What is Accounting Convention?
Accounting Conventions are certain guidelines or principles that help organizations determine the proceedings of recording business transactions that are complicated, unclear, or not fully addressed. Although these restrictions and guidelines are not legally binding, they are generally accepted by the authorities as these principles help maintain consistency and avoid practical obstacles during the preparation of the financial statements of businesses. Accounting conventions are used in the standard financial reporting system for comparing different forms of transactions, analyzing their significance, applicability, and complete disclosure in the financial statements. Accountants try to implement the principles of accounting conventions while preparing accounting statements and reports.
Geeky Takeaways:
- Accounting conventions are a set of guidelines that help businesses determine the proceedings of recording business transactions that are complicated, unclear, or not fully addressed.
- These principles are not legally binding, however, they are widely accepted by the accounting authorities.
- Suppose an oversight organization (such as parliament, government, supreme audit organizations, or ombuds office) defines certain principles that convey the topic relating to the accounting convention, then the accounting convention is no longer relevant.
- There are four types of accounting conventions: consistency, conservatism, materiality, and full disclosure.
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Accounting Convention Relationship with Accounting Standards
In accounting, there exist conventions, concepts, assumptions, and standards. In standardizing the financial reporting process, concepts like relevance, comparability, materiability, and dependability are supported by accounting conventions.
When a particular situation is not mentioned in the accounting standard, then the accounting convention comes to the rescue. This means that accounting conventions covercover the areas where accounting standards don’t exist. In case of an oversight organization or regulatory body such as the Financial Accounting Standards Board (FASB) or the Securities Exchange Commission (SEC) creates a rule that is covered in the accounting convention, then this accounting convention is no longer relevant.
The area and scope of accounting standards is steadily broadening thus making the use of accounting conventions narrower. Further, these conventions are flexible, i.e., with time different ideas, options, and dimensions can be created to effectively and efficiently record business transactions.
Accounting conventions are essential as they ensure that there is uniformity in recording transactions among the different organizations. It becomes easier for investors to evaluate and comparing the performance of different organizations, including competitors of the same industry, using a standardized technique. This does not mean, that the accounting conventions are perfect. Sometimes, due to their vagueness and improper explanation, accountants and users of several companies have to modify and groom to their benefit.
Types/Methods of Accounting Conventions
1. Conservatism: The conservatism principle means to play safe while recording transactions considering all the possible negative scenarios. There are particular stances where the conservatism principle can be criticized. For instance, the market value and book value are two values for recording a particular asset. Considering the worst-case scenario as per the accounting convention, the lower value of the asset is considered. Further, in some other cases, private reserves are mentioned representing excess allocation for bad and doubtful debts, depreciation, etc. This violates the principle of the true and fair value of financial conditions.
2. Consistency: If a business adopts a particular method for reporting its transactions, it should maintain the consistency of continuing that method for rest of the years. When reading, analyzing, and comparing the financial statements of the company, analysts and investors might benefit from this principle. If the business wishes to alter the procedure, it should only do so if there are valid reasons to do so. certain arguments challenge this principle, such as the idea that accounting consistency is violated when certain things are valued at market value while others are considered at cost. Accounting convention, however, takes into account uniformity in reporting techniques throughout time rather than uniformity concerning line items in comparison.
3. Materiality: The influence of an event or item and its applicability in financial statements are included in the materiality convention. That is, when an item is not material, materiality permits an accountant to disregard certain principles. Any such occurrences or anything that could affect an analyst’s or investor’s judgment must be reported by the accountant. The information should, however, be valuable enough to warrant further inquiry and be worth more than the expense of statement preparation.
4. Full Disclosure: Even after including the accounting convention, full details, and relevant and essential information related to the financial status of the company must be mentioned in the financial statements. For instance, contingent liabilities and lawsuits against the company must be disclosed in the footnotes of the financial statements.
Importance of Accounting Convention
1. Separate Entity: The accounting conventions are important while dealing with different entities in the financial world. They ensure that organizations despite their type of business can adopt standardized guidelines for reporting financial transactions by setting uniform criteria. This consistency and standardization are important for building a uniform ground for businesses encouraging fair comparisons across organizations and developing a thorough knowledge of financial statements among stakeholders.
