What is a principle of conservatism in accounting?

Conservatism Principle also known as the “Prudence Concept” states gains should be recorded if their occurrence is certain but losses with a remote chance are recognized. The conservatism principle in accounting is a guideline that requires accountants to be cautious and conservative when preparing financial statements. As per this guideline, when faced with two options, accountants should choose the one that gives the least optimistic view of the situation. This prudence concept helps to prevent the overstatement of assets and income and ensures that financial statements are more reliable and prudent. It also protects accountants from legal liability.

Under GAAP accounting standards, the conservatism principle must be applied when preparing the financial statements of companies. In particular, for any revenue or expense to be recognized on the financial statements, there must be clear evidence of occurrence with a measurable monetary amount. It means “potential” revenue and anticipated profits cannot yet be recognized. Only verifiable revenue and profits can be recorded while receipt is certain.

The conservatism concept can lead to a “downward bias” in the values of a company’s assets and revenue. As per U.S. GAAP, the lower of the two values of the inventory must be recorded on the books. It means if the fair market value (FMV) of the inventory like raw material, finished goods, etc. is declined to the level of less than the original cost, the company must record an inventory write-off. On the other hand, if the FMV of inventories increases, the company cannot inflate the value of the assets based on present market value.

The idea behind the conservatism principle is NOT intentionally understating the value of assets and revenue, but rather, it is intended to prevent the overstatement of the two. Therefore, the financials of companies are expected to be presented fairly without any misleading stated values, so accountants must carefully verify and use caution when preparing and auditing financial statements.

The principle of conservatism is applied in India as part of the Generally Accepted Accounting Principles (GAAP). Auditors are not expected to sue because financial statements are too conservative. However, according to IFRS, modern accounting standards are primarily future-oriented, aiming to aid investors and other stakeholders in their decision-making. For that reason, conservatism is not the governing accounting principle under International Financial Reporting Standards (IFRS). Financial statements under IFRS should be understandable, relevant, reliable, and comparable, but without a conservative bias. This is also reflected in the accounting methods prescribed by the International Accounting Standards Board (IASB).

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