Conservatism

The concept of conservatism refers to an accounting principle. The idea should not be confused with conservatism’s political and social philosophy. Conservatism in accounting relates to some guidelines and regulations by which the accounting for a company or organisation is performed.

One of the ideals of conservatism is that strict verification processes are to be performed before the accounting can declare a profit. Hence, there are stringent criteria to be met in assessing the liabilities, expenses, and assets such that a conservative estimate is made for the company’s financial health.

On that note, let’s delve into the details of conservatism in accounting and its associated advantages and disadvantages.

What is Conservatism in Accounting?

Broadly speaking, there are two chief criteria of the conservatism concept. They are:

• Expenses and liabilities must be noted and recognised quickly, even when there is the slightest hint of certainty regarding the outcome
• Assets and revenue are only to be noted when they are completely sure of being received

Hence, when performing accounting according to the conservatism principle, any accountant that has faced two outcomes should take the more conservative approach. 

Overall, this is the meaning of conservatism in English.

How does the Conservatism Concept work

Whenever the accountant has a potential or causes for bias, they are expected to take the more conservative route, i.e., they are to choose the numbers that yield the inferior results. Simply put, an accountant is supposed to assume the worst-case scenario before setting down to do the accounts.

Moreover, any profits are not to be recorded unless and until they actually occur. Furthermore, whether truly occurred or not, any loss should be pre-mentioned and over-amplified.

Therefore, the approach is to amplify losses and undermine profits. This gives a very conservative view of the company’s financials. Gains are not mentioned until they occur, while losses, even those without the potential for not occurring, are recorded.

How Revenue is Recorded in the Conservatism Concept

When using this accounting principle, payments are recorded in a rigorous manner. Furthermore, it is not documented until there is a cash or asset exchange between the parties. Once money has been exchanged for products or services, the transaction should only be recorded as successful completion. As a result, it should be emphasised that revenue is not recognised when there is no exchange of currency in the transaction. Because of this, the recording of income is done in a precise and methodical manner.

Advantages of the Conservatism Concept

Below are some key benefits of the conservatism accounting approach.

• Conservative accounting will always state a lower income and future financial benefits
• Since conservative accounting shows a bleak and often unsatisfactory report of the company’s financials, it ensures managers make better decisions and are careful in their company’s estimates
• The orientation of this concept is such that it allows scope for positive surprises rather than negative upsets
• This factor is essential because a company’s share price can greatly vary based on the company’s financial statements
• This method of accounting makes it easy to compare the financial results
• These results can be compared across time periods
• Moreover, investors can measure a more accurate picture of the company from this conservative approach

Disadvantages of the Conservatism Concept

Listed below are some disadvantages of the conservatism principle.

• This method of accounting significantly underestimates the future value of the company
• It means investors will get a poorer view of the prospects of any company than it is
• The written down value of the company will increase
• Companies can always find a way to manipulate the results of conservative accounting
• The problem of revenue shifting is another key issue that arises when the conservative concept of accounting is applied
• In the event that an accountant does not choose to include certain transactions in the current period, they can always include them in the following month
• This does not provide a clear picture of the financial condition of the organisation
• It can make businesses unable to track their business operations internally

When to Use Conservatism Principle of Accounting

• This accounting principle is used frequently in recording the revenue of the business
• Both the revenue and expenses must be realisable before one can record them
• You can also use this accounting principle when you are valuing inventory
• Again, the lower historical cost will be recorded as monetary value
• Casualty losses and uncollectible account receivables can also be measured from the conservative accounting principle

Conclusion

Conservatism is an accounting principle responsible for a less showy approach to presenting a company’s financial information. It is a set of principles that an accountant follows in order to determine or offer an accurate depiction of a company’s financial position. The strategy is straightforward: overstatement of losses and potential losses, understatement of profits and profits in the making. As a result, a company’s financial statements are only prepared after a great deal of caution and verification.