Conservatism Concept

Today, the business world faces uncertainty and risks which are inherent. The solution to such a business situation is a prudent reaction. Conservatism concept can be viewed as a practical justification for certain accounting treatments. This requires the business enterprise to record an event in such way as to 'play safe' at the time of uncertainty. The practice of reporting the closing inventory at lower of the cost or market value appears to justify this principle of conservatism.

The concept often works on the principle - 'Recognize all losses, anticipate no gains'. This concept requires the accountants to underplay favorable prospects until they are actually realized. The idea behind this principle is that recognition of revenue requires better evidence than recognition of expenses. Thus, revenues are to be recognized only when they are reasonably certain, and expenses as soon as they are reasonably possible. For example, a sales manager might have finalized a deal with his client for say, 100 units of the product. But unless these units are produced and delivered to the client there is no reasonable certainty about receiving payment. It is only when the payment is received that he can record the sales amount for these 100 units that the deal would be complete. On the other hand, if he comes to know that a customer has lost all his assets and is likely to default payment, then he should immediately provide for such loss.

It is more often argued that conservatism may lead to understating of revenue and income and overstating of liabilities and expenses. It must be remembered that this principle cannot justify deliberate overstatement or understatement, undermining the usefulness of financial statements. It must be applied prudently so as not to result in secret profits and reserves which contravenes the convention of full disclosure (as discussed earlier).