Accounting conservatism refers to financial reporting guidelines that require accountants to exercise a high degree of verification and utilize solutions that show the least aggressive numbers when faced with uncertainty. It is a longstanding principle in financial reporting intended to protect users of financial information from inflated revenues and to make sure that all potential liabilities are recorded as soon as they are realized.
The guideline requires that losses be recorded as soon as they are quantified (certain or uncertain), while gains are only recorded when they are assured of being realized. The general concept is to minimize the overstatement of revenue and assets and to understate the liabilities and expenses.
Accounting conservatism is a financial reporting principle that requires accountants to prepare financial statements with caution and perform proper verification of accounting entries.
The U.S. Generally Accepted Accounting Principles (GAAP) requires all companies to adhere to the accounting principles to guarantee the utmost accuracy when reporting their financial statements.
Although accounting conservatism encourages managers to use professional judgment, it leaves some room for manipulating accounting values.
How Accounting Conservatism Works
Companies are required to follow several accounting conventions to guarantee the utmost accuracy when reporting their financial statements, as provided by the Generally Accepted Accounting Principles (GAAP). Conservatism is one of such accounting standards that require accountants to choose methods and estimates that keep the book values of net gains relatively low in situations of uncertainty.
The accounting rule provides guidelines for estimation in times of uncertainty and in circumstances where there is a likelihood of measurement bias from an accountant. It also arises naturally from two contracting parties and is considered an efficient concept for contracting.
Such a perspective is based on the idea that contracting parties face asymmetric payoffs from certain contracts – such as executive compensation and debt. As a result, the payoffs lead to timelier financial reporting that can potentially impact the contracting parties.
Accounting conservatism affects the quality of figures reported in the balance sheet, income statement, and other financial statements. In the event of increased investment, this principle leads to relatively lower reported earnings than other liberal accounting options. However, the unrecorded reserves created by the lower earnings give the flexibility to report more earnings in the future. A company can inject more funds in reserve to increase investment, thereby reducing earnings.
Conversely, a company can also distribute funds in reserve to increase earnings and subsequently minimize investment. However, uncertainties can still arise, whether intended or not. With accounting conservatism, current earnings are increased, making them a poor indicator of the future marginal return.
Accounting conservatism sets the guideline when an accountant is facing a financial reporting dilemma between two alternatives. In such a situation, the accountant selects the inferior option. A company is forced to adopt a cautious approach in a worst-case scenario.
For example, the book values of assets and revenues are intentionally understated when reporting, while losses and liabilities are overstated. Accountants are required to record and expand the potential impact of uncertainty about incurring losses. In the same vein, accountants are advised to ignore any possibility of market reward until it occurs.
Examples of Accounting Conservatism
The principles of accounting conservatism provide guidance for inventory valuation. The principles require a company to use historical cost or replacement value when estimating the reporting value for inventory. They are also applicable in accounting standards, such as casualty losses and accounts receivable.
For example, a company that expects to win litigation is obliged to meet all the requirements of revenue recognition before it reports the gains. However, the company must record the economic loss if it expects to lose a lawsuit. Other information that is subject to the disclosure requirement includes contingent liabilities, such as product warranty compensation, unearned revenue, or royalty payments.
Accounting conservatism is also used to record and report revenue. The principle requires that revenues and related expenses are matched in the same period that they occur. The revenue cannot be recorded if it is not realizable. It is premised on the fact that no revenue may be recognized if a transaction does not create a claim to an asset or exchange of cash.
Pros of Accounting Conservatism
The asymmetric treatment of financial transactions suggests that accounting conservatism will persistently report a lower net income, as well as lower future market rewards. The unconditional understatement of a company’s financials offers several advantages.
Most notably, it encourages management to face optimism or exaggerated uncertainty in its decisions. It also means that there is a higher margin of security against distressed outputs.
In addition, accounting conservatism also leads to objective book values that are prepared based on the Generally Accepted Accounting Principles (GAAP), making it easier for investors to compare performance across different markets and periods.
Limitations of Accounting Conservatism
Several disadvantages affect accounting conservatism. First, the asymmetric response of earnings to economic gains and losses is open for interpretation. In such regard, the management of a company may manipulate accounting values to their advantage.
Secondly, accounting conservatism promotes revenue shifting. A transaction can be deferred into the next period if it does not meet the reporting requirements of the current period.
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