Conservatism in accounting or accounting conservatism is a sub-branch in accounting. It demands a high level of verification before making any legal claims about profits as it also involves the proper determination of losses and expenditures that can occur.
In simple words, it is the concept to calculate and estimate the liabilities and expenses soon when there is some uncertainty about the outcomes, but the assets and revenues are recognized once they are received. Thus when there is a similar probability of an outcome of events, the transaction, which is causing small profits or deferral of profits, should be considered.
Similarly, a transaction recording low value of an asset should be considered. This method anticipates a lower amount of profits with the greater amounts of losses. This approach is adopted to avoid any misleading factors for the internal and external stakeholders.
Under this principle, if there are uncertainties about some loss occurring, you should record loss. If there are uncertainties about some gains occurring, you don’t record the gains.
Accounting conservatism is not meant to manipulate the amount of dollar or the time of reporting the financial figures. It is intended to provide adequate guidance when any uncertainty or need for making estimation arises.
The accounting conservatism allows the amount to be objective and fair unless multiple outcomes are there. In that case, this theory acts to guide rule out any possible bias.
The rules are way stricter with the revenue reporting. Accounting conservatism demands revenues to be reported at the same time when expenses are incurred. All information in the transaction should be recorded. If the transaction doesn’t cause an exchange to the assets, revenue is not recognized.
The companies following the accounting conservatism are required to recognize the revenues strictly. It follows the normal concept of accounting known as matching principle. It means that all of the expenses that occurred during a specific period are to be noted along with the revenues on financial statements.
When those items get sold, or the services get completed, the revenue becomes realizable. It becomes recognized. Realizable revenue denotes a transaction in which items have been exchanged for the amount of cash like in the case of accounts receivable.
The revenue is not recorded unless information that is related to transactions is realizable. This prevents any company from over-reporting of revenues which can falsely depict the increased gross profits.
The second approach is to overestimate the allowances for debts value. Companies when selling goods, they have a high account of receivable balance. It means that the company’s cash is owned by many customers for finalization of the transaction.
This allowance for debts shows a figure amount which is not expected to be received from customers. For a doubtful account, high values of allowances are recorded to ensure a company’s accounts show an accurate outlook for the cash collection.
Accounting conservatism is also used when the company measures the exact value of its assets and various liabilities. It shows a relatively conservative approach in the balance sheet of a company. In recent years, the balance sheets of a company are considered to be more reliable in financial markets.
The reason is that the balance sheets show the accurate economic status of any company. The calculation of the economic value of any company involves the total amount of assets minus the total amount of liabilities.
The conservative approach in accounting helps to confirm that this value is not increased in efforts to show a better image of the company’s financial accounts.
What the approach of conservatism is accounting is very beneficial as it prevents the dissemination of any false information regarding any company’s financial status to the various stakeholders.