What is the Conservatism Principle of Accounting?

The accounting principle of conservatism – also referred to as the concept of prudence – ensures that the financial statements present an accurate picture of the financial position of a company.

Professional accountants must verify each transaction and remain prudent when recording income and expenses. Here you will learn more about the accounting concept of conservatism that outsourced bookkeeping service providers follow when making entries.

The Principle of Conservatism: An Overview

The conservatism accounting principle states that bookkeepers should record income only when the outcome is certain. On the contrary, expenses should be recorded even when there is a remote chance of the outcome.

Conservatism is one of the Generally Accepted Accounting Principles (GAPP) that must be applied by bookkeepers when preparing financial statements. The principle is also the foundation of the international financial reporting standards (IFRS).

The principle of conservatism encourages bookkeeping service providers to remain cautious when recording income and expenses. They must anticipate losses but never record profits unless certain.

The implication here is that the accountant must record the lowest possible estimated income amount. On the contrary, they must be liberal when recording expenses for a company during the same period.

Accountants need to make provisions for all income, and liabilities and assess whether they are certain or not. Probable losses should be established and recoded in the books. It involves estimating the future income and expenses and making appropriate entries in the books.

Application of the Conservatism Principle in Accounting

The accounting principle of conservatism is used when recording uncertain outcomes. It involves looking at historical data to make assumptions. The principle is applied when calculating the allowance for bad debts. In addition, the principle is applied when estimating income from activities.

The principle of conservatism is also applied when calculating inventory values. A few examples will further clarify how an outsourced bookkeeping service provider uses the accounting principle when recording transactions.

Example 1 – Bad Debts Expenses

Suppose that the accounting staff estimates a 3 percent bad debt expense based on the review of historical accounts receivable data. But the staff has also estimated that the bad debt expenses could be 5 percent based on the recent economic data.

In the above hypothetical situation, the accountants will select 5 percent for estimating bad debt expenses as per the accounting principle of conservatism.

Example 2 – Inventory Valuation

Let’s suppose that the market value of the inventory of a company is $5,000. But the purchase cost of the inventory is $8,000. In this situation, the inventory is recorded at $5,000.

The above estimate is based on the principle of selecting a lower value for estimating the income of a company. Inventory is current assets that are converted into income. So, a lower value is selected when estimating the value of the asset.

If the value of the market value of the inventory decreases to $4,000, the balance sheet will be adjusted as per the conservatism principle.

Example 3 – Gain on Investment

Assume that a company invested $1,000,000 in stock. The asset value is estimated to double due to positive market fundamentals regarding the stock. In this situation, the company will not record the appreciation in the stock value.

Now suppose that the company is sued by investors and the court rules against the company ordering it to pay $100,000. In this situation, the company must record the payout to investors even when the amount has not been paid.

The company in the above example may file an appeal. But unless the court reverses the decision, the accountant will have to record the loss in the financial statements.

Reasons for Application of the Conservatism Principle

The US GAAP and international IFRS both require companies to apply the conservatism principle. The reason for the emphasis on the principle is to ensure that the losses are not under-reported and the revenues are not overstated.

The application of the principle aims to allow investors to gauge the financial health of the company. It will allow them to know whether the company is in a good financial position or struggling. The information provided in the financial statements will be used by investors to decide on investing in the company or granting loans.

An important thing to remember is that the principle of conservatism does not mean selecting the lowest income and the highest expenses. The principle encourages accountants to remain prudent when deciding between two uncertain events. That’s why the accounting principle is also known as the principle of prudence.

The income of the company must not be overestimated as it will mislead the stakeholders. The application of the principle of conservatism ensures that investors don’t make decisions based on inflated figures. It provides a more transparent and accurate picture of the current financial position and future trajectory of the company.

The principle of conservatism involves an upward bias when estimating the expenses and liabilities of the company and a downward bias when estimating income and assets.

But the conservatism principle should be applied with prudence. Accountants should take care not to intentionally understate expenses and overstate income to mislead investors or taxation authorities.

The conservatism principle serves as a guide for accountants when recording uncertain financial transactions.  The foundation of the principle is that it is better to underestimate assets and income rather than overestimate them.

Conclusion

Bookkeepers apply the principle by recognizing expenses and liabilities as soon as possible even when the outcome is not certain. Contrarily, they must delay the record of income until the event is certain. They must recognize the lower the income in case two events are equally likely to happen.

Application of the conservatism principle will result in a report of lower profit. In addition, it will result in a lower recorded value of the asset in the balance sheet.

Maxim Liberty Inc offers experienced outsourced bookkeeping services in the US. Our professional CPAs can simplify the task of recording transactions using generally accepting accounting principles. Contact us by dialing (703) 957-6938 today.