Accounting conventions determine the rules which are applied to accounting procedures. Accounting conventions are constantly being adapted to meet the changing demands of business, and at any point in time there may be more than one accepted way of treating a particular class of transaction. A thorough knowledge of these conventions is necessary for a complete understanding of the data contained in financial statements.
Recording is the mechanical process by which financial transactions are systematically placed in accounting records. Recording may be made in the form of pen markings by hand, or it may be accomplished by various mechanical or electronic devices. Transactions are analysed so that they can be classified according to a predetermined system of accounting. Periodically, this recorded and classified information is summarized by the preparation of financial statements and reports to the managers of an enterprise and to other interested parties. Interpreting basically refers to that utilization of the recorded, classified and summarized data which reveals and emphasizes significant changes, trends and potential developments in the affairs of an enterprise.
Conventional accounting procedures are associated with the periodic production of financial statements. Two such statements are the balance sheet, and the income statement. Their contents are illustrated below. Funds flow and cash flow statements are additional financial statements, which explain the flow of financial resources to and from the enterprise.
(i) The balance sheet, sometimes called the Statement of Financial Position lists the assets and liabilities of the business at the close of the accounting period. At the same time, it provides a measure of the capital invested by the owner(s) in the business. It will be seen that the balance sheet has four main sections-fixed assets, current assets, capital and other liabilities. This classification assists the financial analysis of the business. Fixed assets are deemed to be available for use in the business, and are not intended for resale. They include assets having a long life in use, such as buildings, plant, machinery and vehicles, which are deemed to be available for use in the business, but are not intended to generate profits by their resale. Current assets represent those assets which are transformed during the operating cycle into cash, inventories such as materials, supplies, work-in-process and finished goods, as well as debtors.
Cash balances are always shown as current assets, as such balances are regarded as available for immediate use by the business.
(ii) The income statement is used to show the calculation of the profit of the business for the accounting period
It will be seen that the net income for the period is added to the owner's capital. Until such time as the owner draws upon that income, it remains in the business and is described as 'retained income'. In effect, the net income which is retained adds to the invested capital, and the drawings reduce invested capital.
The establishment of concepts is very important to the development of a theoretical framework. Accounting concepts have been given terms which are used to describe the events that comprise the existence of business of every kind. It is for this reason that accounting is often characterized as 'the language of business'. The basic concepts provide the essential material of accounting theory.
Assets are things of value which are possessed by a business. In order to be classified as an asset the money measurement convention demands that a thing must have the quality... see: Basic Concepts