ACCOUNTING PRINCIPLES AND CONVENTIONS

Accounting is called the language of business that which communicates the financial condition and
performance of a business to interested users, also referred to as stakeholders.There are general rules
and concepts that govern the field of accounting.
In order to become effective in carrying out the accounting procedure, as well as in communicating the
financial information of the business, there is a widely accepted set of rules, concepts and principles that
governs the application of the accounting procedures, and it is referred to as the Generally Accepted
Accounting Principles or GAAP.
These general rulesreferred to as basic accounting principles and guidelinesform the groundwork
on which more detailed, complicated, and legalistic accounting rules are based
If a company distributes its financial statements to the public, it is reuired to follow generally accepted
accounting principles in the preparation of those statements. !urther, if a company"s stock is publicly
traded, law reuires the company"s financial statements be audited by independent public accountants.
#oth the company"s management and the independent accountants must certify that the financial
statements and the related notes to the financial statements have been prepared in accordance with
GAAP.
GAAP is e$ceedingly useful because it attempts to standardi%e and regulate accounting definitions,
assumptions, and methods. #ecause of generally accepted accounting principles we are able to assume
that there is consistency from year to year in the methods used to prepare a company"s financial
statements. And although variations may e$ist, we can make reasonably confident conclusions when
comparing one company to another, or comparing one company"s financial statistics to the statistics for its
industry. &ver the years the generally accepted accounting principles have become more comple$ because
financial transactions have become more comple$.
EATURES O ACCOUNTING PRINCIPLES
!" Accoun#ing Principles are $an%$ade&% They are the best possible suggestions based on practical
e$periences.
'" Accoun#ing Principles are le(ible&% Accounting Principles are not rigid but fle$ible. 'henever a
situation arises that reuires solution, accountants arrive at a reasonable decision, which gradually
becomes the accepted Accounting Principle.
)" Accoun#ing Principles are Generall* Accep#ed&% Accounting Principles are the bases and guide for
accounting and are generally accepted. The general acceptance of Accounting Principles usually
depends on how it meets the criteria of relevance, ob(ectivity and feasibility.
ACCOUNTING CONCEPTS
!" T+e ,usiness En#i#* Concep# &% The #usiness )ntity *oncept holds the business to be separate
and distinct form its owners. #usiness transactions, therefore, are recorded in the books of accounts
from the business point of view and not owners. &wner+s considered separate from the business are
considered creditors of the business to the e$tent of their capital. Any personal transactions of its
owner should not be recorded in the business accounting book, vice versa. ,nless the owner+s
personal transaction involves adding and-or withdrawing resources from the business.
'" T+e $one* $easure-en# concep#&% The .oney .easurement concept holds that transactions
and events that can be measured in money terms are recorded in the books of accounts of the
enterprise. In other words, money is the common denominator in recording and reporting all
transactions. Thus, any non/financial or non/monetary information that cannot be measured in a
monetary unit are not recorded in the accounting books, but instead, a memorandum will be used.
)" T+e Going Concern Concep# &% The Going *oncern *oncept holds that a business shall continue
for an indefinite period and there is no intention to close the business or scale down the operations
significantly. It is because of this concept that a distinction is made between an e$penditure that will
render benefit for a long period and one whose benefit will be e$hausted uickly, say, with the
year.Also,In this basis, assets are recorded based on their original cost and not on market value.
Assets are assumed to be used for an indefinite period of time and not intended to be sold
immediately.
4) T+e Accoun#ing Period Concep#& % The Accounting Period *oncept holds that the life of an
enterprise be broken into smaller periods so that its performance is measured at regular intervals.
The accounts of an enterprise are maintained following the Going *oncern *oncept meaning the
enterprise shall continue its activities in the foreseeable future. This principle entails a business to
complete the whole accounting process of a business over a specific operating time period. It may be
monthly, uarterly or annually. !or annual accounting period, it may follow a *alendar or !iscal 0ear.
." T+e Cos# Concep#&% The *ost *oncept holds that an asset is recorded in the books of accounts
at the price paid to acuire it and the cost is the basis for all subseuent accounting of the asset.
