Question

In certain instances, companies do not strictly apply accounting principles because of modifying conventions or constraints. Identify and describe the impact on the accounting process of the three modifying conventions as presented in the Accounting Principles: A Business Perspective, Financial Accounting text. Provide an example of where each modifying convention or constraint may be employed.

Answer 1

Modifying conventions are customs emerging from accounting practice that alter the results obtained from a strict application of accounting principles.

Three modifying conventions are cost-benefit, materiality, and conservatism.

Cost-benefit -consideration involved deciding whether the benefits of including optional information in financial statements exceed the costs of providing the information. Users tend to think information is cost free since they incur none of the costs of providing the information. Preparers realize that providing information is costly. The benefits of using information should exceed the costs of providing it. The measurement of benefits is inexact, which makes application of this modifying convention difficult in practice.

Materiality - Materiality refers to the convention that some material is immaterial and can be dealt with quickly though it that may not be theoretically correct. In order to apply this convention, the theoretically incorrect information has to have no bearing on a user’s decision making process over the course of its useful life.

Conservatism - means being prudent or cautious during preparation of financial statements to not overstate assets and net income. Overstatements could mislead investors and creditors into making poor decisions with regards to the company. Possible losses can be anticipated and recorded, but potential gains are not to be recorded until they are realized. A conservative approach would be to delay the entry of a sale which would produce a gain on the end of year financial report just in case the sale does not get finalized. The reported gain for a sale that fell through would be inaccurate and misleading.

1. Inventory is recorded at the lower of cost or market value.(Conservatism)

2.For example, they may debit the cost of a wastebasket to an expense account rather than an asset account even though the wastebasket has an expected usefullife of 30 years. It simply is not worth the cost of recording depreciation expense on such a small item.(Materiality)

3.