Accounting conservatism definition
/What is Accounting Conservatism?
Accounting conservatism is the concept that a business should take the most conservative view to recording business transactions. Doing so reduces the risk that transactions entered into an accounting system will need to be adjusted at a later date. This means that expenses and liabilities are recorded as soon as possible, while revenues and assets are recorded only when there is significant assurance of their receipt.
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How Accounting Conservatism Works
The major accounting frameworks (which are Generally Accepted Accounting Principles and International Financial Reporting Standards) mandate that several accounting conventions be followed, so that accountants compile financial statements in a cautious manner, where overly optimistic financial results and financial positions are avoided.
This conservative approach is not intended to result in arbitrarily reduced financial statements, but rather to produce results that are unlikely to require future adjustments, thereby gaining the public’s trust in the contents of financial statements.
Realistically, there are only a few areas to which the accounting conservatism concept can be applied, since the bulk of all transactions are relatively routine, involving standardized accounting processes such as accounts payable, accounts receivable, and payroll. The focus of this concept is on transactions where there is a material amount of uncertainty involved, such as in the determination of estimates of bad debt, obsolete inventory, and sales returns. Similarly, conservatism can be applied to the recognition of gains and losses, where losses are generally recognized as soon as possible, while gains are deferred until it is quite certain that they will be realized. For example, a possible loss from a lawsuit must be reported as a contingent loss, while a possible gain from a lawsuit cannot be reported until a favorable lawsuit ruling has been issued and the related cash has been received.
Accounting conservatism is especially applicable to the recognition of revenue. There are numerous rules mandating that the recognition of revenue be deferred until all performance conditions by the seller have been completed. Similarly, a business cannot recognize a gain (for example) from a lawsuit, despite being certain of winning it, until the verdict is announced and cash is received. This level of conservatism can put off the recognition of gains for substantial periods of time.
Advantages of Accounting Conservatism
A business that applies accounting conservatism will tend to produce financial statements with lower profits or higher losses. A key advantage of doing so is that there are few financial surprises that may come to light at a later date, since management is encouraged to report negative results as soon as possible. Further, because optimistic reporting is discouraged, this leaves for room for valid additional profits and gains to be reported; these sudden spikes in financial results can drive unexpected improvements in a firm’s share price due to enthusiasm by investors.
Also, when accounting conservatism is enforced by auditors across an industry, it is less likely that any anomalies will be found in the financial statements produced by anyone in the industry. This makes it easier for analysts to compare the financial results produced by a group of competitors.
Disadvantages of Accounting Conservatism
A management team can use accounting conservatism to its advantage by recording large loss reserves. Doing so tanks the reported results in the current period, but creates a large reserve against which management can dump any number of losses in later periods. The outcome is a services of overstated financial statements in later reporting periods.