A quick introduction to accounting conventions
Accounting conventions are guidelines which dictate how to record business transactions. These guidelines only apply to situations where the accounting standards are not applicable. Hence by their very nature accounting conventions are only applied in exceptional cases and accounting standards are used for general cases.
The purpose of accounting standards is to provide a uniform basis for financial reporting and disclosure, thereby facilitating comparison among firms and economies. However, firms use accounting conventions to account for transactions that do not meet the prescribed format but still need to be accounted for in a consistent manner.
These procedures may not be applicable in all situations, but they are common enough to warrant mention.
What are the different accounting convention methods?
The main purpose of accounting conventions is to avoid confusion and ambiguity in financial reporting. This is accomplished by four different methods. Let’s understand what these are:
Clarity and accuracy is one of the most important underlying principles of accounting. Without accuracy any report prepared by an accountant is useless. Towing this line the accounting convention method of conservatism tells accountants to give the highest importance to caution when estimating the values of assets and liabilities. So for instance, if in any transaction there are two values then the lower value should be used and favoured. This is because by selecting the lower value you are accounting for the worst-case scenario of a company’s future and financial health. If at a later date, the other higher value turns out to be the right figure then there won’t be any problem because in that scenario the financial health of the company would still be better than the worst-case scenario, so whatever strategies you made by considering the worst case scenario would still apply to the good scenarios.
This is an extremely important accounting convention that is often overlooked. It essentially states that regardless of what accounting principles you choose to follow they should be followed in all the accounting cycles.
Changing accounting principles across different cycles could severely impact the financial projections of the company which in turn would impact all the operations within the company. Additionally, if the accounting principles are changed across different cycles then it would be extremely difficult for the investors to compare how the company is performing at various periods. Hence consistency is of the utmost importance.
If at all the accounting principles are to be changed then this decision should be taken by the stakeholders and executives at the highest level and after doing regression testing of measuring the impact of the change.
- Full disclosure
Any crucial or critical information associated with the financial health of the company should be revealed to the stakeholders. This method ensures that while making critical decisions the investors, stakeholders or executives have all the information they should have.
What are the most common areas where accounting conventions are applied?
Accounting conventions are generally used in inventory valuation, measuring accounts receivables, dealing with quasi contracts etc.