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Convention of Conservatism | JAIIB AFM MAY 2023 FREE NOTES

Convention of Conservatism | JAIIB AFM MAY 2023

Do you find the AFM (Accounting & Financial Management for Bankers) paper i.e. Paper No. 3 of JAIIB (Junior Associate of the Indian Institute of Bankers) difficult to understand? We will understand one of the important topic of Accounting Convention (Conservatism) in this page.

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Now, let us begin with one of the important topic from the AFM JAIIB Syllabus 2023:

Convention of Conservatism

Also known as doctrine of prudence the Principle of Conservatism is one of the major accounting principles and concept listed under GAAP which states to minimize the overstatement of revenue and assets and to understate the liabilities and expenses.

The Convention of Conservatism states that “anticipate no profit, provide for all losses.” This implies that an accountant must always be cautious and record the lowest possible value for assets and revenues and the highest values for liabilities and expenses. As per this concept, revenues or profits should only be recorded if they are realized with reasonable certainty.

However, Conservatism should not mean understating of earnings or assets. Both overstatement and understatement of earnings and assets are bad. Understatement in one year will mean overstatement in the subsequent year. For example, if the closing stock of a year is understated, it will reduce the profit of that year.

The closing stock of that year will become the opening stock of next year so it will increase profit because the trading account will be debited with a lower figure.

ADVANTAGES OF CONSERVATISM PRINCIPLE

  • The principle motivates the management to execute better care when making decisions.
  • Accounting conservatism also leads to objective book values that are prepared based on the Generally Accepted Accounting Principles (GAAP), making it easier for investors to compare performance across different markets and periods.
  • The conservatism approach provides an accurate measurement of the risks involved.

DISADVANTAGES OF CONSERVATISM PRINCIPLE

  • This method underestimates the future value of the company.
  • This method might mislead the stakeholders or investors as the value is not estimated accurately.
  • This principle promotes revenue shifting which means a transaction can be deferred into the next period if it does not meet the reporting requirements of the current period.
  • Since the profits of the company are understated, the actual taxation liabilities of the firm may not be reflected.

Thus in simple words, the Convention of Conservatism is an important accounting principle that requires company accounts to be prepared with caution and high degrees of verification

 

IMPACT OF CONSERVATISM CONCEPT ON THE FINANCIAL STATEMENTS OF A COMPANY:

Below are the impacts of the conservatism concept on financial statements:

1. It states that a company must always observe the most conservative side of financial dealings, which can be done by decreasing the profits (by taking into record uncertain liabilities and expenses while not recognizing gains of uncertain nature)

2. In case there are casual losses, doubtful debts or any such future event which are uncertain in nature, the error should be done on the side of conservatism. It basically means that accountants should put their focus on recording more estimated expenses while recording fewer assets.

This concept also helps in presenting the true financial position and the path of the business in the foreseeable future.

So, as per the convention or principles of conservatism:
All probable losses are to be taken into consideration and expected profits to be ignored.
Creating the provision for doubtful debts

Under-written is some of the Mock MCQs on the concept of conservatism from the JAIIB AFM Syllabus for JAIIB MAY 2023 Exams:

JAIIB Accounting & Financial Management for Bankers Multiple Choice Questions:

1. Under which convention the valuation of inventories is done by a business company at cost price or market price, whichever is lower?
a. Convention of Full Disclosure
b. Convention of Materiality
c. Convention of Conservatism
d. Convection of Consistency
Answer – c

2. Which of the below concept considers that the business enterprise will not be sold or liquidated shortly?
a. Conservatism concept
b. Money measurement concept
c. Going concern concept
d. Accounting period concept
Answer – c

3. Which accounting convention(s) do not consider the qualities and disqualities of general manager?
(i) convention of conservatism,
(ii) convention of feasibility,
(iii) convention of materiality
a. Only (i) and (ii)
b. Only (i) and (iii)
c. Only (ii) and (iii)
d. (i), (ii) and (iii)
Answer – c

4. “Expect no profits but provide for all potential losses” is the essence of which accounting concept?
a. Dual Aspect concept
b. Materiality convention
c. Convention of Consistency
d. Convention of Conservatism
Answer – d

5. As per conservatism concept, __________- is not taken into account.
(i) all future losses but leaves all future profits,
(ii) all future profits but leaves all future losses,
(iii) all future profits and all future losses
a. Only (i) and (ii)
b. Only (i) and (iii)
c. Only (ii) and (iii)
d. (i), (ii) and (iii)
Ans – d

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