6 Accounting Conventions
Ms. Deepika Gautam
LEARNING OBJECTIVES
This module helps to understand the meaning of accounting conventions and its classification. After going through the module, students will be able to understand the consistency, full disclosure, materiality and conservatism conventions and also explain them in detail.
INTRODUCTION
In drawing up accounting statements, whether they are external “financial accounts” or internally focused “management accounts”, a clear objective has to be that the accounts fairly reflect the true “substance” of the business and the results of its operations.
Accounting is used by the business houses to keep a record of the monetary transactions that have taken place in an accounting year. Accounting is a way by which the one’s who invest in the business(owners), can easily keep a record of whether their invested capital is increasing or decreasing and whether their business is earning profits or incurring losses. Basically the owners come in a position, where with the help of these accounts they can ascertain the position of their finances.
As per AICPA, “Accounting is the art of recording, classifying, summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof.”
It is clear from the definition that accounting deals in recording and interpreting the results, and every organisation tries to interpret its results in such a manner that it depicts the true and a fair picture of the business and its workings.
The theory of accounting has, therefore, developed the concept of a “true and fair view”. The true and fair view is applied in ensuring and assessing whether the accounts do indeed reflect the true and clear picture of business affairs. To make sure that the true and fair image of the accounts is reflected in front of the interested users, accounting has adopted certain concepts and conventions which help in ensuring that uniformity and clarity is being maintained while recording the transactions and that the accounts so being prepared will be universally understandable and acceptable.
MEANING OF ACCOUNTING CONVENTIONS
The dictionary meaning of convention states that it is a custom or a way of acting or doing things that is widely accepted and followed. Basically the term convention includes those customs and traditions which guide the accountant while preparing the accounting statements. It is not a legal binding upon them but the general agreement on the usage and practices in social and economic life i.e. it is a customary practice, rule or usage. They are derived from usage and continuous practice. The accountancy bodies of the world may change any of the convention to improve the quality and standard of accounting information.
According to MWE Glautier and B Underdown, “the term accounting conventions serve in another sense to understand the freedom which accountants have enjoyed in determining their own rules.”
WHY CONVENTIONS MATTERS
Accounting conventions provide a standardized methodology that creates a reliable means of comparing financial results from industry to industry and from year to year within one industry. Accordingly, accounting conventions govern how companies and accountants prepare quarterly balance sheets or income statements, or annual reports. Following the set conventions increases the reliability of the data, maintains uniformity, and helps the accountants in recording only the relevant information, thus saving time and energy.
CLASSIFICATION OF ACCOUNTING CONVENTIONS
There are four widely recognized accounting conventions that guide the accountants throughout:
Be Conservative – Conservatism
Disclose in Full – Full Disclosure
Be Consistent – Consistency
Report only that thing which is important – Materiality
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Generally Accepted Accounting Principles(GAAP) are updated regularly and reflect the latest accounting conventions |
CONVENTION OF CONSISTENCY
Accounting rules, methods, practices and conventions should be continuously and consistently observed and applied i.e. they should not change from one year to another. The accounting information provided by the financial statements would be useful in drawing conclusion regarding the working of an enterprise only when it allows comparisons over a period of time as well as with the working of other enterprises and this comparison is possible only when consistency is maintained throughout.
According to auditing interpretations of section 420, Consistency of Application of Generally Accepted Accounting Principles, paragraph 02, states: “the objective of the consistency standard is to ensure that if comparability of financial statements between periods has been materially affected by changes in accounting principles there will be appropriate reporting by the independent auditor regarding such changes.”
The rationale behind this concept is that frequent changes in accounting treatment, would make the financial statements unstable, incomparable and unreliable and may seem difficult to be compared by the persons who use them. For Example: the principle of “valuing stock at cost or market price whichever is less” should be followed year after year without any change to get comparable results. Similarly, if depreciation on fixed assets is provided on straight line method in one accounting year, it should be followed year after year to maintain uniformity. Consistency serves to eliminate personal bias because the accountant will have to follow consistent rules, practices and conventions year after year and cannot apply his own judgement or views while maintaining records.
Consistency also means external consistency, i.e. the financial statements of one enterprise should be comparable with another. It means that every enterprise should follow same accounting methods, and procedures of recording and reporting business transactions. This will help in inter-firm as well as inter-period comparison. It should be pointed that the development of international and national accounting standards is due to the convention of consistency; they are framed so as to maintain global uniformity in accounts.
