Advanced Financial Accounting Theory and Analysis: The Concept of Conservatism

Advanced Financial Accounting Theory and Analysis: The Concept of Conservatism

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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 releva.............