Accounting conventions are informal rules or ads prescribed for the consistent reporting of business transactions in the absence of clearly specified technical standards. Accounting conventions play a vital role in financial reporting, regardless of the fact that they carry no formal legal authority, but accounting bodies tend to accept them to enhance the consistency, reliability, and comparability of reports. The four popular accounting conventions are conservatism, consistency, materiality, and full disclosure.

In this blog, we will examine the importance, types and practical applications of accounting conventions. We will also see the difference between accounting concepts and conventions, which help businesses make informed decisions and work towards growth.

Convention Meaning in Accounting

Transactions in the financial world are not always governed by law or formal rules. Such transactions rely on accounting conventions for guidelines on how they must be recorded and reflected in financial statements. These conventions are generally accepted accounting principles as they provide uniformity and clarity and oftentimes simplify dealing with financial statements.

Such accounting conventions are ad hoc agreements among accountants to treat circumstances where formal rules may not be applicable. They help companies record their transactions in a way that they are still comparable with transactions of similar kinds. These conventions do change as business practices and accounting standards evolve.

The Importance of Accounting Conventions

Accounting conventions are important because they set uniform standards and reporting requirements for companies. It ensures financial data is accurate, reliable and comparable not only between firms but also across industries.  

1. Promoting Transparency

Accounting conventions like full disclosure and materiality provide a clear picture of a company’s financial prospects and various material risks. It helps investors, creditors and other stakeholders transparently access financial reports and make sound investment decisions.

2. Ensuring Comparability

With conventions such as consistency and objectivity, stakeholders have a basis for comparing financial statements over time and across business sectors. This helps investors uniformly compare the financial performance of multiple companies.

3. Enhancing Decision-Making

The use of accounting conventions ensures that financial statements include data that is a realistic description of the company’s condition. Stakeholders make decisions based on reliable accounting and not the optimism of management.

Read more: Financial Accounting

Types of Accounting Conventions

Accounting conventions ensure financial statements are accurate and transparent and a true representation of a company’s condition. Let’s explore these different types of accounting conventions with examples.

1. Convention of Conservatism

Whenever accountants have to choose between two different outcomes to record a particular transaction, they should select the outcome that would result in lower profits or asset values. This principle is known as the conservatism convention. It ensures companies don’t overstate their assets or earnings.

Example of Conservatism

If the company thinks there’s a possibility that the customer won’t pay an outstanding invoice, then it has to book the expected loss, not the full amount.

2. Convention of Consistency

The consistency convention states that, once a company has selected a particular accounting method, the same must be used in future reporting periods unless a change in circumstances warrants a switch to a different method. The consistency ensures users can compare financial reports across time with ease.

Example of Consistency

If a company uses the straight-line method to depreciate its assets, it must use the same method in the years that follow. If it wishes to switch to the declining balance method, it must disclose the facts and explain the reason for doing so.

3. Convention of Materiality

The materiality convention instructs that relevant financial information must be disclosed in the financial statements. An item is material in a financial statement if it is sufficiently important to affect the economic decisions of a reasonable person. The trivial items can be omitted or aggregated with others.

Example of Materiality

if a large multinational suffers a loss of ₹100,000 on a small transaction, it might view the amount as immaterial against its revenue. But if a small business were to lose that same ₹100,000, it could be material and must be disclosed in financial statements.

4. Convention of Full Disclosure

The full disclosure convention requires that all information that affects the interpretation of financial statements must be disclosed. It requires both financial and non-financial material information (such as litigation in process), to be disclosed in the financial reports.

Example of Full Disclosure

A company that is waiting on a pending potential legal settlement must disclose the information in its financial reports. This directive is to ensure that stakeholders are aware of every contingent liability.

5. Historical Cost Convention

The historical cost convention requires that assets be recorded at their original purchase cost, without adjusting for inflation or market developments. This establishes an accurate, auditable record without requiring speculative revisions in value. It provides a more objective view of the asset value.

Example of Historical Cost

If Company ABC purchases land for ₹2,000,000 in 2013, it continues to record the land at the same purchase price, even when its value rises to ₹3,000,000 in 2024.

6. Convention of Prudence

The prudence convention describes how revenues and expenses must be recorded. For example, revenues must be recorded only after they have been received, derived or become realizable. Expenses or losses should be recognized at the earliest possible moment. Also known as the caution principle, it ensures that companies don’t show an over-optimistic depiction of their financial position.

Example of Prudence

If a company expects to win a lawsuit that will earn it ₹500,000, it can’t mark that revenue in its books until the result is finalized. If it expects to lose ₹500,000 in some other lawsuit, it must enter it as a liability in the books right away.

7. Convention of Objectivity

The objectivity convention mandates that all invoices, receipts, contracts and so forth must be associated with a financial transaction. It ensures financial reports are backed by facts and not personal opinions.

Example of Objectivity

The sale of an asset must be recorded only when an agreement or contract is made available. This provides stakeholders a truthful view of the company’s financial picture.

8. Revenue Recognition Convention

In accordance with the revenue recognition convention, revenues are recognized when they are earned, rather than when cash is received. It aligns revenues with the period in which the services were rendered or the products delivered.

Example of Revenue Recognition

A service provider completes a service in September but payment is made in October. Here the revenue will be recorded in September and not October, the month payment is received. 

9. Cost-Benefit Convention

The cost-benefit convention states that the cost of collecting and reporting financial information should not exceed the benefits of using that information. It aims to balance the benefits of having useful information with the costs of excessive reporting.

Example of Cost-Benefit

For a company keeping track of minor office supplies expenses in detail may be too costly compared with the information gained from actually having the details. The company may choose to lump these minor expenses with other general expenses.

