Accounts Notes: Accounting Conventions

Tuesday 12 April 2011

Accounting Conventions

The term "conventions" includes those customs or traditions which guide the accountants while preparing the accounting statements. The following are the important accounting conventions.

Convention of Conservatism:
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.
Critics point out that conservatism to an excess degree will result in the creation of secrets reserves.
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 idea behind this convention is that anybody who want to study the financial statements should not be mislead. He should be able to make a free judgment.
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.
Convention of Materiality:
The accounting convention of ‘materiality’ means that the effect of all significant or material transactions must be reported in conformity with the general accepted accounting principles. This convention puts a check on the necessary disclosure in the financial statements. The financial statements should not be bulky with unnecessary details which are not material. A separate disclosure would be necessary, if an item is material in nature. The Companies Act, 1956 also says that a separate disclosure of items of income and expenses should be made if it exceeds 1% of total revenue of the company.