Accounting ConventionsA review of accounting conventions that are widely accepted and used by accountants
Accounting conventions are a set of guidelines or best practices that accountants have adopted in recording and reporting business transactions in the absence of definitive guidance by accounting standards.
In this role, accounting conventions allow accountants to apply consistent practices in maintaining a company’s accounts in all instances.
Accounting conventions are generally accepted principles throughout the accounting industry, but they are not legally binding.
These conventions are used whenever an unclear situation arises and accounting standards do not provide suitable guidance.
- Accounting conventions are best practices that help company accountants to record transactions when accounting standards fail to provide suitable guidance.
- Accounting conventions are generally accepted throughout the accounting industry, but they do not create any legal obligation.
- The four most important accounting conventions are consistency, conservatism, materiality, and full disclosure.
- Whenever an accounting standard covers a given type of transaction, it should always be used instead of relying on accounting conventions.
How Are Accounting Conventions Used?
In some cases, accounting standards fail to provide suitable guidance for a given situation.
In these cases, accountants rely on accounting conventions in determining how to proceed.
These conventions are broad guidelines that help accountants determine the best course of action when accounting standards do not provide a firm rule governing a situation.
Adhering to conventions such as consistency, conservatism, materiality, and full disclosure helps to standardize the financial reporting process even in the absence of a firm rule.
Because these are not firm rules, only best practices developed by accountants over time, they are continuously evolving as new ideas develop and the general consensus evolves regarding the best way transactions can be recorded.
However, accounting standards are continuously evolving and growing as well, meaning that the situations in which accounting conventions are used are shrinking.
It is also important to keep in mind that in any case in which an oversight organization provides guidelines on how to handle a topic, it will take precedence over accounting conventions.
Despite this, they provide an important means for helping to ensure standardization in cases where accounting standards have not yet provided a firm rule.
One notable advantage to this is that it can provide a valuable ability for investors to compare financial results from multiple competing firms making it easier for investors and company leaders to analyze and contrast performance.
However, because accounting conventions are broad and unregulated, they are not a perfect substitute for strict accounting standards.
In some cases, companies and accountants have taken advantage of these conventions to bend or manipulate their flexible interpretation to their advantage.
The Types of Accounting Conventions
There are four primary accounting conventions that are widely accepted and used by accountants.
These include the accounting conventions of consistency, conservatism, materiality, and full disclosure.
The Convention of Consistency
The convention of consistency means that once a method is selected for recording and reporting a given type of transaction, it should be followed consistently from then on.
This helps to ensure uniformity and consistency in reporting and is crucial for calculations of profit and loss as well as to allow comparisons of company performance.
Frequent changes in rules and practices will lead to inconsistent accounts that are unreliable and inconsistent.
Changes in the way a transaction will be recorded should only be made with good reason, and an explanation of the changes should be provided in the disclosures for the financial statements.
This will help management and investors to make educated decisions based on these financial statements.
The Convention of Conservatism
The convention of conservatism essentially means to play it safe when it comes to creating an estimate regarding assets and liabilities.
In other words, this means that until realized, a company will not anticipate a profit, yet it will provide for likely losses.
As such, it will act conservatively and anticipate the worst-case scenario in creating its financial statements while choosing not to recognize gains unless they are certain.
This will ensure that, to the greatest degree possible, it will avoid overstating its financial position.
The Convention of Full Disclosure
The convention of full disclosure means to provide any and all relevant and material information in financial statements.
Financial statements are critical for management, regulators, creditors, banks, and investors.
Management requires a wide breadth of financial information and performance data in order to plan for the future.
A company’s creditors and banks need relevant financial data to judge the financial health of an organization as well as its creditworthiness.
Regulators are primarily concerned with information that shows compliance with relevant laws as well as the general state of financial markets.
The Convention of Materiality
The convention of materiality means that a company should record the impact of an item or invention as well as its relevance in financial statements.
This means including all material information regarding an event as well as information that would influence the interpretations of the users of a financial statement.
Other information that is not relevant to users of accounting information would not be considered material and thus can be left out.
