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Wednesday 16 March 2011

Accounting Conventions

The term ‘CONVENTIONS’ refers to those rules, which common consent, express or implied, are employed in the solution of given class of problem or guides the behavior in certain situation. For Example, keeping to the left while driving is an example of convention. Using the sign ‘+’ for addition and ‘-‘ for subtraction are another examples of convention.

The following are the important accounting conventions:

1. Conservatism or Prudence
This principle suggests that “the future profits should not be recognized in present, but all the possible future losses should be provided at present.”

On account of this convention, the inventory is valued at cost of market price whichever is lower, a provision is made for possible bad and doubtful debts against, but a provision for discount on creditors is not made.

Its effect: However, it is to be noted that this principle mainly affects the current assets. The fixed assets are not affected by this principle. Inventory valuation, estimation of doubtful debts etc. are some area, where this principle plays important role.

Drawbacks: This doctrine of accounting has been seriously criticized by experts on the following grounds:

Confliction with the convention of consistency: If this principle is followed, then it is possible that the stock of one accounting period is valued on the cost and of other year at market value. Thus this principle conflicts with the principle of consistency.
Based on subjective judgments: The estimation of future losses is a subjective judgment and thus this principle conflicts with the principles of disclosure.

Whatever the criticism may be, ultimately we see that the main intention of this principle is to prohibit the “Window Dressing” of Financial Statements, i.e. showing a position better than what it is.
Recording only Actual Income
Recording only Actual cost
Recording even Expected Losses.


2. Full disclosure:
According to this principle, the financial statement should act as means of conveying information and not as means of concealing information. Therefore, financial statement must disclose, truly and fairly, all the information,

Which they purport to represent, and
Which are material interests to the users of accounts?

However, Full Disclosure does not mean that all the information, that one might expect, should be given in the financial statement. If the information is of material interest to the users of accounts, such information must be disclosed in Financial Statements:

It is due to this principle, the Companies Act, 1956, requires that Income Statement and Balance Sheet of a company must given in a prescribed the form, Generally, different notes, such as notes about contingent liabilities or market value of investments etc., are annexed with the financial statement, which do not find place in the accounting. This is done in pursuant to convention of full disclosure.

3. Consistency:
According to this convention, accounting policies should remain unchanged from one period to another. For example, if the stock is valued if FIFO method is one accounting year, then this policy should be followed in the subsequent years also. Similarly, if depreciation is charged in accordance with WDV Method, then this method should be followed in the year after year.


4. Materiality:
This principle is basically a modified form of the Principle of Full Disclosure. The full disclosure principle requires that all facts, necessary to ensure that the financial statements are not misleading must be disclosed. However, according to the Materiality principle, only material items are required to disclose in the financial statements and the items, which immaterial to the users of accounts may not be disclosed.
Now the question arises. “What is the meaning of Material Information?” This is because what information is material from the view-point of one person, may be immaterial from the view –point of other person.
This is a question of facts and circumstances. However, as per AS-1, issued by ICAI, any information, misstatement of which may change the decision of users of financial statements, shall be deemed to be material information and should be properly disclosed in the financial statements

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