Accounting Conventions and Concepts

Accounting
Accounting Finance

Accounting Conventions and Concepts

What is Accounting Conventions?

Accounting conventions are principles or guidelines suggested by professional bodies based on previous experiences in the industry which involves professional judgment. These focus on the true and fairness of the financial statements. These conventions provide general guidelines for situations not completely dealt with by the specific accounting standards, The job of any AS is “to limit” the possible accounting treatments for a given situation. Basically, accounting conventions are common practices which will act as a guideline for the entities to record few business-specific types of business transactions, which are not specifically dealt by any AS.

Accounting Conventions and Concepts

Accounting conventions are principles or guidelines suggested by professional bodies based on some standard thought process involving professional judgment, prevalent over the years so as to focus on the true and fairness of the financial statements and these conventions provide general guidelines for situations not completely dealt with by the specific accounting standards.

Brief Explanation

Accounting standards (AS) are nothing but recommendatory procedures to be followed by all entities so that a common practice is prevalent in the industry. The job of any AS is “to limit” the possible accounting treatments for a given situation.

  • However, no standard in the world can cover standard solutions for every problem. Some problems are to be dealt with “using the experience” and there cannot be an AS for every problem. This is the job of accounting conventions.
  • Basically, accounting conventions are common practices which will act as guideline for the entities to record few business specific types of business transactions, which are not specifically dealt by any AS.
  • Now, these practices are commonly accepted by all professionals across the globe. These are presently developed due to past experiences and may change according to the change in the financial world or change in the nature of businesses.
  • The focus of accounting of convention is true and fairness of the financial statements, which in turn ensures that financial statements for any company within the same industry are easily comparable. Comparability helps the decision making of the reader of financial statements.

Types of Accounting Conventions

Let us now discuss the top 5 accounting conventions:

  • Consistency:

This is the most basic accounting convention. It helps the reader of financial statements to conduct a time-series analysis of the Company. Time-series analysis means the comparison of the same company year on year. Now, the obvious question arises “what if a company changes the accounting treatment for a transaction every year?” The reliability of the reader is lost due to frequent changes in treatment. The only concern of this convention is that, whatever principle, concept, the treatment you wish to follow, you should follow it consistently. However, this convention allows an entity to change the treatment with disclosure regarding the financial impact of such change.

  • Historical Cost:

This convention specifies that the transactions should be recorded at the price prevailing at the time of the transaction itself. Thus, assets are to be recorded at their original costs. Even if assets are to be retained and used for the business for a longer period of time, these should not be recorded at market value. However, specific accounting standards do allow an option to the entity to revalue its assets. This convention applies when there is no specific accounting standard applicable for valuing the transaction.

  • Disclosure:

Every corporate law specifies the format of the presentation of the financial statements. This format is nothing but a framework. In the absence of any such framework, the accounting standards provide a framework. Such frameworks often require the disclosure of various treatments, policies, assumptions, and estimates taken by the management. Now, the disclosure convention merely requires the entity to disclose every essential information (not all information) which may be necessary (i.e., significant) for the reader of the financial statements. Disclosure helps in independent decision making. 

  • Prudence

Prudence is also called conservatism. This convention simply states that we cannot anticipate the gains or profits since, without any reliable base, we may not realize the cashflows. However, this convention favors the fact the losses can be anticipated at any time and so does the doubtful debts. Thus, this convention askes to recognize the anticipated losses but not the anticipated gains.

  • Materiality:

Information is said to be material, if such disclosure may influence the decision making of the users. If it does so, such information should be disclosed with complete facts. For example, all expenses cannot be reported in the financial statements by way of notes. We need to club many expenses as “miscellaneous expenses” at the end of the note. However, materiality convention generally requires that nature-wise expenses should be reported which exceeds 1% of the revenue from operations. For individual nature of expenses, falling below 1% criteria may be clubbed as miscellaneous expenses. 

Example of Accounting Conventions and Concept

Sr. No. PARTICULARS EXAMPLE
1 Consistency
2 Historical Costs A building has been purchased at $ 500,000 in the year 2018. The market value of the building is $ 615000 in the year 2020. Historical cost convention requires the building to be valued at $ 500,000 only. 
3 Disclosure A Company has ongoing litigation. The company expects 10% chances that the company will lose the case. In such a case, the disclosure convention requires the company to disclose the fact as “contingent claims” so that readers have complete of the fact.

On the other hand, even if the company is 100% assured that it will win the case, it cannot disclose the gain. This restriction is imposed by prudence convention.

4 Prudence Accounts receivables as of the balance sheet date are $ 625,000. However, as a matter of previous experiences, the management has estimated that approximately 5% of debts may be doubtful. In such a case, the Prudence convention requires the company to make a provision for doubtful debts i.e., $ 31,250

Another example can be a valuation of inventory at cost or realizable value, whichever is less. Prudence requires the inventory to be valued at “lower of the two” and does not allow upward revaluation of inventory.

5 Materiality The company is engaged in the business of manufacture of mobiles. It incurs the commission expense on the sale of the mobile phones through dealers and online retailers both of which forms 5% of total revenue. Materiality convention requires separate line of item presentation in notes to accounts.

The Company incurs repair of building expense which is hardly 0.5% of total revenue. Materiality convention allows such expense to be clubbed under miscellaneous expenses.

Conclusion

Accounting convention simply assists in resolving the conflicting situations for which no solution has been provided by any specific accounting standard. The overall conventions help in the consistent and efficient flow of information from the detailed accounting books to the summarised financial statements. On the other hand, the conventions ensure that sufficient disclosure of facts has been made.

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