What is conservatism in accounting?
The concept of conservatism encourages a cautious approach to bookkeeping, recording figures only when they are fully verified. Heres a closer look at how this works, along with the pros and cons of conservatism in financial accounting. Conservatism accounting explained  Conservatism accounting is a set of guidelines in bookkeeping. Following the conservative approach, companies can only claim profit when its fully realized and legally verified. A company should factor in the potential worst-case scenario when making financial forecasts under these guidelines. For example, if there are two options to choose from, the accountant should choose the one with lower numbers to stay on the safe side. While uncertain liabilities would be recorded upon discovery, revenues can only be recorded upon assurance of receipt. Approaching your financial statements using conservatism accounting ensures that theyre prepared with caution. The aim of this concept is to protect investors from potentially inflated revenues and assets. This approach also limits any understatement of liabilities. How conservatism accounting works  Conservatism is one of the generally accepted accounting principles (GAAP), which is a set of guidelines drawn up to ensure that companies report financial information in a clear and accurate way. This particular principle requires companies to exercise caution when recording financial activity, opting for solutions that show the least favorable outcome. This is used as guidance when theres a need for estimation in accounting, preventing inflated figures or bias. When to use conservatism accounting  Conservatism accounting is most frequently used when a business records revenue. It helps you meet the reporting requirement that revenues and expenses be recorded during the same accounting period. According to conservatism in accounting principles, both the revenue and expenses must be realizable in order to be recorded on the balance sheet or income statement. If the transaction doesnt result in a monetary exchange with a specific dollar amount, the revenue isnt recognized and shouldnt be recorded. Another situation when you might use conservatism accounting is when youre valuing inventory. Using the conservative method, the lower historical cost would be recorded as monetary value. Youd also use this concept when estimating casualty losses or uncollectable account receivables, along with any time you expect to win gains but dont yet know the specific amount. Pros and cons of conservatism in financial accounting  As one of the principles included in the GAAP, conservatism is widely used in accounting. However, there are both benefits and drawbacks to consider with this technique. Advantages of conservatism in accounting  At first glance, it might seem like there are few advantages of conservatism in accounting. After all, youre overstating losses and understating profits, which can lead to your businesss finances looking worse on paper. However, there are distinct benefits to this practice. For example, it reduces the chance of financial recording errors. Theres less risk of unexpected disappointment or surprise loss when youre conservative with your accounting. Youve already listed the lower estimates or worse outcomes, which means theres good potential for positive gains in comparison. Finally, advantages of conservatism in accounting include those for investors. Standardized accounting procedures like conservatism make it easier for investors to compare financial statements, no matter the industry. Disadvantages of conservatism in accounting  On the other hand, conservatism accounting comes with a few potential downsides. GAAP regulations might offer standardization in principle, but there is always room for some interpretation. The biggest issue is that of revenue shifting. If a company cant report a transaction because it hasnt yet been legally verified, it might have to be pushed into the following accounting period. This leads to an imbalance, with the current period understated and the future period overstated. There are also disadvantages of conservatism in accounting from a tax authority perspective. Under conservatism, taxable income reporting might be lower, which results in reduced tax payments. While these are made up in the future as revenue is recorded, it can cause a temporary imbalance. These are just a few factors to keep in mind when applying this concept. We can help  GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.