Concept of Conservatism Principle in Accounting
- Definition: Conservatism Principle in Accounting refers to financial reporting guidelines that require accountants to exercise a high degree of verification and utilize solutions that show the least aggressive numbers when faced with uncertainty.
- Goal: It is a longstanding principle in financial reporting intended to protect users of financial information from inflated revenues and to make sure that all potential liabilities are recorded as soon as they are realized.
- The guideline requires that losses be recorded as soon as they are quantified (certain or uncertain), while gains are only recorded when they are assured of being realized.
- The general concept is to minimize the overstatement of revenue and assets and to understate the liabilities and expenses.
Benefits of Conservatism Principle in Accounting
- The unconditional understatement of a company’s financials offers several advantages like-
- It encourages management to face optimism or exaggerated uncertainty in its decisions.
- There is a higher margin of security against distressed outputs.
- Also leads to objective book values that are prepared based on the Generally Accepted Accounting Principles (GAAP), making it easier for investors to compare performance across different markets and periods.
Limitations of Conservatism Principle in Accounting
- The asymmetric response of earnings to economic gains and losses is open for interpretation. In such regard, the management of a company may manipulate accounting values to their advantage.
- Accounting conservatism promotes revenue shifting. A transaction can be deferred into the next period if it does not meet the reporting requirements of the current period.
Examples of Conservatism Principle in Accounting
- Accounting conservatism may be applied to inventory valuation: When determining the reporting value for inventory, conservatism dictates the lower of historical cost or replacement cost is the monetary value.
- Estimations such as uncollectable account receivables (AR) and casualty losses also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles.