Fundamental Conventions

Fundamental conventions

(a) The entity convention

The practice of distinguishing the affairs of the business from the personal affairs of its owner originated in the early days of double-entry book-keeping some 400 years ago. Accounting has a history which reaches back to the beginning of civilization, and archaeologists have found accounting records which date as far back as 4000 B.C., well before the invention of money. Nevertheless, it was not until the 15th century that the separation of the owner's wealth from the wealth invested in a business venture was recognized as necessary. This arose from the habit of employing managers or stewards to run a business and to require them to render accounts of their stewardship of the funds and assets entrusted to them. Consequently, the 'capital' invested in the business represented at once not only the initial assets of the business but a measure of its indebtedness to the owner. This principle remains enshrined in modern financial accounting, and the owner is shown as entitled to both the 'capital' which he has invested in the business, and also the profits which have been made during the year. The accounting and legal relationship between the business and its owner is shown on the balance sheet, which states the firm's assets and liabilities and hence indicates its financial position and financial well-being.

Example

J. Soap has recently inherited £30,000 and decides that the moment is opportune for him to realize his life-time ambition and open up a hairdressing salon. Accordingly, he makes all the necessary arrangements to begin on 1 April 19X0, under the name J. Soap-Ladies Hairdresser', and commits £10,000 of his money to that business. He will, therefore, open another account at his bank under the name U. Soap-Ladies Hairdresser', or he may simply call it the 'No. 2 account'.

As a result, the financial position of the firm on 1 April 19X0, from an accounting point of view will appear as follows:

J. Soap-Ladies Hairdresser

Balance sheet as at 1 April 19X0

Capital account £10,000 Cash at bank £10,000

The business is shown as having £10,000 in cash as its asset at that date, and as owing J. Soap £10,000, that is, recognizing its indebtedness to him in respect of the capital he has invested.

The accounting effect of the entity convention is to make a clear distinction between J. Soap's private affairs and his business affairs: what he does with his remaining £20,000 is of no concern to the accountant, but what happens to the £10,000 invested in the business is the subject-matter of accounting.

The interesting aspect of the entity convention is that it establishes a fictional distinction between J. Soap and the business which is not recognized at law: he remains legally liable at law for the debts of the business, and should the business fail, he will have to pay the creditors out of his private funds.

In the case of corporations, there is a legal distinction between the owners, that is, the shareholders and the business, so that the shareholders are not liable for the corporation's debts beyond the capital which they have agreed to invest. The accounting treatment of the relationship between the shareholders and the corporation is no different from that accorded to the sole trader and his business, except of course that the capital of the corporation is divided into a number of shares.

Example

Multiform Toys Ltd is registered on 1 April 19XO as a public company, the objectives being to manufacture a wide range of children's toys. The promoters of the company need £100,000 to launch the company. They decide to offer for sale 100.000 ordinary shares of £1 each to the public, and the promoters themselves will subscribe for 25,000 of these shares.

If we assume that all the shares have been taken up and paid for on 1 May 19X0, the balance sheet of the company will be as follows:

Multiform Toys Ltd

Balance sheet as at 1 May 19X0

Share capital £100,000 Cash at bank £100,000

The promoters have become shareholders, along with the members of the public who have subscribed for the shares. The liability of the company to the shareholders amounts to £100,000, and the company has £100,000 in cash by means of which it may pursue its objectives.

The effect of the entity convention in the case of incorporated business is to recognize the separate identity of the company from that of its shareholders. The shareholders themselves are not liable for the debts of the company, and their total liability is limited to the £100,000 which they have subscribed. We shall discuss full implications of incorporation from an accounting point of view.


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Read on: Types of Financial Accounting Conventions

Types of financial accounting conventions

We may classify accounting conventions into two broad groups-those which may be said to go to the very roots of financial accounting, which we shall call 'fundamental conventions', and those which bear directly on the quality of financial accounting information, which we shall describe as 'procedural conventions'.

In our view, there are only two 'fundamental conventions' which may. be said to characterize financial accounting:

(a) the entity convention, which states that financial accounting information relates to the activities... see: Types of Financial Accounting Conventions