Accounting conservatism is a principle that requires the immediate recognition of future expenses and liabilities in a volatile situation, rather than future assets and revenues.
What Is Accounting Conservatism?
In accounting, conservatism refers to the concept that in a highly uncertain situation, expenses and liabilities should be recorded immediately while revenues and assets should be recognized when there is a high degree of certainty that they will be obtained.
Conservatism, a principle set by Generally Accepted Accounting Principles (GAAP), does not instruct the accountant to be extremely conservative and bring down the company’s revenue to lower levels. An accountant is expected to maintain impartiality and objectivity. However, the concept of conservatism states that transactions should be recorded in a manner that results in a lower amount of profit and assets and/or a higher amount of liabilities and expenses. This is because conservatism favors the less favorable outcome.
Why Is Accounting Conservatism Used?
This strategy is used by companies to avoid giving a false impression that they have good fiscal health or integrity. It’s possible for accountants to apply accounting conservatism to multiple internal accounting processes. When it comes to fiscal gains, the criteria for recognizing a gain are far more stringent than those for recognizing a loss.
Pros and Cons of Accounting Conservatism
As is the case with any other type of accounting procedure, there are pros and cons to consider. Benefits offered by this principle are:
Conservatism lowers the negative impact of volatility significantly, hence improving the brand identity.
Access to funding is made easier by the firm since it provides a clear image of the financial status of the organization.
The accounting approach gives financial analysts the ability to make projections that are both impartial and accurate.
As is the case with all assets, there are some potential drawbacks as well:
It is possible that the projections may end up showing an inaccurate downtrend in terms of finances.
There is an asymmetry in the information.
It may offer an inaccurate future value of the organization.
Example of Accounting Conservatism
The rule requires reporting the inventory on the balance sheet at its cost or net realizable value (NRV), whichever is lower. Any related “loss” is reported in the current income statement.
For example, a company has inventory worth $10,000. The current market value of the inventory declined by $2,000. Therefore, it can be sold at $8,000, only if the company spends $3,000 more on the shipment of the goods.
The accountant is required to report the NRV (net realizable value) of $5,000 ($10,000 – $2,000 – $3,000) on the balance sheet and a write-down loss of $5,000 on the income statement (even if the goods have not been sold yet).