Introduction to the concept
Generally accepted accounting principles (GAAPs) are laid down across accounting areas to ensure an accurate and consistent recording of financial transactions. Among these, one important and basic principle is the conservatism principle (also referred to as prudence concept of accounting). This principle states that the business entities must record all likely expenses and liabilities, whereas revenues and assets should only be recorded when there is a certainty that they will materialize.
The conservatism principle lays down recognition rules for entities, specifically in cases where there is uncertainty with regards to the occurrence of a financial event or the amount involved. It works as a guideline for accountants who have to continue to use their own judgement and discretion while recording transactions in case of uncertain events. The concept is followed by GAAPs of all jurisdictions to ensure that the accounts and statements derived from entities’ accounting systems present a fair and consistent view to their readers.
Examples of conservatism concept
One of the most relevant examples of conservatism principle is in the case of impending legal suits. Let’s say, ABC Inc. is a software company that has filed a suit against XYZ Inc. for using its patent technology. ABC has claimed the damages of $500,000 owing to patent infringement. The case is ongoing in the court.
Although ABC Inc. may have a strong case in their favor, yet under the principle of conservatism, it will not record this amount as a gain in their books until it actually materializes with a favorable ruling. This is simply because recording a sizeable gain before it actually is received or receivable may be misleading for the users of its financial statements.
In the reverse case, however, if a competitor files a case on ABC Inc. for patent infringement, the recording in the books may be different. Since it can be a likely loss for the company, it will definitely record it as a contingent liability in footnotes to its financial statements. In fact, depending on the specific facts, if it is likely that the company may actually lose the case and have to incur a heavy pay-out, it may actually make a provision of the same in the books.
This is once again under the conservatism principle that any likely expense or loss must be recorded or provided for so that users have a true and fair view of the entity’s financial condition.
Kim Company has outstanding debtors to the tune of $50,000. It gets information that one of its debtors owing $10,000 has filed for bankruptcy and will be unlikely to repay the dues. Under conservatism principle, the company ought to provide for the entire dues from the debtor amounting to $10,000 as there is a likelihood that he will default on the payment.
Why is the conservatism principle important?
Apart from the fact that it is a must as per GAAP, the conservatism principle has a very sound rationale as well. The principle is important to follow so that profits are not overestimated by companies and their accountants. It necessitates that accountants exercise abundant caution and prudence while accounting for business transactions.
The users who rely on financial statements for various reasons range from investors to creditors, bankers and lenders etc. If profits are overestimated due to overestimation of incomes and revenues or underestimation of losses and expenses, the accounting statements can be misleading for users. When accountants are conservative with respect to recording liabilities and recognising assets, financial statements can be fair, trustworthy and appropriate for decision making.