According to the convention of conservatism, how are profits and losses recognized in financial statements?a)Profits are recognized when earned, losses are recognized when incurredb)Profits and losses are recognized when earnedc)Profits and losses are recognized when realizedd)Profits are recognized when realized, losses are recognized when incurredCorrect answer is option 'D'. Can you explain this answer?

Question

Answer

Recognition of Profits and Losses in Financial Statements: The Conservative Convention

The convention of conservatism is a principle followed in financial accounting to ensure prudence and caution in recognizing and reporting financial information. It dictates that profits and gains should not be recognized until they are realized or certain, whereas losses and expenses should be recognized as soon as they are probable. According to this convention, option 'D' is the correct answer, which states that profits are recognized when realized, and losses are recognized when incurred.

Explanation:

Profits Recognition:
Profits, also referred to as gains or revenues, are recognized when they are realized. Realization occurs when the earnings process is complete, and the company has the right to collect the revenue. In simpler terms, profits are recognized when the company has provided goods or services to its customers, and there is a reasonable assurance of receiving payment in the future.

Losses Recognition:
On the other hand, losses, also known as expenses, are recognized when they are incurred. Incurrence of losses happens when an expense has been consumed or a liability has been accrued, regardless of the actual payment. This means that even if the company has not made the payment yet, but it has incurred the liability or expense, the loss should be recognized in the financial statements.

Reasoning behind the Conservative Convention:
The conservative convention is followed to avoid overstating profits and gains, as it aims to prevent the recognition of uncertain or unrealized gains. This approach ensures that financial statements are reliable and free from potential manipulation. By recognizing profits only when they are realized, the convention promotes a cautious approach, safeguarding the interests of stakeholders and reducing the risk of misleading financial information.

Conclusion:
In accordance with the conservative convention, financial statements should recognize profits when they are realized and losses when they are incurred. This approach ensures prudence, reliability, and transparency in financial reporting, allowing stakeholders to make informed decisions based on accurate and conservative financial information.

Answer

The convention of conservatism, also known as the prudence concept, states that profits should only be recognized when they are realized, meaning when they are actually earned. On the other hand, losses should be recognized when they are anticipated or incurred, even if they are not yet realized. This conservative approach ensures that financial statements present a more cautious and realistic view of the company's financial performance and position.

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