Definition
Accounting conventions are the set of guidelines that companies use to record financial transactions. These conventions play a vital role in the entire accounting world. Although these conventions do not have any legal obligations yet accountants need to use these conventions to record financial transactions.
These conventions are generally accepted guidelines around the globe. The accounting conventions have changed with time because of the financial conditions. The most common accounting conventions are materiality, full disclosure, conservatism, and consistency. These have been discussed later in this article.
Importance of accounting conventions:
The primary importance of accounting conventions is that it clears the way to record transactions for companies. This helps understand the overall financial performance/position of the companies. Let’s discuss the accounting conventions with examples:
- Conservatism:
The convention of conservatism states that when there are two possible values available for a transaction, the lowest one should be recorded on the income/asset side. This is to ensure that the possibility of any loss is taken care of. This convention aims to understate the assets and profits for dealing with any loss. The assets and profits are recorded keeping in mind the worst possible scenarios. This practice helps to enhance the reliability of the financial statement.
Example:
When inventory is recorded, accountants record it lower cost and the realisable value.
- Consistency:
The accounting convention of consistency, as the name suggests, states that there should be a consistent application of accounting principle for different cycles. If the company has chosen one method, it should also apply the same method in the future. This convention is important because it makes the financial statements of different accounting periods comparable.
Example:
The businesses should use the same method of calculating depreciation over different accounting periods. Another example can be the valuation of inventory valuation using FIFO/AVCO policy. In simple words, if the business has valued inventory with FIFO, it should continue to use FIFO in the next accounting period as well.
3. Materiality:
According to the convention of materiality, all the related material facts should be included in the financial statements. These facts are very important for financial decision-makers. Materiality refers to any information that can influence the decision of the financial statement user. It differs from company to company; for a multinational company, specific information might not be material, but for a small firm, the same information can be material. So, it’s about the context of analysis.
Example:
Consider a large firm that has encountered a loss of Rs.100,000 from specific customer. The net income of the company is Rs.200,000,000. So this loss of 0.05% may be immaterial for the firm. On the other hand, a small firm with a smaller net income amounting to $150,000 will consider this loss as material information.
4. Full disclosure:
As the name states, the convention of full disclosure emphasizes disclosing all the relevant and material information. It aims to provide relevant and complete financial supportive information to the user of finanical statement.
Example:
The disclosure of information like encumbered assets is an example of full disclosure. Businesses can also disclose their relationship with the related parties. Another example that a business needs to disclose is why it has changed any accounting method or principle.
Conclusion
Accounting conventions are set guidelines/rituals adopted by accountants. These conventions help an accountant in posting and controlling accounting transactions. Although there is no legal ground to follow these conventions yet, auditors need to comply with these conventions.
Main accounting conventions include conservatism, consistency, materiality, full disclosure etc.
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Frequently asked questions
Is there any difference between the prudence/conservatism concept?
There is no difference between prudence and conservatism concepts. It’s the same without any difference.
Why is materiality important?
Materiality is important because it helps businesses decide if they should consider some specific information. It’s about the impact of the transaction and the use of resources. In simple words, it helps decide if the business should allocate more resources on material/important items.
Why full disclosure is an important accounting concept?
Full disclosure helps the financial statement user understand and interpret the financial statement. It’s about getting a detailed perspective of the business performance and financial status of the business.
