Basics of Financial Accounting - Conventions:

The term "accounting conventions" refer to the customs or traditions, which are used as a guide in the preparation of meaningful financial records in the form of the income statement (Profit and Loss Account) and the position statement (Balance Sheet).

These are as follows.

1. Conservatism :

Financial statements are drawn on a conservatism basis where better evidence is required of losses. This is necessary as Management and ownership are in different hands and a cut is needed on management to show overoptimistic, favourable performance results. For example, inventories are valued at the cost or market price whichever is lower. Revenues are recognised when they are certain but expenses as soon as they are reasonably possible e.g. it encourages the accountant to create provisions for bad and doubtful debts.

Since inception, it has come to mean the following:

a)        delay in recognition of income;

b)        expedite recognition of income;

Note : This obviously affects the reliability of the process of matching cost against revenue.

c )  if in doubt, understate assets and income;

d)        if in doubt, overstate liabilities and expenses.

Note : (c) and (d) above violate the postulates of consistency and therefore comparability.

It may result in creation of Secret Reserves if overdone, which vitiates reliabilities of financial statement as the opposite operation, namely, window-dressing. To day’s accountants condemn both the practices. The driving-force behind conservatism is: it is better to be wrong on the minus side than on the plus side of financial statements. This is pessimism and not sceptics. An accountant should be sceptic and not a pessimist; the former can be convinced by sound logic while the latter can be made to change her/his mindset. Moreover, there is no standard by which the degree of conservatism may be standardised. Hence, it becomes highly subjective and may even go to the length of seriously affecting the doctrine of disclosure.

2. Consistency :

This concept states that once the organisation has decided on a method, it should use the same method subsequently unless there is a valid reason for a change of method. If frequent changes are made it is not possible to carry out comparisons on an inter-period or inter-firm basis. If a change is necessary it has to be highlighted. e.g. if depreciation is charged on diminishing balance method, it should be done year after year.

It is an accounting postulate since it develops the growth of the subject of accountancy with only a few constraints. By this standard, it is difficult to call conservatism an accounting postulate since it acts as constraints in many cases, as we have seen above. The basic prerequisite of the postulate of consistency is that the same accounting procedure, treatments, approaches, techniques, tools, concepts and principles should be applied from year to year within the firm; and also to the extent it is possible to ensure the same in all other organisations. But there are difficulties in having uniform principles and concepts and tools and procedures to be used by all the firm within a country, if not globally, mainly because of the following reasons:

a)       Local custom, economic, social and political environments may differ from place to place.

b)        The different nature of business of different kinds and size.

c ) Presence of valid alternatives, accepted by law and standard – setting bodies consistency serves two purposes, one directly and the other indirectly. Directly, it facilitates comparison, which is a vital tool for complex decision-making. Indirectly, when used over a considerable length of time it reduces risks surrounding operating enterprises.

3. Matching :

When an event affects both revenues and expenses, the effect on each period should be recognised in the same accounting period. This leads to matching concepts. The matching concepts is applied by first determining the items that constitute revenues for the period and their amounts in accordance with the conservatism concepts and than matching costs to these revenues. Thus both the aspects of an event are recorded in terms of revenue and expense in the same accounting period.

4. Disclosure :

Apart from legal requirements all significant information should be disclosed. The matching concept states that all significant information should be disclosed and all insignificant information should be disregarded. However, there are no definite rules to separate the two. For recording purposes also only significant events are recorded in detail taking into consideration the cost of detailed record keeping.

5. Materiality :

The accountant should attach importance to material details and ignore insignificant details. The question what constitutes a material detail is left to the discretion of the accountant. An item is material if there is reason to believe that knowledge of it would influence the decision of the informed investor. This has already been referred to above in connection with Disclosure. In addition to what has already been discussed, the reader is to note the following points:

a)	Materiality of information	b)	Materiality of amount
c)	Materiality of procedure	d)	Materiality of nature

Materiality of Information : Misdescription of assets, liabilities, receipts and expenditures. Likewise, wrong classification between Capital and Revenue would also come under this category.

              

              Materiality of Amount : This is a highly relative term. A fraud or an error of Rs. 5,000 may be material

              in a small organisation while not so in a large organisation. Which is why, the Companies Act 1956 and 

              MAOCARO, 1988 have indicated at different places as to the degree (relatively) of tolerance. 

              For example, an item of expense should be shown separately if it constitutes a certain percentage of the                 total expenses for the period.

Materiality of Procedure : Every accountant knows that some procedures are superior to others for certain purposes. For example, the various methods of depreciation, treating liability for gratuity on Cash Basis and on Actuarial Basis, etc.

Materiality of Nature : Some items are material by nature regardless of the amount involved and any other factor. A small error in such items will be considered as material always. For example, Director’s Fees, Audit Fees, amount due from directors etc.