The conservatism or prudence principle in accounting is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty.
Put simply, it states that you should always err on the most conservative side and record uncertain losses and expenses, but not record uncertain gains. It is almost impossible for anyone to predict the future successfully and so this principle advises you to lean towards the more conservative side of any transaction.
The nature of business is such that the financial statements depend on future events. Accounting through the accrual concepts allow businesses to record transactions (revenues & expenses) that have not been received or paid yet. This gives accountants leeway to misrepresent accounts by over or understating income and revenues.
Such manipulation could allow companies to depict a rather unfair picture and present a more lucrative picture to the shareholders. To curb this practice, the accounting authorities introduced the conservatism principle.
While the rationale of the concept of conservatism is clear, we can go deeper into the concept to bring about clarity. We may often hear the case that life is unfair. Some might feel that this is particularly true for the authorities that developed the Generally Accepted Accounting Principles (GAAP) but if we really think about it, we can understand why this principle was introduced.
Normally, we as individuals would love the idea of maximizing gains. But no matter how optimistic or lucrative a deal may sound, GAAP does not allow us to record such gains unless they are fully realized. We may look at the revenue recognition concept to further enhance understanding of the topic.
Examples of the Conservatism Principle
Revenue Recognition Concept
With the revenue recognition principle, revenue cannot be realized until a company or a business has received the proceeds from revenue or is 100% certain of receiving the amount. The most common example quoted to help you understand this concept is a hypothetical situation where one company (ABC) is set to sue another company (XYZ) for copyright infringement.
Company ABC would expect to win a large settlement by suing XYZ but there is a fair degree of uncertainty involved. As no one knows for sure the outcome of the lawsuit, ABC would not record the transaction in its financial transaction. The company might or might not win the amount and in the case of the latter, the shareholders would be presented with a misleading picture.
However, if the company was to expect to lose the lawsuit it would need to record the loss it expects to incur. By following the conservatism principle, one is expected to adopt the more conservative approach. This way the shareholders would know the true picture as they wouldn’t be presented with an overstated value of the company on its financial statements.
We have looked as to how companies record transactions keeping revenues and losses as a basis for conservatism. We now explore the concept further by looking into other examples.
Lower of Cost or Net Realizable Value
According to GAAP, companies should record their inventories at the lower of cost or the net realizable value (NRV). The NRV shows us the difference between the selling price of an item and the cost incurred by the company in preparing that item for sale. The general concept is that the company would record the asset at the lower value.
To explain it further, if the company bought 10 baseball bats at $190 each. The total purchase price would be $1900. However, the market price of one bat under the current conditions is $220. Thus the market value of the bats is $2200. As per the lower of cost method the company would record the inventory at $1900 which is the lower of cost.
Similarly taking the above example, if the market value of the bats goes down to $170 each, the company is bound to record the inventory at $1700 and also record a loss on LCM adjustment of $200. The loss on LCM adjustment would be debited by $200, while the inventory would be credited by $200.
Provision for Doubtful Debts
Almost all businesses sell their products on credit. While credit may allow companies to get better bargains in terms of rates, they also lead to the development of doubtful debts. Doubtful debts are debts that have chances of not being recovered.
Businesses are therefore advised to estimate debts that they believe will not be recovered by making a provision for such debts. Again, there is a possibility that at the end of year all debts are recovered but just to abide by the principle of conservatism, businesses must take this cover.
Advantages of Conservatism
As mentioned before, conservatism allows the shareholder to get a clear and transparent picture of the organization. The financial statements are not overstated and the shareholder can get an accurate picture of the company’s financial position.
This also allows the company to play it safe by basing their actions on a less optimistic picture. Companies would thus remain modest in their approach as they would factor in the uncertainty of the expected future gains.
Another advantage that companies might have is that of lower taxation. With inventories valued at lower of cost, provision of debts accounted for no future revenues recorded, the net income of the company might be understated which would allow them to pay much less in taxes.
Disadvantages of Conservatism
The prudence concept may also come with its side effects. The concept is generally based on certain assumptions and estimates. To correctly predict all these factors may be quite difficult and time-consuming.
Companies may also create misleading provisions just to understate their net income so that the benefits of lower taxation can be reaped. There is also a possibility of companies overstating expenses and understating income thus also presenting a bleak picture to the shareholders.
Today’s world is changing rapidly. Investors have a lot of information asymmetry and this can lead them to take positions in companies that are not showing them the full picture. So, the principle of conservatism may allow authorities to keep companies in check & safeguard the investors.