February 22nd, 2010

 Accounting conventions

The main accounting conventions used by accountants are the following:

1. Separate entity

Every business is treated for accounting purposes as a separate entity. It’s financial performance is meausred seperately from that of other businesses and from that of its owners.

2. Going concern

The assumption is always made when preparing accounting statements that the business is a going concern, i.e. that the business will continue to trade. If this assumption was not made then asset values for example would be calculated differently.

3. Money measurement

Only transactions and assets that have a monetary value can be recorded in financial statements. The one exception to this is that in the event of a business being sold, the purchaser may be willing to pay an additional premium for goodwill that the business has generated over the years with its customers.

4. Double entry bookkeeping

This might be familiar to most people from their school days. We will deal with it in more detail in a later section but it basically means that every transaction is recorded twice so that we can cross check figures and produce balancing totals.

5. Realization

Much business is done on credit whereby goods and services are exchanged between sellers and buyers and payment is made at a later date. From an accounting point of view, when does the sale occur? It is when the goods change hands or when the money is paid. The realization principle of accounting states that we recognise and record the sale when the goods change hands and that is the principle that we use.

6. Matching

The matching principle requires us to match sales in any given accounting period with the costs incurred to generate those sales. So for example if we buy 1000 units at €1 each we have purchases costs of €1000. However, if over the course of the year we sell 800 units for €1.50 then we have sales of €1200. Using the matching principle we have sales of €12,000 (800×1.50) and we have a cost incurred in generating those sales of 800 (800x€1) giving us a profit of €400. The 200 unsold units must be carried over and recognised in the next accounting period.

7. Accrual

This principle states that income and expenditure must be recognised in the accounting period to which they relate and not when they were paid for. So for example if you have recieved an invoice for goods or services but you have not yet paid for them then you must recognise theis expense as an accural due in your costs by making an addition adjustment. Similarly if you paid in advance for an expense such as rents you must recognise that as a prepayment and adjust to deduct it from your expenses in this accounting period.

8. Capital and revenue expenditure

Expenditure must be classifed as either capital or revenue. In general, revenue expenditure is consumed immediately or in the very short term and it included in the profit and loss account for the current period, e.g. rent, wages, advertising. Capital expenditure is likely to be consumed over a number of accounting periods and is recorded in the balance sheet, e.g. builings, vehicles.

9. Depreciation

Assets that are purchased through capital expenditure will reduce in value over time. This reduction in value - called depreciation -  can be treated as a revenue expense each year until the full value of the asset is used. The amount of depreciation is recorded in the profit and loss account. The mechanism for caculating depreciation will vary but there are strict accounting rules around what is allowed. To provide a simple example, an asset that is bought for €20000 might be expected to provide value to the business over 5 years. In this case €4000 each year will be ‘written off’ the value of the assets and included in the profit and loss account as an expense.

10. Historic cost accounting

In general, values are recorded in the accounts at their costs price so inflation is ignored. There will be an exception to this in some cases for example buildings where there may be a revaluation and updated amounts entered.

11. Materiality

This principle means simply that items should be recorded related to the significance and importance they have to the business. For example adding a shelf in the office might strictly speaking be improving an asset but in practice it is not material enough to be treated as such for accounting purposes and should be treated as revenue expenditure.

12. Consistency

The methods used to calculate the financial statements should be the same each year. For example the same methods used to calculate depreciation should be used every year.

13. Objectivity

The principle of objectivity must always be applied to the preparation of accounts.

14. Prudence

This principle requires that profit not be anticipated but only recorded when it is certain. For example, a sale is not recorded as such when the order is recieved but when the goods or services are exchanged.