Article : Accounting Conventions

An accounting convention is a basic principle or concept underlying the preparation of financial accounts. These statements of profit and loss, balance sheet and cash flow are usually prepared monthly for manage-ment purposes, but particular emphasis is placed on the annual and half-yearly accounts which are the only ones that inform shareholders and other interested external parties.

Although the basic recording of financial transactions using double-entry bookkeeping is a mechanical exercise, there is, however, also a subjective side to accountancy. The production of the financial accounts is not totally automatic and various rules, principles or conventions are followed in addition to statutory and financial reporting standard requirements. By way of illustration, let us consider some examples where conventions are required, before we can proceed to answer them.

Examples : 1. A company buys a new machine for £10,000 and expects it to last for five years. Does it charge this cost to the profit and loss account in the year it buys it, or in the year when it will be scrapped?
2. A retail store buys a quantity of washing machines one month for £4,000 and sells three-quarters of them for £3,600 in the same month. The remainder are sold in the following month for £1,200. Should the total cost of £4,000 go into the first month’s profit and loss account or should it be £3,000?
3. Now suppose that the washing machines in the previous example were bought on credit and the agreed credit terms with the supplier do not require payment until the end of the following month. Should the cost to go into the first month’s profit and loss account be nil, or £4,000, or £3,000?

Answers to these questions will be given after discussing the main accounting conventions used by accountants. These are now listed and then each one considered separately :

1. Separate Entity
Every business is regarded as an entity on its own. We need to keep its financial transactions separate from those of other businesses, and from the personal transactions of its owners, to enable accountants to measure the financial performance of each business.

2. Going Concern
When preparing financial statements, the assumption is made of continuity; that the business is a ‘going concern’. If a firm ceases to trade, its possessions are sold off to the highest bidder, but it would be very unlikely they would fetch their cost price. Buildings may fetch more, but stocks, work-in-progress and specialist equip-ment may fetch much less on a forced liquidation. Unless any infor-mation is known to the contrary, the assumption is made that a business will continue trading. This is particularly important regard-ing the valuation of assets which might have very different values placed on them in the event of a liquidation.

3. Money Measurement
Accountants can only record transactions that have a money measurement. Money is the means of adding transac-tions together, which is only possible when we can express transac-tions in money terms. For this reason, internally generated goodwill never appears in a list of assets as its value is unknown until someone wants to take over the business and buy the goodwill. Only if we buy up another company and pay £x for its goodwill will it appear as a financial transaction.

4. Double Entry Book Keeping
Most people have heard of this even if they are hard put to define it precisely! It refers to the dual aspects of recording financial transactions. By this is meant that every transac-tion is recorded twice, in two different ledger accounts, recognizing the giving and receiving aspects separately. This topic is examined in the following chapter.

5. Realization
With the exception of some retail trade, most business-to-business sales are done on credit rather than for immediate cash settlement. It is therefore important to define when exactly a sale takes place. Is it when goods or services change hands or when the cash is finally received by the supplier? The realization concept adopts the former timing, so we place a sale in the month the goods and services are delivered to the customer, regardless of when the cash is received.

6. Matching
This principle requires accountants to match the cost of sales against the value of those same sales in the same time period.

When determining the profit or loss. In the first example at the beginning of this section, the cost of sales is £3,000 and is matched against the sales value of £3,600 to show a gross profit of £600. The unsold goods costing £1,000 are carried forward as stock and shown in the next month’s profit and loss account when they were sold for £1,200, thus realizing a profit of £200. The answer to the third example is the same £3,000 based on the accrual convention below.

1. Accrual
Expenses which relate to any accounting period must be included in that period’s profit and loss account irrespective of when they are paid for. If an invoice has been received for goods or services supplied to the business, the bookkeeping system will auto-matically include that expense in the profit and loss account. However, if the goods or services have been received but no invoice received by the period end, then an ‘accrual’ is raised to get the cost into the bookkeeping system. Conversely, if an expense has been paid for but not yet received, then an adjustment is made for the prepayment. The two principles of realization and accrual are crucial to measuring business performance accurately over short periods of time.

2. Capital and Revenue Expenditure
The expenditure that is consumed and has no value remaining is charged to the profit and loss account as revenue expenditure and matched against revenue or income. Some expenditure, however, lasts for many accounting periods. Buildings and equipment are examples of items which it would be unfair to charge in full to any one accounting period. This is deemed to be capital expenditure and is placed in the balance sheet.

3. Depreciation
The value of most capital expenditure reduces as the assets wear out over time. Depreciation is the process of reducing the value in the balance sheet by transferring part of it to the profit and loss account each period. Hence capital expenditure becomes revenue expenditure bit by bit over the asset’s expected lifetime. This process is explained more fully in Chapter 3. Referring back to the first example earlier, it should now be appreciated that neither of the solutions offered as alternatives is correct. The £10,000 cost of the equipment should be depreciated by, say, £2,000 in each of the next five years.

4. Materiality
This convention might be used to overrule a strict inter-pretation of another convention. For example, the installation of coat hooks in a room is an improvement of an asset and should be treated as capital expenditure and depreciated each accounting period. Such administrative effort for a trivial sum of money is pointless, so businesses usually set a minimum sum below which capital expen-diture is treated as revenue expenditure for expediency. Another example of materiality might be not bothering to count and value small amounts of stationery left at the end of each period to include them in stocks. In this case stationery is charged as revenue expendi-ture on purchase regardless of when it will be used.

5. Consistency
Where there is a subjective judgement made in account-ancy, this will be adhered to from one year to another. An example of this might relate to the method used to calculate depreciation. Alternative methods are available, as discussed in a later chapter, but the chosen method should be consistently applied year after year.

6. Objectivity
Accountants try to produce financial accounting state-ments as objectively as possible, but as a number of items require an element of judgement this may not always be achieved.

7. Prudence
A salesperson will count a sale when an order is received whereas the realization concept used by accountants requires the product to first be delivered to the customer. This is one example of prudence where a profit is not anticipated before it is realized. This might seem at odds with the treatment of a loss to be incurred in the future when an accountant provides for the estimated loss immedi-ately. Accountants view prudence as anticipating a loss but never anticipating a profit.

All these accounting conventions find their way into the financial statements of profit and loss account and balance sheet. We first need to find out how all the information going into those statements is recorded, and then see how we sort out which information goes into which statement. These topics are discussed in the following chapter.

From : Graham Mott