Is it Conservatism or Prudence?
Audrey M. Siahaan
1
, Danri Toni Siboro
1
, Iskandar Muda
2
and Syafruddin Ginting
2
1
Student Postgraduate, Faculty Economic and Business, Universitas Sumatera Utara, Medan Indonesia
2
Lecture Faculty Economic and Business, Universitas Sumatera Utara, Medan Indonesia
Keywords: Agency Theory, Positive Accounting, Conservatism, Prudence
Abstract: The purpose of financial statements is to provide information regarding the financial position, company
performance and changes in financial position that are beneficial to a number of parties in decision making.
Therefore, quality financial statement information is free from material misstatement. The impact of
harmonizing financial accounting standards makes the wider spread of the concept of prudence more
widespread. Researchers in this matter used literature studies to see how conservative concepts and
prudence concepts in several countries. The concept of Prudence and the concept of conservatism are two
contradictory things. From the results of the literature study, it was concluded that the concept of prudence
would help financial reporting so as not to provide false optimism to users of information in the event of
high uncertainty. Meanwhile, conservatives must be careful but if losses are recognized immediately. So,
the concept of prudence is more transparent. However, the concept of prudence in developing countries has
not been used differently from developed countries that have used prudence.
1 INTRODUCTION
The financial statements are prepared based on the
Financial Accounting Standards that have been
prepared by the body authorized to develop
standards in this case in Indonesia, the Indonesian
Accountants Association. The financial statements
of a company describe the performance of the
company's management in managing the company's
resources entrusted to it. Information conveyed in
financial statements is useful for internal parties and
external parties in decision making. Therefore public
companies are obliged to publish and present
financial statements as a form of accountability for
the management of resources.
The purpose of financial statements is to provide
information regarding financial position, company
performance and changes in financial position that
benefit a large number of users in economic decision
making. Therefore, quality financial statement
information is free from engineering and presents
actual information in accordance with the facts so as
not to harm all parties who use it.
When preparing financial statements, companies
are given the freedom to choose the accounting
method used. Freedom in choosing a method can be
used by companies to produce different financial
reports with other companies in accordance with the
wishes and needs of the company. Or in other words,
companies have little freedom in choosing one of
several alternatives offered in financial accounting
standards that are considered to be in accordance
with company conditions. For example, the
company needs to reduce risks from unstable
economic conditions, so to reduce the risk,
companies usually take prudence in presenting
financial statements. The concept of prudence is
carried out by carefully recognizing and measuring
assets, profits, debt, and costs. The concept of
prudence is implied by recognizing the possible
costs or losses that will occur, but not immediately
recognizing future revenues or profits even though
the likelihood is large. Prudence reporting is often
referred to as accounting conservatism.
Conservatism is an important principle in financial
reporting that is intended so that the recognition and
measurement of assets and profits are carried out
with great care, this occurs because economic and
business activities are surrounded by uncertainty.
The implication of this conservative method is to
report lower profits and assets or higher debt.
968
Siahaan, A., Siboro, D., Muda, I. and Ginting, S.
Is it Conservatism or Prudence?.
DOI: 10.5220/0009499009680972
In Proceedings of the 1st Unimed International Conference on Economics Education and Social Science (UNICEES 2018), pages 968-972
ISBN: 978-989-758-432-9
Copyright
c
2020 by SCITEPRESS Science and Technology Publications, Lda. All rights reserved
Accounting conservatism will increase bad news
in a timely manner that is more relevant according to
existing standards carefully so that it helps company
managers and investors at the time of
implementation. (Hsieh, Ma and Novoselov, 2018).
The views of some researchers that the
conservatism of its popularity has lately diminished
in the accounting cycle. The last few years are
standard compilers and researchers are more likely
to see about consistency, realization, going concern,
and others.
There are researchers who support accounting
conservatism because they can help corporate
management to overcome agency problems.
