Conservatism principle - What is the conservatism principle?
The idea of conservatism suggests that you, as a business, should anticipate and record future losses rather than future gains.
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The principle of conservatism in accounting gives guidance when recording cases of uncertainty or estimates. In other words, you should always lean towards the most conservative side of any transaction.
The conservatism principle is one of the main accounting principles and guidelines listed under UK GAAP. GAAP is a regulatory body of principles and standards that all accountants should follow when reporting the financial activity of a business. Hence, for stakeholders interested in the financial data of a company, the conservatism principle ensures that the financial statements and information of that business is not overestimated or misleading.
The conservatism principle explained
In situations where uncertainty exists and there is doubt between two reasonable alternatives for recording an item, according to the conservatism principle your accountant should always choose the “less favourable” outcome. This could mean minimising profits by recording estimated expenses or losses, and not recording the estimated gains or revenues.
- If there is uncertainty about a loss or potential loss - then you should record it.
- If there is uncertainty about a gain or potential gain - then you should not record it.
And of course, if there is certainty about a gain - then you should record it.
Example of conservatism principle
Here is an example to show when the conservatism principle is used, and what situations it is relevant for:
- A cosmetic company Beauty Pacific, Inc. is in the process of a patent lawsuit against another cosmetic company Pure Pacific, Inc.
- Beauty Pacific, Inc anticipate to win the patent claims as well as a large settlement.
Beauty Pacific, Inc. cannot report the gains in their financial statements as long as this gain is still uncertain. By recording the large settlement win, their financial statements could mislead their users, so it should not be recorded until it is certain.
If Beauty Pacific, Inc. anticipate to lose the patent claims, and might also have to pay out a large settlement, then they should record this loss in the notes of the financial statement. Whether they end up winning or losing the lawsuit, Beauty Pacific, Inc. should take the most conservative approach. Their financial statement users should be made aware of any potential large losses that the company might experience in the future.
This is also known as “playing it safe”, or taking the least optimistic approach to a situation, assuming that losses will be incurred and therefore adjusting the financial statements accordingly. The purpose of this is to ensure that a business’s financial statements are reliable.
Another way of looking at the conservatism principle is that losses or expenses are recorded as soon as they are incurred, whereas profits or gains are recorded only when they have been received.
The importance of accounting principles
The conservatism principle is one of many accounting principles, which stand for standardizing the way in which businesses perform their financial reporting activities.
It is important to keep track of your incomes and expenses not only for your customers but also for you to evaluate the current position of your business. With Debitoor invoicing software you can easily manage and track your financial statements, and draw up your financial reports at any time!