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Accounting conservatism is a financial approach many companies use to limit the amount of risk in their accounting information. This cautious method anticipates lower profits along with higher losses. Companies may use this approach to avoid misleading internal or external business stakeholders regarding the company's financial health. Several methods exist to apply the conservative approach to a company's accounting practices.
Strict revenue recognition is a common policy for many companies using accounting conservatism. Revenue recognition follows the basic accounting concept known as the matching principle, which requires that all expenses incurred during the accounting period are included with all revenues reported on the financial statements. When the goods are sold or services complete and the revenue is realizable, it is recognized; realizable revenue indicates a transaction where items are exchanged for cash or claims to cash, such as an accounts receivable. Accounting conservatism does not record revenue until all information relating to financial transaction is realizable; this ensures the company does not over-report revenue, which can lead to inflated gross profits.
Another conservative approach in accounting is overestimating the allowance for bad debts. Companies that sell goods or services usually find they have high account receivable balances; this means several customers owe the company cash in order to completely finalize a transaction. The allowance for bad debts represents a figure the company will expect to not receive from customers. Accounting conservatism records higher allowances for doubtful accounts to ensure that the company's accounts receivable presents 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 rely more on a company's balance sheet information than on an income statement, usually because the balance sheet provides information on the true economic value of a company. The basic calculation for a company's economic value is total assets minus total liabilities; conservative accounting approaches help to ensure that this information is not overinflated in order to present a better picture of the company's financial information.
A significant issue when using accounting conservatism is the ability for a company to under-report income during a current accounting period and over-report income at a later date. This occurs because the company does not recognize revenue or creates a high allowance for doubtful accounts even though the money is actually collectible. Extremely high income at later dates may lead business stakeholders to believe the company is performing better than it really is under current conditions. This fluctuating income statement and balance sheet can create distorted information, making it difficult for a company to track its true financial performance.
Accounting conservatism ought to be the approach embraced by every company and organization. Why? It seems that boards of directors tend to get a big optimistic, thus coming up with what might best be described as the "Jesus Money Principal."
Under that principal, the assumption is that profits will just happen, as if Jesus will show up and give a company a big old bag of cash.
More than one organization has gotten in trouble with overly rosy accounting. Being conservative in forecasts is perhaps the best way to deal with downturns and other calamity.