Accounting Principles and Conventions student learning

Accounting Principles and Conventions: Key Distinctions With Examples

Two terms often heard in accounting are “accounting principles” and “accounting conventions.” Accounting principles and conventions are the foundation for the entire field, ensuring that financial reporting is consistent and meaningful.

While they may seem interchangeable, there are crucial distinctions between the two that every student, aspiring accountant or business enthusiast should understand. 

Accounting Principles: The Bedrock of Financial Reporting

Accounting principles are standardized guidelines and rules governing financial reporting. They serve as a compass for accountants, ensuring that financial statements are prepared accurately under consistent policies. Here are some key characteristics of accounting principles:

Consistency

One of the fundamental principles is consistency. It dictates that a company should use the same accounting methods and procedures from one period to another. It ensures that financial statements can be compared over time, providing valuable insights into a company’s performance.

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Example: A retail company consistently uses the FIFO (First-In-First-Out) method to account for inventory. It assumes that the oldest items in inventory are sold first when it sells products. This consistent application allows for meaningful comparisons of inventory costs over time.

Relevance

Accounting principles aim to provide relevant information to users of financial statements. The information presented should be useful for making informed economic decisions.

Example: A technology company reports the research and development (R&D) expenses separately in its financial statements. This information is relevant for investors and stakeholders interested in the company’s commitment to innovation and investment in future products.

Reliability

Financial information must be reliable and free from bias. Accounting principles emphasize the importance of faithfully representing a company’s financial position, operational performance, and cash flow situation.

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Example: A manufacturing firm employs independent auditors to verify its financial statements. This external audit adds credibility and reliability to the company’s financial information, assuring investors and creditors that the numbers are accurate.

Comparability

Financial statements should be comparable over time and with those of other companies. It allows stakeholders such as investors, creditors, and the Government to make meaningful comparisons.

Example: Two competing pharmaceutical companies follow the same accounting principles and conventions. As a result, their financial statements are comparable, making it easier for investors to assess which company is more profitable or financially stable.

Materiality 

This principle suggests that insignificant items can be ignored to avoid cluttering financial statements with immaterial details. Materiality is a judgment call, but it ensures that financial reports focus on what truly matters.

Example: A multinational corporation does not report a minor office supply expense of $20 in its financial statements. While this expense is real, it is considered immaterial and can be safely ignored, keeping the financial statements concise and focused on significant figures.

Substance over form

This principle emphasizes that the economic substance of a transaction or event should be considered more important than its legal form. In other words, accountants should focus on the underlying economic reality of a transaction rather than just its appearance on paper or its legal structure.

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Example: Imagine a construction company in a long-term building project. While the contract suggests billing only at completion, the company incurs losses during construction. To reflect the true economic reality, the company should recognize revenue and expenses periodically instead of waiting until the project ends, ensuring accurate financial reporting.

Accounting Conventions: The Common Practices

While accounting principles provide the overarching framework, accounting conventions are the common practices followed by businesses. These conventions are not mandatory but are widely accepted within the industry. They provide flexibility and practicality in accounting processes. Here are a few key accounting conventions:

Historical Cost Convention

It states that assets should be recorded at their original purchase cost. While it may not reflect the current market value, it provides a reliable and verifiable basis for financial reporting.

Example: A real estate company purchases a building for $1 million. According to the historical cost convention, the company records and continues to show the building on its balance sheet at the original purchase price of $1 million, even if the property’s market value has increased.

Conservatism Convention 

Accountants should err on the side of caution when there is uncertainty in financial reporting. It means recognizing losses as soon as anticipated but only recognizing gains when they are certain to be realized.

Example: A manufacturing company holds inventory of a certain raw material that has declined in market value due to a supply glut. The conservatism convention suggests that the company should record a write-down of the inventory value to reflect the lower market value, even if the inventory hasn’t been sold yet.

Consistency Convention 

While consistency is a principle, it’s also a convention. It emphasizes that businesses should follow the same accounting methods from one period to another, promoting stability in financial reporting.

Example: A bakery consistently uses the straight-line depreciation method for its baking equipment year after year. Maintaining this consistent accounting practice ensures that the depreciation expense is calculated similarly in every financial statement, facilitating comparability.

Full Disclosure Convention 

This convention dictates that all material information regarding the financial affairs of a company should be disclosed in the financial statements or accompanying footnotes. It ensures transparency, even if some details are not included in the main financial statements.

Example: A publicly traded technology company provides detailed footnotes in its financial statements that disclose the terms of its long-term debt, including interest rates, maturity dates, and any covenants. This full disclosure ensures investors have all relevant information to assess the company’s debt obligations.

Difference Between Accounting Principals and Conventions

Now that we’ve explored the definitions of accounting principles and conventions let’s unravel the key distinctions:

  • Mandatory vs. Optional: Accounting principles must be followed. Accounting conventions, on the other hand, are optional but widely accepted practices.
  • Rigidity vs. Flexibility: Accounting principles provide a rigid framework that leaves little room for interpretation. Conventions offer flexibility, allowing businesses to adapt to specific circumstances.
  • Legal vs. Industry Standards: Legal bodies often establish accounting principles, while conventions are industry standards developed over time.
  • Consistency vs. Common Practice: Principles focus on consistency and comparability, while conventions reflect common industry practices.

