What it means
Accounting standards cannot anticipate every transaction a business will ever enter into. Conventions fill those gaps with widely accepted habits of treatment that preparers, auditors and regulators all recognise.
They are less formal than a written rule but far more binding than personal preference. The four conventions named most often are conservatism, consistency, materiality and full disclosure.
Conservatism says that when two treatments are equally defensible, you pick the one that reports lower profit or lower assets. Consistency says that once a method is chosen you keep using it, so this year can be compared with last year.
Materiality asks whether an item is big enough to change a reader's decision, and if it is not, precise treatment is not worth the cost of achieving it. Full disclosure requires that anything a reasonable reader would want to know appears either in the statements themselves or in the notes attached to them.
Together the four keep reporting cautious, comparable, proportionate and open. In business conversation conventions matter because they explain why two honest companies can report different profits from almost identical trading.
A firm applying conservatism firmly will write inventory down sooner and recognise revenue later than a firm sitting at the optimistic end of the same rules. Neither is cheating, but a lender comparing the two needs to know which posture each has taken.
Conventions are also the first thing an auditor probes when a number looks suspiciously convenient. If a company changes an estimate or a method in the very year it needs to hit a bonus target, the consistency convention gives the auditor a reason to challenge it.
That challenge is usually settled by extra disclosure rather than by forcing a different figure.
In practice
Real-world examples.
Example
A software company with $12,000,000 of revenue sets a materiality threshold of $25,000 for its year end work. When a $1,800 keyboard and monitor bundle is bought for a new hire, it is expensed straight away rather than capitalised and depreciated over three years, because the convention says the extra precision is not worth the effort.
Example
A restaurant group has valued food inventory on a first in, first out basis for nine years. The finance director is tempted to switch method because it would lift reported profit, but the consistency convention means any change must be justified, applied to prior year comparatives and disclosed in the notes.
Example
A contract manufacturer is being sued by a former distributor for $600,000. No provision is made because the lawyers think a loss is unlikely, but the full disclosure convention requires a note describing the claim so that readers can form their own view of the risk.
Formula
Calculation
Most conventions are qualitative, but conservatism has a direct arithmetic form in inventory measurement:
Carrying value = the lower of cost and net realisable value
Net realisable value = expected selling price - costs to complete and sell
A homeware wholesaler holds a batch of ceramic planters that cost $80,000 to buy in. Demand has dropped, and the batch can now realistically be sold for $70,000, but only after $5,000 of repackaging and freight.
Net realisable value = $70,000 - $5,000 = $65,000. The lower of cost ($80,000) and net realisable value ($65,000) is $65,000, so inventory is written down by $80,000 - $65,000 = $15,000. Inventory on the balance sheet falls from $80,000 to $65,000, and the $15,000 is charged against profit in the current period rather than left sitting as an asset that will never be recovered.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Harbourline Ceramics, an invented mid-sized homeware importer, ended its financial year with a warehouse full of a discontinued planter range that had cost $80,000. The sales director argued that the range would eventually clear at full price and that no write-down was needed.
The financial controller applied the conservatism convention instead. Working from actual clearance offers received, she set net realisable value at $65,000 and booked a $15,000 write-down, which cut reported profit from $310,000 to $295,000 and cost the sales team part of its bonus.
Eleven months later the range sold for $68,000 gross, about $63,000 after selling costs, which was close to the cautious figure and well below the optimistic one. Because the fictional company had taken the hit early, its bank saw a steady profit trend rather than a sudden loss, and the renewal of its overdraft went through without an argument.
Watch out
Common mistakes.
- Treating conventions as optional, when auditors, lenders and regulators expect them to be applied and will question a set of accounts that ignores them.
- Confusing conservatism with pessimism, and deliberately understating profit or hiding reserves, which is a distortion in the opposite direction and equally unacceptable.
- Setting a materiality threshold once and never revisiting it, so a growing business keeps agonising over items that no longer matter to any reader.
Questions
People also ask.
Are accounting conventions the same as accounting standards?
No, standards are written rules issued by a standard setter, while conventions are the customary practices that guide judgement where the rules are silent or allow a choice.
Can a company change a convention it has been applying?
It can change the accounting policy that flows from a convention, but only with a genuine reason, disclosure of the effect and usually restatement of the comparative figures.
Why does materiality vary between companies?
Because it depends on what would change a reader's decision, so a threshold of $25,000 may be sensible for a business with $12,000,000 of revenue and far too high for one with $500,000.
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