Accounting Concepts and Convention – SS1 Financial Accounting Lesson Note (Second Term)

Accounting concepts and conventions are generally accepted rules used in preparing and presenting financial statements. They give every accountant a common basis, so that financial statements are uniform and can be compared.

Behavioural objectives

1. Define accounting concepts and accounting conventions.
2. State and explain the eight accounting concepts in this note.
3. State and explain the materiality, conservatism and consistency conventions.
4. Give an example of an item that is not reported because of the materiality convention.
5. Distinguish between accounting concepts and accounting conventions.

Which financial statements use these rules?

The trading account, the profit and loss account and the balance sheet are prepared using accounting concepts and conventions.

• Trading account: shows the gross profit or gross loss from buying and selling goods.
• Profit and loss account: shows the net profit or net loss after expenses.
• Balance sheet: lists the assets, liabilities and capital of the business on a given date.

Why do we need accounting concepts and conventions?

They are needed so that all businesses prepare their accounts in the same accepted way.

• Uniformity: accountants follow the same rules when preparing accounts.
• Comparison: accounts of different years or different businesses can be compared.
• Guidance: they tell the accountant how to treat a transaction when no clear rule exists.
• Confidence: owners, banks and tax officials can trust the statements.

What are accounting concepts?

Accounting concepts are the fundamental assumptions on which the financial accounts of a business are prepared and presented.

This note treats eight concepts: business entity, going concern, money measurement, cost, accrual, matching, dual aspect and realisation.

1. What is the business entity concept?

• Rule: the business is a separate and distinct person from its owner.
• Effect: only transactions that affect the business are recorded.
• Owner’s wealth: it is left out, apart from the amount the owner invested as capital.
• Example: a trader’s house and private car do not appear in the shop’s balance sheet.
• Example: goods taken home by the owner are recorded as drawings.

2. What is the going concern concept?

• Meaning: the business will continue to operate for the foreseeable future.
• Basis: there is no reason or fear that the business will be closed down (liquidated).
• Effect: assets are not valued at what they would fetch in a forced sale.
• Example: the cost of a machine is spread over its useful life as depreciation.

3. What is the money measurement concept?

• Rule: only transactions and events that can be expressed in money are recorded.
• Recorded: purchases, sales, cash, debtors and creditors.
• Not recorded: the skill of the staff, the loyalty of workers or the health of the manager.

4. What is the cost concept?

• Rule: assets are recorded at their cost price.
• Reason: the business is a going concern and is not meant to be sold.
• Example: land bought for N5,000,000 stays at that figure even if its market value rises later.

5. What is the accrual concept?

• Rule: revenue and expenses are recognised when they are earned and incurred.
• Effect: the time cash is received or paid does not decide the period.
• Example: December rent that is still unpaid is an expense of the year ending in December.

6. What is the matching concept?

• Rule: expenses of a period are matched against the revenue earned in that same period.
• Purpose: to find the true net profit for the period.
• Link: it is closely related to the accrual concept and is often treated as the same in SS1 texts.

7. What is the dual aspect concept?

• Rule: every transaction has two equal effects, a debit and a credit.
• Basis: this is the principle of double entry.
• Example: buying goods for cash increases stock and reduces cash by the same amount.
• Equation: Assets = Capital + Liabilities.

8. What is the realisation concept?

• Rule: income is recognised as soon as goods are exchanged for valuable consideration.
• Example: a credit sale is income on the day the goods are delivered, before the customer pays.
• Example: an order that has not yet been supplied is not yet income.

What are the key ideas of the eight concepts?

What are accounting conventions?

Accounting conventions are generally acceptable approaches to the application of accounting concepts.

There are three conventions in this note: materiality, conservatism and consistency.

1. What is the materiality convention?

• Rule: items that are significant in value must be recorded in the financial statements.
• Small items: events whose value is too small to affect the statements are not reported separately.
• Example: the depreciation of a calculator or a wall clock is ignored.
• Example: a cheap stapler is treated as an expense, not as an asset.

2. What is the convention of conservatism?

• Purpose: it sets out how to treat income, losses and the value of assets.
• Rule 1: income should not be anticipated.
• Rule 2: all possible losses must be provided for.
• Rule 3: where there is more than one way of valuing an asset, choose the lower value (the lower of cost and market value).
• Example: a provision for doubtful debts is made before the debt is known to be bad.
• Example: profit from a contract not yet completed is not recorded.

3. What is the consistency convention?

• Rule: similar transactions must be treated in the same way.
• Within a period: two similar items in the same year get the same treatment.
• From period to period: the method used last year is used again this year.
• Example: if a business uses the straight line method of depreciation, it keeps using it each year.
• Danger of change: a change of method may distort the profit calculation and make years hard to compare.

How do concepts differ from conventions?

Concepts are the basic assumptions behind accounts. Conventions are the accepted ways of applying those assumptions in practice.

Evaluation

1. What are accounting concepts and conventions?
2. Explain the business entity concept.
3. Land was bought for N5,000,000 and its market value has since risen. Explain how the cost concept treats it.
4. Why are some items, such as the depreciation of a calculator, not reported in the financial statements?
5. State the three rules of the convention of conservatism.

Assignment

1. Explain the going concern concept and the consistency convention, and state what may happen if a business changes its method of treating similar transactions.