Under the principle of conservatism, which of the following should be done?
A. Anticipate all profits
B. Ignore all losses until realised
C. Recognise all probable losses and ignore uncertain gains
D. Recognise both losses & gains
Answer (2)
The principle of conservatism is a key concept in accounting and financial reporting that instructs accountants to exercise caution and adopt a more pessimistic approach when there is uncertainty regarding financial transactions. This principle is intended to ensure that an entity's financial statements are presented fairly and do not overstate assets or income, nor understate liabilities or expenses.
Here is a step-by-step explanation of why the correct option is (C) Recognise all probable losses and ignore uncertain gains:
Conservatism Principle Defined : Conservatism in accounting means recognizing expenses and liabilities as soon as possible when there is any uncertainty about the outcome, but only recognizing revenues and assets when they are assured of being received.
Avoid Overstating Profits : By conservatively estimating finances, the principle ensures that the profits are not overstated. This means that when faced with two options, one being more optimistic and the other more pessimistic, conservatism guides you to choose the more pessimistic estimate.
Recognizing Probable Losses : According to conservatism, if there is any indication or likelihood that a loss might occur, it should be recorded in the books as soon as it is reasonably estimated, even if it has not yet been realized. This includes setting aside funds or making provisions for items like bad debts or inventory obsolescence.
Ignoring Uncertain Gains : Gains or income should not be recognized until they are realized or virtually certain. This prevents the potential inflation of financial results based on uncertain or speculative future events. For example, potential increases in the value of an asset or anticipated profits should not be recorded until they are confirmed.
Conclusion : By recognizing probable losses and ignoring uncertain gains, the conservatism principle protects stakeholders by presenting a cautious view of an organization’s financial health.
Thus, option (C) is consistent with the conservatism principle, making it the correct choice.
The correct choice under the principle of conservatism is option (C), which states to 'Recognise all probable losses and ignore uncertain gains'. This principle guides accountants to acknowledge expenses as they occur while only recording gains when they are assured, ensuring financial statements are cautious and realistic. Ultimately, it helps maintain an accurate view of a company's financial health.
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