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.
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