Accountants are expected to be prudent when preparing financial reports. The prudency or conservatism convention shows why preparers of financial information should be cautious when recognizing income, expenses, assets, and liabilities in the books of accounts.
Accounting conservatism convention is defined
The principle of conservatism or prudency states that accountants should understate revenue and assets while all known expenses and liabilities are accounted for.
This convention suggests that accountants should be meticulous and cautious to avoid reporting revenue the company has not realized or posting an asset whose value is deflated. And at the same time ensure that all expenses incurred are recorded. In addition, make provisions for future expenses that might occur.
Note: the principle is not saying that an accountant must understate revenue and assets or overstate expenses and liabilities as it were. But, ensure the prepared financial statements contain the correct amounts for each item.
Misconception about the conservatism convention
There are two misconceptions of the conservatism convention.
Stinginess:
People without an accounting background and some accountants believe that this principle makes professionals stingy. They thought that applying it to personal life means that an accountant will conserve their income rather than spending it to meet their necessities.
This is not true, the principle of prudency explains why accountants should be cautious in recognising revenue and how they spend their personal income.
Provisions for expenses:
Some accountants incorrectly apply the principle. This is in the areas of making provisions. They thought that, as the principle wants accountants to ensure that all expenses are taken care of, they make provisions for certain expenses not required by accounting standards.
They make provisions for an end-of-the-year bonus every month on their financial statements. An expense that will occur at the end of the year. However, IAS 37 Provisions, Contingent Liabilities and Contingent Assets provides guidance on how provisions should be applied.
Application of Prudency Convention
Revenue:
The IFRS 15 on revenue states the five-step model applied when recognizing revenue in the books of accounts. This applies the revenue realization concept and prudence.
In the area where revenue is received before the performance obligation is completed, the standard states clearly that such revenue should not be recognized as it is not a prudence measure. Instead, it is treated as a contract liability.
Inventory:
Another area of application is inventory. Inventories are assets and must not be overstated. Where an item of inventory value diminished due to a technology change, the net realisable value (market value), a lower amount is recorded in the books of accounts rather than the historical amount.
For example, an item's historical cost is N250,000. However, due to technological changes, the value diminished, and its current market value is N56,000. Applying the conservatism principle, the market value of N56,000 is recorded.
Provisions:
This convention creates provisions accounts in a business book of accounts. Provisions are made for depreciation, to ensure that an amount is allocated for using plant and equipment every month. Impairment loss provisions from financial assets are also provided as expenses to ensure sales on credit are not overstated.
Contingency:
When a contingency is probable, a provision can be made for that regard. For example, if a lawsuit against a company will result in a substantial loss of money for the company, a provision for such contingency will be set aside pending its occurrence.
Conclusion
To conclude, prudency convention ensures caution in the presentation of financial statements. Accountants who fail to comply end up preparing reports that are inaccurate and irrelevant to users of financial information.