Accounting conventions are a set of industry best practices adapted by company requirements to serve as guidelines to record financial transactions of the company.
The accounting conventions play a crucial role in the transition to record financial transactions as per accounting standards in the company’s accounting system.
Accounting conventions do not have any legal obligation although the whole of the accounting industry is based around the generally practiced accounting conventions.
Accounting conventions have developed over time and changes depending on changing financial conditions. The conventions promote consistency and comparability of financial statements across several domains and further the cause of accounting and bookkeeping professionals and also the users of financial statements in order to understand and draw conclusions from the financial statements. Accounting conventions are also called accounting doctrines.
The most important accounting conventions are consistency, conservatism, materiality and full disclosures. These are discussed below:
1) Convention of consistency
The convention of consistency provides that the business shall follow the same accounting principles and methods for upcoming accounting periods.
Consistency helps the users of accounting to make conclusions and draw comparisons between financial statements of different accounting periods.
The financial statements between two or more accounting periods can be only compared when the accounting convention of consistency is followed.
If the business makes unnecessary changes in accounting policies each year, it would render the comparison useless and futile.
Convention of consistency does not imply that the company shall be rigid, rather it should only adapt to accounting principles only when necessary.
The proper explanations shall be provided under disclosures to the financial statements for changes in accounting principles and methods.
The convention of consistency helps to make financial statements more accurate and helps the management as well as users of accounting to make effective decisions.
2) Convention of conservatism
The convention of conservatism provides that company shall provide for all the probable losses and anticipate no profit unless realized.
This convention is based on being prudent. The business shall record all the expenses and liabilities when it sees uncertainty of incurring loss or liability.
The business shall take into consideration the worst possible scenarios and provide for those scenarios in the financial statements. If the business is certain of realizing the revenue, only then it shall record as such in the books of accounts.
The convention of the conservatism of accounting advises to provide for all the losses and liabilities and understate the profits and assets.
Take for example, while valuing inventory, the businesses mostly following the accounting convention of recording the inventory at lower acquisition cost or market value.
Another example would be to provide for bad debts as much as possible owing to the probability of being realized.
3) Convention of materiality
The convention of materiality states that business shall include all the relevant and material facts separately in the financial statements.
Material information refers to facts, if those are being left out or interpreted in any other way other than what it is in the financial statements, it could lead to influencing the decisions of users of financial statements.
Hence, exclusion or misreporting of any material information would change and impact the decisions of users of accounting or financial statements.
If any information does not influence the decisions of users of accounting, then that information is not considered material in nature. Take, for example, the materiality of the threshold.
The accounting decides that if any expenses cross $ 500 in a particular accounting period, it shall be recorded separately and if the expenses fall below $ 500 it shall be recorded under miscellaneous expenses.
This provides that based on the professional competence of an accountant, expenses above $500 for a particular accounting period shall be considered material in nature.
4) Convention of full disclosure
The Convention of full disclosure provides that all the relevant and material information shall be properly disclosed in the preparation and presentation of financial statements.
Financial statements are analyzed by various stakeholders as management, employees, debtors, creditors, governments, banks, etc.
Hence, management needs to be concerned about the performance of the business and plan the accounting policies accordingly.
Banks and creditors are concerned about the well-being of the business and important ratios as liquidity ratios and interest coverage ratios.
The management and employees are concerned that the business shall be on the right trajectory to achieve its medium- and long-term objectives related to growth.
The business shall also appropriately disclose all the information that takes place between the date of the balance sheet and the date of publication of the balance sheet.