Conservatism Principle of Accounting

What is Conservatism Principle?

Conservatism Principle is a concept in accounting under GAAP which recognises and records expenses and liabilities-certain or uncertain in nature, as soon as possible but recognises revenues and assets when they are assured of being received. It gives a clear guidance in recording cases of uncertainty and estimates.

The principle of Conservatism is one of the major accounting principles and guidelines listed under UK GAAP, which is a regulatory body of principles 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.

 Conservatism Principle Example

Conservatism Principle Example #1

Let us make an assumption 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 large 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 large 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 statements. This 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 be bought for $50. Then the company must immediately write down the value of the asset to $50 i.e. the lower of the cost of market. But if the inventory was bought for $120 and now will cost 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

• Conservatism 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 uncertain or estimated gains. It always states 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 incomes. 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. This means one has to record uncertain losses while staying away from recording uncertain gains. So when the conservatism principle of accounting is followed lower asset amount is recorded on the balance sheet lower net income is recorded on the income statement. So, adhering to this principle results in lower profits being recorded in the statements.

Why Follow 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 it is overestimated it will be misleading for the company stakeholders. When conservatism principle of accounting is followed then people like tax prep pro or a potential business investor or partner gets a more clear and realistic picture of the company’s financial standing and the future trajectory of the company.

The two main aspects of conservatism principle of accounting are – recognizing revenue only if they are certain, 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 highest values for liabilities and expenses. As per this concept revenues or profits should only be recorded whey are realised with reasonable certainty.
• Provisions must also be made for all liabilities, expenses, and losses- certain or uncertain in nature. 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, the 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 main basis for lower of cost or market rule, 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 in order to maintain a clear picture of the financial standing of a business entity.

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This has been a guide to what is Conservatism Principle of Accounting. Here we discuss conservatism principle in detail along with practical examples and its impact on the financial statements.

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