What guidance does the accounting constraint of conservatism offer. Please provide a concrete example.
Conservatism in Accounting is a branch of accounting requiring a high degree of certainty and verification in order to legally claim a profit.
Here are examples of techniques used in conservative accounting:
1. Recognize and include all probable losses as they are discovered, anticipated or actually occur
2. Defer revenue until it is actually received
3. Use strict criteria for recognition of revenue
4. Overestimate projected losses from doubtful accounts
5. Underestimate the value of an asset, especially if the value is uncertain
Here is an example of conservative accounting that employs the application of the “lower-of-cost-or-market-value” rule. If an item in inventory cost $20.00 but can be replaced for $15.00, the rule requires reporting the item in inventory at $15.00, and reporting an immediate loss of $5.00.
Accountants themselves needn’t be “conservative”. Instead they must be fair and objective. The term “conservatism” requires such an accountant to “break a tie” between two reasonable interpretations in order to avoid the danger of overestimating the firm’s profitability.
Conservatism in accounting is particularly important in today’s doubtful economy. This has been dramatically demonstrated in recent failures of large corporations in which accounting practices were highly questionable and irregular…the antithesis of conservative accounting.