CHAPTER THREE - ACCOUNTING CONCEPTS AND CONVENTIONS

3.0 Learning Objectives……………………………………………………………….
3.1 Accounting Concepts and Conventions……………………………………………
3.1.1 Entity Concept……………………………………………………………………
3.1.1.1 Accounting Equation……………………………………………………………
3.1.1.1.1Assets…………………………………………………………………………
3.1.1.1.1.1 Non-Current Asset………………………………………………………
3.1.1.1.1.2 Current Asset………………………………………………………………
3.1.1.1.2 Liabilities…………………………………………………………………..
3.1.1.1.2.1 Non-Current Liabilities……………………………………………………
3.1.1.1.2.2 Current Liabilities………………………………………………………
3.1.2 Money Measurement Concept…………………………………………………….
3.1.3 Going Concern Concept……………………………………………………………
 3.1.4 Periodicity Concept………………………………………………………………..
3.1.5 Prudence Concept………………………………………………………………….
3.1.6 Substance Over Form………………………………………………………………
3.1.7 Consistency Concept……………………………………………………………….
3.1.8 Accrual Concept……………………………………………………………………
3.1.9 Matching Concept………………………………………………………………….
3.1.10 Materiality Concept………………………………………………………………..
3.1.11 Historical Cost Concept……………………………………………………………
3.1.12 Objectivity Concept……………………………………………………………….
3.1.13 Fairness……………………………………………………………………………
3.1.14 Realisation Concept………………………………………………………………
 3.2 Summary………………………………………………………………………….

CHAPTER THREE

ACCOUNTING CONCEPTS AND CONVENTIONS

3.0  Learning Objectives
At the end of this chapter candidates should be able to:
  Identify and explain the relevance of accounting concepts.
  Explain the relationship between a business entity and its owner.
  Explain the relationship between accounting equation and statement of financial position.
  Differentiate between assets, liabilities and Owner’s equity.

3.1  Accounting Concepts and Conventions
Accounting concepts and conventions are the basic assumptions that underlie the preparation of the periodic financial statements of a business entity. They are rules regulating the manner in which transactions are recorded. They are deemed to be in existence though not actually stated or referred to. The concepts and conventions give reasons why accounting data are prepared in a typical manner.

We shall now discuss some of the fundamental concepts and their importance in the preparation of financial statements. (SAS 1)

3.1.1 Entity Concept
In the strict legal sense, only limited liability companies are regarded as legal entities separate from their owners. It can acquire assets and incur liabilities. It can enter into contract on its own and can owe debt. It can sue and be sued.
In accounting, however, all forms of businesses are regarded as being separate from their owners. The assets (such as cash) contributed by the owner to the business is regarded as the liability of the business to the owner, which is called capital or owners‟ equity.

The essence of the entity concept is to distinguish the income and costs of the business from the private income and costs of the proprietor or his drawings from the business. For instance, if the owner of a business draws cash from the business bank account to repair delivery vans, it would be regarded as business expenses. But if he pays his child’s school fees with the cash, the amount will be treated as drawings of the owner rather than expenses of the business. The entity concept also gives rise to what is called the Accounting Equation.

3.1.1.1 Accounting Equation
The cash or other assets invested in a business by the owner are liabilities of the business to the owner. Therefore, assets = capital (liability to owner) at the commencement of the business.

As the operation progresses the owner may obtain goods on credit from suppliers or borrow additional loan from the bank to finance the business. The value of the goods supplied and the cash received as loan would increase the assets of the business, while liabilities to third parties (not owners) would increase. The accounting equation becomes Assets = Capital + Liabilities.

Let us illustrate the two scenarios.
(a) Ade, a proprietor of Adisco Enterprises started business with cash of N50,000
The accounting equation is
Assets = Capital + Liabilities
N50,000 (cash) = N50,000 +  0

(b) Assuming that in addition to the cash invested, Ade introduced N25,000, borrowed from a friend into the business. The cash position is now  N75,000, made up of Owner’s capital of N50,000 and liability N25,000
    Assets = Capital + Liability
    N75,000 (Cash) = N50,000 + N25,000

We shall now consider the effect of different transactions on the Assets, Capital and Liability of a business.

(c) Adisco Enterprises spent N20,000 to rent an office and bought furniture for N10,000. He also purchased for cash some textile materials for resale at the cost of N30,000.

