Generally Accepted Accounting Principle--part 2

Accounting convention:

Now we have come to the second part of the GAAP which is called Accounting convention. Accounting convention is the tradition that has been famous since long and that helps us in preparing accounting statements. There are four Accounting traditions that have been followed in doing accounting. They are as follows:  

1)    Conservatism:

According to the principle of conservatism we should anticipated all the possible loss but not possible profits. The reason behind this concept is earlier accountant anticipated all the possible  profits and recognized them in the balance sheet but later on used to find that the anticipated profits have not been materialize and thus shaken the trust of the users of financial statements that is why this concept came into existence that an accountant should anticipated all the losses and recognized them but cannot recognized anticipated profits thus “playing safe” is the main concept of this tradition or convention. It is because of this concept that stock is to be recorded at a lower of “cost” or “Net Realizable Value”.

This concept is also called “prudence”. It is also to be noted that the “secret reserves” created in the name of prudence is forbidden because if it were allowed, every losses of the company can easily be adjusted from the secret reserves which would be against the system of accounting which reflects the true financial position and performance of business.

Consistency:

Consistency is the fundamental accounting assumption. The principle of consistency states that the method of accounting should be consistent year after year; it should not be changed. This is followed because it helps in the comparability of the performance of business. Thus if depreciation is followed in straight line method, the company is expected to stick with that method in every year unless otherwise provided or guided by the act or government. Consistency is the tradition in accounting that every accountant should keep in mind while recording transaction in the books of accounts.

However consistency doesn’t mean inflexibility. When there are compelling reasons for a change, when management thinks that change in the method of accounting can reflect true and fair view of the financial position of a business they can change the method and notes should be disclosed stating reason of change in the method of accounting and its effect on the balance sheet.

Materiality:

Materiality refers to an importance of an item or event in the financial statement. This convention says while recording transaction in the financial statement an accountant should consider which is important and material and immaterial items should be ignored. Information is material if its absence can influence the economic decision of the users of financial statements. Materiality not always depend on the size of an item sometimes small item can have significant affect on the decision of the users of financial statement. Thus, this convention allows an accountant to think whether an item can have any effect on the decision of the users of financial statement.

If this convention were not come into existence, an accountant would have no choice but to recognized every single detail with small amount and the results would be that the financial statement would be impossible to read and the reader first would have to edit unwanted part of the balance sheet and then would read, that is why it was the tradition made by an accounting body to recognized in the financial statements only material items.

Thus, we have come to the end of our very important topic of GAAP about which every student of accounting should have deep and sound knowledge. Hope I have succeeded  in my attempt to make the reader understand this full topic conceptually.

Coming soon guys with the new topic of accounting a step  to follow after learning GAAP.