What is an 'Accounting Convention'
An accounting convention consists of the guidelines that arise from the practical application of accounting principles. It is not a legally binding practice; rather, it is a generally accepted convention based on customs and designed to help accountants overcome practical problems that arise out of the preparation of financial statements. If an oversight organization, such as the Securities and Exchange Commission (SEC) or the Financial Accounting Standards Board (FASB) sets forth a guideline that addresses the same topic as the accounting convention, the accounting convention is longer applicable.
BREAKING DOWN 'Accounting Convention'Accounting is full of assumptions, concepts, standards and conventions. Concepts such as relevance, reliability, materiality and comparability are often supported by accounting conventions that help to standardize the financial reporting process.
Examples of Accounting Conventions
Conventions are used to provide guidelines around the basic rules of accounting. The historical cost convention requires all transactions to be recorded at the original cost. Adjustments to line items are not made for inflation or market value. This means book value is often less than market value. For example, if a building costs $50,000 when it is purchased, it should remain on the books at $50,000 regardless of changes in market value. The going concern convention assumes a business will continue on for an indefinite period of time. This helps accountants to make entries that impact multiple time periods.
The accounting period convention breaks time into periods such as weeks, months, quarters and years. These periods help to report on how the company is performing on a periodic basis. The accounting entity convention applies to business owners and says personal and business records should be kept separately. Conservationism is both an accounting principal and convention. It tells accountants to err on the side of caution and conservatism when providing estimates for assets and liabilities.
One of the most important conventions is the matching convention. The matching convention tries to match revenues and expenses to the period in which they were incurred. This is accomplished through cash accounting and accrual accounting. Most companies use accrual-based accounting, which is when the matching principle is required. The cash basis of accounting matches revenue with expenses as they are paid. Under accrual accounting, a company can expense the cost of a truck over the life of the truck. In cash accounting, the company expenses the cost of the truck in the year it was paid, even though the company receives value from the truck for the next 10 years.