What is conservatism constraint in accounting?

What is the Conservatism Principle?

The Conservatism Principle states that gains should be recorded only if their occurrence is certain, but all potential losses, even those with a remote chance of incurrence, are to be recognized.

Conservatism Principle Definition

Under GAAP accounting standards, the conservatism principle – also called the “prudence concept” – must be applied when preparing the financial statements of companies.

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 conservatism principle states that:

• Potential Gain → If there is uncertainty regarding future revenue and profits, the accountant should avoid recognizing the gain.
• Potential Loss → If there is uncertainty about incurring a loss, an accountant should be predisposed to record the loss on the financials.

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.

That said, “potential” revenue and anticipated profits cannot yet be recognized – instead, only the verifiable revenue and profits can be recorded [i.e. there is a reasonable certainty in delivery].

Regarding the accounting treatment of expected future gains and losses:

• Expected Gains → Left Unaccounted in Financials [e.g. Increase in PP&E or Inventory Value]
• Expected Losses → Accounted For in Financials [e.g. “Bad Debt”/Uncollectible Receivables]

Conservatism Principle Effect on Valuation

The conservatism concept can lead to a “downward bias” in the values of a company’s assets and revenue.

However, 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.

Central to the conservatism concept is the underlying belief that it would be better for a company to understate revenue [and the value of assets] than to overstate them.

On the other hand, the reverse is true for expenses and the value of liabilities on the balance sheet – i.e. it is better to overstate expenses and liabilities than to understate them.

In effect, the conservatism principle reduces the likelihood of two occurrences:

• Overstated Revenue and Asset Values
• Understated Expenses and Liabilities

Conservatism Principle Example

Let’s assume that a company has purchased raw materials [i.e. inventory] for $20 million.

However, due to a changing market landscape and headwinds to the company’s products, customer demand has decreased.

If the fair market value [FMV] of the inventory – i.e. how much the raw materials can be sold for in the current market – has declined in half to $10 million, then the company must record an inventory write-off.

Since inventory is an asset, the value shown on the balance sheet reflects the inventory’s market value because per U.S. GAAP, the lower of the two values must be recorded on the books:

1. Historical Cost [or]
2. Market Value

Yet, if the fair value of the inventory increased to $25 million instead, the additional $5 “gain” above the historical cost of $20 million would NOT be reflected on the balance sheet.

The balance sheet would still show the $20 million in historical cost, as gains are recorded only if the item is actually sold [i.e. a verifiable transaction].

This scenario illustrates the conservatism principle, in which accountants must be “fair and objective.”

If there is any doubt concerning the value of an asset, liability, revenue, or expense, the accountant should opt for the choice of:

• Lesser Asset and Revenue Value
• Greater Liability Expense Value