Underlying Assumptions and Conventions:
Below is a list of important conventions or assumptions that govern the regulation of businesses:
Accounting period convention: The life of the business is divided into periods of the same length for the purpose of measuring profit. For example in New Zealand a firm must present an interim report (6months) and an annual report (12months)
Going concern (continuity) convention: The going concern convention assumes that a business will continue to operate to perpetuity (forever). This suggests that non-current assets (those that are held to generate revenue rather than to be sold) should be valued at historical cost rather than its market value. The market value is inappropriate in this sense because it is less reliable and more subjective. If we assume that the company will continue to perpetuity then we assume that they will not sell their non-current assets in the foreseeable future. Therefore, it is more appropriate to use the more reliable historical cost.
Money measurement convention: Deals with items that can be expressed in monetary term’s only. This means we only put items that have a money value or can be quantified on the balance sheet. This explains why we do not put the “value” of our staff etc on the balance sheet.
Dual aspect convention: Every transaction has two effects that affect the balance sheet. This is the basis of debit-credit accounting (see article debit & credit accounting).
Example 1: When we purchase a building for $20,000, the asset “building” increases by $20,000 while the asset “cash” decreases by $20,000.
Example 2: When we pay our suppliers money owed we experience a decrease in the asset cash followed by a decrease in the liability accounts payable.
Conservatism/prudence convention: Financial reports should err on the side of caution. I.e. we should avoid overstating assets and understating liabilities. For example if we have inventory it is better to value it at the price it cost us then the price we can sell it for because we can‘t be 100% certain that we can sell it for that price at a single point in time. The inventory might become obsolete, we may not be able to find a seller or it may break.
The convention represents a pessimistic view of financial position and is evolved to counteract the excessive optimism of some managers and owners which result in an overstatement of financial position.
Stable monetary convention: The value of money does not change over time.
Objectivity/reliability convention: Seeks to reduce personal bias and error in financial reports. Thus financial reports should be based on objective, verifiable evidence rather than on matters of opinion. For example we should only value PP&E at the current market value if we know reliably that it is a fair valuation.
Realization convention: Revenue/ gains are recorded when they are realized. For example if we were a retail clothing shop, we would not record revenue at the point we complete it but the point at which the customer chooses to sell it. Furthermore if we sell a piece of clothing on credit, then we should still record it at the point we sold it (not at the point we receive cash) because the buyer has already entered an agreement to buy the item.
Matching convention: Match revenue with its corresponding expense. Thus expenses are recorded in the period in which they are realized (accrual accounting).
Consistency convention: Rules and policies are consistent from year to year. If a rule or policy changes it must be disclosed as a note of the financial statements.