FIN101 #11: FINANCE VERSUS ACCOUNTING: CONSERVATISM AND ACCRUAL ACCOUNTING

Sep 20, 2021 FINANCE 101

Finance takes issue with two of the foundations of accounting: conservatism and accrual accounting.

The Conservatism Principle

The conservatism principle implies that companies should record lower estimated values of their assets and, by extension, higher estimates of their liabilities – in short, they err on the side of being conservative. Thus, balance sheets typically record assets at their historical cost, not their current or replacement value, and many assets simply don’t show up on their books. Apple’s balance sheet in 2016, for instance, valued its brand at $0 even as Forbes valued the forty-year-old brand at $154.1 billion. Which do you think is closer to reality?

The Rules of Accrual Accounting

The rules of accrual accounting try to smooth out both revenues and costs in an effort to better reflect economic reality. They allow a company to capitalize an investment as an asset, and to expense it as depreciation charges every year over the asset’s entire life, for instance. For example, Airbus Group, the European Aerospace and defense manufacturer, built a new factory in Mobile, Alabama, that cost $600 million. Because of accrual accounting, Airbus would report more moderate profits over time rather than losses in 2015 and then profits after the plant started production. But this representation of profits is quite distinct from their true cash out‑flows, obscures the time value of money, and may reflect managerial discretion while cash flows would not.

By thanhnambui

I am a bank employee specializing in trade finance- a field that is not directly linked to my university major in Financial Investment. However, with a passion for economics and finance, I determined to pursue a higher education degree and successfully achieved a Master in Economics of Banking and Finance from CFVG in 2019. During that study time, I encountered many difficulties in consolidating background knowledge studied at university, which made me realize the necessity of building foundation for effective learning outcomes. Therefore, my friend and I decided to create Econfin-Invest to record basic knowledge of economics, banking, finance, and investment fields. The articles I write are carefully selected and collected from a wide range of different reliable sources such as textbooks, economic and financial reports and relevant journals. Most importantly, these articles are not A to Z lectures of subjects related to the aforementioned fields, yet simply articles I consider to be accessible to all interested readers as well as being essential to apply in everyday practices. Thank you for reading and supporting!

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