What is Accounting Convention?
Accounting conventions are certain guidelines for complicated and unclear business transactions, though it is not compulsory or legally binding, however, these generally accepted principles maintain consistency in financial statements. While standardizing financial reporting process these conventions consider comparison, relevance, full disclosure of transactions, and application in financial statements.
There are specific problems faced by accountants while making financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. regarding certain business transactions, which are not entirely specified by accounting standards that are addressed by accounting conventions. It is referred to when; there is uncertainty in business transactions and when accounting standards fail to address such issues.
Types of Accounting Convention
#1 – Conservatism
The accountant has to follow the conservatism principle of “playing safe” while preparing financial statements, considering all possible scenarios of loss while recording transactions. Two values occurred while logging assets, i.e., Market value and Book Value, in general, a lower value is considered since these conventions consider the worst-case scenario. There are specific points used for criticizing such a principle. In some instances, it’s observed that secret reserves are being created by showing excess provision for bad debtProvision For Bad DebtA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year. and doubtful debts, depreciation, etc. And this affects the principle of ‘true and fair status of financial conditions.’
#2 – Consistency
Once a particular method is selected by the business while reporting process, it should be followed consistently in ensuing years. This principle is helpful for investors and analysts to read, understand, and compare the financial statements of the company. If the company wants to make a change in method, it should do so only with proper reasons to make specific changes. There are certain points, which criticize this principle, like considering certain items on a cost basis while others at market value void the principle of consistency in accounting. Still, accounting convention considers consistency in reporting methods over the years and not consistency with line items in comparison.
#3 – Full Disclosure
Relevant and important information regarding the financial status of the company must be revealed in financial statements even after the application of the accounting convention. E.g., Contingent LiabilitiesContingent LiabilitiesContingent Liabilities are the potential liabilities of the company that may arise at some future date as a result of a contingent event that is beyond the company's control. , Law Suits against a business should be reported in adjoined notes in the financial statements of the company.
#4 – Materiality
Materiality ConceptMateriality ConceptIn any financial accounting statements, there are some transactions that are too small to be recognized and such transactions might not have any impact on the analysis of the financial statement by an external observer; removal of such irrelevant information to keep the financial statement crisp and consolidated is called as the concept of materiality. includes the impact of event or item and its relevance in financial statements. The accountant must report all such events and items that might influence the decision of investors or analysts. However, the information should be worthy of investigation and should have high value than the cost of preparation of statements. It means materiality allows an accountant to ignore certain principles when items are not material. For, E.g., Low-cost assets like stationery, cleaning supplies are charged under expense accountExpense AccountExpense accounting is the accounting of business costs incurred to generate revenue. Accounting is done against the vouchers created at the time the expenses are incurred. instead of regular depreciating assets. Such issues have very little importance.
- If Company built a plant worth $250,000 10 years ago, it should remain as per book value even today.
- Revenues for the firm are recorded only after realization while Expense, loss, a contingent liability, is recorded as soon as it occurred.
- Monetary Impact: Accounting considers only items and events with monetary value. Items such as Market leadership, management efficiency, skills are not considered in accounting as it does not directly reflect the financial impact on business.
- Different Entity: Accounting convention makes sure that private transactions of owners should not interfere in business transactions. Since businesses and owners are treated as two separate legal entities by law, this should be followed in business as well.
- Realization: Convention concentrates on the completed transaction. Transfer of ownership or sale of an asset or product should not be considered at the point of contract, but when the entire process completes.
- Understanding: There should be clarity of information in financial statements in a certain way that investors or analyst who reads them must understand such data.
- Comparison: Many Investors and analysts compare financial statements of the company with their peers to analyze performance over a period. They make sure any information reported is in a way that will make it easy for investors.
- Reliable: They make sure reliable information is segregated and reported in financial statements.
- Neutral: They state that the accountant should make financial statements with no stake in a company or a biased opinion.
- Credibility: Financial Statements prepared according to accounting standards and conventions are much more reliable and accurate. The following specific methods disclose relevant information. It increases the confidence of investors.
- Planning and Decision: It provides enough information regarding financial data.
- Easy to Compare: Accounting conventions makes sure that multiple companies report the transaction in the same manner as described. Thus making it easy for investors, creditors, analysts to compare the performance of peer groups of companies.
- Efficiency: Accounting standards and conventions provide efficiency in the reporting process, which makes it easier for an accountant. Even users of such financial statementsUsers Of Such Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers. benefitted as such standards are applicable and followed by all companies.
- Management Decisions: They help management to make certain important decisions that affect business. E.g., the Prudence conceptPrudence ConceptPrudence Concept or Conservatism principle is a key accounting principle that makes sure that assets and income are not overstated and provision is made for all known expenses and losses whether the amount is known for certain or just an estimation i.e. expenses and liabilities are not understated in the books of accounting. makes sure revenues are recorded when realized, but liabilities and expenses are recorded as soon as they occurred.
- Reduce Fraud: It is guidelines for certain business transactionsCertain Business TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements., which are fully explained by accounting standards. Accounting conventions, although not legally binding, make sure that financial statements provide relevant information in a particular manner.
- Reduce Wastage and Save Time: Accounting convention like materiality makes sure that financial statements record all items and events worth value. This convention helps the accountant to ignore certain principles and concentrate on relevant items.
- Uncertainty: Many accounting conventions don’t wholly explain concepts or transactions, which are recorded in financial statements. They are thus making it easy for management to manipulate specific figures through the accountant, e.g., Provisions for bad debt, depreciation.
- Lacks Consistency in Different Line Items: Assets and income recorded at cost and when a transaction completes while liability and expenses are recorded as soon as it occurred. They operate with worst-case scenarios, which might not reflect actual information of the company.
- Manipulation: Although they are designed to avoid manipulation, many times, these conventions help the management of the business to manipulate specific financial data through the reporting process, which shows a different picture of a company’s financial status.
- Estimates: Certain accounting estimate might not show a clear picture of the financial data of the company.
Accounting conventions are designed to resolve the issue of certain transactions through guidelines, which are not adequately addressed by accounting standards. These conventions help many companies while efficiently reporting their financial data. At the same time, it makes sure financial statements have all relevant information for the benefit of investors.
Though these convention helps management to manipulate specific figures in financial statements, it also helps in the smoothening reporting process of a company. It makes sure relevant information is disclosed in financial data or adjoined notes. For an investor, it is essential to go through all the information before making any decision. Usage of these conventions reduces as accounting standards are developed over time and increase the level of details and answers questions.
This article has been a guide to what is Accounting Convention and its meaning. Here we discuss four types of accounting conventions and their examples and importance. You may learn more about Financing from the following articles –