Conservatism principle is the accounting principle that concern about the reliability of Financial Statements of an entity. The conservatism principle provides guidance to accountants on how to records and recognizes the uncertainty outcome of revenues, expenses, assets, and liabilities in financial statements.
This principle also intends to ensure that the users who use financial statements receive enough and reliable information as they should be.
Under the conservatism principle, assets and revenue could be recorded or recognize unless it is clear that the entity could measure those transactions reliably. In addition, the expenses and liabilities are records at the highest value where assets and revenues are records at the lowest value.
This principle could help to minimize the entity to overstate the revenue and assets and understate the liabilities and expenses in its financial statements.
For example, without using this concept, the accountant could manipulate the accounting records where those transactions are not reliable.
Then, the financial statements result unreliable. Subsequently, there is an effect on the users of Financial Statements.
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In real life, smart CFO and CEO might play some tricks on how to ensure that Financial Statements of the company look healthy while the reality doesn’t.
Over recognition of revenues and assets, and negligently relay to recognize liabilities are the basic place to start.
Example of Conservatism Principle:
For example, the entity should recognize the liabilities that claim to the employee for the legal case even the entity not sure if they are failing. And the recognition should be at the highest value.
But, the entity should recognize assets for legal claims from an employee unless there is a clear statement from the court.
And if assets are recognized, it should be at the lowest value. In this case, it is helping users of FS to understand all types of liabilities and expenses that probably happen to the entity. And, it assures that the revenues recorded are realistic.
Conservatism principle assumes the entity could possibly try to overstate assets and revenues, and understate expenses and liabilities.
For recognition revenue, conservatism principle, the entity could recognize the revenue if the revenue transaction could not measure reliably and the outcome of those transactions are unpredictable.
This concept seems difficult, but it is quite straight forward. Here is the summary of principle:
- Assets and Revenue are recognized at the lowest value and unless we can measure it is reliably
- Expenses and Liabilities as soon as possible when there is uncertainty
In case, you found Conservatism Principle difficult. I give you one statement and hope it helps.
The same to in real life, you recognize bad news first, and for goods news, wait until it come true.
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Written by Sinra