Introduction to the Role of Accounting Conventions
As described earlier that accounting has a number of rules or conventions which have developed over time. They have developed because attempts to deal with practical problems that are experienced through preparers and users of financial statements, than to imitate some theoretical ideal. In preparing the financial position's statements earlier, we have followed several accounting conventions, while they have not been explicitly mentioned. We shall now recognize and discuss the main conventions that we have applied. The conventions are as followed:
BUSINESS ENTITY CONVENTION
The business and its owner(s) are considered like a being quite separate and different for accounting purposes. That's why owners are considered as being claimants in opposition to their own business in respect of their investment in the business. The business entity convention might be differentiated from the legal position that may available among businesses and their owners. For partnerships and sole proprietorships, the law does not make any difference among the business and its owner(s). Alternatively, for limited companies there is a clear legal difference among the business and its owners. For accounting reasons these legal differences are not relevant and the business entity convention relates to all businesses.
HISTORIC COST CONVENTION
The historic cost convention preserves that the value of assets that is displayed on the statement of financial position should be rely on their acquisition cost (i.e. historic cost). This technique of measuring asset value obtains preference over other techniques relies on some type of current value. Though, several people find the historic cost convention hard to support, because outdated historic costs are not likely to assist in the assessment of current financial position. It is frequently argued that recording assets on their current value would give a very realistic view of financial position and would be appropriate for a wide range of decisions. Though, a system of measurement relies on current values can depict a number of problems.
The prudence convention holds that care should be exercised while making accounting judgements. The meaning of this is that losses and liabilities should not be understated when assets and profits should not be overstated. The application of this convention generally includes recording all losses immediately and in full; this considers to both actual losses and expected losses. Alternatively, profits are recognised only while they actually arise.
So, greater importance is placed on expected losses than on supposed profits. To demonstrate the application of this convention, let us suppose that specific inventories held through a business demonstrate unpopular with customers and thus a decision is made to sell them less their original cost. The prudence convention needs that the supposed loss from future sales be familiar immediately than while the goods are eventually sold. Though, if these inventories could have been sold higher than their original cost, profit would only be known at the time of sale.
The prudence convention developed to counteract the excessive optimism of a number of managers and owners and is intended to avoid an overstatement of financial position. Though, there is a risk that it will introduce a bias in the direction of understatement of both financial position and profit.
GOING CONCERN CONVENTION
The going concern convention contains that the financial statements have to be ready on the assumption that the business will carry on operations for the foreseeable future, except this is well-known not to be true. Other words, it is supposed that there is no intention, or requirement, to sell off the non-current assets of the business. Such type of a sale might take place in which the business is in financial difficulties and requires paying amounts borrowed that are unpaid for repayment. This convention is significant as the market (sale) value of several non-current assets is frequently low in relation to the values on which they emerge in the statement of financial position. The meaning of this is that a forced sale to take place, there is the probability that assets will be sold for less than their statement of financial position value. Such type of anticipated losses should be completely recorded as soon as the going concern status of business status is called into question. Though, where there is no expectation of a requirement to sell off non-current assets, they can carry on to be displayed at their recorded values.
DUAL ASPECT CONVENTION
The dual aspect convention emphasizes that every transaction has two issues, both of which will influence the statement of financial position. So the purchase of a motor car for cash results in a raise in one asset (motor car) and a get decrease in another (cash). The repayment of borrowings results in the reduced in a liability (borrowings) and the reduced in an asset (cash).
Keeping the dual aspect of every transaction makes sure that the statement of financial position will carry on to balance.
Figure 2.3 summarises the main accounting conventions that exert an affect on the construction of the statement of financial position.
Accounting conventions influencing the statement of financial position
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