Updated July 20, 2023
Introduction to Conservatism Principle of Accounting
Conservatisms principle of accounting, a principle of accounting which mandates recognition of expenses and liabilities despite having the uncertainty regarding the outcome, is also applicable in recognising, and measuring the assets and revenues as well in case there is a possibility of the receipt of same in future and applies to different situations such as accounting, bookkeeping, taxation, etc
This is the concept of recognizing the expenses or uncertain liabilities of the company as soon as possible and define the probability of better outcome when to be received. It is a set of guidelines for bookkeeping and to record accounting transactions in the company for better management and good results of profit. Under this concept, if there is any uncertainty regarding loss then the company should record the outcome of incurring losses and vice- versa in case of the outcome of gain.
The conservatism principle is a set of guidelines that enables the recognition of the estimates during business activities. These guidelines recognize expenses whereas assets are taken into consideration only when it is certain to receive or there is the existence of actual receipt.
Examples of Conservatism Principle of Accounting
Following are the examples are given below:
Example #1
Suppose company X Ltd. is involved in a lawsuit of the patent. X Ltd suing ZY Ltd for infringement of patent and is supposing to win a large settlement. As it is not sure that X Ltd will win the case. Hence, it should not record in the financial statements. Now the question arises why it does not record in the financial statement? So, the answer is X Ltd may lose or win depends on the circumstances and the amount is expecting to be received in case of a winning situation. If in case, it should be recorded in the financial statement it may mislead the financial position of the company.
On the contrary, if company ZY Ltd may win the suit then it must be recorded to warn the company for upcoming losses and there should be appropriate funds to manage the loss. Hence the losses uncertainty should be recorded in the financial statement of the company X Ltd.
Example #2
Suppose an inventory owned by the company ABC and purchased it for $200 but can now be bought for $100. Then the company must write down the value of the asset to $100 that is the lower of the cost of the market but if the inventory was bought for $ 200 and now it will cost $250, it must be shown as $200 only in the financial statement. The gain is recorded only when the inventory is sold.
Impact of Conservatism Principle of Accounting
The Conservative principle of accounting implies that the company should follow the conservative side of any financial transaction. It must be done by minimizing the profits by stating uncertain liabilities or expenses rather than recording uncertain gains without actual receipts. While doing the estimate for doubtful debts or casual losses or any other uncertain future events, the error on the side of conservatism.
The accountant should focus on estimated expenses and the least assets. It is the main backbone of the market concept for recording the estimates. The principle states that the company should select the most conservative outcome when two or more outcomes are available to the company. Hence, when the principle of conservatism is followed lower asset is recorded on the balance sheet and the lower asset is recorded on the income statement.
Importance of Conservative Principle of Accounting
The conservative principle is the set of guidelines that is particularly important for the benefit of the company by focusing the future losses with estimated terms and conditions. It helps to break a tie that arises when equal probable outcomes are there in a transaction. When the stakeholders or investors have gone through the financial statement of the targeted company it will assure the estimated losses and it makes the profile of the company more attractive in front of investors.
If it is overestimated, then it should be misleading for the investors or stakeholders of the company. This principle helps in shoeing a realistic picture of the financial position and future trajectory of the business. The principle focuses on the uncertain possibility of losses in which the company can deal with certain strategies and probable outcomes that are taken into consideration earlier.
Advantages and Disadvantages of Conservative Principle of Accounting
Some of the advantages and disadvantages are given below:
Advantages
Some of the advantages are given below:
- Negative revenues fully reflect the entire profit at the time when they occur.
- It can help in improving the measurement of cash flows.
- It facilitates a positive impact on book value compared to market value.
- It ensures the stakeholders to determine the financial position of the company.
- It will provide an accurate measurement of the risk involved in the day to day business.
- It is a more flexible method than others.
- It encourages professional judgment regarding the company.
Disadvantages
Some of the disadvantages are given below:
- It will enhance the written down value of assets of the company.
- This method underestimates the future value of the company.
- It may differ from the results related to taxation.
- It reduces the options for the company in terms of comparability.
- This method might mislead the stakeholders or investors as the value estimated not accurately.
- It is a huge challenge to enforce the principles of an organization.
Conclusion
The principle of conservative accounting is the main thing for lower of cost or market value specifies that inventory shall be recorded at acquisition cost or lower cost or maybe the current value. It is the accounting guidelines for the accountant of the company to follow to create a clear picture of the financial statement of a business. The two main aspects of this conservatism principle are recognizing expenses or liabilities as early as they are reasonably possible and ascertaining revenue only if it is certain. This principle is concerned with the accuracy and reliability of the financial statements of the business activity and shows the real picture of the financial position of an organization.
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