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Choosing the correct accounting convention

Under the accounting framework, a company needs to follow the accounting conventions and asset valuation principles in preparing and publishing its financial declarations. According to Atrill and McLaney (2008), a company's financial position is measured and reported based on the following conventions and asset valuation:

(i) Business entity convention
(ii) Historical cost convention
(iii) Prudence convention
(iv) Going concern convention
(v) Dual aspect convention


Of the conventions listed (or some other convention), which is the most important to follow? Why?

Solution Preview

Let's start by taking a brief look at what each convention means, in its simplest form.

The business entity convention means that, for all accounting purposes, the business and its owner or owners are treated as separate entities. An example of this would be a corporation, as opposed to a sole proprietorship, where the business and owner are seen as one in the same. This concept is also known as the enterprise concept, and is actually one of the most important concepts taught in accounting.

The historical cost convention holds that assets should be recorded only at their historic cost, which is the cost the asset was acquired at (purchased for).

The prudence convention is about being prudent - and basically states that when preparing an income statement, accountants should be cautious in their numbers. This has also been called the conservative convention, since it's all about those preparing the financial statements to be conservative. Other names for it are the conservative accounting approach, which also stems off of the minimalist reporting method (only included what's bare-bones needed in our figures). This convention basically maintains that assets should not, in any way, be overstated, and liabilities should not, in any way, be understated. A good example that's always used when discussing the conservative approach is inventory valuation. When inventory is valued, a conservative convention would value inventory for what is what purchased at, which is the minimum it's guaranteed to be worth (since that's what the company bought it for). The non-conservative approach would be to value the inventory at what it's worth today (presumably higher in value than when purchased).

The going concern convention assumes that the business can continue to operate in the near future. As the ...

Solution Summary

The solution provides a detailed discussion of each of the accounting conventions and how to choose the correct convention that is the most important to follow.