The Conservatism Concept in Accounting
The Singapore Financial Reporting Standards (SFRS) is substantially similar to the International Financial Reporting Standards (IFRS). One way this similarity is exhibited is in the expectation for accountants to observe the conservatism concept.
This concept guides providers of accounting services in Singapore, and indeed accounting professionals internationally, to choose the less than optimal estimate when facing a choice in uncertain figures. That is, whenever an accountant comes across an uncertain event, they should lean on the side of caution and moderation as opposed to optimism or indulgence.
For instance, when the levels of incomes and expenses are uncertain, the conservatism concepts guides accountants to record the lower level of income and the higher level of expenses. In other words, they are expected to minimise profits as opposed to maximising them.
What Does the Conservatism Principle Mean for the Accountant?
Singaporean accounting standards require that accountants become sceptic overestimates in uncertain business events. This may make the accountant clash with management, as management will almost always lean towards what is more optimistic and opportunistic outcome. However, it’s the job of the accounting services provider to provide a realistic estimate of the transaction and record it accordingly with a less than optimal outcome.
However, the principle doesn’t stipulate an unfavourable outcome always. Rather, it’ll take the more conservative outcome from a pool of available possibilities.
What the Conservatism Principle Means for Management and other Users of Accounting Information
The conservatism principle protects management and other users of financial information from expectations of inflated revenues, profits or asset values. It makes potential losses, costs or waning in assets value as soon as possible.
Impact of Conservatism to the Business
You have already seen how the conservatism concept guides providers of accounting services in Singapore to intentionally understate the revenue and assets figures and overstate the liabilities and overstate the liabilities and expenses. Therefore conservatism will always lead accountants to report lower net income.
Also, there’s a potential of revenue shifting to occur. That is, if a transaction does not meet the reporting requirements in the current period, it may be reported in future periods thus exaggerating the performance of one period but understating the other. The overall effect of such reporting issues is that the company will have difficulty tracking its’ business operations.
Here’s an example to help you grasp the concept
On 2 September 2016, the Giant electronics company, Samsung, suspended sales of the Galaxy Note 7 and announced a recall of the product. The device was found to have a manufacturing defect that caused the batteries to generate excessive heat which in some cases resulted in fires.
Suppose that some of the affected clients sued the company for damages and the estimated total value of the suits would amount to $10 million. The conservatism concept requires accountants at the company to take the least optimistic approach that they would lose all the suits, and adjust the books of the company accordingly irrespective of the outcome.