2. Understanding: Accounting conventions enable stakeholders and financial specialists with a common language. They offer a shared understanding of the recording and reporting procedures for financial data, facilitating accurate interpretation. Because it allows users to analyze financial data and make informed judgments based on a set of standardized principles, this understanding is essential for decision-making.
3. Reliable: Reliability is the cornerstone of financial reporting, and accounting practices are essential to preserving this essential attribute. When rules are applied consistently, financial statements accurately depict the state and performance of a company’s finances. Stakeholders, including creditors and investors, rely on accurate financial data to make informed decisions.
4. Comparison: Uniform accounting principles enable meaningful comparisons across different entities. For investors, analysts, and other stakeholders evaluating the performance and financial situation of various organizations, this comparability is important. It facilitates benchmarking and aids in identifying market trends, which improves decision-making.
5. Impact on Money: The direct effect that accounting conventions have on how monetary values are represented in financial statements is one of their most important features. By offering a regulated and standardized approach to measuring and recording financial transactions, these conventions guarantee the precision and correctness with which an entity’s monetary condition is reported.
Advantages of Accounting Convention
1. Credibility: Financial statements that are prepared in compliance with accounting guidelines and standards are far more accurate and dependable. Investor confidence is bolstered by it.
2. Planning and Decision: Accounting conventions help in planing and take decision as it provides essential financial data.
3. Ease in Comparison: Accounting conventions guarantee that the transaction is reported by several businesses in the same way as stated. This facilitates the process of comparing the performance of peer groups of companies for investors, creditors, and analysts.
4. Efficiency: Accounting conventions and standards streamline the reporting process and make it simpler for accountants. Users of these financial statements also benefit as all organizations apply and adhere to these standards.
5. Managerial Decisions: They support managers in making crucial choices that have an impact on the company. For example, the principle of Prudence ensures that revenues are recorded at the time of realization, but obligations and expenses are recorded at the time of occurrence.
6. Reduction in Frauds: Accounting standards provide a comprehensive explanation of the norms about specific company operations. Accounting conventions ensure that financial statements present pertinent information in a specific way even though they are not legally binding.
Disadvantages of Accounting Convention
1. Uncertainty: A lot of accounting rules leave out important details about ideas or transactions that are documented in financial accounts. As a result, they are making it simple for management to manipulate certain numbers with the help of the accountant, such as depreciation and provisions for bad debt.
2. Manipulation: Despite being intended to prevent manipulation, these conventions frequently assist the company’s management in manipulating particular financial data through the reporting process, which presents an inaccurate image of the financial health of the organization.
3. Lack of Consistency: Liabilities and expenses are documented as soon as they happen, but assets and revenue are recorded at cost and transaction completion. They make decisions based on worst-case scenarios, which may not accurately represent the company’s circumstances.
Areas Where Accounting Conventions Apply
1. Valuation of Inventory: Inventory valuation can be done using accounting conservatism. Conservatism implies that the lower of historical cost or replacement cost should be the monetary value for establishing the reporting value of inventory.
2. Market Valuation or Inflation: Additionally, line item adjustments for market value or inflation are prohibited by accounting rules. This implies that book value may not always equal market value, rather it can be a lower value than the market price. For instance, if a building is bought for $50,000, it should be recorded on the books at $50,000 even if its value has increased after that.
3. Casualty Losses and Receivables: The conservatism principle is used to estimate such as the uncollectible accounts receivable and casualty losses. A business cannot record a gain from a lawsuit that it expects to win unless all revenue recognition requirements are satisfied. On the other hand, an estimated economic impact must be included in the notes to the financial statements if it is anticipated that a lawsuit claim would be lost. Disclosure of contingent liabilities, such as unearned revenue or royalties, is also required.
Frequently Asked Questions (FAQs)
What is the difference between accounting concepts and accounting conventions?
Accounting concept is known to help prepare and record financial transaction along with maintaining the bookkeeping processes. Whereas, accounting convention are guidelines which maintain a standardize reporting of unclear and complicated transactions.
Which accounting convention method is better?
All the methods have their own applicability and speciality. There is no proper explanation of the accoutning convention methids. Depending the type of business, different methods is applicable and beneficial for different businesses.
What if accounting convention is not used?
If accounting convention are not used, then the financial statements of the company cannot be comparable. It will be difficult for investors to make informed decisions on that particular company. Accounting conventions help with consistency in reporting and major .