The Role of Conservatism in Financial Reporting

Topics: Balance sheet, Financial statements, Information asymmetry Pages: 12 (3906 words) Published: June 4, 2011
The Role of Conservatism in Financial Reporting

Table of Contents

Applications of Conservatism in Accounting4
Advantages associated with Conservatism7
Disadvantages associated with Conservatism11
Recommendations and conclusions14

This report investigates the application of conservatism in accounting and its role in financial reporting. We also examine and compare the advantages and disadvantages associated with conservatism and provide our opinion about conservatism. Conservatism may be a controversial accounting measurement principle but it has a long history and its use is far-reaching. Conservatism by definition is that all probable losses or expenditures will be recognized as they are discovered and revenue will be deferred until it is verified. As an important accounting principle, it has been widely used for preventing the overstatement of assets and income, understatement of debt and cost, and plays the role of early warning signal to help reduce risks. Conservatism principle's origins can be traced back to the Middle Ages. For the purpose of alleviating responsibilities of entrusted property, the custodians did not appreciate any expected value for its custody property; then as the 19th century the popularity of accounting accountability, the idea was gradually recognized and accepted by the accounting profession in order to reduce the rising litigation risks accountants were facing. However, the principle implicates that accountants can use all sorts of means to undervalue assets and income, overestimate liabilities and cost, in order to reduce accountability; also this view is lack of accounting and economics theory basis; consequently, leading to many criticisms. During the 1980s, along with accounting target by accountability view shift to decision-making usefulness, the criticism towards conservatism has increasingly intensified. The principle of prudence and its connotation was reviewed by accounting professional groups and by standard setting bodies. FASB Concepts Statement 2 discusses conservatism—meaning prudence—, defining it as “a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered,” but pointedly leaves it out of its table of qualitative characteristics. Meanwhile FASB also explicitly pointed out that, the concept of conservatism may conflict with some important characteristic quality, such as fair representation, neutrality and comparability; and in the financial statements conservatism should no longer deliberately and consistently be used to underestimate net assets and profits. Despite many criticisms, including from standard setters, conservatism has become the most influential contemporary accounting concept, and is widely used in modern financial reporting. It appears not only to have survived in accounting for many centuries, but also to have increased in the last 30 years. Actually, as long as the uncertainty and inherent risk exist in business operations, conservatism must be an essential accounting principle or convention to protect the benefit of investors, creditors and potential financial statement users. The important implication we discussed in this report is to understand the concept of conservatism clearly and how to use it properly. Applications of Conservatism in Accounting

Conservatism appears to have withstood the test of time and despite increasing criticism from many groups including regulators, it continues to prevail in accounting (Watts, 2002). Conservatism is applied in many areas of accounting including but not limited to the following areas; contracting, tax optimization, shareholder litigation and corporate governance. Contracting – One of the most common applications of conservatism relates to contracting. According to Watts, the reason why conservatism is used in contracting relates to asymmetric information, asymmetric...
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