(Dhaliwal et al., 2014). Regulations regulated in
financial accounting standards are intended that the
standards made are expected to make the
information in the financial statements must be
neutral. Neutral is meant to be free of bias from
anything that will influence decisions, for example,
free from market friction, strong capital markets or
full rationality or others.
To fulfill the qualitative characteristics of the
IFRS conceptual framework, the concept of
conservatism was abolished. The concept of
conservatism has a role in accounting, but not in the
form of qualitative characteristics. The concept of
conservatism will serve to resolve problems
regarding recognition and measurement within the
conceptual framework. The concept of conservatism
can solve the problem of determining whether it
enters the balance sheet or profit or loss at certain
times when the framework is weak. The concept of
prudence will react when uncertainty occurs (such as
a weak conceptual framework). The concept of
conservatism will provide information to investors
regarding investment returns, especially regarding
the uncertainty of the investment.(Penman, 2016)
Under the concept of prudence, company
management must not increase the amount of
revenue recognized or underestimate the amount of
expenditure. The management of the company must
also be conservative in recording the number of
assets, and not lowering liabilities. However, the
results must be in the form of financial statements
that are stated conservatively.
Everyone acknowledges that prudence is very
necessary for accounting, therefore, its role must be
recognized within the conceptual framework. This
study wants to see the concept of conservatism or
prudence in several countries.
2 LITERATUR STUDY
Agency Theory
Agency theory is a theory that arises because of a
conflict of interest between the principal and the
agent. Principal as the shareholder while agent as
manager. Principals contract agents to manage
resources within the company. In other words, the
principal provides facilities and funds for the
company's operations. The agent is obliged to
manage the resources owned by the company,
besides that the agent is also obliged to account for
the tasks assigned to him. While the principal has
the obligation to provide compensation for the tasks
that have been charged to the agent.
Companies that separate management functions
from ownership functions will be vulnerable to
agency conflicts. The causes of conflict between
managers and shareholders include making decisions
related to fundraising activities and making
decisions related to how the funds obtained are
invested. Shareholders or owners who are assumed
to be principals are only interested in increased
financial results or their investment in the company.
Human nature is when information produced by
humans for other human beings is always questioned
about their rentability and can be trusted whether or
not the information delivered. The choice of
conservatism method is inseparable from the
interests of managers to optimize their interests at
the expense of the interests of shareholders.
Positive Accounting Theory
Positive accounting theory sees that managers,
shareholders and stakeholders are rational people,
and they will try to maximize their abilities and this
will be related to compensation and welfare. The
nature of a manager will definitely improve his
welfare. Positive accounting theory will predict poor
manager performance that can be covered by an
increase in profit.
Conservatism Theory
Conservatism arises because of the tendency of the
management to report net assets at the lowest value.
Current conservatism is more associated with
caution. Conservatism is a careful reaction to the
inherent uncertainty in the company to try to ensure
that uncertainty and inherent risks in the business
environment are sufficiently considered. Risk
uncertainty must be reflected in financial statements
so that predictive and neutral values can be
corrected. Careful reporting will benefit all users of
financial statements.
If the company chooses one of the two existing
accounting techniques, then an alternative that is less
Is it Conservatism or Prudence?
969
profitable for shareholder equity must be chosen.
The technique chosen is a technique that produces
low asset and income values or that produces high
debt value and costs. Consequently, if there are
conditions that might cause losses, costs or debt,
then the losses, costs, and debts must be recognized
immediately. Conversely, if there is a condition that
allows profit, income or assets, then profits, income
or assets cannot be recognized immediately until the
condition actually occurs. Conservatism is a
pessimistic view of accounting. Conservative
accounting means that accountants are pessimistic in
the face of uncertainty in profit or loss by using the
principle of slowing down revenue recognition,
accelerating recognition of costs, lowering valuation
of assets and raising debt valuations.
Prudence Theory
Another way to look at prudence is to simply record
income or asset transactions when they are certain,
and record transaction costs or liabilities when
possible. Another aspect of the prudence concept is
when company management tends to delay the
introduction of income or asset transactions until
company management feels confident about it.
