Accounting Convention: Definition & Example
Every business recognizes the importance of accounting and the role it plays. It helps with everything from cash flow to analyzing your financial position. It also shows insights into your business performance. And this is the same with standard accounting practices or conventional accounting.
As well, you gain insights into some areas of your business that might need to get adjusted. In financial accounting, conventions are certain rules to help with processes. So how do they work and what do you need to know?
We put this guide together to explain everything that you need to know. We’ll also cover some methods and examples. Keep reading to learn more!
Table of Contents
- Accounting conventions got created to make accounting more comparable and consistent.
- The primary types include conservatism, consistency, full disclosure, and materiality.
- Businesses aren’t required to use accounting conventions, but they are commonly adopted.
What Is an Accounting Convention?
An accounting convention is a set of rules and practices. These are guidelines for recording your business transactions. Why? Because some financial statements can have transactions that aren’t clear.
However, there’s a difference between this and accounting standards. Accounting conventions are common among accounting professionals. But, there’s no legal obligation to follow them. This is because there can be different accounting policies and financial conditions.
These rules got created to make accounting more comparable and consistent. One of the biggest reasons is to compare financial statements from more than one business. As well, they help to understand the financial position and performance of business activities.
Accounting conventions aren’t legally binding or mandatory. But they help with understanding unclear or complicated business transactions. At the end of the day, this helps maintain consistent financial statements.
What Are the Types of Accounting Conventions?
The main accounting conventions include:
- Full disclosure
Let’s take a closer look at each and how they work.
With the accounting conservatism convention, assets and liabilities get recorded at their lowest. This helps with a more conservative estimate of your financial position. Expenses and liabilities get recorded if there’s a chance of loss or liability. As well, a business will record profits and assets but only when they’re realized.
Basically, it’s a good way to play it safe. Accountants will consider any scenarios of potential loss when recording these transactions.
The consistency convention follows the same methods and accounting principles. Staying consistent allows a business to accurately compare financial statements. Even if they are from different periods.
Implementing the consistency accounting convention doesn’t mean you must keep it forever. If you want to change your accounting methods, you can. But, if you do you need to make notes of changes in financial statements.
This convention makes financial statements more accurate. Which can help in making better business decisions. Valuing inventory is a good example of conservatism. You record all inventory at its current market value or acquisition cost, whichever is the lowest.
The full disclosure accounting convention relates to relevant and important information. Anything about the financial status of your business needs to get highlighted, and this gets done in your financial statements.
For example, if your business has lawsuits or contingent liabilities, the details must get included in adjoined notes.
In this convention, you only include relevant or important facts. It’s information that could impact or potentially influence decisions.
For example, let’s say some material facts get left out or misreported. This might lead to a decision being influenced. That said, materiality depends on the nature of the information and this can change from year to year.
Accounting in any business is important. But there can be times when information might not be comparable to unclear. Accounting conventions help make things more consistent and easier to compare. Common accounting processes still get used, but these allow for making effective decisions.
They also help with understanding the financial position and performance of your business. The conventions aren’t legally required or compulsory. But they help maintain consistent financial statements and an accurate balance sheet. Your financial reporting process will also improve and you can avoid bad debts.
Frequently Asked Questions
Which Accounting Convention Method is Better?
There is no proper explanation when it comes to accounting convention methods. It’s all going to depend on the type of business you operate. So it is up to you to decide which method works best for your business.
Can I Change My Convention Method?
Businesses can change their accounting convention method from year to year. But they must be consistent. If any changes get made, it’s important to note this on your financial statements.
Do I Have to Use One of These Methods?
No, businesses are not required to use one of the accounting convention methods. They can use any method they want as long as it is consistent from year to year.
What If I Don't Use a Convention?
If you do not use a convention, your financial statements may not be comparable. This can make it hard for investors to make informed decisions about your company. Conventions help with consistency in accounting and major accounting concepts.
Why Do Accounting Conventions Matter?
They provide a framework for businesses to record their financial transactions. This allows investors and other interested parties to compare a company’s financial statements.
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