What is Accounting Conservatism in Finance and How Does it Work?

Accounting conservatism involves a conservative set of accounting guidelines wherein the worst-case scenarios are taken into consideration when preparing financial accounts. 

Under this principle, the expenses or liabilities are recorded as and when they occur (accrual basis of accounting records transactions even if no payment is made for them), while any income or assets are recorded only when they are received or when the company is assured of receiving them (cash basis of accounting). Read on to know its benefits, impact, example and more!

How Does Accounting Conservatism Work?

Accountants are expected to use the accounting conservatism principle when creating accounts for a business. Under the principle, the accountants record the firm’s expenses or liabilities immediately after they are incurred. 

On the other hand, if the business is expected to receive any form of income or earn an asset, the accounting entry for the same is passed only when the income or asset is realised. 

Thus, the liabilities are recorded at the onset, while the assets or incomes are recorded after a delay only when the business receives it, for sure. This prepares the business for the worst-case scenario as you see the profit or net loss even if the expected income or assets are not earned.

Why is Accounting Conservatism Used?

The primary reason for using the accounting conservation method is to avoid presenting a rosy financial picture when the company might be struggling with its inflows. The principle ensures that financial gains are recorded only after they are realised. This means that reporting unearned gains to inflate the profits can be avoided.

Example of Accounting Conservatism

To understand how the principle is used, consider the following conservatism accounting example:

Assume a business pays a monthly rent of Rs.25,000 for its premises. In this case, the accountant will record Rs.3 lakh in the profit and loss statement immediately, even if the payment is made over the next months. 

Alternatively, if the business believes in making a provision for bad debts, the provision is recorded in the income and loss statements even if the business might not incur any bad debts. 

On the other hand, say the business is due to receive Rs.1 lakh as interest on its investment. The interest is due on 1^st March 2021 but is received on 1^st June. In this case, the accountant will record the interest earned only on 1^st June 2021, i.e., when it is received. Thus, for the financial year 2020-21, the overall profit of the business, as depicted in the financial statements, will be reduced by Rs.1 lakh, even though the business is expected to earn this profit in the said financial year. 

Also Read

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Advantages of Accounting Conservatism

The advantages of the conservatism principle in accounting include the following:

• The impact of market volatility and its effect on profit is considerably reduced. As the accounting statements do not record any expected profits or earnings, if such earnings are reduced due to volatility, the accounting statements are not highly impacted.
• Through conservative accounting policies, a transparent picture of the business’s financial outflows and inflows can be accessed. This makes it easier for lenders to assess the creditworthiness of the business and grant loans. The business can, thus, easily access loans for its needs.
• Analysts and stakeholders can assess the correct financial picture of the business without any ambiguity. As such, they can forecast business growth without any bias or favouritism.

Disadvantages of Accounting Conservatism

While beneficial, the principle of accounting conservatism also has its share of limitations. They are as follows:

• Many businesses sell on credit where the credit cycles can be long. As such, if the earnings accrued in a financial year are not reflected in the said year, the business profitability might be considerably reduced. This would paint a negative picture of the business’s financial standing.
• Accessing information about what is earned and what is outstanding might be challenging. Even if received, the information might not be symmetrical.
• The future valuation of the business might be skewed if the profit figures are low due to unrecorded earnings and conservative revenue recognition.

Impact of Conservatism Principle in Accounting

The principle of accounting conservatism works on the conservative side of recording transactions. 

Suppose a business estimates any potential losses or liabilities; then, the same is recorded in the accounting books. As such, if the estimated losses or contingent liabilities do occur, the profitability is not impacted since it is already factored in the accounting statements. If contingent liability does not occur, the business can write off such expenses and increase the profits.

Additionally, per this principle, the income is recorded only when earned. As such, even if the company fails to recover the expected income, the existing profitability is not affected considerably as the profit is calculated before recording the expected earnings. So, any earnings will enhance profitability.

Through the accounting conservatism principle, a lower value of assets is recorded on the balance sheet.

Why Follow the Principle of Conservatism?

The principle of conservatism is followed to present an accurate picture of a company’s financial standing and to ensure that it can absorb potential losses. 

The principle tells accountants that when an accounting entry has two possible outcomes, the less favourable one must be employed. This way, they can make a cautionary accounting statement which shows the company’s financial position in the worst possible cases. Since the company cannot suffer any more losses than those depicted in the statements, the company can prepare itself to provide for the expected losses without depending on their incomes and assets.

Thus, the principle of accounting conservatism is widely used in creating accounting and financial statements.

Final Word

The principle of accounting conservatism guides the accountant on how to record the financial transactions of the business, including expenses, incomes, assets, and liabilities. The principle states that transactions should be recorded as and when they occur. This help depicts a clear picture of a company’s standing. Moreover, on the basis of the accounting conservatism principle, you can compare the financial metrics of different businesses in the same industry. This comparison will help you pick the right company to invest in. 

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