Is it Conservatism or Prudence?

Audrey M. Siahaan

, Danri Toni Siboro

, Iskandar Muda

and Syafruddin Ginting

Student Postgraduate, Faculty Economic and Business, Universitas Sumatera Utara, Medan Indonesia

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

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

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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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