One way to judge whether an item might be considered material enough to record separately is if it crosses a pre-established cost threshold such as $1,000.
The convention of materiality is crucial to ensure that investors and other users of financial statements have all information necessary to interpret the information contained within.
Example of Accounting Conventions
Accounting conventions can be employed in any instance in which accounting standards do not apply a firm rule.
For example, the convention of conservatism can be applied to estimations regarding uncollectible accounts as well as ongoing litigation.
A company would assume, using this convention, that any receivables that are at a high probability of being uncollectible should not be recorded as revenue.
In addition, if a company were in the midst of litigation and expected to receive a significant amount of revenue, as a result, it would not report the expected gain until it is recognized.
Inversely, if the company expected to lose the litigation, it would report an estimated conditional impact in the notes of its financial statements.
The same would apply to other types of material contingent liabilities.
- Realization: Accounting conventions specify that the sale of a product or asset should only be recognized once the transaction is completed, not at the point of contract.
- Clarity: Information in financial statements should be clear so that it is easy for analysts and investors to understand.
- Comparability: A lot of investors like to compare different companies, and accounting conventions ensure that information is presented in a way that makes this easy to do.
- Separate Entities: Accounting conventions make sure that business transactions and private transactions are kept separate because owners and businesses are separate legal entities.
- Reliable: The conventions require that only reliable information is used in financial statements.
- Neutrality: Accounting conventions state that only accountants with no interest in the company or biases concerning the company should prepare the financial statements.
Advantages & Disadvantages of Accounting Conventions
- Reliability: When companies follow accounting standards and conventions in preparing their financial statements, they are more accurate and credible. This increases the trust investors have in these statements.
- Comparability: Because accounting conventions apply to all companies required to follow accounting standards, these companies report transactions in the same way, thus making it easier for users of financial statements to compare similar companies.
- Efficiency in Reporting: Accounting conventions, as well as accounting standards, help to make the reporting process more efficient, which helps accountants. The standards are helpful for those who use financial statements as well because they apply to all companies, thus the financial statements of different companies are presented in a similar manner.
- Managerial Decisions: The conventions are helpful for management when making important decisions concerning their business.
- Prudence Concept: This concept states that revenues should be recorded when realized, and liabilities and expenses should be recorded immediately when they occur.
- Reduces Fraud: Accounting conventions give the companies guidelines for some transactions that are not covered in the accounting standards. These guidelines are not legally binding, but they do ensure that companies furnish relevant information in their financial statements in a designated manner.
- Save Time and Decrease Waste: Some accounting conventions, such as materiality, help ensure that a business’s financial statements record all assets of sufficient value. It also helps accountants by allowing them to disregard some principles and only spend their time on relevant items.
- Not Consistent When Accounting for Certain Line Items. Liabilities, as well as expenses, get recorded immediately when they occur. But, assets and income get recorded at cost only after a transaction is completed.
- Estimates: Some accounting estimates may not be an accurate picture of the company’s financial data.
- Lack of Clear Explanation in Some Cases: Some of the accounting conventions fail to adequately explain certain transactions that are recorded in financial statements or some concepts. This failure makes it easier for companies to have their accountants manipulate some figures, such as depreciation or agreements for bad debts.
- Manipulation: Accounting provisions can unintentionally help a company’s management to use the reporting process to manipulate some financial data, thus giving users of the financial reports an inaccurate view of the company’s finances.
Accounting conventions are intended to clear up uncertainties regarding certain transactions by providing guidelines to address these issues that are not adequately covered in the accounting standards.
These conventions are useful and make it easier for a number of companies to correctly record their financial data.
Though the guidelines may allow companies to manipulate some of the data in their financial statements, it also makes the reporting process easier for many companies.
Additionally, it ensures that significant information gets disclosed in a company’s financial statements or the footnotes to the reports.
Because important information could be in the financial statements or reports, investors need to read both of these before making an investment.
Accounting conventions should decrease over time as they become part of accounting standards, thus making how to handle certain transactions clearer.
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University of Mississippi "Basic concepts and accounting principles underlying financial statements of business enterprises;" White paper. November 7, 2022