Accounting convention refers to the established and agreed-upon method of documenting specific elements within a company's financial records. These conventions are essentially the backbone of financial accounting practices, creating a set of guidelines that have arisen from the practical implementation of accounting principles. This system of guidelines ensures consistent and comparable financial statements across different businesses and industries.
Accounting conventions form part of the Generally Accepted Accounting Principles (GAAP). The GAAP is a set of accounting standards used by businesses in the United States for their 10-Q filings with the Securities and Exchange Commission (SEC). Its widespread use and acceptance have led to its adoption as the foundation for regulatory accounting practices in other countries.
While GAAP plays a crucial role in accounting practices, it's not the only method businesses employ. Non-GAAP methods, also known as pro-forma accounting practices, represent alternative, informal conventions. Companies may choose to use these when they feel that GAAP's strict adherence doesn't provide sufficient flexibility to articulate some of their financial decisions in the most comprehensible or advantageous light.
Non-GAAP conventions are often used in marketing materials and exclude certain one-time transactions labeled as "unusual" or "non-recurring." These methods tend to spotlight a company's revenue, often obscuring its expenses. However, it is essential to remember that these methods should not be used to deceive investors. The SEC has clearly warned that using pro-forma accounting to mislead investors is tantamount to fraud. Consequently, a publicly-traded company should tread carefully when using conventions other than GAAP.
Accounting conventions have a fundamental role in guiding how companies record certain business transactions not yet fully encompassed by accounting standards. While they are not legally binding, these conventions are generally accepted by accounting bodies. They promote consistency, help accountants navigate practical issues in preparing financial statements, and contribute significantly to the overall financial transparency of a business.
A convention also provides guidance on which types of businesses should use cash accounting versus accrual accounting. It's worth noting that if an oversight organization introduces a guideline that addresses the same subject as an accounting convention, the latter becomes inapplicable.
Four key accounting conventions are widely recognized in the financial world: conservatism, consistency, full disclosure, and materiality. These conventions play an indispensable role in how companies report their financial performance and condition, ensuring that all stakeholders have a clear and reliable view of a company's financial health.
Accounting conventions serve as the bedrock of reliable and consistent financial reporting. From the widely-accepted GAAP to alternative non-GAAP methods, these conventions ensure that businesses across various industries adhere to recognized accounting standards. Moreover, these conventions aid in the preparation of financial statements, helping accountants overcome potential hurdles and ensuring transparent disclosure of a company's financial position. The practice of adhering to these conventions enhances the credibility of a company's financial reporting, ultimately fostering trust among investors and other stakeholders.
Summary:
An accounting convention is an established an agreed-upon method of documenting specific items on a company’s books.
The most widely-used accounting conventions are part of the Generally Accepted Accounting Principals (GAAP), which is the only accounting methodology accepted for quarterly 10-Q filings with the SEC in the United States, and has also become the basis for regulatory accounting practices in other countries.
There are also non-GAAP methods, also known as pro-forma accounting practices, which represent more informal conventions. Companies are likely to use non-GAAP methods in marketing materials, especially if they feel that GAAP does not give them enough flexibility to illustrate some of their financial decisions clearly, or in the best possible light.
Even so, investors have full access to the documents filed with the SEC if they request them. Pro-forma conventions disregard one-time “unusual or non-recurring” transactions, which could take many forms, and tend to obscure the expenses of the company and focus on the revenue.
The SEC has made it clear that using pro-forma accounting to mislead investors will be considered fraud, so a publicly-traded company must be very careful if using conventions other than GAAP. These non-GAAP methods will be used to make proposals and give projections to the board, lending banks, and others who are not investors.
A convention may also say which types of businesses should use cash accounting vs accrual accounting, which are explained in another article.
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