What is Accounting Conservatism?
Accounting conservatism is a set of bookkeeping guidelines that call for a high degree of verification before a company can make a legal claim to any profit. The general concept is to factor in the worst-case scenario of a firm’s financial future. Uncertain liabilities are to be recognized as soon as they are discovered. In contrast, revenues can only be recorded when cash exchanges hands.
How Accounting Conservatism Works
The conservatism principle is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received. Thus, when given a choice between several outcomes where the probabilities of occurrence are equally likely, you should recognize that transaction resulting in the lower amount of profit, or at least the deferral of a profit. Similarly, if a choice of outcomes with similar probabilities of occurrence will impact the value of an asset, recognize the transaction resulting in a lower recorded asset valuation.
Under the conservatism principle, if there is uncertainty about incurring a loss, you should tend toward recording the loss. Conversely, if there is uncertainty about recording a gain, you should not record the gain.
The conservatism principle can also be applied to recognizing estimates. For example, if the collections staff believes that a cluster of receivables will have a 2% bad debt percentage because of historical trend lines, but the sales staff is leaning towards a higher 5% figure because of a sudden drop in industry sales, use the 5% figure when creating an allowance for doubtful accounts, unless there is strong evidence to the contrary.
The conservatism principle is the foundation for the lower of cost or market rule, which states that you should record inventory at the lower of either its acquisition cost or its current market value.
The principle runs counter to the needs of taxing authorities, since the amount of taxable income reported tends to be lower when this concept is actively employed; the result is less reported taxable income, and therefore lower tax receipts.
The conservatism principle is only a guideline. As an accountant, use your best judgment to evaluate a situation and to record a transaction in relation to the information you have at that time. Do not use the principle to consistently record the lowest possible profits for a company.
Examples of Accounting Conservatism
Accounting conservatism may be applied to inventory valuation. When determining the reporting value for inventory, conservatism dictates the lower of historical cost or replacement cost is the monetary value.
Estimations such as uncollectable account receivables (AR) and casualty losses also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles. However, if a litigation claim is expected to be lost, an estimated economic impact is required in the notes to the financial statements. Contingent liabilities such as royalty payments or unearned revenue are to be disclosed, too.
Why Does Accounting Conservatism Matter?
Accounting conservatism, along with the other accounting conventions, provides a standardized methodology (or, more realistically, an ethical guideline) that creates reliable financial statements. In turn, accounting conservatism creates a reliable means of comparing financial results from industry to industry and from year to year.
Accounting Conservatism Methods
For companies that utilize accounting conservatism, following a stringent fiscal reporting is paramount. This policy adheres to the standard accounting principle of congruence. This requires all losses to be recorded in the expense statements. This expendable income stipulates an occurrence of cash or claims being exchanged known as an account receivable.
In accounting conservatism, only when fiscal gains are actualized does it appear on the financial records. This methodology allows business’ to avoid over-reporting income. Likewise, accounting conservatism overestimates the possibility of negative transactions. For businesses that deal in goods or services often find in their ledger a high amount of assets that have not been actualized as customers still owe on accounts. Companies in similar situations choose to use accounting conservatism to give a more accurate account of the future fiscal climate.
Other businesses may choose conservative accounting when assets and liability. This creates a conservative approach to the company’s ledger. However, recent years have seen a change in business equity to reflect the equity structure than on the ledger. However, the calculation of economic value is based on the assets minus the liabilities. Conservative accounting ensures fiscal reporting is representative of the true economic health.
This method of accounting can misused to over-report earnings at a later date. The can be for dubious reasons or simply because the method allots for a high estimate for unreliable income though it has been collected. This may lead to a distorted view of the companies fiscal state.
Accounting conservatism is most stringent in relation to revenue reporting. It requires that revenues are reported in the same period as related expenses were incurred. All information in a transaction must be realizable to be recorded. If a transaction does not result in the exchange of cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to be reported.
Advantages of Accounting Conservatism
Understating gains and overstating losses means that accounting conservatism will always report lower net income and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.
Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.
Disadvantages of Accounting Conservatism
On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. That means that some companies will always find ways to manipulate them to their advantage.
Another issue with accounting conservatism is the potential for revenue shifting. If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods to be overstated, making it difficult for an organization to track business operations internally.