Read More: Cost accounting and financial accounting

Areas Where Accounting Conventions Apply

Accounting conventions have several applications which help businesses compare financial statements from one year to the next with consistency. Let’s view some applications of accounting conventions with examples.

1. Inventory Valuation

The conservatism convention is applied in inventory valuation. It records the value of inventory as the historical price or market value. The convention prevents businesses from overstating the value of their inventory.

Example

If a company has bought goods at ₹1,000,000, but their market value falls to ₹900,000 because of low demand, the value of the inventory will be shown as ₹900,000, which is lower of the two.

2. Recognition of Revenue and Liabilities

If a potential liability might arise, for example a lawsuit, it must be recorded in the accounts right from the beginning, even before the outcome is known. Conversely, any gains should not be recognized until they are realized.

Example

If the company thinks it’s likely to win the lawsuit, it won’t be able to record the win as revenue until the verdict is in. But if it thinks it’s likely to lose, it must record the potential liability.

3. Depreciation and Amortization

The consistency convention states that the methods used for depreciation and amortization must be consistent across time periods. 

Example

If a company uses the annuity method to calculate depreciation of an asset, it must continue to use the same method. If it wants to switch to another method like units of production, it must do so with a proper explanation.

4. Contingent Liabilities

This materiality convention implies that a contingent liability should be disclosed in the financial statements if it’s material. In the same vein, contingent assets must also be disclosed, once they are certain.

Example

A company expects to be fined by a regulatory body but the precise amount is not known. As the future payout would affect the company’s financial health, it needs to be written up in the financial statements.

Read More: Expense Management Software

Accounting Concepts vs. Accounting Conventions

Accounting concepts are the theoretical ideas that steer the accounting process. Accounting conventions are practical rules arising from long-standing accounting practices.

All accounting concepts are based on reasonable, logical and sound evidence. Some of the popular accounting concepts include going concern, matching, accrual and money measurement.

Key Differences Between Accounting Concepts and Conventions

Limitations of Accounting Conventions

Accounting conventions offer consistency and comparability but they also have some drawbacks.

1. Subject to Interpretation

Accounting conventions are not part of the law. Different interpretations might lead to different treatment of similar situations across companies.

2. Susceptibility to Manipulation

Conventions like conservatism can be misused to manipulate reported financial results. A company may overstate bad debts or understate significantly profitable assets to create the appearance of a worse financial position than exists.

3. Lack of Global Uniformity

Accounting rules are not identical everywhere in the world, and there could be a limit to the international comparability of financial statements.

Industry-Specific Considerations

Different industries, like manufacturing, technology or pharmaceuticals, might require tailored applications of accounting convention principles. For example, a manufacturing company will rely more on inventory valuation methods such as FIFO (First In, First Out) and LIFO (Last In, First Out), while a tech company will likely place a greater emphasis on overhead costs related to R&D. Industry-specific accounting practices help reports produced by firms to better reflect the nature of the underlying business, enhancing their usefulness to the other relevant interested parties.

For instance, a construction company undertaking long-term projects might use the percentage-of-completion method to recognize revenue over time. A retail company would use cash-based accounting for its short-term transactions.

Read More: Expense management

Conclusion

Accounting conventions offer a set of practical guides that provide firms with an answer when no official accounting standards are available. These conventions help to increase the consistency, reliability and comparability of financial statements and make them more meaningful for the financial decision-making needs of stakeholders. Yet, it should also be noted that these conventions are far from perfect, are open to interpretation and can be misused to present inaccurate financial data. 

Over time changing accounting standards will undermine the reliance on conventions but the basic principles will still be needed to ensure the transparency and fairness of financial statements.

FAQs

How do accounting conventions impact different industries?

Accounting conventions can have varied applications depending on the industry. For example, manufacturing relies on conventions like inventory valuation (FIFO or LIFO), while service industries focus on revenue recognition. Industry-specific challenges, such as long-term projects in construction or frequent R&D costs in tech, require the adaptation of conventions like the percentage-of-completion method or cost-benefit convention, ensuring that financial statements reflect the specific business model.

Why is the historical cost convention criticized for not reflecting current market value?

The historical cost convention records assets at their purchase price, which can diverge significantly from current market values, especially in high-inflation environments. This conservative approach can lead to undervalued asset representation, which critics argue fails to show a company’s true worth. Despite this, historical cost remains widely used due to its objectivity and verifiability, minimizing speculative adjustments that could lead to overstated asset values.

How do international accounting conventions like IFRS enhance global business practices?

International Financial Reporting Standards (IFRS) facilitate consistency in financial reporting across borders, promoting comparability between companies in different regions. It provides a unified accounting framework, making it easier for international investors to assess financial statements, reducing barriers to cross-border investments. It also helps multinational corporations avoid the complexity of complying with multiple national standards.

How do accounting conventions apply to long-term construction projects?

For long-term construction projects, the accounting convention method of percentage-of-completion is usually used. The method allows for revenue recognition during the different stages of the project completion, ensuring financial reports reflect ongoing progress. It prevents misrepresentation of revenues by spreading them proportionately over the project timeline, giving a more accurate picture of both revenue and expenses during extended project periods.

How does materiality convention contribute to mergers and acquisitions?

In the context of mergers and acquisitions, to decide what financial information is important enough to disclose, accountants use the convention of materiality. Trivial details can be left out if it is not likely to alter decision-making, but everything material, which is defined as being capable of altering a merger’s likelihood of success or its valuation, must be revealed.

How does the cost-benefit convention affect reporting in small businesses versus large corporations?

For small businesses, the cost-benefit convention means that they report only when the benefits of reporting exceed the costs of data collection. They might only focus on reporting material items to reduce operational costs. Larger businesses might have the resources to do more granular reporting because of higher stakes in the investor relations process, but they still apply the convention to avoid administrative costs.