Just imagine, if two companies sell the same product, earn the same revenue, but present completely different profit figures. We will confuse, right? This is why accounting Conventions and Policies exist to bring order, comparability, and fairness to financial reporting. Let’s discuss them one by one and see why they matter so much for students and professionals alike.
Accounting Conventions vs Accounting Policies
Before going into individual conventions, it’s important to distinguish Conventions from Policies. These two terms often appear in exams, and students mix them up unnecessarily.
| Aspect | Accounting Conventions | Accounting Policies |
|---|---|---|
| Meaning | General practices and traditions developed over time through common usage. | Specific choices or methods adopted by management within the framework of accounting standards. |
| Nature | Broad guidelines, less rigid. | Company-specific decisions, flexible but must be disclosed. |
| Examples | Conservatism, Consistency, Materiality, Full Disclosure. | Choice between FIFO vs. Weighted Average method for inventory, Straight-line vs. WDV depreciation. |
| Regulatory Requirement | Generally accepted practice, not strictly codified. | Must be disclosed in financial statements if changed. |
Key difference: Conventions are like traffic rules everyone follows; policies are the routes management chooses while staying within those rules.
Major Accounting Conventions
a. Conservatism (Prudence)
“Anticipate no profit but provide for all possible losses.” That’s the essence of conservatism. It ensures financial statements don’t overstate assets or income. This is why provisions are created for doubtful debts, and inventories are valued at “cost or market price, whichever is lower.”
Illustration: If goods purchased cost ₹1,00,000 but market price falls to ₹90,000, closing stock will be valued at ₹90,000. The loss is recognized immediately, but potential gain (if price had risen to ₹1,10,000) is ignored until it is actually realized.
b. Consistency
Consistency ensures that once a method of accounting is chosen, it’s applied from one period to another. This allows meaningful comparison over time. Changing methods frequently would make trend analysis meaningless.
Example: If a company uses straight-line depreciation this year, it should continue using it next year unless there’s a justified reason for change (like better representation of asset usage). If changed, disclosure must be made in notes to accounts.
c. Materiality
Not every tiny detail deserves separate disclosure. Materiality states that financial statements should focus on information significant enough to influence decisions.
Example: A stapler costing ₹200 is treated as an expense, not capitalized as an asset, because its effect on decision-making is negligible. But a machine costing ₹2,00,000 must be capitalized and depreciated.
d. Full Disclosure
Users of financial statements — investors, creditors, regulators — deserve full, fair information to make decisions. The principle of full disclosure requires that all material facts be reported clearly, either in the main statements or in footnotes.
Example: Contingent liabilities such as a pending lawsuit must be disclosed in the notes to accounts, even if they’re not yet certain. This transparency helps users judge risk.
Accounting Policies – A Closer Look
While conventions guide general practice, policies allow management some choice within the accepted framework. The Institute of Chartered Accountants of India (ICAI) requires disclosure of significant accounting policies, typically at the beginning of the financial statements.
Infosys Limited discloses its policy for revenue recognition, depreciation method, inventory valuation, and treatment of foreign exchange differences. If any policy changes from previous year, the company discloses the impact on profit or loss.
Quick Points
- Conservatism → Record expected losses, ignore anticipated profits.
- Consistency → Use same method across periods unless justified.
- Materiality → Focus on information that affects decision-making.
- Full Disclosure → Report all relevant information, including contingencies.
- Policy Change → Must be disclosed with effect on financials.
Question: “Which accounting convention requires recognizing a probable loss from a lawsuit before it is finally settled?”Answer: Conservatism (Prudence).
Practical Comparison Table
| Convention | Purpose | Example |
|---|---|---|
| Conservatism | Prevent overstatement of income/assets. | Provision for doubtful debts, lower of cost or market for stock. |
| Consistency | Enable comparability over periods. | Depreciation method used consistently year after year. |
| Materiality | Avoid clutter with irrelevant details. | Expensing small items like stationery instead of capitalizing. |
| Full Disclosure | Provide complete information to stakeholders. | Disclosing contingent liabilities, accounting policy notes. |
Conclusion
Accounting conventions and policies shape how financial truths are presented to the world. Conventions give the general direction, while policies allow management the flexibility to choose the best route, provided they stay transparent.
Next time you look at a company’s annual report, try to spot its significant accounting policies and match them to these conventions.