The accounting equation will remain as in (b) above but the composition of the assets has changed. Assets = Capital + Liability
Furniture + Inventories of Goods + Rent + Cash = Capital + Liability N10,000 + N30,000 + N20,000 + N15,000 = N50,000 + N25,000 i.e. N75000 = N50,000 + N25,000

(d) If the goods above have been purchased on credit the accounting equation would be Assets = Capital + Liability
Furniture + Inventories of Goods + Rent + Cash = Capital + Loan + Supplier
N10,000 + N30,000 + N20,000 + N45,000 =  N50,000 + N25,000 + N30,000
N105,000  =  N50,000 + N55,000
We shall now consider the effects of profits and drawings on Owner’s equity and the accounting equation.

Profits will increase the Owner’s equity/capital while drawings will reduce it.
(e) Assuming that in illustration (d) above, Adisco Enterprises sold all the textile     materials for N52,000 and made a profit of N22,000 (N52,000 – N30,000). The cash from the sale would increase cash balance by N52,000 while capital is increased by N22,000 profit.
  Assets = Capital + Liability
Furniture + Rent + Cash =  Capital + Profit + Loan + Supplier
N10,000 + N20,000 + N97,000 = N50,000 + N22,000 + N25,000 + N30,000
  i.e.Assets = Capital + Liability         N127,000 = N72,000 + N55,000 (f) In addition to the information in (e) above, Ade withdrew N16,000 cash for private use. The accounting equation will become  Assets = Capital + Liability will be:
   127,000 – N16,000 = N72,000 – N16,000 + N55,000
  N111,000 = N56,000 + N55,000
You will notice that though capital is described as a sort of liability, it is not described with the word „liability‟. It is only the amount owed to third parties by the business that is described as liability. In the event that the business ceases to exist, the liabilities to third parties are settled first from the business assets.

Other examples on accounting equation are
Transactions        Effects on Assets and Liabilities
1. Buy goods on Credit for N1,200,000     Assets (Inventories) is increased Liabilities (Creditors) is increased by N1,200,000  by N1 ,200, 000
2. Buy goods in Cash for N300,000                  Asset (Inventories) is increased by
 Asset (Cash) is also decreased by N300,000  N300,000
3.  Pay Creditors for N1,200,000            Asset    (Cash) is decreased by
Liability (Creditors) is decreased by N1,200,000 N1,200,000
4. Proprietor takes N400,000 for private use  Asset (Cash) is decreased by
Capital decreases by N400,000  N400,000
         Let us now see how the above four transactions affect the accounting equation. 
1. Buy goods on Credit  N1,200,000  Inventories  N1,200,000
2. Buy goods in Cash  N300,000     Inventories  N300,000)
3. Pay Creditors            (N1,200,000)         Cash  (N1,200,000)
4 Proprietors‟ drawings           N400,000)           Cash  N400,000
Grand total effect  N400,000           =  N400,000  Creditors
Cash
Creditors
Capital
Assets  =  Liabilities
All figures in brackets denote decrease while others denote increase.

The two sides of the equation are equal, that is (N400,000) both ways. This confirms that for any transaction, the effect is of equal weight on the two sides of the accounting equation i.e. Asset = Liability


Explanation of some of the terms used in the Accounting Equation

The accounting equation: assets = capital plus liability represents the two sides of a statement of financial position; Assets on one side and capital and liabilities on the other side. The capital and liabilities are claims against the assets. The net worth of the business is the capital. The net worth is the original capital plus the profits earned (or less the losses incurred) during the period less the proprietor’s drawings during the same period.

3.1.1.1.1 Assets
Assets are the economic resources of a business that are expected to bring immediate and future benefits to the business. They are classified into non-current and current assets.

3.1.1.1.1.1  Non-current Assets
These are the economic resources that aid income generation for more than one accounting period. They include land and buildings, motor vehicles, equipment, machinery, furniture etc.

3.1.1.1.1.2  Current Assets
These are the economic resources of the business which are easily converted to cash or can be consumed within an accounting period or operation cycle, whichever is longer. Examples are cash in hand and at bank, receivables and other receivables, prepaid expenses and inventories of goods meant for resale.

3.1.1.1.2  Liabilities
Liabilities are claims against the assets of the business. Liabilities give rise to creditors. Some of the liabilities may arise from the use of the services or goods of another person on credit basis; some other liabilities may arise from financing the organization i.e. loan creditors. They are divided into current liabilities and longterm liabilities.

