Conservatism principle

Conservatism principle
See also
Accounting Convention Accounting conservatism Prudence concept Cost principle Change in accounting estimate Materiality principle Qualitative characteristics Accrual method Consistency principle

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

Examples of Conservatism principle

• Inventory: An example of conservatism principle is when recording inventory in the balance sheet, the accountant should use the lower of the cost price or the current market price. This is to ensure that the inventory is not overstated and the financial statements reflect a more realistic view of the company’s assets.
• Asset Valuation: An example of the principle of conservatism is when valuing assets. The accountant should use the lower of the historical cost price or the current market value. This is to ensure that the assets are not overstated and the financial statements reflect a more realistic view of the company’s assets.
• Revenue Recognition: Another example of the principle of conservatism is when recognizing revenue. The accountant should use the lower of the amount received or the amount due. This is to ensure that the revenue is not overstated and the financial statements reflect a more realistic view of the company’s revenue.
• Provisions: An example of the principle of conservatism is when making provisions for bad debts. The accountant should make a higher provision than what is due in order to ensure that the financial statements reflect a more realistic view of the company’s liabilities.

Advantages of Conservatism principle

The Conservatism principle is an important part of Generally Accepted Accounting Principles (GAAP). It is a concept that requires accountants to go for the most unlikely alternative when there is doubt and to minimize profits instead of maximizing them. There are a number of advantages associated with this principle, such as:

• Accurate Financial Statements: By minimizing profits, the Conservatism principle helps to ensure that the financial statements are accurate and represent the true state of the company’s finances. This is important for investors, creditors and other stakeholders, who rely on the financial statements to make informed decisions.
• Conservative Business Decisions: The Conservatism principle encourages accountants to opt for the most conservative option when in doubt, which can help to promote responsible decision-making and better risk management. This can help to protect the company from potential losses in the future.
• Trust and Reliability: By following the Conservatism principle, companies can demonstrate to investors and other stakeholders that they are taking responsible measures to ensure the accuracy of their financial statements. This can help to build trust and reliability in the company’s financial position.

Limitations of Conservatism principle

The principle of conservatism is an extremely important accounting principle, however it has some limitations. These limitations include:

• The principle of conservatism may lead to the overstatement of liabilities and understatement of assets, resulting in an inaccurate record of a company’s financial position.
• The principle of conservatism may also lead to underestimating future revenues, as conservatism only looks at the current situation. This can have a negative effect on business plans and forecasts.
• The principle of conservatism can also create a bias in the financial statements, as the figures may be more conservative than necessary. This can lead to investors having an inaccurate view of the company’s financial health.
• The principle of conservatism may also lead to a reduction in the quality of financial statements, as the figures may not accurately reflect actual performance. This can lead to investors and other stakeholders having an inaccurate view of the company’s financial health.
• The principle of conservatism may also be costly, as it requires more resources to implement and maintain. This can lead to an increase in operational costs, which can have a negative effect on profitability.

Other approaches related to Conservatism principle

• Matching principle - this principle requires that expenses be matched with related revenues in the same period. This is done to ensure that the financial statements accurately reflect the performance of the business for a given period of time.
• Accrual principle - this principle requires that expenses and revenues be recorded in the period in which they are incurred or earned, regardless of when they are actually paid or received. This ensures that the financial statements accurately reflect the performance of the business for a given period of time.
• Realization principle - this principle requires that revenues and gains be recognized when they are realized or when they become real economic benefits, not when they are earned. This ensures that the financial statements accurately reflect the performance of the business for a given period of time.

The conservatism principle, along with the matching principle, accrual principle and realization principle, are important accounting principles used to ensure that the financial statements accurately reflect the performance of the business for a given period of time. The conservatism principle emphasizes caution and moderation in accounting, while the other principles ensure that revenues and expenses are recorded in the proper period. Together, these principles help to ensure that financial statements are reliable and accurate.

References

• 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