Financial Accounting Conventions | Importance of Accounting Conventions |

 ACCOUNTING CONVENTIONS:

In this session, explain What is Accounting Conventions and its importance and limitation. 

What is Accounting Conventions:

Accounting conventions are strategies or procedures which are widely accepted. When transactions are recorded or interpreted, they observe the conventions. On many occasions, however, the terms-principles, concepts, and conventions are used interchangeably.

Professional Accounting Bodies have published statements of these concepts. Over years, many of those concepts are being challenged as outlived. 

Yet, no main deviations have been made as yet. Path-breaking ideas have emerged and the accounting standards of modern days do require firms to record and report transactions that may not be necessary based on concepts that are in vogue for long. 

It is important to study accounting from the basic levels and perceive these concepts in entirety.

There are different types of Accounting Conventions which are describing below:

Accounting Conventions of Disclosure:

The Accounting Conventions of disclosure implies that accounts must be honestly prepared and all material information must be disclosed therein. The notion is so important(because of divorce between ownership and management) that the Companies Act makes ample provisions for the disclosure of essential information in the company accounts. 

The contents of the balance sheet and profit and loss account are prescribed by law. These are designed to make disclosure of all material facts compulsory.

 The term disclosure does not imply that all information that anyone could conceivably desire is to be included in accounting statements.

 The term only implies that there is to be a sufficient disclosure of information which is of material interest to proprietors, present and potential creditors, and investors.

 The practice of appending notes relative to various facts or items which do not find a place in accounting statements is in pursuance to the convention of full disclosure of material facts. Examples are:

• Contingent liabilities appearing as a note,
• The market value of investments appearing as a note.

 Business is now increasingly managed by stewards(managers) and they owe a duty to make full disclosure to the persons who have contributed the capital.

 Financial accounting, while reporting on stewardship, has to make full disclosure. Openness in company affairs is the best way to secure responsible behavior.

 Because of the wide recognition of this principle now there is an Accounting Standard that requires the disclosure of all significant accounting policies adopted in the preparation of financial statements, due to the effect of such policies on the financial statements. 

                 

 The accounting principle of Going Concern, Consistency, and Accrual are considered fundamental in the preparation of financial statements and need not be disclosed. 

Only when the assumption is not followed the fact should be disclosed. Apart from the disclosure of accounting policies, A.S.-1 deals with information to be disclosed in financial statements.

Read Also:  The Accounting Concepts with examples.

The concept of disclosure also applies to events occurring after the balance sheet date and the date on which the financial statements are authorized for issue. 

Such events include bad debts, destruction of plant and equipment due to natural calamities, major acquisition of another enterprise, and the like. 

Such events are likely to have a substantial influence on the earnings and financial position of the enterprise. Their non-disclosure would affect the ability of the users of such statements to make proper evaluations and decisions.

Accounting Conventions of Materiality:

The role of Accounting Conventions of Materiality cannot be over-emphasized in as much as accounting will be unnecessarily overburdened with more details in case an accountant is not able to make an objective distinction between material and immaterial matters. American Accounting Association (AAA) defines the term materiality as under:

An item should be regarded as material if there is reason to believe that knowledge of its would influence the decision of an informed investor.

Kohler has defined materiality as under:

The characteristic attaching to a statement, fact, or item whereby its disclosure or the method of giving it expression would be likely to influence the judgment of a reasonable person.   

Some examples of material financial information to be disclosed are likely to fall in the value of stocks, loss of markets due to competition or Government regulation, increase in wage bill under recently concluded agreement, etc. 

It is now agreed that information known after the date of the balance sheet must also be disclosed.

 Another example, Accounting Conventions of materiality is the question of the allocation of costs. An item of small value may last for three years and technically its cost must be allocated to every one of the three years. 

Since its value is small, it can be treated as the expense in the year of purchase. Such a decision is in accordance with the principle of materiality.

 Likewise, unimportant items can be either left out or merged with other items. Sometimes items are shown as footnotes or in parentheses according to their relative importance.

 It should be noted that an item material for one concern may be immaterial for another. And similarly, an item material in one year may not be material in the next year.

 As per A.S.-1, Accounting Conventions of materiality should govern the selection and application of accounting policies. According to the consideration of materiality financial statement should disclose all items which are material enough to affect evaluation or decisions.

Accounting Conventions of Consistency:

In order to enable the management to draw important conclusions regarding the working of a company over a number of years, it is but essential that accounting practices and methods remain unchanged from one accounting period to another. 

The comparison for one accounting period with that in the past is possible only when the Accounting Conventions of consistency are adhered to. But the idea of consistency does not imply non-flexibility as not to permit the introduction of improved techniques of accounting. 

 According to A.S.-1 Accounting Conventions of consistency is a fundamental assumption and it is assumed that accounting policies are consistent from one period to another. Where this assumption is not followed, the fact should be disclosed together with reasons.

The principle of consistency plays its role particularly when an alternative accounting method is equally acceptable. 