Asset is recorded at the cost at the time of its purchase but is systematically reduced in the value by
charging depreciation. All business resources acuired should be valued and recorded based on the
actual cash euivalent or original cost of acuisition, not the prevailing market value or future value.
)$ception to the rule is when the business is in the process of closure and liuidation.
/" T+e Dual Aspec# Concep#&% this is the basic concept of the accounting. According to this
concept, every transaction entered into by an enterprise has two aspects. If a transaction has taken
place or an event has occurred, it is bound to have a two/sided effect. 'hen the Proprietor starts the
business and invests money, the enterprise will have that much money but, also, the enterprise will
owe that much amount to the Proprietor.
or
0" T+e Re1enue Recogni#ion Concep#&% The 1evenue 1ecognition *oncept holds that revenue is
considered to have been realised when a transaction has been entered into and the obligation to
receive the amount has been established.
2" T+e $a#c+ing Concep# &% The .atching *oncept is based on the accrual concept of accounting
and related to the revenue concept. It holds that the cost incurred to earn the revenue should be set
out against the revenue in the period during which it is recogni%ed as earned.Thus, This principle
reuires that revenue recorded, in a given accounting period, should have an euivalent e$pense
recorded, in order to show the true profit of the business.
3" T+e Accrual Concep# &% The Accrual *oncept holds that a transaction is recorded at the time
when it takes place and not when the settlement takes place. The concept is particularly important
because it recogni%es the assets, liabilities, incomes and e$penses as and when transactions relating
to it are entered into. This principle reuires that revenue should be recorded in the period it is
earned, regardless of the time the cash is received. The same is true for e$pense. )$pense should be
recogni%ed and recorded at the time it is incurred, regardless of the time that cash is paid.
ACCOUNTING CONVENTIONS
!" Con1en#ion of ull Disclosure &% The *onvention of !ull 2isclosure holds that there should be
complete and understandable reporting on the financial statements of all significant information
relating to the economic affairs of the entity
'" Con1en#ion of Consis#enc* &% The *onvention of *onsistency holds that the accounting
practices once selected and adopted, should be applied consistently year after year. The concept
helps in better understanding of accounting information and makes it comparable 3 a ualitative
characteristic of accounting information 4 with that of previous years. *onsistency eliminates personal
Owners Equity or Capital + Claims of outsiders = Assets
Assets =Owners Equity + Claims of outsiders
bias and helps in achieving results that are comparable. This principle ensures consistency in the
accounting procedures used by the business entity from one accounting period to the ne$t. It allows
fair comparison of financial information between two accounting periods.
)" Con1en#ion of Prudence or Conser1a#ion &% 5iterally speaking, conservatism means taking a
gloomy view of the situation. It is playing safe policy. The Prudence *oncept is many a times
described using the phrase Do not anticipate a Profit, But Provide for all Possible Losses. This
principle states that given two options in the valuation of business transactions, the amount recorded
should be the lower rather than the higher value.
4" $a#eriali#* Concep# &% The .ateriality *oncept refers to the relative importance of an item or
an event. According to the American Accounting Association, an item should be regarded as
material if there is a reason to believe that knowledge of it would influence the decision of an
informed investor Ideally, business transactions that may affect the decision of a user of financial
information are considered important or material, thus, must be reported properly. This principle
allows errors or violations of accounting valuation involving immaterial and small amount of recorded
business transaction.
In order to manage a business effectively from the financial perspective, it is always important to
measure: (1) how many assets there are; (2) how much profit is being generated; (3) when the
cash is coming in, and () how it is being spent!
Accoun#ing is no#+ing -ore #+an #+e -easure-en# of #+ese processes #o reflec# 5+a# +as
+appened #o a business o1er a rele1an# period of #i-e. The asset piece is measured by the Balance
heet, whilst the profit and cash pieces are measured by the !ncome tatement - Profit and Loss "ccount
and the #ash $low tatement respectively.
