Accounting Conventions are a widely accepted set of unwritten rules followed by companies and businesses all over the globe. These conventions, also known as accounting doctrines, do not intend to overrule any of the available accounting standards or accounting principles. Still, they help and guide an entity to record and maintain the transactions in a particular way, especially for those transactions which are not fully covered by any specified accounting standard.
They are not legally binding but are well recognised across present accounting bodies. In simple terms, they help bring consistency in record maintenance and reduce the scope of ambiguity and complexity for the accountants or the other accounting professionals, making the financial statements easy to understand for the stakeholders or the users. The financial institutions or accounting bodies can alter or surpass any accounting convention whenever they require; doing so will lead to a better, true, & fair presentation of financial records. So, they are quite flexible in the hands of authoritative bodies.
Did you know? Convention of materiality, one of the major conventions of accounting, dissuades misreporting and omission of material details that could affect the decision of financial statements’ users.
Why do accountants use Accounting Conventions?
The main objective of systematising the accounting conventions was to bring uniformity and similarity in the books of accounts while maintaining them. In other words, they provide the accountants with some guidance in bookkeeping and the preparation of financial statements and financial reports.
Let's now discuss and understand the major accounting conventions:
Convention of Conservatism
The convention of conservatism emphasises anticipating all the possible future losses and ignoring the uncertain gains and profits. As the name suggests, the convention of conservatism advises taking a conservative approach. It means that a business should not acknowledge or account for any anticipated profit or income until they are realised in actuality. The convention of conservatism suggests being prudent, which means recording all the foreseeable expenses and liabilities even if their occurrence is not certain but do not record any revenue if their realisation is not certain.
For example, to provide for the due taxes and duties, the entities create 'provision for tax' in their books in the context of tax liability which is not yet incurred. And most of the entities create a provision in the name of 'provision for doubtful debts' against their sundry debtors based on their experience or business's customs. It means they are already accounting for the loss that might occur in the future as per their experiences, even though their current debtors have neither stated nor shown any sign of defaulting in payment.
Another example of adopting the convention of conservatism is that the entities record the closing inventory in the books at 'cost' or net realisable value, whichever is lower rather than recording it at the sale price of such inventory, which is frequently higher than the cost. Because recording the closing stock at the sale value implies that an entity is accounting for anticipated income, which is not even realised yet, which is inaccurate.
The convention of materiality makes a point that the financial statements should include all the facts and information which is material. Whether a fact or information is material or not is a subject matter of judgement in the hands of an accountant or the bookkeeping professional. But they should focus on including all the facts in the financial statement, which can influence the stakeholders' decision or other users of the statements.
Hence if there is any information whose omission, exclusion or inappropriate reporting might impact the decisions of the stakeholders, then such information is material and by any chance can not be ignored while preparing financial statements. If there's any information available that the reasonable users will not acknowledge while making their decision, then such information is immaterial, and there's no need to report it specifically.
The concept of materiality may vary for every entity, with nature and size.
For example, default in payment of ₹10,000 by any debtor is a material amount for an entity whose net worth is ₹2 lakhs. Still, at the same time, it is comparably immaterial for an entity with a net worth of ₹20 crores. So, the convention of materiality emphasises including significant and credible facts in financial statements. And this leads to the presentation of financial statements to its user in a more understandable and time-effective manner.
Another example of this convention can be the materiality of the threshold. The materiality of the threshold usually states that when any expense accounts for more than 10% of the net income of an accounting period, it should be considered material and should be recorded separately. If any expense is below 5% of the net income, it can be considered immaterial. The expenses in the range of 5% to 10% are subject to the accountant's matter of judgement.
Convention of Disclosure
The convention of disclosure implies that statements should be qualified enough to disclose all the relevant, material and potentially important information properly so that the reasonable users can make calculated decisions with the assistance of such provided information. The convention requires the accountant to disclose all the financial information in the statements and reports.
The disclosure can be made in one of the following ways:
- In the body of financial statements
- In the notes accompanying the financial statements
And if any major incident occurs between the date of preparation of financial statements and the date of finalisation of audited financial statements, which is materially significant and financially relevant, it shall be disclosed and accounted as an adjusting event or an event occurring after the balance sheet date.
There are various stakeholders of financial statements, and they require such statements for their respective purposes.
