Definitions and conventions of accountingMoney measurement convention
Accounting defines things in terms of money, and can do nothing else. Thus informa-
tion that cannot be expressed in monetary terms cannot be included in accounting
statements. This can also be seen as a deficiency of accounting.Historic cost convention
Assets are shown in the balance sheet at a value that is based on their cost to the
business when they were first acquired, not their current market value or any other
value. This means that attempts to use the balance sheet to place a value on a business
are likely to lead to misleading results. Some businesses break the historic cost con-
vention and show certain assets, particularly those relating to land and buildings,
at an estimate of their current market value. A particular asset may have a low
market value but be worth much to the business itself. This could arise where the asset
is highly specialised or specific to a business, and has little or no use to any other
business.
Adherence to the historic cost convention means that the reader of accounting state-
ments is unable to assess the opportunity cost of using a particular asset for some pur-
pose. For example, when the historic cost of some inventories sold is included in an
income statement, as an expense, the reader is not able to judge how much more the
wealth of the business would have been increased had the inventories been deployed
in some other way.Stable monetary unit convention
Accounting tends to assume that the value of the currency remains constant in terms
of its ability to buy goods and services. In other words, financial statements are pre-
pared as if there were no price inflation or deflation, either generally or in relation to
particular goods and services. The fact that inflation is a constant feature of almost
every economy in the world means that this is likely to lead to financial statements
giving impressions that could be misleading. Attempts have been made to agree an
approach that allows for the distortions of price changes in financial statements. So far,
no major economy in the world has developed an approach that is consistently and
widely used by its businesses.Realisation convention
The realisation convention is concerned with the point in time at which a revenue, that
is, an increase in wealth arising from trading, is recognised. For example, if a customer
orders goods in one month, receives them in the next, and pays for them in the third
month, when should the business supplying the goods treat the revenue (sale) as
having taken place? This is not an academic question where the business is preparing
financial statements for each month and comparing one month’s performance with
that of another, or where the three months do not all fall within the same account-
ing year.
The realisation convention says that the revenue should be recognised at the point
where: