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.
- Accounting conservatism is a principle that requires company accounts to be prepared with caution and high degrees of verification.
- All probable losses are recorded when they are discovered, while gains can only be registered when they are fully realized.
- If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.
How Accounting Conservatism Works
Generally Accepted Accounting Principles (GAAP) insist on a number of accounting conventions being followed to ensure that companies report their financials as accurately as possible. One of these principles, conservatism, requires accountants to show caution, opting for solutions that reflect least favorably on a company’s bottom line in situations of uncertainty.
Accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.
Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.
A cautious approach presents the company in a worst-case scenario. Assets and revenue are intentionally reported at figures potentially understated. Liabilities and expenses, on the other hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to record it and amplify its potential impact. In contrast, if there is a possibility of a gain coming the company's way, they are advised to ignore it until it actually occurs.
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.
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.