The conservatism concept in Accounting-By this post, we shall study in detail the important conservatism concept out of 12 various accounting concepts on which accounting is based. If you have a business and you are in a situation where there is uncertainty about the outcomes then you should know about these important conservatism concepts to know how to finalize your financial statements.
Contents of this post
What is the conservatism concept?
The conservatism concept is a concept of accounting that describes the expenses and liabilities that should be recognized as soon as possible in a condition where there is uncertainty about the possible outcome and must choose that outcome that is most conservative or has the least possible chance of profit.
Conservatism concept in Hindi
लेखांकन में, रूढ़िवाद के सम्मेलन, जिसे विवेक के सिद्धांत के रूप में भी जाना जाता है, भविष्य के संभावित नुकसान की आशंका है, लेकिन भविष्य में लाभ नहीं है। यह नीति शुद्ध संपत्तियों और शुद्ध आय के बजाय समझने की प्रवृत्ति रखती है और इसलिए कंपनियों को “सुरक्षित खेलने” के लिए प्रेरित करती है। जब कई परिणामों के बीच एक विकल्प दिया जाता है, जहां होने की संभावनाएं समान रूप से होती हैं, तो आपको यह पहचानना चाहिए कि लेनदेन में लाभ की मात्रा कम होती है, या कम से कम एक लाभ की विकृति होती है।
How can you explain the conservatism concept?
Conservatism concept tells that the accountant should not anticipate any future income however they should provide for all possible losses. When there are many alternative values of an asset, an accountant should choose the method which leads to the lesser value. Later on, we shall see that the golden rule of current assets valuation – ‘cost or market price whichever is lower’ originated from this concept.
The Realisation Concept also tells that no change should be counted unless it has materialized. The Conservatism Concept puts a further brake on it. It is not prudent to count unrealized gain but it is desirable to guard against all possible losses.
For this concept, there should be at least three qualitative characteristics of financial statements, namely,
- Prudence means judgment about the possible future losses which are to be guarded, as well as gains that are uncertain.
- Neutrality means the unbiased outlook is required to identify and record such possible losses, as well as to exclude uncertain gains,
- Faithful representation of alternative values.
Many accounting authors, however, are of the view that conservatism essentially leads to an understatement of income and wealth and it should not be the basis for the preparation of financial statements.
Example of conservatism concept?
We can understand the conservatism concept in accounting with the help of the example given below-
For example– an asset owned by an entity like machinery was bought for 1200₹, but can now buy for 500₹. Then the company must immediately write down the value of the asset to 500₹ because the lower the cost of the market. But if the machinery was bought for 1200₹ and now costs the company 1500₹, it must still be shown as 1200₹ on the books. because the gain is only recorded when the inventory or the asset is sold.
What is the importance of conservatism concept?
Here is the importance of the conservatism concept:
- First, it helps stakeholders in determining the financial position of the company.
- Second, it provides a positive impact on the book value of the company.
- and the third helps investors in measuring the performance of the company more accurately and also across different periods.
- and more it can help in improving the measurement of cash flows.
- It facilitates a positive impact on book value compared to market value.
- Negative revenues fully reflect the entire profit at the time when they occur.
- It ensures the stakeholders determine the financial position of the company.
- It will provide an accurate measurement of the risk involved in the day-to-day business.
- And It is a more flexible method than others.
- It encourages professional judgment regarding the company.
How does the conservatism concept work?
According to the conservatism concept, an accountant is required to show caution, opting for solutions that reflect least favorably on a company’s bottom line in situations of uncertainty. because Generally Accepted Accounting Principles (GAAP) insist on a number of accounting conventions being followed to ensure that companies report their financials as accurately as possible. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.
The accounting conservatism concept establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.
Assets and revenue are intentionally reported at figures potentially understated. Liabilities and expenses, on the other hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to record it and amplify its potential impact. In contrast, if there is a possibility of the gain coming the company’s way, they are advised to ignore it until it actually occurs.
What are Impact of Conservatism concepts on Financial Statements?
The impacts of the conservatism concept on financial statements are:
- In case of casual losses, doubtful debts, or any such future events that are uncertain in nature, the error should be done on the side of conservatism. It means that accountants should focus on recording more estimated expenses and less on assets.
- It states that a company must always follow the most conservative side of a financial transaction, which can be done by minimizing the profits (by recording uncertain liabilities and expenses and not recognizing uncertain gains)
- This concept helps in showing a true view of the financial position and the path of the business in the future.
Faqs related to conservatism concepts
- What are the advantages of the conservatism concept?
Here are some of the advantages of the conservatism concept:
1. First it helps stakeholders in determining the financial position of the company.
2. Second it provides a positive impact on the book value of the company.
3. and the third it helps investors in measuring the performance of the company more accurately and also across different periods.
- What are the disadvantages of the conservatism concept?
Some of the disadvantages of the conservatism concept are as follows:
1. First it underestimates the company’s future value.
2. Second it will result in increasing the written-down value of the company.
3. and the third promotes revenue shifting, which means a transaction can be pushed back into the next accounting period.
- What do you mean by the Conservatism concept?
Conservatism concept is the accounting concept that concerns the reliability of the Financial Statements of an entity. The conservatism concept provides guidance to accountants on how to record and recognizes the uncertain outcome of revenues, expenses, assets, and liabilities in financial statements.
- Is the conservatism concept good for an organization?
Yes, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices.
An Accountant, GST Practitioner, GST blogger, Website Developer, SEO Builder & Ceo & Co-founder of website https://gstportalindia.in for the help of GST Taxpayers of India. Having a perfect accounting experience of more than 10 years in a Private Company.