Example: Depreciation of a Business Vehicle

Imagine a small business, ABC Corporation, that purchases a delivery van for $30,000. The van is expected to have a useful life of 5 years and a residual or salvage value of $5,000. ABC Corporation follows accounting principles and commonly accepted accounting conventions.

Here’s how various principles and conventions come into play:

Historical Cost Convention: The van is initially recorded on ABC Corporation’s books at its historical cost of $30,000 by the historical cost convention.

Consistency Convention: ABC Corporation uses the straight-line depreciation method for all its vehicles. This adherence to a consistent accounting method ensures uniformity in its financial reporting.

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Substance over Form Principle: While the legal form suggests that the van can be used for more than 5 years, the economic reality dictates that it will be used and depreciated over this period. The substance-over-form principle ensures that the financial statements reflect the economic reality.

Depreciation Principle: ABC Corporation follows the depreciation principle, which requires spreading the cost of the van over its estimated useful life. The calculation is as follows:

  • Depreciation Expense = (Cost – Residual Value) / Useful Life
  • Depreciation Expense = ($30,000 – $5,000) / 5 years
  • Depreciation Expense = $5,000 per year

Full Disclosure Convention: In the financial statements or accompanying footnotes, ABC Corporation provides full disclosure about its accounting policies, including the depreciation method used and the estimated useful lives of its assets. This convention ensures transparency for stakeholders.

Conclusion: Accounting Principles vs. Conventions

Accounting principles and conventions play a pivotal role in ensuring the accuracy, consistency, and transparency of financial reporting. In our example of depreciating a business vehicle, we observed how these principles and conventions work in tandem to guide accounting practices and financial disclosures.

Together, these principles and conventions create a robust framework for financial reporting, helping businesses provide reliable and meaningful financial information to stakeholders. Adhering to these standards ensures compliance with regulatory requirements and fosters trust among investors, creditors, and other interested parties. 

Ultimately, applying these principles and conventions ensures that financial statements convey a faithful representation of a company’s financial position and performance, facilitating sound decision-making in business and finance.

FAQ

Most frequent questions and answers

The 5 basic accounting principles are:

  • Consistency Principle: This principle requires a company to use the same accounting methods and procedures from one period to another, ensuring consistency in financial reporting.
  • Relevance Principle: Financial information should be relevant and useful for making informed economic decisions.
  • Reliability Principle: Financial information must be reliable and free from bias to instill confidence in stakeholders.
  • Comparability Principle: Financial statements should be prepared in a way that allows for meaningful comparisons over time and with other companies.
  • Materiality Principle: Immaterial items can be ignored to avoid cluttering financial statements with insignificant details.

The 3 basic principles of accounting are often referred to as the “Three Pillars of Accounting”:

  • Revenue Recognition Principle: This principle elaborates the conditions about when and how revenue should be recognized in financial statements, ensuring it is earned and realizable.
  • Matching Principle: This principle states that expenses should be recognized in the same period as the revenue they help generate, creating a cause-and-effect relationship.
  • Accrual Principle: Transactions should be recorded when they occur, not necessarily when cash changes hands, to show a more accurate picture of a company’s financial position.

Important accounting principles include:

  • Historical Cost Principle: Assets on the balance sheet should be recorded at their original purchase cost.
  • Going Concern Principle: Assumes that a business firm will continue to operate indefinitely unless evidence suggests otherwise.
  • Conservatism Principle: Encourages accountants to recognize losses as soon as anticipated but only recognize gains when realized.

The “Three Golden Rules” of accounting are:

  • Debit (Dr) what comes in, credit (Cr) what goes out: When an asset or expense increases, it is debited. When it decreases, it is credited.
  • Debit the receiver, credit the giver: In a transaction involving a transfer of assets or funds, the account receiving the benefit is debited, and the account providing it is credited.
  • Debit (Dr) all expenses and losses, credit (Cr) all incomes and gains: Expenses and losses are debited, while incomes and gains are credited.

    What are the 5 conventions of accounting?

The 5 conventions of accounting are:

  • Historical Cost Convention: Assets are recorded at their original purchase cost on the balance sheet.
  • Consistency Convention: Consistency in accounting methods and procedures should be maintained over time.
  • Full Disclosure Convention: All material information should be disclosed in financial statements or accompanying footnotes.
  • Materiality Convention: To avoid clutter, immaterial items can be omitted from financial statements.
  • Conservatism Convention: Accountants should be cautious when estimating values and recognizing revenues or gains.

Accounting conventions are widely accepted practices in the accounting industry. They include the historical cost convention, consistency convention, full disclosure convention, materiality convention, and conservatism convention. These conventions help ensure uniformity, transparency, and practicality in financial reporting.

Accounting principles are mandatory rules and guidelines that provide the foundation for financial reporting. They include consistency, relevance, reliability, comparability, and materiality. In contrast, accounting conventions are widely accepted practices within the industry that provide flexibility and practicality in applying those principles. 

Conventions, like the historical cost or consistency convention, are not mandatory but help ensure that accounting practices align with the principles while accommodating specific business circumstances. Principles are mandatory, while conventions are optional but highly recommended for consistency and industry standards.

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