Meanwhile, company management will tend to
record costs and liabilities as long as possible. In
addition, company management will periodically
check assets to see if the asset has decreased in
value, and see whether the obligation has increased.
In short, the tendency under the precautionary
concept is not to recognize profits or at least delay
their recognition until the underlying transaction is
more certain.
Prudence is usually done in terms of
arrangements, for example, allowance for doubtful
accounts or reserves for obsolete inventories. In both
cases, certain items that will cause costs have not
been identified, but wise people will record reserves
in anticipation of a reasonable amount of costs that
arise at some point in the future.
Applicable accounting principles will combine
the concept of prudence in many accounting
standards, for example, requiring company
management to write fixed assets when the fair
value of the asset falls below its book value, but
company management does not allow to write fixed
assets when the opposite occurs. The International
Financial Reporting Standard allows a revaluation of
fixed assets and thus does not comply strictly with
the concept of prudence.
Prudence is the convergence of accounting
conservatism or which means the principle of
prudence in recognizing income or assets and
expenses that can result in minimizing the profits
generated by a company to reduce the risk of
uncertainty in the future. With the implementation of
prudence by management, it will generate relatively
small profits which are also a positive signal to
investors, which means that they have implemented
prudence to reduce information asymmetry within
the company. And this will make investors more
confident with recognized profits not overstating.
The relevance of information will give
consideration and uncertainty to the measurement of
an account compared to where the account is
recognized first. Fair value is made based on the
model of the value and uncertainty of future cash
flows that must be recognized. The conclusion of the
current IFRS example is that the conceptual
framework requires an element of prudence when
recognizing assets and liabilities not only to reflect
measurement uncertainty. Prudence when
recognition of assets and liabilities is more
transparent than potential prudence at the time of
measurement.
In measuring historical costs, for some accounts,
it will provide a level of prudence for profit
recognition and asset valuation. Fair value requires
an honest application of measurement techniques.
Accounting standards should not inject prudence
elements in assessment because they will tend to
provide biased measurements. Accounting standards
should only provide guidance, even though reality
actually involves measurement. This will make
financial reporting uncertain and, management
opinion will be an error and not prudence.
3 METHODOLOGY
The researcher conducted a literature study to find
out how conservative and prudence concepts are
currently in several countries. The researcher
examines and collects conclusions from several
journals related to the concept of conservatism and
the concept of prudence
4 RESULT AND ANALYSIS
Conservative accounting is an important principle
that has long influenced financial statements. These
past thirty years financial reporting has not only
been conservative but has become increasingly
conservative. Many benefits are obtained from
conservative accounting reporting and proving that
company managers get incentives to present
financial reports in a conservative way even in the
absence of rules or regulations that order
conservative reporting. The concept of conservatism
UNICEES 2018 - Unimed International Conference on Economics Education and Social Science
970
reaps a variety of criticisms from standard compilers
including academics.
Hsieh, Ma, and Novoselov conducted research on
accounting conservatism. Hsieh, Ma, and Novoselov
want to see whether accounting conservatism can be
explained in a rational way to ambiguity. Companies
that face financial reports with greater ambiguity,
the company is more conservative. Hsieh, Ma, and
Novoselov in their research looked at companies of
two types of strategies namely "prospector" and
"Defender". Companies whose strategy models are
"Defender" will focus on utilizing existing
resources, and companies whose strategy models are
"Prospector" will look for new business
opportunities. The results of his research are that
companies that face greater report ambiguity will be
more conservative. (Hsieh, Ma and Novoselov,
2018).
Within the conceptual framework, the concept of
prudence must be maintained. The French
Accounting Standards Authority and the Australian
Accounting Standards Board (AASB) do not agree
with reintroduction. The concept of prudence in
financial reporting is permitted, where it will be
useful for the need to protect the interests of
investors in financial reporting. And, this also
applies internationally and European countries.
