ACCOUNTING CONVENTIONS - Convention of Materiality

The role of this convention cannot be over-emphasised in as much as accounting will be
unnecessarily overburdened with more details in case an accountant is not able to make an
objective distinction between material and immaterial matters. American Accounting
Association (AAA) defines the term materiality as under :
“An item should be regarded as material if there is reason to believe that knowledge of its
would influence the decision of informed investor”.
Kohler has defined materiality as under :
“The characteristic attaching to a statement, fact, or item whereby its disclosure or the
method of giving it expression would be likely to influence the judgement of a reasonable
person”.
Some of the examples of material financial information to be disclosed are likely fall in the
value of stocks, loss of markets due to competition or Government regulation, increase in wage
bill under recently concluded agreement, etc. It is now agreed that information known after
the date of balance sheet must also be disclosed.
Another example of materiality is the question of allocation of costs. An item of small
value may last for three years and technically its cost must be allocated to every one of the
three years. Since its value is small, it can be treated as the expense in the year of purchase.
Such a decision is in accordance with the principle of materiality. Likewise, unimportant items
can be either left out or merged with other items. Sometimes items are shown as footnotes or in
parentheses according to their relative importance.
It should be noted that an item material for one concern may be immaterial for another.
And similarly, an item material in one year may not be material in the next year.
As per A.S. – 1, materiality should govern the selection and application of accounting
policies. According to the consideration of materiality financial statement should disclose all
items which are material enough to affect evaluations or decisions.

ACCOUNTING CONVENTIONS - Convention of Disclosure

The convention of disclosure implies that accounts must be honestly prepared and all
material information must be disclosed therein. The notion is so important (because of divorce
between ownership and management) that the Companies Act makes ample provisions for
the disclosure of essential information in company accounts. The contents of balance sheet and
profit and loss account are prescribed by law. These are designed to make disclosure of all
material facts compulsory.

The term disclosure does not imply that all information that anyone could conceivably
desire is to be included in accounting statements. The term only implies that there is to be a
sufficient diclosure of information which is of material interest to proprietors, present and
potential creditors and investors. The practice of appending notes relative to various facts or
items which do not find place in accounting statements is in pursuance to the convention of
full disclosure of material facts. Examples are :
(a) Contingent liabilties appearing as a note,
(b) Market value of investments appearing as a note.
Business is now increasingly managed by stewards (managers) and they owe a duty to
make a full disclosure to the persons who have cotributed the capital. Financial accounting,
while reporting on stewardship, has to make full disclosure. ‘Openness in company affairs is
the best way to secure responsible behaviour. Because of the wide recognition of this principle
now there is an “Accounting Standard” which requires the disclosure of all significant
accounting policies adopted in the preparation of financial statements, due to the effect of such
policies on the financial statements. The accounting principle of ‘Going Concern’, ‘Consistency
and ‘Accrual’ are considered fundamental in the preparation of financial statements and need
not be disclosed. Only when the assumption is not followed the fact should be disclosed. Apart
from disclosure of accounting policies, A.S. – 1 deals with information to be disclosed in financial
statements.
The concept of disclosure also applies to events occurring after the balance sheet date and
the date on which the financial statements are authorised for issue. Such events include bad
debts, destruction of plant and equipment due to natural calamities, major acquisition of another
enterprise and the like. Such events are likely to have a substantial influence on the earnings
and financial position of the enterprise. Their non-disclosure would affect the ability of the
users of such statements to make proper evaluations and decisions.

Accrual Concept

An associated concept to be discussed in the context of ‘matching principle’ is the accrual
system of accounting which is favoured by the modern accountants as against cash system of
accounting. Under this method revenue recognition depends on its realisation and not actual
receipt. Likewise costs are recognised when they are incurred and not when paid. This necessitates
certain adjustments in the preparation of income statement. In relation to revenue, the
accounts should exclude amounts relating to subsequent period and provide for revenue
recognised but not received in cash. Likewise, in relation to cost provide for costs incurred but
not paid and exclude costs paid for subsequent period. Under the cash system of accounting
revenue recognition does not take place until cash is received and costs are recorded only after
they are paid. From the discussion it is clear that the matching principle is not followed in the
case of cash system of accounting and the operating result prepared on this basis are not in
conformity with generally accepted accounting principles. There are hybrid systems of accounting
which combine the features of cash and accrual systems and are also recognised by
taxation authorities. Under hybrid system certain revenues may be shown on cash basis while
others are shown on accrual basis.

Verifiable and Objective Evidence Concept

It expresses that accounting data are subject to verification by independent experts i.e.
there must be documentary evidences of transactions which are capable of verification. Otherwise,
the same will neither be verifiable nor be realisable or dependable. In other words, accounting
data must free from any basic. Because, verifiability and objectivity imply reliability,
trustworthiness, dependability which are very useful for conveying the accounting data and
information furnished in periodical accounting reports and statements. There should always
be some documentary evidences in establishing the truth reflected in the said reports or statements.
Entries which are recorded in accounting from the transactions and data which are
reported in financial statements must be based on objectively determined evidence. The confidence
of users of the financial statement cannot be maintained until there is a close adherence
to this principle, invoices and vouchers for purchases, sales and expenses, physical checking of
stock in hand.

Balance Sheet Equation Concept

The Historical Cost Concept needs support of two other concepts for practical purposes
viz. (i) the Money Measurement Concept (ii) the Balance Sheet Equation Concepts. Accounting
processes, however, conforms to an algebric equation which, in other words is involved in
two laws of nature, i.e., the law of constancy of matter and the law that every effect originates
from a case.
In relation to the former, it may be deduced that all that has been received by us must be
equal to (=) all that has been given to us (In accounts, receipts are classified as debits and
giving or sacrifices are classified as credits). Here, the equation comes
Debit = Credit
(That is, in other words, every debit must have a corresponding equal credit or viceversa).
All receipts (referred to above) may again be classified into (i) benefits/services received
and totally consumed (which are known as expenses), (ii) benefits or services received but not
used properly or misused (which are known as losses) and (iii) benefits or services received
but kept to be used in future (which are known as assets). Similarly, in the opposite case, all
that have been given by others may also be classified into (i) What has been given to us but are
not to be repaid (which are known as incomes or gains) and (ii) What has been given by others
but has to be repaid at a later date (which are known as liabilities).
Therefore, the above equation may again be re-written as under :
Expenses + Loss + Assets = Income + Gains + Liabilities
Or, Asset = Net Profit (-) Net Loss + Liabilities
Liabilities become due either to outsider or to the owner, viz. The proprietors, in the case :
Assets = Net Profit or (-) Net Loss + External liabilities + Dues to Proprietors.
We know that proprietors due increases with the amount of net profit whereas decreases
with the amount of net loss. The same is known as equity in the business. So, the above equation
comes down to :
Assets = Equity + External Liabilities
Again, from the proprietor’s point of view, the equation can also be re-written as under :
Proprietor’s Fund or Equity = Asset – Liabilities
E = A - L
From the above, it may be said that the entire accounting process depends on the above
accounting equation.