3.1.1.1.2.1  Current Liabilities
These are the liabilities of the business that are meant to be paid within twelve months. Examples of current liabilities are trade creditors (supplier of goods on credit), and other payables such as outstanding bills on electricity, salary and wages, taxation etc. and bank overdraft.

3.1.1.1.2.2 Non-current liabilities: These are liabilities that will take more than one year before repayment is due. They are long-term loans.
We have discussed the entity concept much because it is fundamental to the principle of double entry. We shall now consider the other concepts and conventions.

3.1.2  Money Measurement Concept
Money serves as the common denominator for measuring the various assets and liabilities of an organization, therefore accounting transactions are expressed in monetary values. The Naira and the Cedi represent unit of value which have the ability to command goods and services in Nigeria and Ghana respectively.
Apart from the fact that money serves as a common unit, accountants also believe that it is stable in value.

There are some limitations in the use of money as measure of value in accounting.
(a) The value of money does not always remain stable particularly in an inflationary economy.
(b) Apart from inflation, the time value of money today is greater than the time value of money in any future time, due to the cost of funds.
(c) There are some activities of an organization that are not recorded because monetary value cannot be attached to them. Examples are good management, employees‟ morale, strength of competition etc.

Thus, accounting does not provide all the information about a firm, it provides only economic information that can be expressed in monetary terms.
We may then understand why limited liability companies are required to disclose a lot of non-accounting information in their annual reports.

3.1.3    The going concern concept
Unless otherwise stated, it is always assumed that a business entity will continue in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or curtailing significantly the scale of operation.

The going concern concept will help investors, creditors, employees, customers and other stakeholders to determine the extent to which they want to continue to patronize the business. The going concern concept may be more justified in a limited liability company where the death or withdrawal of any member (shareholder) may not affect its scale of operation.

Assets and liabilities of a going concern enterprise are valued on historical cost basis. When the going concern is in doubt the assets are valued on break-up value basis i.e. forced sale values.

3.1.4    Periodicity concept
Notwithstanding the going-concern assumption, the operations and performance of a business entity should be subjected to periodic review, for instance limited liability companies are required to present their financial statements to members of the company annually. Management accounting information is even prepared more frequently.

The periodic review would help to assess management efficiency and the planning and control of future operations.

3.1.5    Prudence
The prudence concept requires that an accountant should not recognize income until the income has been earned and that losses should be fully written off. The essence of the principle is that profits are not overstated in any accounting period.

The prudence concept is most useful when matters of judgement or estimates are involved. For instance, if the credit policy of a business requires a customer to pay for the goods sold to him in 60 days and he has not paid after 120 days, it may be reasonable to make provision for the entire amount as bad and doubtful debt. Another example is when inventories becomes obsolete and its net realizable value falls below cost, the difference between the cost and the net realizable value will be written off to income statement.

Failure to write foreseeable losses off or the recognition of unrealized income will produce a misleading result which will eventually lead to losses to creditors and shareholders.

3.1.6    Substance Over Form
Business transactions are usually governed by legal principles; nevertheless they are accounted for and presented in accordance with their financial substance and reality and not merely by their legal form.

Examples are found in; sales and re-purchase agreements, lease contracts and consignment of goods.

3.1.7    The Consistency concept
Consistency concept requires that when a method has been adopted in treating an item in the financial statements, the method should not be changed but used consistently from period to period. For instance, there are many methods of depreciating a non-current assets; straight line, reducing balance, sum of the digits. If straight line is chosen to depreciate building in year one, the company should continue to depreciate building on straight line basis from year to year.

The essence of this principle is to make it easy for users of financial statements to compare the result of one period to another. Constant change in method will distort profits and make comparison difficult.

Occasionally there may be justification to change from one method to another. If the change is made, adequate disclosure must be made about the nature of the change and the effect of the change on profits.

3.1.8    Accrual concept
The accrual concept states that income should be recognized when they are earned and not when they are received. Expenses should be recorded when they are incurred and not when they are paid. The application of this concept gives rise to prepayments and accrued expenses. An accrued expense occurs when it has been incurred but has not been paid. Prepaid expenses occur when payment has been made for services but benefits have not been derived from them. They give rise to liabilities and assets respectively. Prepaid expenses and outstanding receivables are assets while income received in advance and outstanding expenses are liabilities of the business.

All expenses due but not yet paid should be added to the expenses paid in order to determine the total expenses for the period. All expenses prepaid should not be included in the amount to be deducted in the income statement. All income due and receivable should form part of the income for the period. While all income received in advance should be excluded.

