What Is an Accounting Convention?
Accounting conventions are guidelines used to help companies determine how to record certain business transactions that have not yet been fully addressed by accounting standards. These procedures and principles are not legally binding but are generally accepted by accounting bodies. Basically, they are designed to promote consistency and help accountants overcome practical problems that can arise when preparing financial statements.
- Accounting conventions are guidelines used to help companies determine how to record business transactions not yet fully covered by accounting standards.
- They are generally accepted by accounting bodies but are not legally binding.
- If an oversight organization sets forth a guideline that addresses the same topic as the accounting convention, the accounting convention is no longer applicable.
- There are four widely recognized accounting conventions: conservatism, consistency, full disclosure, and materiality.
Understanding an Accounting Convention
Sometimes, there is not a definitive guideline in the accounting standards that govern a specific situation. In such cases, accounting conventions can be referred to.
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.
In short, accounting conventions serve to fill in the gaps not yet addressed by accounting standards. 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(FASB) sets forth a guideline that addresses the same topic as the accounting convention, the accounting convention is no longer applicable.
The scope and detail of accounting standards continue to widen, meaning that there are now fewer accounting conventions that can be used. Accounting conventions are not set in stone, either. Instead, they can evolve over time to reflect new ideas and opinions on the best way to record transactions.
Accounting conventions are important because they ensure that multiple different companies record transactions in the same way. Providing a standardized methodology makes it easier for investors to compare the financial results of different firms, such as competing ones operating in the same sector.
That said, accounting conventions are by no means flawless. They are sometimes loosely explained, presenting companies and their accountants with the opportunity to potentially bend or manipulate them to their advantage.
Accounting Convention Methods
There are four main accounting conventions designed to assist accountants:
- Conservatism: Playing it safe is both an accounting principle and convention. It tells accountants to err on the side of caution when providing estimates for assets and liabilities. That means that when two values of a transaction are available, the lower one should be favored. The general concept is to factor in the worst-case scenario of a firm’s financial future.
- Consistency: A company should apply the same accounting principles across different accounting cycles. Once it chooses a method it is urged to stick with it in the future, unless it has a good reason to do otherwise. Without this convention, investors' ability to compare and assess how the company performs from one period to the next is made much more challenging.
- Full disclosure: Information considered potentially important and relevant must be revealed, regardless of whether it is detrimental to the company.
- Materiality: Like full disclosure, this convention urges companies to lay all their cards on the table. If an item or event is material, in other words important, it should be disclosed. The idea here is that any information that could influence the decision of a person looking at the financial statement must be included.
Areas Where Accounting Conventions Apply
Accounting conservatism may be applied to inventory valuation. When determining the reporting value of inventory, conservatism dictates that the lower of historical cost or replacement cost should be the monetary value.
Accounting conventions also dictate that adjustments to line items should not be made for inflation or market value. This means book value can sometimes be 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 whether it is worth more now.
Estimations such as uncollectible accounts receivables and casualty losses also use the conservatism convention. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles. However, if a litigation claim is expected to be lost, an estimated economic impact is required in the notes to the financial statements. Contingent liabilities such as royalty payments or unearned revenue are to be disclosed, too.