This convention does not completely prohibit changes. It does not debar from introducing improved accounting techniques. However, if a change becomes desirable, the change and its effects on profits and financial position of the company as compared to the previous year should be clearly stated in the financial statements. According to Yorston, Smith and Brown, “Consistency serves to eliminate personal bias and to even out personal judgement but it must not become a fetish so as to ignore changed conditions or need for improvements in technique.”
For Example: A company purchased a fixed asset for Rs 500000 and it charges depreciation @20% on straight line method. At the end of the second year, the book value of the assets will be:
The effect of change will be that depreciation of Rs 100000 will be reduced to Rs 80000 in the second year making an increase of Rs 20000 in profit, and asset will be shown in the Balance Sheet at Rs 320000 and not at Rs 300000.
The above cited example clearly highlights the importance of consistency convention and shows that violating this convention will directly affect the balance sheet of the company and ultimately the image of the enterprise.
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IMPORTANCE OF CONSISTENCY:
Being consistent in preparation of final accounts simply means that the organisation is following the set rules and standards and maintaining its financial image on the higher side in the eyes of the outsiders/investors. Consistent approach improves the comparability of the accounts with those of others or with themselves over years and removes the chance of biasness as well as reduces confusion in the minds of investors.
CONVENTION OF FULL DISCLOSURE
Information provided by the financial statements is used by the different group of people such as owners, investors, lenders, suppliers etc in taking various financial decisions. So, in order to make sure that correct financial decisions are taken, the accounts should be prepared in such a manner that all the information whether good or bad should be disclosed in the report and no information be concealed from the interested parties.
According to this convention, all accounting statements should be honestly prepared and to that end full disclosure of all significant information should be made. All information that carries some interest to proprietors, creditors and investors should be disclosed in accounting statements, in full. Since, financial statements are the only mode of communicating the financial information to all interested parties, it becomes essential that the accounts makes a full, fair and adequate disclosure of the information which is relevant for taking financial decisions.
An obligation is put on the shoulders of those preparing the accounts to see that the books of accounts are as correct, reliable and informative as the circumstances allow and the important facts concerning the financial performance of the enterprise are fairly disclosed in:
- The financial statement
- The accompanying footnotes of such statements special communications.
- The president’s letter or other management reports in the annual report
To ensure proper disclosure of accounting information, the Indian Companies Act, 1956 has provided a format for the preparation of profit and loss account and balance sheet of a company, which needs to be compulsorily adhered to and makes sure that neither of the important information is let out (intentionally or otherwise). The regulatory bodies like SEBI, also mandates complete disclosures to be made by the companies, to give a real and transparent view of profitability and the state of affairs of the company.
If there is no detailed disclosure in the profit and loss account, undisclosed reserves accumulated in the past periods may be used to increase the profits in years to come when the company is working badly and the shareholders may be misled into thinking that company is making profits. In such a case, the shareholders, investors and their advisers will not have the correct information to enable them to estimate the real value of the shares.
For Example: in case of sundry debtors not only the total amount of sundry debtors should be disclosed, but also the amount of good and secured debtors and amount of doubtful debtors should be stated. This does not mean disclosure of each and every item of information. It only means disclosure of such information which is of importance to owners, investors and creditors.
IMPORTANCE OF FULL DISCLOSURE PRINCIPLE:
For an accountant, the full disclosure principle is important because the notes to the financial statements and other financial accounts are subject to audit. To obtain an unqualified (or clean) opinion, one must have an intrinsic understanding of the full disclosure principle to ensure sufficient information for an unqualified opinion on the financial audit by the auditor. An opinion is said to be unqualified when the auditor concludes that the financial statements give a true, fair and transparent view in accordance with the financial reporting framework.
CONVENTION OF CONSERVATISM
The concept of conservatism (also called prudence) provides guidance for recording transactions in the book of accounts and is based on the policy of caution or playing safe and has its origin as a protection against possible losses in the business world of uncertainty. This concept states that a conscious approach should be adopted in ascertaining income, so that profits of the enterprise are not overstated.
It compels a businessman to wear a “risk proof jacket” for the working rule is: anticipate no profits, but provide for all possible losses. This means over optimism in reporting results is considered more undesirable than over passionism results, because it shows position better than what actual financial position is. Some of the examples of the application of convention of conservatism are Valuing closing stock at cost or market value whichever is lower, creating provisions for doubtful debts, writing off intangible assets like goodwill and discount on debtors.
