ACCOUNTING CONVENTION

1. Convention of Disclosure:

The doctrine of disclosure suggests that all accounting statements should be honest, and, to that end, full disclosure of all significant information must be made.

It involves proper classification, summarisation, aggregation and explanation of accounting data in the published financial statement which are of material interest to the users, viz., proprietors, creditors, investors etc.

This doctrine actually gives emphasis on the actuality, materiality, objectivity and consistency of accounting data in order to disclose fully the true and fair view of the economic activities of a firm for a particular period. The doctrine is becoming more popular at present since most of the business units are in the form of joint stock companies.

For this purpose, The Companies Act, 1956, has prescribed the forms and schedules of accounts in which financial statements are to be prepared. Since the Companies Act makes proper provisions for the disclosure of essential information relating to accounting data, concealment of material information-is particularly limited.

Besides the above, the reporting or accounting information is made by means of comments, footnotes, descriptive captions, supplementary schedules etc. in periodical statements which may also require further clarification. However, this doctrine does not express that the trade secrets or other necessary information should also be disclosed. It should reveal simply the full disclosure of all essential or significant material information to the users of financial statement.

In 1945, the Cohen Committee — enquiring company practice in England — made the following statement regarding this accounting doctrine:

“We are in favour of as much disclosure as practicable. It is also important in our opinion to ensure that there should be adequate disclosure and publication of the results of companies so as to create confidence in the financial management of industry and to dissipate any suggestion that hidden profits are being accumulated by industrial concerns to the detriment of consumers and those who work for industry. On the other hand, if there is no detailed disclosure in the Profit and Loss Account, undisclosed reserve, accumulated in the past period, may be used to swell the profits in years when the company is fairing badly, and the shareholders may be misled into thinking that the company is making profits when such is not the case.”

2. Convention of Materiality:

Materiality means relative importance. In other words, whether a matter should be disclosed or not in the financial statements depends on its materiality, i.e., whether it is material or not (immaterial). American Accounting Association (AAA) defines ‘Materiality’ as under:

“An item should be regarded as material if there is reason to believe that knowledge of it would influence the decision of informed investors.” But E. L. Kohler described it as “The characteristic attaching to a statement of fact or item whereby its disclosure or the method of giving it expression would be likely to influence the judgement of a reasonable person”.

In this regard, the account is vitally concerned with the following two important matters:

(i) materiality of information; and

(ii) materiality of amounts.

Of course, an accountant cannot ignore the consideration of materiality of procedures. The term itself is a subjective term. As such, an accountant should record an item of material even though it is of small amount if the same influences the decisions of the users, viz. proprietors, auditors or investors etc. On the other hand, if it is found that information is not sufficiently important to influence the quality of periodical financial statements, the same should be treated as ‘immaterial’ and hence should be avoided.

It has been stated above that materiality depends on the amounts involved and the account so affected. As a result, whether a particular item is material or immaterial depends on the amount and nature of the same. Because, the material information helps the management to avoid unnecessary wastage of time and money on principal matters.

It should be noted that this doctrine of materiality refers to separate disclosure of information in the published financial statements for the user of the same. In short, material items should separately be disclosed whereas immaterial items may not be disclosed separately but may be combined in a consolidated form in the published financial statements.

3. Convention of Consistency:

This doctrine implies that accounting rules, practices and conventions should be continuously observed and applied. In other words, these should not be changed from year to year or one year to another. Comparison of result among different years is meaningful and significant only when the accounting rules, procedures and practices are continuously adhered to from year to year.

For example, the principles of valuing stock at cost or market price, whichever is lower, should be followed every year for making proper comparison, i.e., the method adopted should be consistent for the years. If there is any uncertainty surrounding accounting procedures the same is considerably offset by a consistent method adopted from one accounting period to another. Consistency serves to eliminate personal bias but it must not become a fetish so as to ignore changed conditions or the need for improvements in technique.

However, the doctrine of consistency helps in the following manner:

(i) It helps to eliminate the personal bias of an accountant since he is not allowed to change any accounting method or principles according to his own opinion and desire from one year to another.

(i i) It helps an accountant to use his own judgment.

(iii) It also helps to prepare a periodical financial statement which is more dependable, reliable and comparable.

4. Convention of Conservatism:

Conservatism refers to the principles and practices which are established by way of tradition, reluctance to change from such established principles and practices, and an inclination to play safe. In short, it is a policy of caution or playing safe and had its origin as a safeguard against possible losses in a world of uncertainty.

The accountant wants to play safe, particularly in the determination of income or profit or loss and in the process of valuation which he is associated with in the accounting literature. He is inclined not to assess any gain or income until the same has been realised or converted into money, i.e., until there is actual sale or realisation of income or gains actually accrues. In other words, there seems to be no objective indication of the emergence of income or gain.

This arises due to the keen inclination of the accountant to the doctrine of objectivity. But at the time of estimating expenses or losses, the accountant goes beyond the purview of objectivity and makes a subjective estimate of a possibility. And for this reason, in accounting, proper provisions are always made against current profit for future losses and contingencies.

Therefore, the common accounting practices are:

(i) Do not consider any income or gain till the same is realised in cash.

(ii) Create or make a provision for future expected losses and contingencies on the basis of past performances. This aspect of the doctrine of conservatism has been particularly meaningful and significant with the growth of limited companies.

Practically, this doctrine helps to keep the human desire to be on the safe side as a matter of prudence. In order to protect the interest of the different parties the net profits and net assets must not be overstated but may be understated. Because, conservatism refers to deliberate understatement where uncertainties lie. Of course, this doctrine does not recognise the unnecessary deliberate understatement in order to make a manipulation in accounting data, e.g. the inventory valuation rule—cost prices or market prices, whichever is lower.

The excessive application of conservatism could result in the creation of secret reserve which directly contradicts the convention of disclosure. Conservatism carried beyond what is warranted by reasonable doubt distorts earning in as much as net profit in one period may be declared at less than it should be. As such current accounting thought has shifted somewhat from the principles of conservatism.