Accounting Concepts and Conventions

Introduction
Concepts are essential ideas that permit the identification and classification of phenomena or other ideas

A concept must state all that the given class includes and all that it excludes
Formed primarily by observation and established through agreement

 The American Institute of Certified Public Accountants have defined the accounting principle as, a general law or rule adopted or professed as a guide to action; a settled ground or basis of conduct or practice. It may be noted that the definition describes the accounting principle as a general law or rule that is to be used as a guide to action.

 Rules governing the foundation of accounting actions and the principles derived from them have arisen from common experiences, historical precedent, statements by individuals and professional bodies and regulation of governmental agencies.
Accounting principles, rules of conduct and action are described by various terms such as concepts, conventions, doctrines, tenets, assumptions, axioms, postulates, etc

 The term concept is used to connote accounting postulates i.e. necessary assumptions or conditions upon which accounting is based. The term convention is used to signify customs or traditions as a guide to the preparation of accounting statements.

ACCOUNTING CONCEPTS
Business Entity the entity is separate and distinct from the owners and the entity is liable to the owner Hence, in a limited liability company, the enterprise is liable to the owner (shareholder) based on the proportion of the capital investment (share capital) made by the latter Going Concern entities have a life of infinite duration, unless facts are known that indicate otherwise the basis of valuation of resources is influenced more by their future utility to the business entity than by their current market valuation

 Money Measurement Concept

Accounting records only those transactions which can be expressed in monetary terms. The importance of this concept is that money provides a common denomination by means of which heterogeneous facts about a business enterprise can be expressed and measured in a much better way.

 Matching Determining the profits after charging the expenses of a period with the revenues earned in the same period Realization Determines the point of time when revenue and hence returns (or profits) can be recognized objectively, unbiased, and with certainty.

 Cost Concept
All transactions are expressed in terms of money, i.e. money is considered the common unit of measurement. The common economic value of assets and liabilities is expressed in monetary terms rather than in terms of any other physical dimension.

 Dual Aspect
This is the basic concept of accounting. According to this concept every business transaction has a dual effect. For example, if A starts a business with a capital of Rs 1 lakh, there are two aspects of the transactions.
On the one hand, the business has an asset of Rs 1 lakh. On the Other hand, business has to pay Rs 1 lakh to the owner.

 The properties owned by a business enterprise are referred to as assets and the rights or claims to the various parties against the assets are referred to as equities. The relationship between the two may be expressed in the form of an equation as follows:Liabilities = Assets Liabilities may be subdivided into two principal types: the rights of creditors and the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called capital. Expansion of the equation to give recognition to the two types of equities results in the following which is known as the accounting equation: Liabilities + Capital = Assets

 It is customary to place `liabilities before `capital because creditors have priority in the repayment of their claims as compared to that of owners. Sometimes greater emphasis is given to the residual claim of the owners by transferring liabilities to the other side of the equation as: Capital = Assets Liabilities All business transactions, however simple or complex they are, result in a change in the three basic elements of the equation.

 This is well explained with the help of the following series of examples
(i) Mr. A commenced business with a capital of Rs.3,000: The result of this transaction is that the business, being a separate entity, gets cash-asset of Rs.30,000 and has to pay to Mr. Rs.30,000 his capital. This transaction can be expressed in the form of the equation as follows: Capital = Assets (A ) (Cash) 30,000 30,000

(ii) Purchased furniture for Rs.5,000: The effect of this transaction is that cash is reduced by Rs.5,000 and a new asset viz. furniture worth Rs.5,000 comes in thereby rendering no change in the total assets of the business. The equation after this transaction will be: Capital = Assets A Cash + Furniture 30,000 25,000+ 5,000

(iii) Borrowed Rs.20,000 from Mr. G As a result of this transaction both the sides of the equation increase by Rs.20,000; cash balance is increased and a liability to Mr.G is created. The equation will appear as follows: Liabilities + Capital = Assets Creditors (G) + A Cash + Furniture 20,000 +30,000 45,000 + 5,000

(iv) Purchased goods for cash Rs.30,000. This transaction does not affect the liabilities side total nor the asset side total. Only the composition of the total assets changes i.e. cash is reduced by Rs.30,000 and a new asset viz. stock worth Rs.30,000 comes in. The equation after this transaction will be as follows:Liabilities + Capital = Asset Creditors(G) + A Cash + Stock + Furniture 20,000+ 30,000 15,000 +30,000+ 5,000

 Accounting Period Concept

According to this concept, the life of business is divided into appropriate segments for studying the results shown by the business after each segment. This is because the life of business is considered indefinite and it is necessary to know the business situation after a appropriates interval.

Accounting Conventions
Conservatism Full disclosure Consistency Materiality

Basis of Preparing Accounting

Cash Basis of Accounting Accrual Basis of Accounting

Steps in The Accounting Cycle

Analyze source documents.

Journalize transactions in the general journal.

Post entries to the accounts in the general ledger.

Prepare a trial balance.

Prepare financial statements.

THE ACCOUNTING PROCESS

During the accounting period the accountant records transactions as and when they occur. At the end of each accounting period the accountant summarises the information recorded and prepares the Trial Balance to ensure that the double entry system has been maintained.

Thus the accounting process consists of three major parts: (i) the recording of business transactions during that period; (ii) the summarizing of information at the end of the period, and (iii) the reporting and interpreting of the summary information

 The transactions that takes place in a business enterprise during a specific period may effect increases and decreases in assets, liabilities, capital, revenue and expense items. To make upto-date information available when needed and to be able to prepare timely periodic financial statements, it is necessary to maintain a separate record for each item.

