Conservatism Principle of Accounting provides guidance for the accounting, according to which in case there exists any uncertainty then all the expenses and the liabilities should be recognized whereas all the revenues and gains should not be recorded, and such revenues and gains should be recognized only when there is reasonable certainty of its actual receipt.
What is Conservatism Principle?
Conservatism Principle is a concept in accounting under GAAP which recognizes and records expenses and liabilities-certain or uncertain, as soon as possible but recognizes revenues and assets when they are assured of being received. It gives clear guidance in documenting cases of uncertainty and estimates.
The principle of Conservatism is one of the major accounting principlesMajor Accounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more and guidelines listed under UK GAAP, which is a regulatory body of policies and standards of accounting that all accountants across the globe need to follow while reporting financial activity of the business. The principle of Conservatism is mostly concerned with the reliability of the financial statements of a business entity.
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Conservatism Principle Example
Conservatism Principle Example #1
Let us assume that a company XYZ Ltd. is embroiled in a patent lawsuit. XYZ Ltd. suing ABC Ltd for patent infringement and is expecting to win a substantial settlement. Since the settlement is not a surety, XYZ Ltd. does not record the gain in the financial statements. Now the question is, why does it not record this in the financial statement?
The answer is XYZ Ltd. may win, or it may not win the amount it is expecting by winning the settlement. Since a sizeable winning settlement amount may lead to complexities in financial statements and also mislead the users, this gain is not recorded in the books. Again taking the same example, if ABC Ltd. expects to lose the suit, then they must record the losses in the footnotes of the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more. It will be the most conservative approach because the users will want to be aware of the company will have to pay out a large sum for settlement in the coming days.
Conservatism Principle Example #2
Suppose an asset owned by an entity like inventory was bought for $120, but can now buy for $50. Then the company must immediately write down the value of the asset to $50, i.e., the lower the cost of the market. But if the inventory was bought for $120 and now costs the company $150, it must still be shown as $120 on the books. The gain is only recorded when the inventory or the asset is sold.
Impact of Conservatism Principle on Financial Statements
- The Conservative principle of accounting always says that one should always error on the most conservative side of any financial transaction.
- It is done by minimizing profits by stating uncertain losses or expenses and not mentioning unknown or estimated gains. It always indicates that a more conservative estimate should always be followed.
- While doing an estimate for allowance regarding doubtful accounts, casualty losses, or other unknown future events, one should always error on the side of conservatism. Alternatively, we can say that an accountant should record the most expenses and the least income. This principle of conservatism forms the main backbone of the lower of cost or market concept for the recording of inventory.
Conservatism principle of accounting states that the accountants must choose the most conservative outcome when two outcomes are available to them. The main logic behind this principle of conservatism is that when two reasonable possibilities for recording a transaction are available, one must error on the conservative side. It means one has to record uncertain losses while staying away from recording uncertain gains. So when the conservatism principle of accounting is followed, a lower asset amount is recorded on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, lower net income is recorded on the income statement. So, adhering to this principle results in recording lower profits in the statements.
Why Follow the Principle of Conservatism?
Why do we use conservatism while recording a business entity’s gains and losses? We must keep in mind that the principle of conservatism does not mean making the recorded earnings as low as possible. This principle helps to break a tie when an accountant has to deal with equally probable outcomes for a transaction. When interested users or investors are going through the company’s financial statements, they must get an assurance that the profit of the business coming in is not overestimated. If overestimated, it will be misleading for the company stakeholders. When it follows conservatism principle of accounting, then people like tax prep pro or a potential business investor or partner get a more transparent and realistic picture of the company’s financial standing and the future trajectory of the company.
The two main aspects of the conservatism principle of accounting are – recognizing revenue only if they are confident and recognizing expenses as soon as they are reasonably possible.
Why is the Conservative Principle of Accounting called “Concept of Prudence”
The concept of conservatism is also known as the concept of prudence.
- It is always stated that “anticipate no profit, provide for all losses.” This implies that an accountant must always be cautious and record the lowest possible value for assets and revenues and the highest values for liabilities and expenses. As per this concept, revenues or profits should only be recorded whey are realized with reasonable certainty.
- Provisions must also be made for all liabilities, expenses, and losses- certain or uncertain. Probable losses in respect of all contingencies should also be recorded. So we can safely say that the concept of conservatism helps a business entity to stay safe in the coming days.
- In other words, prudence, which means to act with or to show care for the future, can be synonymous with the conservatism principle of accounting. That’s why we can say that the Concept of Conservatism is also known as the Concept of Prudence.
Conclusion
The principle of conservatism is the primary basis for lower of cost or market ruleLower Of Cost Or Market RuleLower of cost or market (LCM) is the conservative way through which the inventories are reported in the books of accounts. It states that the inventory at the end of the reporting period is to be recorded at the original cost or the current market price, whichever is lower.read more, which tells that inventory should be recorded at the lower of either its acquisition cost or the current market value. Following this process leads to lower taxable income and lower tax receipts. The conservatism principle of accounting is only a guideline that an accountant needs to follow to maintain a clear picture of the financial standing of a business entity.
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This article has been a guide to what is Conservatism Principle of Accounting. Here we discuss the conservatism principle in detail along with practical examples and its impact on the financial statements.
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