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Basic Concepts and Conventions of Financial Accounting

Basic Concepts and Conventions of Financial Accounting

This article aims to understand the meaning of financial accounting and its requirement in the preparation of financial statements to assess financial performance.

Financial accounting refers to recording financial transactions, summarising and interpreting them, and communicating the results to the interested parties. Financial accounting determines profit earned or loss incurred during a given financial period and the financial position on the date when the accounting period ends. The final result of financial accounting is the profit and loss account for the period ended, which indicates the profit earned or losses incurred, and the balance sheet on the last day of the accounting period, which indicates the financial position.

Main objectives of financial accounting:

Maintenance of records: To record financial transactions and events of the organisations in the books of account in a systematic manner and interpret and summarise the results thereof to the users of the financial information.

  • Ascertainment of profits or loss: For this purpose, an income statement or the trading and profit and loss accounts are prepared.
  • Determination of financial position: Every businessman needs to know the financial status of the organisation. For this purpose, a statement consisting of assets, liabilities, and the shareholder’s capital is prepared, called a balance sheet statement.
  • Facilitates management: The management requires financial information for decision making and better control, budgeting, and forecasting. Accounting helps to provide such financial information, based on which the management can effectively take any decision.
  • Provides accounting information to users: Providing accounting information to users and interested parties, they analyse such information as per their necessities.

The essential requirements of accounting principles

Accounting information is understandable in a better manner if prepared with the following set of accounting concepts and conventions uniformly. This means that the same accounting principles and standards are to be followed by all the entities in preparing financial statements. These standards are used to assess the performance of the business.

Accounting information is meant for users, and it can be utilised to compare financial statements and decision-making. Given this essential requirement, accounting concepts and accounting conventions are established.

Accounting concepts

Accounting concepts are the basic assumptions on which accounting operates. These are the following accounting concepts as discussed below:

  • The business entity concept: According to this, the business and owner are separate entities. Business transactions are recorded in the books of accounts from the company’s point of view, and not the owner’s. The owners are considered separate from their business’s point of view and are regarded as creditors to the extent of their capital.
  • The money measurement concept: According to this, transactions and events are measured in monetary terms in the books of accounts of the enterprise.
  • The going concern concept: Under this concept, it is assumed that the business will continue for an indefinite period, and there is no intention to close the business or cut down its operations significantly.
  • The accounting period concept: According to the accounting period concept, the life of an enterprise can be broken into smaller periods, usually termed accounting periods, so that its performance is measured at regular intervals.
  • The cost concept: According to this concept, an asset is recorded in the books of account at the price paid to acquire it, and the cost is the basis for all following accounting of the asset.
  • The dual concept: According to the dual aspect concept, every business transaction entered into by the organisation has two aspects, a debit and an equal creditor amount. For every debit, there will be an equal amount of credit.
  • The revenue recognition concept: According to this concept, revenue is determined to have been realised when a transaction has been written in the books and the obligation to receive the amount has been ascertained. 
  • The matching concept: Here, it is ascertained that every cost incurred to earn the revenue should be recognised as an expense in the accounting period when revenue is earned. In a given accounting period, expenses are matched with the revenue earned.
  • The accrual concept: A transaction is said to be accrued if a transaction is recorded at the time when it takes place and not at the time when the settlement takes place.
  • The verifiable objective concept: The verifiable objective concept states that accounting should be free from personal bias. 

Accounting conventions

The guidelines that are followed to prepare financial statements are called accounting conventions. These are as follows:

  • Full disclosure: Convention of full disclosure states that there should be complete reporting on the financial statements of all important information relating to affairs of the business. All the material facts are to be disclosed.
  • Consistency: Convention of consistency states that accounting practices, once selected and adopted, should be followed consistently year after year for a better understanding and comparability of the accounting information.
  • Prudence concept or conservatism concept: This convention states that we should not anticipate a profit before its realisable but provide for all possible losses which might occur in the course of business.
  • Materiality concept: The materiality concept relates to the relative information of an item or an event. An item is considered material when such knowledge of that could influence the decision of an investor.

Conclusion

Financial accounting is related to the recording of financial transactions, summarising and interpreting them, and communicating the results to the interested parties. Accounting information is understandable in a better manner if prepared with the following set of accounting concepts and conventions uniformly. Accounting concepts are the basic assumptions on which accounting operates. Accounting conventions are guidelines that are followed for preparing financial statements. If the given accounting concepts and conventions are utilised, then firms can easily have control over costs, which will lead to better financial results.