What are Accounting Conventions?
Accounting conventions are general rules of practice arising from customs, usages, and traditions. These conventions serve as the guiding principles for accounting.
Accountants follow these rules based on the widely accepted idea that accounting practices should be consistent, that financial statements should be prepared on a conservative basis to mitigate the risk of loss, and that vital accounting information should be disclosed.
1. Convention of Consistency
This convention affirms that a business unit should be consistent in its accounting practices, enabling users of accounting information to compare accounting statements over time or between different enterprises.
This consistency should be the nature of general acceptability. This means that accounting practices should remain unchanged unless the change is necessarily warranted.
The convention of consistency does not prevent innovative accounting methods from being introduced. However, it is essential for any changes to be incorporated and for their effects to be stated clearly, ensuring that decision-makers are not misled.
For example, if there is a change in depreciation policy (e.g., from the straight-line method to the diminishing balance method), this change should be disclosed clearly along with financial statements.
2. Convention of Conservatism
Generally, financial statements are prepared on the convention of conservatism by following the maxim ‘anticipate no profit but provide for all possible losses’. This prevents accountants from preparing financial statements with ‘prejudice using personal judgment’.
Window dressing is not permitted according to this convention. For example, the general practice for stock valuation is ‘cost or market price, whichever is lower’.
Therefore, if an accountant values a stock consistently at cost price without considering the lower market price, then they have violated the convention of conservatism.
3. Convention of Material Disclosure
Material disclosure requires the disclosure of vital information relating to the preparation of financial statements. What is material or significant information depends on the circumstances and discretion of the accountant.
Importantly, discretion does not mean personal judgment, but judgment based on facts. This does not mean that every detail, irrespective of how small it is, should be provided. It means that accountants should use their discretion only to distinguish between significant and insignificant information.
Accountants should disclose all significant information in the form of footnotes, references, in-text parentheses, and any other means to ensure that users properly understand financial statements.
For example, in addition to asset values, an accountant should also disclose the mode of valuation. If there is any change in accounting policy between the previous years and the current year, this should also be stated in a footnote.
Thus, the Generally Accepted Accounting Principles (GAAP) act as the basic tenets that accountants must follow to ensure the provision of consistent, high-quality, and user-friendly information.