3.1.9     Matching Concept
This is related to the accrual concept in a way. The concept holds that for any accounting period, the earned revenue should be matched with the cost that earned them. If revenue is deferred from one period to another, all elements of cost relating to them will be carried forward.

The concept is important in measuring the cost of goods sold or services rendered in a period. It is also useful in determining when the cost of an item becomes expenses (that is expired cost). The matching concept is applied to products where the costs can be related directly to them. It is applied in relation to time period where the cost incurred cannot be related to the product.

For instance, if a trader bought 50 pairs of shoes for N50,000 and sold 35 pairs for N70,000 at the end of a period. The cost of goods sold would be measured on the 35 pairs sold. That is 35/50 x N50,000 = N35,000. N15,000 would be deferred to the next period.

Some cost that cannot be related to specific transactions are depreciation, electricity bill, insurance cost etc. When the matching concept is not properly applied profits are either overstated or understated.

3.1.10     Materiality Concept
The principle of materiality holds that financial statements should separately disclose items which are significant enough to affect evaluation or decisions. It refers to the relative importance of an item; therefore some level of judgement may be required in determining what is material to an organization; as what is material to a sole trader may be immaterial to a large company.

In any event the amount (size) of an item would affect materiality. For instance, stapler, perforator, waste basket are expected to be used for more than one period, so that their costs should be measured over the period of use. However, because of the insignificant amount involved, the concept of materiality permits the immediate write off of these costs as expenses.

The nature of an item and type of a business entity will also affect materiality.

3.1.11 Historical Cost Concept
The basis for initial recognition of an asset‟s acquisition, service rendered or received and an expense incurred is cost. The concept also holds that after acquisition cost values are retained throughout the accounting process except to allocate a portion of the original cost to expense as the assets expire (see matching concept). The justification for the historical cost principle is its objectivity; that is, the cost can be traced to source documents and that other measures of value would be based on the subjective judgement of management.

The main criticism against the historical cost concept is that with the passage of time, cost would no more represent the fair value of an asset. For instance, the value of a building constructed ten years ago might have appreciated considerably over the period. In periods of inflation, the use of historical cost instead of fair values, normally leads to the recognition of „holding gain‟ because cost would significantly understate the value of the resources being consumed. Recognizing holding gain may lead to the distribution of the profits that would have been retained in the business for further expansion.

3.1.12 Objectivity Concept
Objectivity concept holds that financial statements should not be influenced by personal bias of management. The use of historical cost for asset valuation is an attempt to be objective, because it can be backed up by vouchers, invoices, cheques, bills etc.

A change in the value of an asset should be recognized when it can be measured in objective terms.

Objectivity is useful in accounting in the following ways:
(a) Auditing is made possible
(b) Accounting data are standardized.
(c) Fraud and falsification of accounts are minimized.
(d) Data is available for independent party to cross-check.

In spite of the goals of objectivity concept some personal opinion and judgement are brought into accounting information in few instances. For instance, estimates are required to determine the useful life of a non-current asset, the net realizable value of inventories or the amount to be provided for bad and doubtful debts.

However, figures built into financial statements should rely as little as possible on estimates or subjectivity.



3.1.13     Fairness
This is an extension of the objectivity principle. In view of the fact that there are many users of accounting information, all having differing needs, the fairness principle requires that accounting reports should be prepared not to favour any group or segment of society.

3.1.14     Realisation Concept
Under accrual concept, revenue should be recorded when it is earned. The realisation concept is concerned with determining when revenue is earned.
The realisation concept holds that revenue should be recognised at the time goods are sold and services are rendered; that is the point at which the customer has incurred liability.

Before revenue can be realised and recorded, it must have met the following two conditions
(a) The revenue is capable of objective measurement
(b) The value of asset received or receivable is reasonably certain.

The realisation concept may be difficult to apply in hire purchase transactions, lease transactions, contract jobs, advertisement agencies etc.

You will learn the rules that are applied in recognising revenue as you progress in the accounting profession.

3.2     Summary
In this chapter we have discussed the fundamental accounting concepts including entity, going-concern, historical cost, periodicity, monetary measurement, realisation, matching, consistency, prudence, materiality, accrual, substance over form and fairness concepts.

We discussed the usefulness of these concepts in accounting information and their limitations.

The chapter also treated the importance of accounting equation in the preparation of the statement of financial position.