QUESTION 1

A. In a minimum of 100 words, please define the concept of Conservatism (5%)

Conservativism is an approach in accounting under which the accountant must select the least favorable measurement when declaring net income and financial position for the purpose of constructing financials. This also applies to writing off inventory, estimating warranty expenses, recognizing losses (for example on a long-term project which is currently unlikely to come to fruition) and any other situation where an accountant can make a decision between two values to be input into the financial statements.

Naturally, this is only possible when there is more than one reasonable manner of measuring, and this is no excuse for poor measurement mechanisms. It is not acceptable to create a particularly poor measurement (â€œperhaps a flood will destroy the warehouse, since it has been raining, so we can assume itâ€™ll be destroyedâ€ â€“ this is faulty reasoning) â€“ proper measurement must be used, but the less favorable (more conservative) of them should be included.

B. In a minimum of 150 words, please explain why the concept of Conservatism is important to external users of the financial statement (15%)

This concept is important to external users as they know that if the company has properly adhered to Conservativism, then the financials they are observing are actually the least favorable to the firm. Actual situation should be no worse, and might possibly be better. For example, if an accountant when measuring the value of inventory takes historical values of it, because they are lower than the market ones, when they are sold at the market ones, it will turn out that they were undervalued and the firm will perform better than predicted.

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