

• Conservatism example: evaluating asset values under potential losses vs. gains, and the role of prudence and neutrality in reporting.

• Qualitative characteristics: Understandability, Relevance, Reliability, Comparability, Materiality, Faithful Representation, Substance over Form, Neutrality, Prudence, Full, fair and adequate disclosure, Completeness.

Key Formulas and Equations (LaTeX)

• Accounting equation (basic):
  E + L = A

• Alternative forms:
  E = A - L
  E + Long-Term\ Liabilities + Current\ Liabilities = Fixed\ Assets + Current\ Assets
  E + LTL = FA + (CA - CL)

• Periodic profit with matching (as defined):
  ext{Periodic Profit} = ext{Periodic Revenue} - ext{Matched Expenses}

• Revenue vs. Expenses (accrual):
  ext{Accrual Profit} = ext{Revenue} - ext{Expenses}

• Conservatism guidance (lower of values): the principle used in valuation is often described in the context of current assets as ext{Cost or Market} ext{ price whichever is lower}

• Realisation concept (illustrative idea): changes in asset values are recorded when realised; losses may be recognised before gains.

• Qualitative characteristics (list):
  ext{Understandability}, ext{Relevance}, ext{Reliability}, ext{Comparability}, ext{Materiality}, ext{Faithful Representation}, ext{Substance over Form}, ext{Neutrality}, ext{Prudence}, ext{Full, Fair and Adequate Disclosure}, ext{Completeness}

Note

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