 An account is a statement wherein information relating to an item or a group of similar items are accumulated. The simplest form of an account has three parts:
a title which gives the name of the item recorded in the account a space for recording increases in the amount of the item, and a space for recording decreases in the amount of the item. This form of an account is known as a `T account because of its similarity to letter T.

DEBIT CREDIT
The left-hand side of any account is called the debit side and the right-hand side is called the credit side. Amounts entered on the left hand side of an account, regardless of the title of the account are called debits and the amounts entered on the right hand side of an account are called credits. To debit (Dr) an account means to make an entry on the left-hand side of an account and to credit (Cr) an account means to make an entry on the right-hand side.

 The words debit and credit have no other meaning in accounting, though in common parlance, debit has a negative connotation, while credit has a positive connotation. Double entry system of recording business transactions is universally followed. In this system for each transaction the debit amount must equal the credit amount.

Ledger Account
T-Account Format
Account Name

Debit

Credit

The T-Account
Increases to the T-account are recorded on one side of the Taccount, and decreases are recorded on the other side.

Account Name
Debit Credit

The T-Account
The side which increases and the side which decreases is determined by the type of account.

Account Name
Debit Credit

What Are Debits and Credits?

Tools used for recording transactions
Debit (DR) Credit (CR)

Debit refers to the LEFT and Credit to the RIGHT side of the T-Account
Account Name

LEFT

RIGHT

DEBIT SIDE

CREDIT SIDE

Rules of Debit and Credit

Transactions in accounts are recorded on the basis of rules of debit and credit. For this purpose business transactions can be classified into three categories: Transactions relating to persons Transactions relating to properties and assets Transactions relating to income and expenses On this basis, it becomes necessary for business to keep account of:
Each person with whom it deals PERSONAL ACCOUNTS Each property or asset which the business owns- REAL ACCOUNTS Each item of income or expense- NOMINAL ACCOUNTS

PERSONAL ACCOUNTS
Natural Personal Accounts Artificial Personal Accounts Representative Personal Accounts Rule: DEBIT THE RECIVER CREDIT THE GIVER

Example
Cash paid to Ramesh
Since rule of Personal Account is DEBIT THE RECEIVER. In this example, Ramesh is Receiver, so his account will be debited.

Cash Received from Mr. G

Since rule of personal account is CREDIT THE GIVER, Mr. G account will be credited.

REAL ACCOUNTS
Accounts that belongs to assets, property ad equipments are called Real accounts.
Tangible Real Account Intangible Real Account

Rule
DEBIT WHAT COMES IN CREDIT WHAT GOES OUT

Example
Machine purchased for cash
In this transaction, there are two accounts Machine and Cash both are assets . By applying rule of Real account Debit What comes in, Credit What goes out In this transaction Machine is coming in the Business, so Machine account will be debited and Cash is going out of business, thus Cash Account will be credit with the rule that Credit What Goes Out.

Nominal Accounts
Nominal account include accounts of all expenses, losses, income and gains. Rent, lighting, insurance, dividend, salary are example of nominal Account.

Rule
DEBIT ALL EXPENSES AND LOSSES CREDIT ALL INCOME AND GAINS
Important point to note here is that both Real and Nominal Accounts come in the category of Impersonal Account accounts. When any prefix or suffix is added to a Nominal Account, it becomes a Personal Account

Few examples
NOMINAL ACCOUNT
Rent Account Interest Account

PERSONAL ACCOUNT
Rent Prepaid account, Outstanding rent account Outstanding interest account, Interest received in advance account, Prepaid interest account

Salary Account Insurance account

Outstanding salaries account, Prepaid salaries account Outstanding insurance account, Prepared insurance account

Commission account

Outstanding commission account, prepaid commission

account

Class Exercise
From the following transactions identify the nature of account and also state which account should be debited and which should be credited:Rent paid Interest Received Paid to Suresh Lighting Dividend received Telephone charges paid Machinery sold Furniture purchased Goods purchased Goods Sold

Balance Sheet Model

A = L + C

Balance Sheet Model

Debits and credits affect the Balance Sheet Model as follows:

A = L + C
ASSETS
Debit for Increase Credit for Decrease

LIABILITIES
Debit for Credit for Decrease Increase

Capital
Debit for Credit for Decrease Increase

A L O R E Acronym
Particular
A (ssets) L (iabilities)

Debit
+ -

Credit
+

O (wners' equity) R (evenues) E (xpenses)

+ + -

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Recording Transactions

Initially, all transactions are recorded in the General Journal. Each transaction always affects at least two different accounts.
One

account has a debit effect. The second account has a credit effect.

This methodology was named double entry accounting by whom? F.L. Pacioli

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General Journal Page

GENERAL JOURNAL
Page:

Date

Description

PR

Debit

Credit

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Journal Entries
Example 1
On January 1, 2013, ABC Company started business with a cash of Rs INR1,00,000. Prepare the appropriate general journal entry for the above transaction.

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Journal Entries
Solution 1

Two accounts are affected:

Cash

is increased by Rs 1,00,000. ABC owe Rs 1,00,00 to owner and this become capital.

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Journal Entries
Solution 1

Two accounts are affected:

Cash

is increased by Rs 1,00,000. Capital is created by Rs 1,00,000.

Description

PR

Debit

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Journal Entries
Example 2
On January 15, 2013, ABC Company purchases a motor vehicle for Rs19,500 cash. Prepare the appropriate journal entry for the above transaction.

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Journal Entries
Solution 2

Two accounts are affected:

Vehicle

is increased by Rs19,500. Cash is decreased by Rs19,500.

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Journal Entries
Solution 2

Two accounts are affected:

Trucks

is increased by Rs19,500. Cash is decreased by Rs19,500.

GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

15-Jan Motor Car Cash (Being purchase of truck)

150 100

19,500 19,500