Accountants are guided by principles. These principles are used in posting business transactions in the journals and ledgers. They are also used in preparing financial reports. The well-known general principles applied by accountants worldwide are accounting concepts and conventions. We discussed this below.
What are accounting concepts and conventions?
Accounting concepts and conventions are the general guidelines used by accountants in preparing financial statements and the books of accounts. More so, they are foundational principles that guide the establishment of accounting standards, such as the International Financial Reporting Standards (IFRS).
Journal entries and ledger postings are aided by the accounting concepts and conventions. For example, the dual entity concept states that every transaction has dual entry in the ledger. The business entity concept helps the accountant recognize capital, drawings, and the director's current account.
These principles guide the finance professional in preparing and presenting financial statements. One of such principles is the accrual concept. The concept guides the accountant in treating credit transactions as receivables and payables. These are recognized in the statement of financial position. On the other hand, the materiality convention enables the accountant to determine the threshold for classifying an item as a non-current asset.
The International Financial Reporting Standards are prepared by applying these principles. In fact, they are part of the fundamental framework used by IFRS standard setters in preparing those standards. To illustrate, IAS 16 states and explains the depreciation method to use for property, plant, and equipment. The method chosen by an accountant must be used continuously. This is in line with the consistency convention.
Auditors also apply the accounting concepts and conventions. These are in the areas of materiality, objectivity, and fairness. Auditors ensure that material transactions are substantially tested to ensure accuracy. For a financial statement to be true and fair, the auditor will comply with the principles of objectivity and fairness.
Types of accounting concepts
We have explained the types of accounting concepts and conventions used by finance professionals. In this article, they are summarized below:
Objectivity Principle:
This principle explains why accountants should be objective in preparing financial reports. Objectivity means fairness. It implies using the scientific method of measuring income, expenses, assets, liabilities, and equity.
Money measurement concept:
This explained why currencies are the only measurement basis for preparing financial statements.. Other forms of measurement are useless. Using money as a measurement basis, companies can determine their profit or loss, total assets, and capital employed. More so, businesses are valued using this principle.
Periodicity concept:
Accounting reports are prepared on a period-to-period basis. Management reports are prepared monthly, and annual financial statements, as the name suggests, are prepared yearly.
Realization concept:
This guides the recognition of revenue in a company. Industrial norms are considered when deciding on revenue recognition. IFRS 15 states the five-step model used by accountants to recognize revenue in the financial reports.
Substance over form:
It applies to lease agreements. Here, finance professionals record the substance of the transaction rather than its legal form. In lease, the asset leased legally belongs to the person who leased it. However, the principle states that the leased asset should be recognized in the books of the lessee as if it owns it.
Going concern concept:
This explains that a business is expected to continue for a long time. This principle gives rise to the preparation of financial statements with the assumption of perpetual continuity. When a company is no longer classified as a going concern, then a breakup basis is used to value it.
Historical cost concept:
A concept that says assets should be measured based on their past cost. In financial reports, non-current assets are measured at cost or revalued amount. In future years, the revalued amount also becomes a past cost.
Business entity concept:
This principle explains why accountants differentiate business owner information from the business. Therefore, transactions relating to the business owner are regarded as capital, drawings, dividends, and the director’s current account.
Matching concept:
This is applied to preparing a statement of profit or loss. It states that income should be matched with its related expenses. Therefore, income minus expenses equals profit.
However, certain expenses must be recognised together with their related expenses. For example, the sale of a fixed asset is an income but its related expenses are deducted from it. This gives a gain or loss from the sales before it is recorded in the statement of profit or loss.
Accrual concept:
The concept explains why accountants post credit transactions. This is because it is important to capture all transactions that occur within a period.
The principle is that income is recognized when it is earned and not when cash is received. Expenses are recognised when they are incurred and not when cash is paid.
Three core accounting conventions
Conservative convention:
Financial experts are expected to be prudent. It entails ensuring that all known losses and expenses are accounted for. But, revenue should not be overstated. This convention encourages provision allowance for probable contingencies. IFRS 9 is also based on it. Financial assets are impaired to account for probable losses, whether or not the losses occurred.
Materiality convention:
Materiality convention explains that items recognized in the financial statement should be material. Where a transaction is immaterial, they should be aggregated. However, under the note to the account, the separate transactions can be itemized.
Consistency convention:
Here, there should be consistency in the use of accounting methods and bases in the preparation of financial statements. The method and basis can be changed when management believes that doing so will improve users' decisions.
In conclusion, concepts and conventions form the basis of setting IFRS. They are the fundamental principles used by accountants in posting to the books of account. When there are no standards for a particular transaction, the concept and convention are used to decide on how the transaction should be treated.