TRADING BUSINESSES AND ACCOUNTING RULES
Did You Know?
Accounting conventions (accounting standards) and doctrines (principles) influence accounting and (therefore bookkeeping) practices. If you understand accounting conventions (i.e. the basic rules and principles) you it will give a greater and clearer understanding of why statements are prepared in a certain way.
Accounting standards were commonly accepted accounting practices many of which have now become laws which accountants must follow.
Due to international cooperation (spanning decades of work) accounting standards i.e. the rules which govern the ways in which books are kept and reports are presented, have become standardised (i.e. can be easily recognised through similarities in approach and presentation) throughout many countries.
What are These Conventions?
There are many conventions (rules) which cover a range of situations using accepted accounting methods (conventions). The most important used by bookkeepers include the following:
The Historical Cost Convention
As with all basic accounting this rule deals with what has happened in the past (within a business). It is possibly the most commonly used accounting convention.
Transactions for assets within the business must be recorded at their original cost i.e. the amount paid at the time of purchase less depreciation (if applicable). With some exceptions, for example land which commonly (but not always) appreciates with time, the value of an asset cannot increase – i.e. Inflation or the amount an item could potentially be sold for, are not taken into account.
This can have the effect of distorting the true value of a business on the balance sheet – for example a business may buy a warehouse for £150,000. 10 years later the business owner may have an offer of £300,000 for the same building. On the balance sheet however, it still has to appear at its original cost. This is because values are nebulous i.e. you can’t really predict the future value of anything, and it is deemed a better approach to record historical value then it would be to guess at a market value.
Assets however can from time to time be re-valued to reflect their current worth and appear on the balance sheet with the new value (noted on the balance sheet).
The Business entity convention
This separates the business owner (of any type of business entities) from the business, in accounting terms. So any transactions within the business, relate to the business and not to the owner (e.g. when a business owner invests money into the business, it is recorded as a liability that the business has to the owner.
If the owner buys withdraw cash (or takes home goods) it is not recorded as a business expense. The owner can’t use the purchase of goods (for private use) as a business expense. This rule ensures that the personal and the business dealings of the owners are always separated.
The Going Concern Convention
This assumes that the business will continue its activities indefinitely and are therefore able to meet its current and future commitments. Because of this assumption, a business can classify assets and also liabilities as short, medium or long term and report them as such on the balance sheet; this prevents the write-off as costs of long-term assets, within one accounting period, instead of over many years.
This convention also allows assets to appear at book value (at purchase) rather than market value.
The Accounting Period Convention
In order to compare past to present business performance we need to produce accounting reports for a business at meaningful intervals. The length of an accounting period may be a week, a month, a quarter, or a full year, but must not be any longer due to taxation requirements.
It may be set to start and end on a certain date for example the 1st of July each year and end on the 30th of June each year – known as the ‘financial year’. Note: in some countries ‘financial years’ differ.
A business’s profit and loss account should show the expenses or the income relating to the period in which they were incurred or generated rather than when an account was paid, or income was received.
This system is sometimes also referred to as the accruals concept (see the definition given earlier this lesson. The net profit a business makes is therefore more realistic to a given period of time. Accruals are part of the bookkeeping process.
Monetary Entity Convention
This states that the monetary unit that is used is relevant to the country the business is operating in. In other words, in the USA it is the US dollar, in the UK the pound, and in Australia is the Aust. Dollar, and so on.
Recognition of Law
Financial reporting in a business is accountable by law. Books must be kept correctly reports must be accurate and correctly reflect the financial transactions of a business.
Accounting Doctrines
Accounting is based on accounting conventions – some of which we just covered in the previous pages. Following are some generally used accounting doctrines. They differ from conventions in that they do not have to be adopted – but most companies choose to do so.
Consistency
This states that the way accounting information is presented (for a business) must remain the same for all accounting periods from the present and into the future. This ensures that performance comparisons are valid and equitable and there is less likelihood that financial information is manipulated or biased towards the user.
Relevance
All business transactions within the books and financial reports of a business must be relevant to that business only.
Materiality
All items that are of importance to a business (in a financial sense) must appear in a business’s financial reports. Conversely this means that small items that are of little significance to financial outcomes may be omitted.
The way to test the importance of an item is to decide whether or not its omission with affect the reporting outcome and influence the reader’s or user’s perception of the true financial standing of a business.
The omission of cents for example in a financial report would have negligible effect on ascertaining the true financial standing of a business.
Verifiability Convention
A business (or anyone auditing the business) should always be able to confirm its figures. Any person should be able to look at the figures and use the data to come to the same conclusions.
In order to do this a business needs to produce evidence of its business transactions in the form of receipts, invoices, bank statements, EFT receipts and payments and cheque butts i.e. any documentation that was used to record transactions in the books.
