Accounting conventions are practices that are followed by accountants for communicating financial data. These practices are adopted in order to ensure uniformity in the preparation of financial statements. Accounting conventions help financial accountants in preparing financial statements.
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There are four major accounting conventions are:
According to the consistency concept, the practices and methods of accounting remain constant in different accounting periods. Therefore, the financial information of one period can be compared to another period or another entity if the consistency approach is followed.
When an organisation decides to use one accounting method, it should keep using it consistently from one accounting period to another. If the method of accounting is changed from one period to another, it will make the comparison of financial statements of different periods difficult.
For example, an investor wants to compare the financial performance of a business entity of the current year with that in the previous year. For this, he may compare the current year’s net profit with that in the last year. However, if accounting policies adopted, say with respect to depreciation in the two years, are different, it will be difficult to compare profit figures.
According to the convention of conservatism, financial statements must be prepared by not anticipating any profit but providing for all possible losses. In other words, the concept states that careful supervision and thoughtful consideration should be taken while ascertaining income so that the profits of the business entity are not overstated.
This is because if the profits ascertained are more than the actual ones, it may lead to a distribution of dividends out of capital. As a result, the capital of the entity will reduce.
In accounting, the convention of disclosure states that all material and relevant facts concerning the financial performance of a business entity must be fully and completely disclosed in financial statements and their accompanying footnotes.
The main aim of this convention is to allow users of accounting information to accurately assess the profitability and financial soundness of the business entity, thereby making informed decisions. In order to ensure that organisations adhere to the convention of disclosure, the Companies Act, 2013 has provided the formats in which the balance sheet and the profit and loss statements should be prepared by an organisation.
The Companies Act, 2013 suggests that information related to major accounting policies and all other relevant information must be given in the form of annexures, footnotes, notes, etc.
The materiality concept states that accounting should be focussed on material facts and efforts should not be made on recording and presenting facts that are immaterial in the determination of income. Here, materiality refers to relevance.
However, the question arises what should be considered as material. A fact is considered to be material if its knowledge reasonably impacts the decision of a user of financial statements. For example, money spent on expanding a manufacturing plant will be a material fact as it will increase the earnings of the entity in the future.