A good financial analyst should be aware of these simple facts, which are essential for any financial
modeling e$ercise
The Income Statement / Profit and Loss Account
The income statement - profit and loss account measures the sales made and the costs incurred over a
particular time period. !or e$ternal reporting this is usually for a year but internally most businesses will
prepare their income statement - profit and loss account on a weekly or a monthly basis.
The income statement - profit and loss account captures a sale when the product or service is delivered to
the customer. *ash may or may not change hands at this stage.
*osts are recorded in the income statement - profit and loss account to reflect the costs of making the
sales during that time period. This is called the -a#c+ing or accruals concept. T+is concep# s#a#es
#+a# #+e cos#s recorded -us# -a#c+ #o #+e sales -ade in #+e rele1an# #i-e period.
Although the (argon in an income statement - profit and loss account may vary 3especially from country to
country4 the costs are always deducted from sales in order of how closely they relate to the sale itself. The
order that cost deduction appears is therefore6
7. *ost of product sold
8. 9ales, general and administration costs
:. Interest e$pense
;. Ta$ e$pense
Af#er cos#s are deduc#ed fro- sales6 5e are lef# 5i#+ #+e bo##o- line profi# 7also 8no5n as #+e
ne# inco-e or profi# af#er #a(" 5+ic+ belongs #o #+e s+are+olders6 and conse9uen#l* is reflec#ed
as par# of s+are+olders: e9ui#* on #+e balance s+ee#;
The Balance Sheet
The balance sheet shows the position that the business is in at #+e end of #+e rele1an# #i-e period. It
shows the assets the business has, its liabilities, and the amount of euity belonging to the shareholders.
The reason it is called the balance sheet is because total assets must eual liabilities and shareholders+
euity as illustrated below6
Asse#s < Liabili#ies = S+are+olders: E9ui#*
The 8 sides of this euation -us# al5a*s e9ual or balance.
T+e liabili#ies and e9ui#* sec#ion s+o5s 5+ere #+e business ge#s i#s funds and #+e asse#s
sec#ion s+o5s +o5 #+ose funds +a1e been used.
The assets section is generally divided into 8 sub/sections, showing the short term and long term assets.
In this conte$t, a long term item is one whose life in the business is e$pected to be longer than 7 year.
)$amples of long term or fi$ed assets include6
Property
Plant and machinery
!inancial investments that are to be held for the long term
Patents
5icenses
9hort term assets are those whose lives are shorter than 7 year and include6
Inventories or stock
Account recievables - debtors 3when credit is given to customers4
*ash
!inancial investments that are to be held for the short term only 3i.e. less than 7 year4
5iabilities are also broken down into short and long term items. 9hort term liabilities include6
Accounts payable - creditors 3when credit is taken from suppliers4
Income ta$es payable
9hort term borrowings 3where the repayment date is within 7 year4
5ong term liabilities include borrowings where the repayment date is longer than 7 year from the balance
sheet date.
S+are+olders: e9ui#* is -ade up of ' 8e* pieces. The capi#al piece represents the shares bought by
the investors when the business was set up. This represents #+e cas+ #+a# 5as p+*sicall* gi1en #o #+e
business b* #+e in1es#ors, i.e. shareholders. The 8nd 3and often more significant4 piece is re#ained
earnings > profi# and loss reser1e. This is the cu-ula#i1e profi# earned #+a# +as no# been paid #o
#+e o5ners in di1idends but has been re/invested in the future growth of the business instead.
The Cash Flow Statement
The final area is the cash flow statement. This shows how cash has been generated and used over the
relevant time period. .ost cash flow statement styles will present the flows of cash using : main
categories6
&perating cash flows
Investing cash flows
!inancing cash flows
Opera#ing cas+ flo5s 5ill include #+e flo5s fro- #+e core opera#ions of #+e business and is
dri1en b* #rading. In1es#ing cas+ flo5s deal 5i#+ an* in1es#-en#s in #+e fu#ure of #+e business.
Any new plant and euipment would be included in this section. And finally #+e financing sec#ion deals
5i#+ an* in1es#-en#s -ade b* s+are+olders and an* di1idends paid #o #+e-. Any new borrowings
or any repayments of e$isting loans would also be shown in this section.