Accounting Principles and Concepts

What Are Accounting Conventions, And Why Do They Matter?

Last updated Thursday, June 6, 2024
Accounting Conventions

Accounting conventions are often non-mandatory but essential parts of business for millions of firms out there. Despite that, accountants often mistake conventions for regulations and vice-versa. In this article, we summarized everything you need to know about accounting conventions, so read on to be fully up-to-date on the topic.

Understanding the historical context and evolution of accounting conventions provides a deeper insight into their significance and application today. Accounting conventions have developed over centuries, influenced by economic events, business practices, and regulatory changes. Initially, these conventions emerged as best practices among accountants to address common issues in financial reporting. Over time, they have been formalized by accounting bodies to ensure consistency and reliability in financial statements.

Accounting Conventions Simply Explained

Accounting conventions are rules businesses employ to determine how to record specific business transactions that accounting standards do not yet completely cover. Although not obligatory, these guidelines and practices are typically recognized by accounting organizations.

In essence, they are made to encourage uniformity and assist accountants in resolving real-world issues that might occur when compiling financial accounts.

Main Takeaways

  • Accounting conventions serve as a set of rules that businesses may use to decide how to record transactions that are not yet entirely covered by accounting standards.
  • Although they are not enforceable by law, they are usually recognized by accounting organizations.
  • The accounting convention is no longer relevant if an oversight group establishes a guideline that covers the same subject.
  • There are four generally accepted accounting conventions: materiality, complete disclosure, consistency, and conservatism.

How To Interpret An Accounting Convention

Sometimes, a certain circumstance is not governed by a clear rule in the accounting standards. In these circumstances, accounting conventions may be used.

There are many presumptions, conceptions, norms, and traditions in accounting. Accounting norms that support concepts like relevance, dependability, materiality, and comparability often work to standardize the financial reporting process.

In other words, accounting conventions fill in the areas where accounting standards fall short. The accounting convention is no longer relevant if a regulatory body, such as The Securities and Exchange Commission (SEC) or Financial Accounting Standards Board (FASB), establishes a standard that covers the same subject.

There are currently fewer accounting conventions that can be used as the scope and level of complexity of accounting standards continue to grow. Even accounting practices are not rigid rules. Alternatively, they can change over time to reflect fresh perspectives on the most effective ways to record transactions.

Accounting norms are crucial because they guarantee that transactions are recorded uniformly by several organizations. Investors may more easily evaluate the financial performance of various companies, including rival ones operating in the same sector, by using a consistent technique. Despite this, accounting practices are far from perfect. They can be vaguely defined at times, giving businesses and their accountants room to bend or exploit them to their benefit possibly.

To illustrate the application of accounting conventions, consider the following examples:

  • Conservatism Convention: A company estimates its inventory at a lower value to account for potential market declines. If the cost of inventory is SAR 100,000 but the market value drops to SAR 90,000, the company records the inventory at SAR 90,000.
  • Full Disclosure Convention: A company discloses potential legal liabilities in its financial statements, even if the outcome of the litigation is uncertain, to provide a complete picture of its financial health.
  • Materiality Convention: A company includes all significant transactions in its financial statements. For example, a transaction worth SAR 10,000 is considered material and must be reported, whereas a SAR 100 transaction may not be.

Read more: 7 Common Accounting Mistakes Small Business Owners Make_

The Four Main Accounting Conventions

To help accountants, there are four primary accounting conventions:

Conservatism

This convention urges us to always go with the safe choice. It advises accountants to provide estimates for assets and liabilities that are on the conservative side.

This signifies that the lesser value should be preferred when there are two possible values for a transaction. The fundamental idea is to take the worst-case scenario of a company's financial future into account.

Full disclosure

Regardless of whether the information is harmful to the organization, it must be disclosed if it is thought to be potentially useful and relevant.

Materiality

Similar to full disclosure, this tradition calls for firms to show all of their cards. It should be disclosed if something is material, which is another way of saying important.

The rationale behind this is that all information that can affect a person's judgment after seeing the financial statement must be provided.

Consistency

Throughout many accounting cycles, a business should use the same accounting standards. If it adopts a way, it is advised to continue with it going forward unless there is a compelling reason not to.

Without this convention, it would be considerably harder for investors to compare and evaluate the company's performance over time.

Read more about International Financial Reporting Standards (IFRS).

Areas Where Accounting Conventions Apply

Inventory valuation may be based on accounting conservatism. Conservatism requires that the reported value of inventory be equal to the lowest of the historical cost or replacement cost.

Additionally, line item changes for market value or inflation are prohibited by accounting rules. This implies that book value may occasionally be lower than market value. For instance, even if a building is worth more, it should still be recorded as costing SAR 100,000 when it was first acquired.

The conservatism convention is frequently used to estimate casualty losses and uncollectible accounts receivable. A business cannot record a gain if it anticipates winning a lawsuit unless it complies with all revenue recognition standards.

However, a projected economic effect must be shown in the notes to the financial statements if a lawsuit claim is anticipated to be unsuccessful. Additionally, contingent obligations such as royalties or unearned income must be mentioned.

Read also: Financial Accounting: A Comprehensive Overview

The Conclusion

Overall, we can say that while accounting conventions are not always mandatory to follow, they contain restrictions and rules that are simply necessary to comply with in many instances. By knowing all accounting conventions, accountants can ensure full regulatory compliance and present their figures in the most acceptable way possible.

The landscape of accounting conventions is continually evolving. Emerging trends such as the use of artificial intelligence (AI) and blockchain technology are reshaping accounting practices. These technologies promise greater accuracy and transparency but also pose new challenges in terms of standardization and regulation. Additionally, there is ongoing debate about the relevance and effectiveness of current conventions in addressing modern financial complexities.

If you’d like to learn more about accounting principles, or accounting policies, check out one of our related articles now—see you there!

Frequently Asked Questions (FAQs)

What are accounting conventions?

Accounting conventions are guidelines used to resolve issues in financial reporting when there is no specific accounting standard covering the transaction. They ensure consistency and comparability in financial statements.

Why are accounting conventions important?

They help maintain uniformity in financial reporting, making it easier for investors to compare the financial performance of different companies. They also aid in the accurate representation of a company's financial position.

What is the conservatism convention?

The conservatism convention advises accountants to choose the more conservative estimate when there are multiple possible values for a transaction. This means reporting lower asset values and higher liability values to avoid overstatement.

How does the full disclosure convention work?

The full disclosure convention requires companies to disclose all relevant information in their financial statements, regardless of whether the information is favorable or unfavorable, to provide a complete picture of the company's financial health.

What is the difference between IFRS and GAAP regarding accounting conventions?

IFRS is more principles-based, providing general guidelines that can be applied broadly, while GAAP is more rules-based, offering specific instructions for various scenarios. Both frameworks incorporate accounting conventions differently.

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