Procedural Conventions - the Convention of Periodicity

Procedural conventions - The convention of periodicity

It may safely be assumed that the custom of making periodic reports to the owner of a business dates from the time when wealthy men employed servants to manage and oversee their affairs. Periodic accounting has its origin in the idea of control, therefore, and company law to this day sees the role of financial accounting reports as being essentially the communication of financial information from the managers of the business, that is the directors, to the owners of the business, that is the shareholders. However much we may disagree with this view of the relationship of directors and shareholders as being unrealistic, we must accept that there is an element of shareholder control over company directors which stems from the legal duty laid on the latter to issue financial reports on their stewardship of the firm's assets.

The convention of periodicity is now established by law as regards certain types of reports such as balance sheets and profit and loss accounts. The Companies Act requires yearly reports to shareholders, and the Income Tax Acts require accounts for all businesses to be submitted yearly. There is no reason, however, to prevent companies from providing financial information at more frequent intervals to investors, if they so wish.

The idea of making yearly reports has grown out of custom, and many would question the wisdom of selecting an arbitrary period of 12 months as a basis for reporting upon the activities of a business. The idea of yearly reporting is strongly entrenched, and even the Government runs its business on a yearly basis and budgets for one year, although many of its activities are continuing ones which cannot be seen correctly in the perspective of 12 months. This is equally true for all large companies, and many smaller businesses.

Example

Universal Chemicals Ltd manufactures a wide range of chemical products and has factories throughout the country. Owing to unusually difficult labour relations, Government control on prices, rising raw material costs and stiffening competition, its reported income for the year ended 31 December 19X0 has decreased by 10 per cent over the previous year. Its borrowings, however, have increased by 20 per cent due to an enlarged capital investment programme which is designed to add substantially to income in about five years' time.

Clearly, in this case the reader of the report for the year 19X0 should consider the report in its proper context, and look to the long-term trend of income and to the better financial position which is expected in the future.

The convention of periodicity as expressed in yearly accounting fails to make the important distinction between the long-term trend and the short-term position. Hence, it places limits on the usefulness of the information communicated to shareholders and investors.

Together with the matching convention, the convention of periodicity seeks to relate all the transactions of one particular year with the expenses attributable to those transactions. From a practical point of view, accountants are compelled to carry forward expenses until they can be identified with the revenues of a particular year, and to carry forward receipts until they can be regarded as the revenues of a particular year in accordance with the realization convention. Since all assets are 'costs' in accounting, the convention of periodicity creates difficulties for accountants as regards the allocation of fixed assets as the expenses of particular years.

So far we have mentioned the effect of the convention of periodicity on the usefulness of the information communicated to external users, but we should say a word about its effect on income measurement. The majority of economists treat accounting income as the 'income' of a business, and hence as a measure of the income which investors and shareholders derive from their investment in the firm. As a result, they impose the economic criteria appropriate to the measurement of economic income to accounting income and are very dissatisfied with shortcomings of accounting income which they see as stemming from accounting conventions for calculating periodic income. Ideally, of course, an accurate measurement of the income or loss of a business can only be made after the business has ceased operating, sold off all its assets and paid off all its liabilities. The net income accruing to investors would then be the difference between the sum total of all their receipts, either as dividends or capital repayments, and their initial investment. It is clear, however, that accounting income is merely the result of completed transactions during a stated period: the convention of periodicity is a statement of this view.


For More Information On Verifying Balances

Read on: Procedural Conventions - the Matching Convention

Procedural conventions - The matching convention

One of the important purposes of financial accounting is to calculate income resulting from transactions. This means identifying the gains resulting from transactions and setting off against those gains the expenses which are related to those transactions. The realization convention identifies the timing of gains, and the accrual convention enables the accountant properly to record revenues and expenses; neither, however, helps the accountant to calculate income. The matching convention links revenues with their relevant expenses.

ExampleProcedural Conventions - the Matching Convention