The term “conventions” includes those customs or traditions which guide the accountants while preparing the accounting statements. The following are the important accounting conventions.
M W E Glautier and B Underdown would like to use ‘accounting conventions’ for those principles on which accounting is based. According to them “the term ‘accounting conventions’ serve in another sense to understand the freedom which accountants have enjoyed in determining their own rules”. “We may classify accounting conventions into two broad groups-those which may be said to go to the very roots of financial accounting, which may call ‘fundamental conventions’ and those which bear directly on the quality of financial accounting information , which we shall describe as ‘procedural conventions’. “In our view, there are only two fundamental conventions which may be said to characterize financial accounting
- The entity convention which states that financial accounting information relates to the activities of a business entity only, and not to the activities of the owners.
- The money measurement convention which limits the recognition of activities to those which can be expressed in monetary terms. The alteration of either of these two conventions would change the entire nature of financial accounting.
There are several procedural convention which though of great importance affect the manner in which financial accounting information is selected ,analyzed and communicated .Some of these conventions are subjected to criticism , for example, the realization convention which holds that a gain in value may only result from a transaction. The following conventions are generally regarded as the most important conventions in this group.
1. Convention of Disclosure
The disclosure of all significant information is one of the important accounting conventions. It implies that accounts should be prepared in such a way that all material information is clearly disclosed to the reader. The term disclosure does not imply that all information that anyone could desire is to be included in accounting statements. The term only implies that there is to a sufficient disclosure of information which is of material in trust to proprietors, present and potential creditors and investors. The idea behind this convention is that anybody who want to study the financial statements should not be misled. He should be able to make a free judgment. The disclosures can be in the way of foot notes. Within the body of financial statements, in the minutes of meeting of directors etc.
2. Convention of Materiality
It refers to the relative importance of an item or even. According to this convention only those events or items should be recorded which have a significant bearing and insignificant things should be ignored. This is because otherwise accounting will be unnecessarily over burden with minute details. There is no formula in making a distinction between material and immaterial events. It is a matter of judgment and it is left to the accountant for taking a decision. It should be noted that an item material for one concern may be immaterial for another. Similarly, an item material in one year may not be material in the next year.
According to Kohler “Materiality is the characteristic attaching to a statement, fact or item whereby its disclosure or method of giving it expression would be likely to influence the judgment of a reasonable person.”
Accounting is designed by man with a set of objectives. AICPA has observed “The accounting principles cannot therefore be derived from or proven by the laws of nature.” They are rather in the category of conventions or rules developed by man from experience to fulfill the essential and useful needs and purposes, in establishing reliable financial and operating information system to control business activities. In this respect they are similar to principles of commercial and other social disciplines.
3. Convention of Consistency
This convention means that accounting practices should remain unchanged from one period to another. For example, if stock is valued at cost or market price whichever less is; this principle should be followed year after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance method, it should be done year after year. This is necessary for the purpose of comparison. However, consistency does not mean inflexibility. It does not forbid introduction of improved accounting techniques. If a change becomes necessary, the change and its effect should be stated clearly.
Again consistency increases the acceptability of the financial statements since the users are averse to frequent changes. Consistency should not be maintained at the cost of accounting development. There should be flexibility in the methods and practices employed. Otherwise it will stifle the growth of accounting thought. But full disclosure of the changes effected and its effect on the working results and financial statements of the business should be disclosed. This will help the users to ascertain the impact of the changes on the performance of the business.
4. Convention of Conservatism
The rule of the accountant is ‘anticipate no profit but provide for all possible losses’ at the time of recording the business transactions and preparation of annual financial statements. This convention means a caution approach or policy of “play safe”. This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration.
If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialize. On account of this reason, the accountants follow the rule ‘anticipate no profit but provide for all possible losses’. On account of this convention, the inventory is valued ‘at cost or market price whichever is less.’ The effect of the above is that in case market price has gone down then provide for the ‘anticipated loss’ but if the market price has gone up then ignore the ‘anticipated profits.’ Similarly a provision is made for possible bad and doubtful debt out of current year’s profits.
Because of the convention of conservatism inventory is valued at ‘lower of cost or market price and provision is made for bad and doubtful debts out of current year’s profits. But reckless application of this convention may lead to creation of ‘secret reserves’ and the financial statements may fail to disclose a true and fair view of the state of affairs of the business.