Advanced Financial Accounting Theory and Analysis: The Concept of Conservatism

(Author’s name)

(Institutional Affiliation)

Abstract

Conventionally, the concept of conservatism has been exploited in accounting in relation to financial reporting in organizations. Economists argue that application of the principles of conservatism in financial reporting is beneficial to organizations as it allows them to acknowledge company loses, as opposed to, profits (Schroeder et al., 2010). Conservatism prevents organizations from making financial decisions that are potentially detrimental owing to lack of acknowledgement of the probable financial failures. In relation to capital maintenance concepts, conservatism seems to be more consistent with financial capital maintenance rather than physical capital maintenance owing to the different principles that characterize the two concepts.

Key words: Conservatism, Financial Reporting, Physical capital Maintenance, Financial Capital Maintenance

Introduction

In accounting, conservatism is defined as the discrepancy verifiability mandatory for identification of profits against losses (Watts, 2002). Put simply, conservatism is a method of accounting that acknowledges the losses that a firm has occurred before the firm’s profits. This method of accounting implies accurate authentication of accounting procedures before the claim of any profit, especially incurred expenditures and losses (Schroeder et al., 2010). The principle behind this form of accounting is ‘anticipate no profit, but anticipate all losses’. This further implies that all financial statements created using this theory place more emphasis on losses than profits. This, in turn allows accountants to mitigate the downside risks associated with certain financial decisions as compared to others. Admittedly, conservatism has affected financial reporting because it implies strict revenue-detection, which in turn, fosters proper financial reporting by firms. Firstly, conservatism encourages accountants to defer revenue until full verification is acquired. This ensures that the financial reports presented are accurate and consistent with the organization’s financial activities over time. Additionally, conservatism encourages accountants to, accurately determine, the company’s risk on earning. It guides accountants in terms of recognizing and reporting financial transactions subject to risks and uncertainty hence increase the credibility of the financial reporting system (Schroeder et al., 2010).

This paper examines the concept of conservatism in accounting, illustrating how conservatism has affected financial reporting in firms. The paper explains why conservatism is more relevant, and consistent with financial capital maintenance concepts, as opposed to, physical capital maintenance concepts.

Conservatism and Financial Statements

Economist have long argued on the authenticity and relevance of financial statements that have been developed through the application of principles of conservatism, with most arguing that such financial statements do not provide the necessary information required for proper financial reporting. The provision of financial statements that ignore financial gains and instead recognize fiscal losses provides information that is relevant and authentic. Financial statements that have been created using the concept of conservatism tend to be cautious in nature, with most of them exhibiting a subjective overvaluation of debts and undervaluation of the company assets (Watts, 2002). Such statements only recognize profits after the realization of sales, as well as, the losses incurred during a transaction. Primarily, conservatism implies the reporting of losses in a timely fashion, as opposed to, quick reporting of a company’s profits. Since all the partners to an organization contract on the financial statement to signify financial covenants, conservatism allows all the key players in the transaction to receive a timely warning concerning deteriorating financial performance. By observing the principles of conservatism in the creation of financial statements, accountants are discouraged from committing any financial violations as conservatism seeks to identify such violations straight away (Watts, 2002). Financial statements that have been created using the concept of accounting conservatism allow the organization, as well as, the stakeholders to take protective action, hence reducing the downside risks.

Conservatism and Physical Capital Maintenance

Physical capital maintenance is an accounting concept of capital maintenance stating that return on capital usually occurs when the end period of the physical productive capacity of an organization exceeds the period beginning (Schroeder et al., 2010). This is usually in exclusion of company transactions with its owners. Put simply, physical capital maintenance is a concept in accounting that recognizes income presented after making the necessary physical replacement of a company’s operating assets. The concept of conservatism is not consistent with this theory because it considers losses as returns of capital and for that reason, does not incorporate them in the income (Schroeder et al., 2010). The physical capital maintenance concept tends to exhibit a inclination towards the addition of asset value, which is the opposite of the underlying principles of conservatism.

Conservatism and Financial Capital Maintenance

Financial capital maintenance is another concept of capital maintenance stating that a return on capital occurs when the end period of the financial capacity of an organization exceeds the beginning period (Schroeder et al., 2010). Financial capacity, in this case refers to the financial value of a company’s net assets, excluding company transactions with owners. The concept of conservatism in accounting is consistent with financial capital maintenance as financial capital maintenance acknowledges losses as returns on capital, hence, including them during financial reporting (Schroeder et al., 2010). Unlike the physical capital maintenance concepts, this concept has the tendency to undervalue company assets with the aim of preventing any overestimation of company profits, hence agreeing with the principles of conservatism.

References

Schroeder, R. G. et al. (2010). Financial Accounting Theory and Analysis: Text and Cases. New

York: John Wiley and Sons.

Watts, R. L. (2002). Conservatism in Accounting. Retrieved from:

http://www.ekonomiportalen.se/Ross%20L%20Watts.pdf