Accounting Conventions

Financial illiteracy cannot be afforded by businesspersons. It is popularly known that accounting is the soul of business. Businesspersons and managers use the language of accounting to correspond to the company’s financial details with external parties like shareholders and lenders. It helps you talk business. 

In businesses, accountants are the senders and third parties are the receivers of financial and economic information. Third parties include parties that are associated with the company or organization. 

Any language has a framework that is followed while writing or communicating it verbally. Similarly, accounting follows certain guidelines that aid businesspersons when required. 

What are Accounting Conventions?

Accounting conventions are basic standards that aid companies and business organizations determine how to chronicle particular transactions that have not been completely addressed by accounting norms. 

These accounting conventions are not legally binding but are respected and accepted by accounting bodies. These rules are not hard and fast but should be used as general guidelines for selecting the appropriate accounting methods. 

Why were these Conventions outlined?

• They were outlined to encourage consistency and help accountants combat practical issues that can arise while drafting financial statements

• At times, there is no conclusive guideline present in accounting standards that can help govern a particular condition

• Accounting conventions are referred to, in such conditions
• The accounting domain is filled with assumptions, standards, notions, concepts, conventions, and so on

What are the types of Accounting Conventions?

There are five main accounting conventions in existence. Namely, consistency, full disclosure, convention of materiality, conservatism, and cost-benefit. Concepts like relevance, reliability, materiality, and comparability are usually supported by accounting conventions. They help to simplify the financial chronicling process. 

If supervising organizations such as the Securities and exchange commission (SEC) or the financial accounting standards board (FASB) put ahead standards that address the same topic as the accounting convention, the conventions are void. Let us now see and understand the five main accounting conventions: 

• Consistency

This accounting convention requires accountants to make use of accounting methods and practices in a way that allows comparability in the accounting formation from one period/epoch to another. 

It focuses on the comparability of economic information. Consistency enables users to compare the information in economic or financial statements from one period to another. 

An organization should apply the same accounting standard across various cycles of accounting. Without this convention, the creditor’s ability to compare and analyse how the organization works from one period to the subsequent periods becomes tougher. 

If an inconsistency is observed from one period to the other due to a change in the accounting practices, the organization needs a disclosure in a note to financial statements explaining exactly why the change has been made.

• Full disclosure

The full disclosure convention focuses primarily on the transparency and accountability that the company offers in its financial or economic statements so that they do not mislead the users, investors, creditors, and so on. 

True to its name, it requires the organization to completely disclose all the relevant information to the user’s understanding of the financial statements. The information should be revealed even if it is potentially damaging to the company.

There is always a note to economic statements which discloses a lot of crucial information such as accounting methods used in drafting financial statements, change in accounting methods, important events arising after the balance sheet date, and so on. 

• Convention of Materiality

Similar to the full disclosure convention, the convention of materiality urges organizations to disclose all the relevant assets and information. If an asset or even is material that is, important; then it should be disclosed. 

Any information that could potentially influence the decision of a user looking at the financial statements, must be disclosed. 

In the convention of materiality, materiality refers to something that matters; something that is important and significant. 

It is usually determined by the dollar value of the asset in the financial statement. 

The nature of the asset also determines whether the asset is material or not. Let us see this convention with an example: A ten lakh misstatement may be negligible for a million-dollar company but, if the misstatement is due to theft, bribery, or if it is fraudulent, then it is material.

• Conservatism

Playing it safe is both an accounting principle and an accounting convention. Conservatism refers to being prudent and pragmatic when dealing with uncertain financial situations. Conservatism requires accountants to be alert and cautious when drafting financial statements. 

This convention has an approach of assuming the worst-case scenario, in which the assets and the revenue tend to be understated while liabilities and expenditures tend to be overstated. 

In this approach, net income should never be overestimated.

A provision for losses should always be prepared. 

Let us understand this convention with an example: When an organization needs to make a choice between two pragmatic solutions in accounting practices, it should choose the one that is least likely to result in an overstatement of net income. 

• Cost-benefit

It refers to the accounting process that contemplates the benefit against the cost of offering accounting information. In this convention, accounting information should be provided only if the benefit outshines the cost.

The company should always regulate the minimum acceptable level of relevance and dependability that is required by applicable accounting standards such as GAAP or IFRS. 

Let us understand this convention with an example: Companies today provide only a summary of financial information in their annual report. This is done because costly financial reports overwhelm external users of financial statements in which usually little benefit is provided. 

It is important to note that detailed reports are still required to submit to related regulatory bodies and government agencies. 

What are the advantages of Accounting Conventions? 

• Accounting conventions ensure that various businesses chronicle their transactions following the same standards
• This makes it easier for the investors to compare and contrast the performances of businesses

• Accounting conventions are flexible and can be changed to suit the situation

• Conservative accounting conventions ensure that the financial statements are detail-oriented

• Accounting conventions allow uniformity even in those transactions where accounting standards do not operate

Conclusion:

The guidelines used to aid organisations on how to record financial transactions and maintaining records are called accounting conventions. While they are accepted in general and they are not legally binding and are not completely covered by accounting standards either. There are four major accounting conventions as mentioned above. It is important to note however that if an organization puts down a guideline that talks about the same topic as addressed by the accounting convention, then in that case the accounting convention is not applicable anymore.