In this article you will learn:
Financial information in respect of various aspects of the business enterprise is collected, analyzed and reported in financial statements. The purpose of accounting is to provide financial information in respect of the performance and the financial position of the business to various internal and external users of such information.
Thus, to make this accounting information useful for the various stakeholders, it is important that the information contained in the financial statements is understood by them. This is possible only when Generally Accepted Accounting Principles (GAAP) are used to prepare financial statements of the business enterprise.
Now, these accounting principles include concepts, conventions, rules and procedures that are needed to determine the accounting practice adopted at a particular time.
So accounting conventions are a collection of generally accepted practices that have been developed over a period of time out of experience and practice.
This article talks in detail about what are accounting conventions and the type of accounting conventions adopted by accounting professionals.
What are Accounting Conventions?
Accounting conventions are a set of common practices that act as guidelines while recording business transactions in the financial statements. These are used at times when certain business transactions have not been fully addressed by the accounting standards.
Thus, unlike accounting standards, accounting conventions are guidelines that are commonly accepted by accounting professionals and bodies without any legal obligation. Such practices are developed over a period of time and are subject to change depending on the changing financial conditions.
So, accounting conventions are created to advocate consistency and comparability across the financial statements of various business entities. This further helps accounting professionals and users of financial statements to understand the financial position and the operating performance of the business activities.
Major accounting conventions include consistency, conservatism, materiality and full disclosure. Let’s have a look at each of them individually.
Major Accounting Conventions
1. Consistency Convention
The accounting convention of consistency states that once adopted, a business must continue to follow the same accounting principles and methods in the future accounting periods.
This is because consistency in accounting methods enables management to draw comparison between the financial statements of different accounting periods. Such a comparison helps the management in formulating policies and take decisions.
Thus, financial results of two or more accounting periods can be compared only when convention of consistency is followed. Recurring changes in the accounting methods render financial statements as unreliable.
Given this, it is not to say that convention of consistency means inflexibility for the business to change its accounting methods.
If there exists a sound reason for the business to change its accounting methods, it can do so. But such a change must be accompanied by a proper explanation of the effects of such changes in the notes to the financial statements.
Thus, accounting convention of consistency makes accounting statements accurate and helps management in making effective decisions.
2. Conservatism Convention
Conservatism convention of accounting is a guideline for recording business transactions that is based on the principle: ‘Anticipate no profit, but provide for all possible losses.
In other words, a business must record expenses and liabilities as soon as it sees an uncertainty of incurring a loss or liability.
In contrast, it must record profits and assets only when they are realized. This accounting convention is based on the concept that a business must take into consideration the most unfavorable or worst case possible for the business.
Thus, a business must show reasonable care while recording transactions and must not record profits until it is certain that such profits would be realized.
However, it must record losses even if it is uncertain about their occurrence. The conservative approach of accounting advises the accounting professionals to exaggerate losses and liabilities and understate the profits and assets.
For instance, conservatism is applied when valuing inventory. It states that a business must record inventory at either its acquisition cost or current market value, whichever is lower
Similarly, it is also used to record while estimating accounts receivables. A provision for bad or doubtful debts is created to provide for any losses occurring on account of these accounts receivable that remain unpaid in near future.
The materiality convention of accounting states that the business should include only the important or relevant facts in the financial statements.
Material facts refer to any information, which if excluded or misreported in the financial statements could influence the decision of the users of such financial statements.
Thus, if excluding or misreporting certain information impacts the decision of the users of the financial statements, such information is material in nature.
Likewise, if excluding or misreporting certain information does not influence the decisions of the users of such statements, such information is not material in nature.
Further, materiality of information depends upon the nature and amount involved in such information. That’s why, what may be a material fact to a small concern might not be so in case of a larger concern.
Similarly, what may be material fact for a particular year or purpose might not be the case for some other year or purpose.
For instance, say a business owner deals in computer electronics such as laptops, computers, printers etc. He invests a large sum of money as capital in buying such computer electronic items.
Since a large amount of money is involved in such items and is an information which if excluded or misreported could influence the decision of users of such information, this information is of material nature.
On the other hand, information in respect of stationery bought such as pens, pencils, stick notes and items is needed to maintain the routine work. Thus, such information is not of material nature.
Therefore, items of material nature are recorded in detail separately under their respective heads. However, items that are immaterial in nature are clubbed together under different accounting heads.
4. Full Disclosure
This accounting convention states that all relevant or material information must be disclosed while preparing accounting records of a business entity. In other words, accounting professionals must prepare accounting records diligently and must take care that material information is not missed out at any cost.
This is because these financial statements are used by multiple internal and external stakeholders like management, employees, creditors, etc. While management would be concerned about the overall performance of the business and would plan and adjust its policies accordingly. Creditors, on the other hand, would be concerned about the financial soundness of the business entity and its capacity to pay back.
Thus,if the accounting professionals fail to report important information in the financial statements, it can render such statements as unreliable and useless.
Further, it can be a possibility that some important events take place in the time gap between the date on which the balance sheet is prepared and the date on which it is published. In such cases, relevant information in respect of such an event must also be disclosed in the financial statements, either in their body or as a footnote.