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 since 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 in areas where the accountant has the potential for bias. Because external users base decisions on the financial information reported, accounting conservatism prevents information from incorrectly portraying 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.
Accounting conservatism is most stringent in relation to revenue reporting. It 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.