Generally, these stakeholders are investors, banks, financial institutions, debtors, creditors, employees, management, auditors, government, other authorities, etc.
Banks and Financial Institutions closely pay attention to an entity's liquidity position, which is often checked from liquidity ratios of the entity. They are also concerned with their interest coverage ratios.
Investors and the Shareholders analyse the profitability ratios and the entity's record of profit distribution. Shareholders also consider the Diluted Earning Per Share (EPS) and the retained earnings before making any decision.
The employees are concerned with the employee benefits and the future goals & objectives of the entity. All of these stakeholders rely upon the financial statements of an entity to make rational decisions regarding it.
So convention of disclosure helps them provide a more precise and honest position of the business/entity. For example, the profit of an entity can increase due to numerous reasons. But if it increased because the entity had revalued its property, plant and machinery as per market rate, and if such a rate exceeds the carrying amount of such fixed assets, there is revaluation profit.
Profits can be accounted for in the books on the revaluation date but can be booked only on the sale of the fixed asset. So, to provide a fair and true picture of the entity's financial position to its potential users, the convention of disclosure requires the accountant to disclose the revaluation profit separately.
Another relevant example for the Convention of Disclosure can be in the context of loans.
When there is a loan liability in an entity's books, accountants should disclose the details of such loans, but under two separate heads, 'secured loans' and 'unsecured loans'. It helps the potential finance providers of the entity in making decisions regarding further engagements with such an entity.
Convention of Consistency
The convention of consistency states that an entity should stay consistent and follow a particular accounting method or a particular accounting principle in preparing its financial statements. If an entity adopts a particular accounting principle or method in an accounting period, it should stick with the same principle or method in the upcoming accounting period. Consistencies in the books make the comparison of financial statements possible. The convention of consistency makes comparing financial statements of two different periods easier and quicker.
Making unnecessary changes in the accounting methods will only complicate the comparison process and make it quite ambiguous. This convention sounds rigid, but it does not restrict an entity from changing any accounting principle or method. The entity can change its accounting method whenever necessary, making the financial statements more righteous and reliable. But whenever there is any change, the disclosure regarding such change should be made in the financial statements
Convention of consistency does not only help the outside users only, but it also helps the management of the entity. Consistency helps the managers compare and understand the final results of two accounting periods and evaluate the discrepancies in such results. Eventually, this helps them make more appropriate decisions and set more achievable goals. Hence, we can conclude that the convention of consistency promotes the accuracy and reliability of financial statements. And it also promotes effective decision making among its users.
For example, if an entity has adopted the Straight Line Method (SLM) for depreciating the Plant & Machinery in the accounting period in which the business purchased such asset, then it should depreciate such Plant & Machinery by SLM method during its life. The entity can change the depreciation method to the Written Down Value method or any other method only if such change is necessary or will provide with better presentation of financial statements. And a proper disclosure of change in method of depreciation must be made, and accountants should also disclose its effect on statements.
Another example can be regarding the Inventory Valuation method.
An entity can choose First In, First Out (FIFO) or Last In, First Out (LIFO) or Weighted Average Cost (WAC) method for valuation of its inventory. But once a method is adopted, the entity should stay consistent with it unless the change is required or necessary.
What are the benefits of the Accounting Conventions?
- They help in bringing uniformity and consistency to the financial statements.
- Uniformity eventually makes it possible to compare the results with other firms in the same industry or same market.
- Consistency leads to the easy comparison of various accounting periods' financial results.
- They enhance the accuracy of the financial statements and, ultimately, the financial reports' efficiency.
Also read: Know the Basics of Managerial Accounting
- Accounting Conventions makes financial statements more reliable, credible, trustworthy and user friendly.
- They reduce the scope of mistakes, errors, the occurrence of frauds and misrepresentation of financial statements.
- They help the management in better & realistic planning and make future decisions of the entity by acknowledging the possible and anticipated uncertainties.
- They support the idea of true and fair presentation of the financial position of an entity.
On the one hand, the accounting convention helps the accountants and auditors in bookkeeping, accounting, and finalising the financial statements in the most honest manner. It guides them in addressing some transactions that are not yet fully addressed by financial standards.
On the other hand, it also aims for proper accounting of financial activities so that the interest of potential stakeholders stays unharmed. It ensures that the financial statements or reports should not be deceiving towards the investor end.
So, it considers both the makers and consumers of the financial data and assists them in every possible way.
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