According to Măciucă, Hlaciuc and Ursache that as
long as company management does not use the
concept of prudence to maintain income or hidden
reserves, prudence and other concepts will create a
strong foundation for financial reporting. Therefore,
the concept of prudence will not conflict with the
neutrality of financial statements. Prudence
accounting behavior is the quality of accountants in
understanding the details of the basic accounting
principles relating to asset valuation and profit
measurement. (Măciucă, Hlaciuc and Ursache,
2015)
Geimechi and Khodabakhshi conducted research
on the Tehran Stock Exchange and considered the
size of the company based on assets. The results of
Geimechi and Khodabakhshi's research that there is
no influence of company size on the concept of
conservatism, discretionary accruals do not affect
conservatism. the existence of the concept of
conservatism is recommended in financial
statements for the benefit of investors. (Geimechi
and Khodabakhshi, 2015).
Amanamah and Owusu conducted research on
the Ghana Stock Exchange. Accountants in Ghana
are of the view that measurement based on fair value
is useful, especially with regard to financial
reporting. There is no active capital market for the
recognition of certain assets facing many problems
during implementation. In Ghana, there is no need
for proper, quality and skilled assessment. And, it is
not necessary for the Supervisory Board to help
assess certain assets. Ghana's capital markets are
inefficient to support fair value measurements. This
is due to the challenges for developing countries
where capital markets are inefficient in terms of
conducting prudence concepts that must apply fair
value. Ghana Stock Exchange is an inactive capital
market for certain assets, lack of professional
judgment and regulators.(Amanamah and Owusu,
2016).
Bahadır, Demir, and Öncel conducted a study of
90 companies listing on Turkey Stock Exchange.
The application of IFRS is believed to be able to
improve financial reporting by increasing the
comparability, quality, and transparency of financial
statements. However, the lack of guidance on IFRS
implementation, inadequate sectors in adopting
regulations and difficulties in applying the concept
of fair value which is considered a major challenge
for the implementation of IFRS in Turkey. (Bahadır,
Demir and Öncel, 2016).
Smart planning can provide benefits to
companies that may already have global
competitors. It is recommended that corporate
entities in Nigeria must adapt to International
Financial Reporting Standards rather than complete
adoption of standards. (Okoye and Akenbor, 2014).
The impact of harmonizing financial accounting
standards (the application of IFRS, GAAP, and
IAS), making the spread of fair value more
widespread, means that the spread of the concept of
prudence is also wider. The historical cost system,
which is a conservative concept, is very popular in
the European Union. The concept of prudence and
fair value will make the capital market more
transparent. But it has never been seen how this
concept of prudence in developing countries (such as
central and eastern Europe). For asset revaluation
during financial ratio analysis, the ratio is not too
sensitive to the application of the revaluation model
but is very sensitive to the application of the fair
value model. (Strouhal, 2015).
5 CONCLUSION
The concept of prudence will be able to help
financial reporting so as not to give false optimism
to users of information in the event of high
uncertainty. The concept of prudence is only for
general guidelines. In the end, use the best judgment
Is it Conservatism or Prudence?
971
of company management in determining how and
when to record accounting transactions.
The concept used now is that Prudence is no
longer conservatism. Conservatism is the concept if
fortunately it must be acknowledged carefully, but if
the loss is recognized immediately. But in the
concept of prudence, income or profit is recognized
if indeed the conditions have been fulfilled. For
example in the Statement of Financial Accounting
Standards, income, there are conditions when
income can be recognized. When the terms of
recognition of income have not been fulfilled,
revenue cannot be recognized.
The concept of prudence and fair value will
make the capital market more transparent. But it has
never been seen how this concept of prudence in
developing countries. This makes the concept of
conservatism still be used for developing countries,
so applying the concept of prudence has difficulty.
Meanwhile, developed countries, the concept of
prudence is more acceptable because it will make
the capital market more transparent.
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