Question

Hi Max.Thanks so much for starting our discussion this week! You made an excellent point about the principle of conservatism! When some people hear that accountants are conservative, they may misconstrue it to assume that the accountants are intentionally understating accounts. However, this is not the case at all. It simply means that we stay on the side of caution and upon equally likely outcomes, we assume the one that is the least likely to overstate net income or net assets.

Class, what are your thoughts on conservatism as it relates to Earning Quality?

Answer 1

The principal of conservatism is the general concept of recognizing expenses and liabilities as even if there is uncertainity of the outcome, but the revenues and assets are recognised only if there is certainity of being received. Hence It says to provide for all expenses and losses, but never anticipate profit in advance.

Here we are not understating the revenues, by providing for losses and not anticipating for gains. By being conservative the accountants try to avoid gains or profits which are not certain, if it is certain then accounts definitely show it as a part of revenue, but since it is not certain it doesnt qualify to be posted in the books of accounts. Because if it is recognised in the books of accounts, and if the gain or income doesnt mature, then the income statement would be inflated, hence it would misrepresent the financial statements. Hence it is always better to recognise only those gains which are certain to be realised in future.

Similarly by providing for all expenses and losses, the accountants may reduce the profits by creating provisions, but it is actually preparing the company to meet unexpected expenses or losses. Like provision for bad debts, provision for discounts, etc. Thus in case there is a bad debt, it can be adjusted from the provisions, hence doesnt impact the profitability. Hence financial statements reflect a more realistic and increased Earnings Quality.