Loading the player...

What is 'Accounting Conservatism'

Accounting conservatism is a branch of accounting that requires a high degree of verification before making a legal claim to any profit as it requires recognition of all probable losses as they are discovered and most expenditures as they are incurred. Revenue will be deferred until it is verified as strict revenue-recognition criteria is one of the most common forms of accounting conservatism. An example of accounting conservatism — overestimating an allowance for doubtful accounts — can give a more accurate picture of recoverable receivables given a specific economic outlook.

BREAKING DOWN 'Accounting Conservatism'

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.

Conservative Accounting Theory

Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. This allows accounts to be fair and objective until multiple outcomes are possible. At this point, accounting conservatism provides guidance where the accountant has the potential for bias. Because external users base decisions on the financial information reported, accounting conservatism prevents information to incorrectly portray an entity’s financial situation. This is done through the reduction of risk as a cautious approach puts the company in a “worst case” scenario.

Revenue Reporting

Accounting conservatism is most stringent in relation to revenue reporting. Accounting conservatism requires 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 or cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to be reported.

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 and casualty losses 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.

Impact of Accounting Conservatism

When following accounting conservatism guidelines, assets and revenue are intentionally reported at figures potentially understated. Liabilities and expenses are overstated when using conservative accounting. Therefore, accounting conservatism will always report lower net income and lower financial future benefits.

An 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.

RELATED TERMS
  1. Net Realizable Value - NRV

    The value of an asset that can be realized by a company or entity ...
  2. Contingent Asset

    An asset in which the possibility of an economic benefit depends ...
  3. Allowance For Doubtful Accounts

    A contra-asset account that records the portion of a company's ...
  4. Accounting Convention

    Guidelines that arise from the practical application of accounting ...
  5. Account Activity

    Account activity generically applies to whenever a movement of ...
  6. Account Statement

    An account statement is a periodic summary of account activity ...
Related Articles
  1. Personal Finance

    Accountant: Job Description & Average Salary

    Discover what the job description of an accountant entails, along with education and training, salary and skills necessary for success.
  2. Managing Wealth

    Accounting Research Manager: Career Path & Qualifications

    Discover the basic responsibilities of an accounting research manager, the path this career usually takes and the qualifications needed for this career.
  3. Investing

    The Best Investment Accounts for Young Investors

    What are the best investment accounts for young investors? A few types to consider.
  4. Insights

    A Look At Accounting Careers

    More than just crunching numbers, this career blends detective work with trouble shooting.
  5. Investing

    The Importance Of Analyzing Accounts Receivable

    While investors often focus on revenues, net income, and earnings per share, they should not overlook the importance of analyzing accounts receivable.
  6. Trading

    Pick the Right Brokerage Account for Options

    Follow these steps to pick the right options brokerage account depending on your trading needs.
RELATED FAQS
  1. What are the advantages and disadvantages of horizontal integration?

    Understand the criteria for recognizing revenue recognition. Learn the principles behind when a company can consider its ... Read Answer >>
  2. How is market to market accounting different than historical cost accounting?

    Learn about historical cost accounting and mark to market accounting, the difference between and the limitations of the two ... Read Answer >>
  3. What are the objectives of financial accounting?

    Learn about the principle objectives of financial accounting, including the furnishing of the financial statements for those ... Read Answer >>
  4. What is the difference between the current account and the capital account?

    Learn how to differentiate between the capital account and the current account, the two components of the balance of payments ... Read Answer >>
  5. What Does a Share Liquidation in My Account Mean?

    A liquidation occurs when an account's holdings are sold off by the firm where the account was held. Read Answer >>
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center