What is the conservatism principle in accounting?

The concept of conservatism encourages a cautious approach to bookkeeping, recording figures only when they are fully verified. Here’s a closer look at how this works, along with the pros and cons of conservatism in financial accounting.

Conservatism accounting explained

Conservatism accounting is a set of guidelines in bookkeeping. Following the conservative approach, companies can only claim profit when it’s fully realized and legally verified. A company should factor in the potential worst-case scenario when making financial forecasts under these guidelines. For example, if there are two options to choose from, the accountant should choose the one with lower numbers to stay on the safe side. While uncertain liabilities would be recorded upon discovery, revenues can only be recorded upon assurance of receipt.

Approaching your financial statements using conservatism accounting ensures that they’re prepared with caution. The aim of this concept is to protect investors from potentially inflated revenues and assets. This approach also limits any understatement of liabilities.

How conservatism accounting works

Conservatism is one of the generally accepted accounting principles (GAAP), which is a set of guidelines drawn up to ensure that companies report financial information in a clear and accurate way. This particular principle requires companies to exercise caution when recording financial activity, opting for solutions that show the least favorable outcome. This is used as guidance when there’s a need for estimation in accounting, preventing inflated figures or bias.

When to use conservatism accounting

Conservatism accounting is most frequently used when a business records revenue. It helps you meet the reporting requirement that revenues and expenses be recorded during the same accounting period. According to conservatism in accounting principles, both the revenue and expenses must be realizable in order to be recorded on the balance sheet or income statement. If the transaction doesn’t result in a monetary exchange with a specific dollar amount, the revenue isn’t recognized and shouldn’t be recorded.

Another situation when you might use conservatism accounting is when you’re valuing inventory. Using the conservative method, the lower historical cost would be recorded as monetary value. You’d also use this concept when estimating casualty losses or uncollectable account receivables, along with any time you expect to win gains but don’t yet know the specific amount.

Pros and cons of conservatism in financial accounting

As one of the principles included in the GAAP, conservatism is widely used in accounting. However, there are both benefits and drawbacks to consider with this technique.

Advantages of conservatism in accounting

At first glance, it might seem like there are few advantages of conservatism in accounting. After all, you’re overstating losses and understating profits, which can lead to your business’s finances looking worse on paper. However, there are distinct benefits to this practice. For example, it reduces the chance of financial recording errors.

There’s less risk of unexpected disappointment or surprise loss when you’re conservative with your accounting. You’ve already listed the lower estimates or worse outcomes, which means there’s good potential for positive gains in comparison.

Finally, advantages of conservatism in accounting include those for investors. Standardized accounting procedures like conservatism make it easier for investors to compare financial statements, no matter the industry.

Disadvantages of conservatism in accounting

On the other hand, conservatism accounting comes with a few potential downsides. GAAP regulations might offer standardization in principle, but there is always room for some interpretation.

The biggest issue is that of revenue shifting. If a company can’t report a transaction because it hasn’t yet been legally verified, it might have to be pushed into the following accounting period. This leads to an imbalance, with the current period understated and the future period overstated.

There are also disadvantages of conservatism in accounting from a tax authority perspective. Under conservatism, taxable income reporting might be lower, which results in reduced tax payments. While these are made up in the future as revenue is recorded, it can cause a temporary imbalance. These are just a few factors to keep in mind when applying this concept.

We can help

GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.

4 Min. Read

November 19, 2021

There’s nothing worse than spending the time to do your bookkeeping only to have a small mistake. Even the smallest of mistakes can have some big consequences. It can throw off all your calculations and cause a headache you would surely like to avoid.

Plus, there are certain guidelines and principles that you need to follow. Some companies only claim profits when they become verified and fully realized. In this case, conservatism accounting comes into play.

So what exactly is conservatism in accounting? Let’s take a closer look at everything that you need to know.

Here’s What We’ll Cover:

What Is Conservatism in Accounting?

How Does Conservatism Approach Work?

When Should You Use the Conservatism Approach in Accounting?

What Are the Benefits of Conservatism in Financial Accounting?

Key Takeaways

What Is Conservatism in Accounting?

The Generally Accepted Accounting Principles (GAAP) are a clear set of guidelines. They're meant to help when it comes to reporting financial information. These accounting standards were put in place to report financial information accurately. Conservatism accounting is one of those GAAP principles.

Following this approach, you can only claim profits once they have been realized and verified. It’s important to factor in any potential worst-case scenarios. Basically, uncertain liabilities are going to get recorded once they’re discovered.

Whereas any revenues are only able to get recorded once you receive an assurance of receipt. It ensures that you prepare your financial statements as cautiously as possible.

The goal is to help protect investors from revenues and assets that might be inflated. Plus, using this approach allows you to limit the understatement of any liabilities.

How Does Conservatism Approach Work?

It ensures that the financial information reported gets done clearly and accurately. This GAAP principle requires you to exercise caution when recording your financial activity.

When Should You Use the Conservatism Approach in Accounting?

If you record revenue, the conservatism approach in accounting is common. It helps when it comes to reporting requirements for revenues and expenses. Revenues and expenses need to get recorded during the same accounting period.

In the conservatism accounting principle, revenue and expenses both need to be realized. If they’re not realized, you can’t record them on your income statement or balance sheet. If you make a transaction that doesn’t result in a monetary exchange, revenue doesn’t get recognized. So if there is no specific dollar amount exchanged then it doesn’t get recorded.

An example of when you might use conservatism accounting is with inventory. Any lower historical costs of valuing inventory get recorded as monetary value. You can also estimate uncollectible account receivables or casualty losses.

This can get done any time that you expect to have gains but you’re not entirely sure what the specific amount will be.

What Are the Benefits of Conservatism in Financial Accounting?

It’s all going to depend, as with any GAAP there can be both benefits and disadvantages. And with conservatism accounting, it might seem as though there’s not going to be many benefits. This is since from the outside you’re going to overstate your losses and understate your profits.

Yet, there are some major benefits to using this approach. You have already included the worst possible outcomes and lower estimates. This means that you have great potential for positive gains.

Investors also enjoy the use of conservatism in financial accounting. This approach makes it easier for them to understand and compare financial statements. And it doesn’t matter what the industry is.

They can receive insights into the potential for positive gains. And they can get an understanding of a business’s financial health.

Key Takeaways

The conservatism principle is one of the Generally Accepted Accounting Principles (GAAP). They were put into place to help make financial reporting more clear and accurate. With the conservatism approach, you claim profit once it has become verified and realized.

You also factor in worst-case scenarios, which can help investors. The main goal of this approach is to show accurate revenues and assets. You're going to overstate losses and understate the recognition of profits. But, there's more potential for positive gains. It’s a cautious approach to doing your bookkeeping.

Did you enjoy reading this guide? Head over to our resource hub for more content!

RELATED ARTICLES