Accounting Conventions

  • Post last modified:24/11/2021
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Accounting Conventions

Following are the accounting conventions:

Convention of Materiality

Materiality concept states that items of small significance need not be given strict theoretically correct treatment. In fact, there are many events in business which are insignificant in nature. The cost of recording and showing in financial statements such events may not be well justified by the utility derived from that information.

For example, an ordinary calculator costing Rs. 100 may last for ten years. However, the effort involved in allocating its cost over the ten-year period is not worth the benefit that can be derived from this operation. The cost incurred on the calculator may be treated as the expense of the period in which it is purchased

Similarly, when a statement of outstanding debtors is prepared for sending to top management, figures may be rounded to the nearest ten or hundred.

This convention will unnecessarily overburden an accountant with more details in case he is unable to find an objective distinction between material and immaterial events. It should be noted that an item material for one party may be immaterial for another.

Actually, there are no hard and fast rules to draw the line between material and immaterial events and hence, It is a matter of judgement and common sense. Despite this limitation, It is necessary to disclose all material information to make the financial statements clear and understandable. This is required as per IAS-1 and also reiterated in IAS-5. As per IAS-1, materiality should govern the selection and application of accounting policies.

Convention of Conservatism

This concept requires that the accountants must follow the policy of ‘‘playing safe” while recording business transactions and events. That is why, the accountant follow the rule anticipate no profit but provide for all possible losses, while recording the business events. This rule means that an accountant should record lowest possible value for assets and revenues, and the highest possible value for liabilities and expenses.

According to this concept, revenues or gains should be recognized only when they are realised in the form of cash or assets (i.e. debts) the ultimate cash realisation of which can be assessed with reasonable certainty.

Further, provision must be made for all known liabilities, expenses and losses, Probable losses regarding all contingencies should also be provided for. ‘Valuing the stock in trade at market price or cost price which ever is less’, ‘making the provision for doubtful debts on debtors in anticipation of actual bad debts’, ‘adopting written down value method of depreciation as against straight line method’, not providing for discount on creditors but providing for discount on debtors’, are some of the examples of the application of the convention of conservatism.

The principle of conservatism may also invite criticism if not applied cautiously. For example, when the accountant create secret reserves, by creating excess provision for doubtful debts, depreciation, etc. The financial statements do not present a true and fair view of state of affairs.

American Institute of Certified Public Accountant have also indicated that this concept need to be applied with much more caution and care as over-conservatism may result in misrepresentation.

Convention of Consistency

The convention of consistency requires that once a firm decided on certain accounting policies and methods and has used these for some time, it should continue to follow the same methods or procedures for all subsequent similar events and transactions unless it has a sound reason to do otherwise.

In other words, accounting practices should remain unchanged from one period to another. For example, if depreciation is charged on fixed assets according to the straight-line method, this method should be followed year after year. Analogously, if stock is valued at ‘cost or market price whichever is less’, this principle should be applied in each subsequent year.

However, this principle does not forbid introduction of improved accounting techniques. If for valid reasons the company makes any departure from the method so far in use, then the effect of the change must be clearly stated in the financial statements in the year of change. The application of the principle of consistency is necessary for the purpose of comparison.

One could draw valid conclusions from the comparison of data drawn from financial statements of one year with that of the other year. But the inconsistency in the application of accounting methods might significantly affect the reported data.

Accounting Standards

The accounting concepts and conventions discussed in the foregoing pages are the core elements in the theory of accounting. These principles, however, permit a variety of alternative practices to co-exist. On account of this the financial results of different companies can not be compared and evaluated unless full information is available about the accounting methods which have been used.

The lack of uniformity among accounting practices have made it difficult to compare the financial results of different companies. It means that there should not be too much discretion to companies and their accountants to present financial information the way they like. In other words, the information contained in financial statements should conform to carefully considered standards.

Obviously, accounting standards are needed to:

  • Provide a basic framework for preparing financial statements to be uniformly followed by all business enterprises,
  • Make the financial statements of one firm comparable with the other firm and the financial statements of one period with the financial statements of another period of the same firm,
  • Make the financial statements credible and reliable, and
  • Create general sense of confidence among the outside users of financial statements.

In this context unless there are reasonably appropriate standards, neither the purpose of the individual investor nor that of the nation as a whole can be served. In order to harmonise accounting policies and to evolve standards the need in the USA was felt with the establishment of Securities and Exchange Commission (SEC) in 1933. In 1957, a research oriented organisation called Accounting Principles Boards (APB) was formed to spell out the fundamental accounting principles.

After this the Financial Accounting Standards Board (FASB) was formed in 1973, in USA. At the international level, the need for standardisation was felt and therefore, an International Congress of accountants was organised in Sydney, Australia in 1972 to ensure the desired level of uniformity in accounting practices. Keeping this in view, International Accounting Standards Committee (IASC) was formed and was entrusted with the responsibility of formulating international standards.

In order to harmonise varying accounting policies and practices, the Institute of Chartered Accountants of India (ICAI) formed the Accounting Standards Board (ASB) in April, 1977. ASB includes representatives from industry and government. The main function of the ASB is to formulate accounting standards.

This Board of the Institute of Chartered Accountants of India has so far formulated 39 Accounting Standards, the list of these accounting standards is furnished. Regarding the position of Accounting standards in India, it has been stated that the standards have been developed without first establishing the essential theoretical framework.

As a result, accounting standards lack direction and coherence. This type of limitation also existed in UK and USA but it was remedied long back.

International Financial Reporting Standards are standards for Financial Reporting issued by the International Accounting Standards Board keeping in specifying broad guidelines on how financial reporting around the globe should be done. As the world is squeezing into one global market, it’s imperative to have certain standards of financial reporting for easy understanding and comparison of various financial statements.

Modern economies rely on cross-border transactions and the free flow of international capital. More than a third of all financial transactions occur across borders, and that number is expected to grow. Investors seek diversification and investment opportunities across the world, while companies raise capital, undertake transactions or have international operations and subsidiaries in multiple countries.

In the past, such cross-border activities were complicated by different countries maintaining their own sets of national accounting standards. This patchwork of accounting requirements often added cost, complexity and ultimately risk both to companies preparing financial statements and investors and others using those financial statements to make economic decisions.

Applying national accounting standards meant amounts reported in financial statements might be calculated on a different basis. Unpicking this complexity involved studying the minutiae of national accounting standards, because even a small difference in requirements could have a major impact on a company’s reported financial performance and financial position—for example, a company may recognize profits under one set of national accounting standards and losses under another.

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