For Example: closing stock is valued at cost or market price whichever is lower. If market price is higher than the cost, the higher amount is ignored in the accounts and closing stock will be valued at cost which is lower than the market price. But if the market price is lower than the cost, the higher amount of cost will be ignored and stock will be valued at market price which is lower than the cost. Thus, as per the above example the principle of conservatism is inherent in the valuation of stock.
IMPORTANCE OF CONSERVATISM:
The benefit in being conservative while preparing the accounts is that at the end of the accounting year it is always better that the net assets and net income are understated rather than being overstated and misleading the investors by depicting their false image outside, which might ruin after the investors come to face the reality. And also, more of a rosy image of the organisation may also attract more tax liabilities as well. Following the conservatism approach, will keep the organisation on a safer side as this approach makes the management wear a risk proof jacket.
CONSERVATISM OF MATERIALITY
The concept of materiality requires that accounting should focus on material facts. It means whether something should be disclosed or not in the financial statements will depend on whether it is material or not. Efforts and time should not be wasted in recording and presenting facts which are immaterial in the determination of income. The term “materiality” is a subjective term. The accountant should record an item as material even though it is of small amount and its knowledge seems to influence the decision of the proprietors or auditors or investors. For Example: commission paid to sole selling agents should be disclosed separately in the profit and loss account. Similarly, amount due to the directors or other officers should be disclosed separately in the balance sheet of Bank to know the exact amount of advances due from the directors or officers who are managing the affairs of bank.
Any fact would be considered as material if it is strongly believed that its knowledge would influence the decision of informed users of financial statements. For Example: money spend on creation of additional capacity of a customer interaction hall would be a material fact as it is going to increase the future earning capacity of the enterprise. Similarly, information about change in the method of depreciation adopted or any liability which is likely to arise in the near future would be considered an important information.
IMPORTANCE OF MATERIALITY APPROACH
If an organisation follows the materiality approach, it means that its financial statements are full of relevant data and the immaterial things are not shown in the accounts. This will maintain the accuracy of the accounts and only that information which is important to different users is disclosed. As a result only accurate accounts are communicated to the outside/inside world.
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SUMMARY
In drawing up accounting statements, whether they are external “financial accounts” or internally focused “management accounts”, a clear objective has to be that the accounts fairly reflect the true image of the business and the results of its operations. For reflecting the true view of the organisation it is essential for the accounts to be fair, consistent and complete. For maintaining this consistency, certain accounting conventions have been set by the accounting bodies that act as a guiding force for the organisations to maintain their financial statements.
Convention includes those customs and traditions which guide the accountants while preparing the accounting statements. It is not a legal binding but the general agreement on the usage and practices in social and economic life. The accountancy bodies of the world may change any of the convention to improve the quality of accounting information from time to time.
There are four widely recognized accounting conventions that guide accountants: convention of consistency, convention of conservatism, convention of full disclosure and materiality convention. Consistency convention states that Accounting rules, practices and conventions should be continuously observed and applied i.e. they should not change from one year to another.
Full disclosure convention states that in order to make sure that correct financial decisions are taken, the accounts should be prepared in such a manner that all the information should be disclosed in the report and no information be concealed from the interested parties. To ensure proper disclosure of accounting information, the Indian Companies Act, 1956 has provided a format for the preparation of profit and loss account and balance sheet of a company. The full disclosure principle is important because the notes to the financial statements and other financial documents are subject to audit.
The concept of conservatism (also called prudence) provides guidance for recording transactions in the book of accounts and is based on the policy of caution or dealing safely and has its origin as a safeguard against possible losses in a world of uncertainty. Whereas, the concept of materiality requires that accounting should focus on material facts. It means whether something should be disclosed or not in the financial statements will depend on whether it is material or not.
These conventions help the organisations to prepare their financial statements in such a way that it increases the reliability, accountability, consistency and accuracy of the accounts. Though it is not compulsory to follow these conventions, but it is surely advisable to keep them in mind while maintaining the accounts.
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Few suggested readings to learn more:
- C. Shukla, T.S. Grewal & S.C. Gupta “Advanced Accounts, Volume I” Sultan Chand & Company Ltd, New Delhi.
- N. Maheshwari & S.K. Maheshwari “Advanced Accounting, Volume I” Vikas Publishing House (Pvt.) Ltd., New Delhi.
- S.P. Jain & K.L. Narang “Advanced Accounting, Volume I” Kalyani Publishers, New Delhi