Table of Contents
What is the Principle of Conservatism?
The conservative principle entails recognizing expenses and obligations as soon as possible when the outcome is uncertain, but only revenues and assets when they are certain to be received. Thus, when presented with an option between many outcomes with equal probabilities of occurrence, you should acknowledge the transaction that results in a reduced profit or at the very least the deferral of a profit. Similarly, if a selection of possibilities with similar probabilities may affect the value of an asset, acknowledge the transaction resulting in a reduced recorded asset valuation.
In accordance with the principle of conservatism, if the likelihood of incurring a loss is uncertain, you should lean toward recording the loss. In contrast, if uncertainty exists over the recording of a gain, the gain should not be recorded.
The idea of conservatism can also be used to the recognition of estimations. If the collections staff believes that a cluster of receivables will have a 2% bad debt percentage based on historical trend lines, but the sales staff is leaning towards a higher 5% figure due to a sudden drop in industry sales, use the higher 5% figure when creating an allowance for doubtful accounts, unless there is strong evidence to the contrary.
The conservative principle is the basis for the lower of cost or market rule, which dictates that inventories should be recorded at the lower of their purchase cost or their current market value.
The notion runs opposite to the needs of taxing authorities, as the quantity of taxable income declared tends to be smaller when this concept is actively utilized; the outcome being less reported taxable income and, consequently, reduced tax revenues.
The conservatism concept is merely a recommendation. Use your best judgment as an accountant when evaluating a situation and recording a transaction based on the available information. Do not regularly record the lowest potential profits for your business using this method.
How Accounting Conservatism Operates
As stipulated by the Generally Accepted Accounting Principles, companies are required to adhere to a number of accounting rules in order to publish their financial accounts with the highest accuracy (GAAP). In uncertain scenarios, conservatism is one of the accounting rules that requires accountants to use procedures and estimations that maintain relatively low book values of net profits.
The accounting rule sets recommendations for estimating during periods of uncertainty and in situations where an accountant’s measurement bias is likely. It also emerges organically between two contracting parties and is regarded as an efficient contracting idea.
This viewpoint is predicated on the notion that certain contracts, such as CEO remuneration and debt, result in unequal payoffs for the parties. Consequently, the payoffs result in timelier financial reporting, which may have implications for the contracting parties.
The quality of statistics reported in the balance sheet, income statement, and other financial statements is affected by accounting conservatism. This approach results in lower reported earnings than other liberal accounting solutions in the event of increasing investment. However, the unrecorded reserves built by the lesser profits provide the option to report a greater amount of earnings in the future. A corporation may increase its reserve reserves to increase investment, while decreasing its earnings.
In contrast, a corporation might distribute its reserve cash to enhance earnings and subsequently reduce investment. Nonetheless, unintended or not, doubts can still develop. With accounting conservatism, present earnings are inflated, rendering them an unreliable estimate of future marginal return.
When an accountant is faced with a choice between two financial reporting alternatives, accounting conservatism serves as the guiding principle. In such a circumstance, the accountant chooses the inferior alternative. In the worst-case situation, a corporation must take a cautious strategy.
For instance, while reporting, the book values of assets and revenues are purposefully undervalued, while losses and liabilities are inflated. Accountants must document and broaden the potential impact of loss uncertainty. Similarly, accountants are instructed to disregard any potential market benefit until it really materializes.
Recognizing and Recording Income
Revenue reporting is where conservatism in accounting is most strict. It stipulates that revenues must be recorded in the same period as associated expenses. For a transaction to be recorded, all information must be realizable. No revenue may be recognized if a transaction does not result in the exchange of cash or claims to an asset. The monetary amount must be known in order to report it.
Examples of Accounting Conservatism
Inventory value is guided by the accounting conservative principles. The guidelines stipulate that when evaluating the reported value of inventory, a corporation must utilize either historical cost or replacement value. They are also applicable to accounting rules, such as for accounting for casualty losses and accounts receivable.
For instance, a corporation that expects to win a lawsuit must adhere to all revenue recognition standards prior to reporting the gains. However, if the corporation expects to lose a case, it must record the economic loss. Other information required to be disclosed includes contingent liabilities such as product warranty compensation, unearned income, and royalty obligations.
Revenue is also recorded and reported using accounting conservatism. The matching principle stipulates that revenues and expenses must be matched in the same accounting period. Unless the revenue is realizable, it cannot be reported. It is predicated on the reality that no revenue can be recognized if a transaction does not result in a claim on an asset or cash exchange.
Accounting Conservatism’s Benefits
Understating gains and overstating losses indicates that accounting conservatism will always report a lower net income and fewer future financial rewards. There are various advantages to presenting a company’s financials in a less favorable light.
In the most visible way, it pushes managers to make more deliberate decisions. It also indicates that there is a greater potential for good surprises, as opposed to disappointing upsets, which are major share price movers. These standards, like other standardized techniques, should make it easier for investors to evaluate financial results across industries and time periods.
Negative aspects of Accounting Conservatism
In contrast, GAAP regulations such as accounting conservatism are frequently susceptible to interpretation. This means that some businesses will always find methods to manipulate them for their own benefit.
Another difficulty associated with accounting conservatism is the possibility of revenue shifting. If a transaction does not comply with the reporting requirements, it must be reported in the subsequent quarter. This will result in the current period being understated and future periods being overstated, making it challenging for a company to monitor its internal business processes.
Utilizing Accounting conservatism
Inventory valuation may be subject to conservative accounting practices. When calculating the reporting value of inventory, conservatism demands that the lesser of the historical cost or replacement cost should be the monetary value.
This technique is also applied to the estimation of uncollectible account receivables (AR) and casualty losses. If a business expects to prevail in a lawsuit, it cannot record the gain unless it complies with all revenue recognition criteria.
However, if a lawsuit claim is anticipated to be lost, the notes to the financial statements must include an assessment of the resulting economic impact. In addition, contingent obligations, such as royalty payments and unearned revenue, must be mentioned.
