Conservatism principle also known as prudence principle is one of the major Accounting Principles which are essential rules that should be followed in doing account planning and financial statements. Principle of conservatism is concept in accounting under GAAP (Generally Accepted Accounting Principles) that requires that when in doubt, the accountant should go for the alternative that will be the most unlikely to exaggerate assets and net income. This means that inventory is recognized on the balance sheet depending which is lower: cost price or current market price. In other words, when there is a possibility of precarious event, accountants should make a mistake on the side of caution and moderation. This generally means in a situation where revenue and costs are questionable, less income is recorded and more expenses are recorded. This does not happen every time, but minimizing profits is in most cases more conservative that maximizing them (D.E. Kieso, P.D. Kimmel, J.J. Weygandt 2010, s.275; I.MacKenzie 2012, s.19).
The conservatism principle is one of the most impactful practical agreement underlying currently available accounting since the beginning of this century. Nevertheless, the concept of conservatism is very contentious in accounting literature, and it has long been called as a "convention", instead of a "principle" or "standard" in accounting literature and official statements of accounting standards. However, this concept has a wide using in accounting standards and practices today in most developed countries. This assumption requires conservative attitude on the part of accountant in his appraisals, opinions and choice of procedure. In accounting, conservatism concerns to the early identification of unfavorable incidents. For example, losses ought to be identified and reflected in the financial record if sensible probability exists that they might happen. The prudence principle also assumes that expected gains and other financial profits should not be realized. This does not mean that income should be understated or that asset should be undervalued. Rather, the principle has disadvantages because conservative attitude can make the business seem to be in a negative financial position than actually is. The conservatism approach to financial reporting is a consequence of the uncertainty of happenings and historical experience (M.A. Sahaf, 2013, s.71).
Remember, the prudence principle does not say that we always have to appraise effects unfavorably. Accountants just need to choose the most conservative result if two different outcomes are available.
Generally Accepted Accounting Principles
Generally accepted accounting principles (GAAP) are currently accepted procedures, standards or methods for presenting financial accounting information, which accountants must follow to introduce authentic and fair view of an enterprise's finances. A standardized presentation format makes easy way for users to compare the financial information of various companies. Generally Accepted Accounting Principles have been either developed through accounting practice or established by authoritative organizations. Many countries now use International Financial Reporting Standards (IFRS)(J.D. Edwards, R.H. Hermanson, s.216.).
The major of accounting principles are as follows (I.MacKenzie 2012, s.19):
- The conservatism principle,
- The economic entity assumption,
- The continuity or going concern assumption,
- The unit-of-measure assumption,
- Periodicity or the time-period assumption,
- The historical cost principle,
- The revenue or realization principle,
- The Matching principle,
- The consistency principle,
- The full-disclosure principle,
- Materiality principle
- Edwards J.D., Hemrmanson R.H.,(2010). Principles: A Business Perspective Volume 1 Financial Accounting, 216.
- Kieso D.E., Kimmel P.D., Weygandt J.J., (2010). Accounting Principles John Wiley & Sons, Inc. , 275.
- MacKenzie I. (2012). Financial English with financial glossary Cengage Learning, 18-19.
- Sahaf M.A. (2013). Management Accounting: Principles & Practice, 3rd Edition Vikas Publishing House PVT LTD., 71.
Author: Sylwia Mierzwa