What is accounting conservatism?
Accounting conservatism is a financial approach that many companies use to limit the amount of risk in their accounting information. This cautious approach anticipates smaller profits along with bigger losses. Companies can use this approach to avoid misleading the company's internal or external stakeholders regarding the company's financial health. There are several methods of applying the conservative approach to a company's accounting practices.
Strict revenue recognition is a common policy for many companies that use accounting conservatism. Income recognition follows the basic accounting concept known as the matching principle, which requires that all expenses incurred during the accounting period be included in all income reported in the financial statements. When goods are sold or services are completed and revenue is realizable, it is recognized; Realizable income indicates a transaction in which items are exchanged for cash or cash claims, such as accounts receivable. Accounting conservatism does not record profit until all information related to financial transactions is realizable; This ensures that the company does not overstate revenue, which can lead to inflated gross profits.
Another conservative approach to accounting is to overstate the allowance for doubtful accounts. Companies that sell goods or services often find that they have high accounts receivable balances; This means that multiple customers owe the business money to fully complete a transaction. The allowance for doubtful accounts represents an amount that the company does not expect to receive from customers. Accounting conservatism records greater provisions for bad accounts to ensure that the company's receivables present a more accurate future outlook for cash collections.
A company may also use accounting conservatism when measuring the value of the company's assets and liabilities, which presents a conservative approach to the company's balance sheet. In recent decades, financial markets have depended more on information from a company's balance sheet than an income statement, often because the balance sheet provides information about a company's true economic value. The basic calculation of a company's economic value is total assets minus total liabilities; Conservative accounting approaches help ensure that this information is not exaggerated to present a better picture of the company's financial information.
An important issue when using accounting conservatism is a company's ability to under-report revenue during a current accounting period and over-report at a later date. This is because the company does not recognize revenue or creates a high allowance for doubtful accounts, even though the money is actually collectable. Extremely high revenues at later dates can lead business stakeholders to believe that the company is performing better than it actually is under current conditions. This fluctuating income statement and balance sheet can create skewed information, making it difficult for a company to track its true financial performance.