For example, in applying the principle that fixed asset is depreciated over its useful life a company may adopt any of the several methods of depreciation, viz.,written-down-value method, straight-line method, sinking fund method, annuity method, sum-of-years-digit method, unit-of-production method, or any other method.

Read: What is the depreciation in accounting?

But in keeping with the Accounting Conventions of consistency, it is expected that the company would consistently follow the same method of depreciation which is chosen. Any change from one method to another would result in inconsistency.

In the following cases, however, there is no inconsistency although apparently they make look inconsistent:

• The application of principle for stock valuation at cost or market price whichever is lower will result in the valuation of stock sometimes at cost price and sometimes at market price. But there is no inconsistency here because the shift from the cost to market is only the application of the principle.
• Similarly, if investments are valued at cost or market price whichever is lower, it is only an application of the principle.

Kohler has talked about three types of consistencies:

• Vertical consistency: This consistency is maintained within the interrelated financial statement of the same day. Vertical inconsistency will occur when an asset has been depreciated on one basis for income statement and on another basis for the balance sheet.
• Horizontal consistency: This enables the comparison of the performance of an organization in one year with its performance in the next year.
• Third-dimensional consistency: This enables the comparison of the performance of one organization with the performance of other organizations in the same industry.

Accounting Conventions of Conservatism:

Accounting Conventions of Conservatism is the policy of playing safe. It takes into consideration all prospective losses but leaves all prospective profits. This accounting principle is given recognition in A.S.-1 which recommends the observance of prudence in the framing of accounting policies. Uncertainties inevitably surround many transactions. This should be recognized by exercising prudence in financial statements. Prudence does not, however, justify the creation of secret or hidden reserves. 

Following are the examples of the application of the Accounting Conventions of conservatism:

• Making the provision for doubtful debts and discount on debtors in anticipation of actual bad debts and discount,
• Valuing the stock in trade at market price or cost price whichever is less,
• Creating provision against fluctuation in the price of investments,
• Charging of small capital items, like crockery, to revenue,
• Adopting the written-down-value method of depreciation against the straight-line method. The written-down-value method of depreciation is more conservative in an approach.
• Amortization of intangible assets like goodwill which has an indefinite life,
• Showing join life policy at surrender value as against the amount paid,
• Not providing for a discount on creditors,
• Taking into consideration claims intimated but not accepted as a loss for calculating profit for a general insurance company,
• Considering the loss relating to premium on the redemption of debentures when they are issued at par or at discount but redeemable at a premium, at the time of their issue.

 The principle of Accounting Conventions of conservatism is applied:

• When there is uncertainty inherent in the activity, e.g., uncertainty as to the useful life of an asset, occurrence of loss, the realization of income, the remaining utility of an asset, estimated liability.
• When there are two equally acceptable methods then the one which is more conservative will be accepted.
• When there is a judgment based on estimates and doubt exists as to which of the several estimates is correct, the most conservative would be selected.
• When there is a possibility of the occurrence of a loss or profit, losses will be considered and profits will be overlooked.

 The principle has an effect on:

• Income statement:- Here the principle results in lower net income than would otherwise be the case.
• Balance sheet:- When applied to the balance sheet, the conservative approach results in an understatement of assets and capital and overstatement of liabilities and provisions.

Let us take an example. A company had purchased goods for 12 lakhs before the end of an accounting period. If sold at the usual selling price, the goods would fetch the price of  15 lakhs. 

Due to the innovative products introduced by the competition, the goods are likely to be sold for 10 lakhs only. Which value should the goods be shown in the balance sheet? 

Would it be at 12 lakhs being the actual cost of buying? Or would it be at  10 lakhs? 

Here, the Accounting Conventions of the conservatism principle will come into play. The stock of goods will be valued at 10 lakhs, being the lower of cost or net realizable value, as per AS-2.

The principle of conservatism, however, should be applied cautiously. If the principle is stretched without reservations it results in the creation of secret reserve which is in direct conflict with the doctrine of full disclosure.

Timeliness Concept

Under this principle, every transaction must be recorded at the proper time. Usually, when the transaction is made, the same must be recorded in the proper books of accounts.

 In short, transactions should be recorded date-wise in the books. Delay in recording such transactions may lead to manipulation, misplacement of vouchers, misappropriation, etc. of cash and goods. 

This principle is adopted particularly while verifying day-to-day cash balance. The principle of timeliness is also followed by banks, i.e. every bank verifies the cash balance with their cash book and within the day, the same must be completed.

CONCLUSION

The above paragraphs bring out essentially broad concepts and Accounting Conventions that lay down principles to be followed for an accounting of the business transaction. 

While going through different topics, students are advised to keep track of concepts applicable to various accounting treatments. One would have by now understood the importance of these concepts in the preparation of basic financial statements. 

More clarity will emerge as one explores the ocean of different business transactions arising out of complex business situations. The legal and professional requirements also have their say in deciding the accounting treatment.