What is the Conservatism Principle?

The conservatism principle is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty about the outcome, but to only recognize revenues and assets when they are assured of being received. Thus, when given a choice between several outcomes where the probabilities of occurrence are equally likely, you should recognize that transaction resulting in the lower amount of profit, or at least the deferral of a profit. Similarly, if a choice of outcomes with similar probabilities of occurrence will impact the value of an asset, recognize the transaction resulting in a lower recorded asset valuation.

Under the conservatism principle, if there is uncertainty about incurring a loss, you should tend toward recording the loss. Conversely, if there is uncertainty about recording a gain, you should not record the gain.

The conservatism principle is the foundation for the lower of cost or market rule, which states that you should record inventory at the lower of either its acquisition cost or its current market value.

The conservatism principle is only a guideline. As an accountant, use your best judgment to evaluate a situation and to record a transaction in relation to the information you have at that time. Do not use the principle to consistently record the lowest possible profits for a company.

Advantages of the Conservatism Principle

There are several advantages associated with adhering to the conservatism principle when you record financial transactions. They are as follows:

Less financial trouble. When you are already reporting financial results that are on the lower side of the possible range of outcomes, it is more difficult for you to get into financial reporting trouble. No one can realistically accuse you of over-reporting profits or assets.
More investor trust. When you gain a reputation for reporting financial results conservatively, the investment community is more likely to trust your financial reports, which may make investors more willing to invest in your business.

Conservatism Principle Impact on Reserves

The conservatism principle can be applied to the recognition of estimates. For example, if the collections staff believes that a cluster of receivables will have a 2% bad debt percentage because of historical trend lines, but the sales staff is leaning towards a higher 5% figure because of a sudden drop in industry sales, use the 5% figure when creating an allowance for doubtful accounts, unless there is strong evidence to the contrary. Auditors tend to be strong believers in conservatism as it applies to reserves, since it results in reduced levels of reported income.

Conservatism Principle Impact on Taxation

The conservatism principle runs counter to the needs of taxing authorities, since the amount of taxable income reported tends to be lower when this concept is actively employed; the result is less reported taxable income, and therefore lower tax receipts. The IRS has implemented several rules to mandate the recognition of taxable income in certain circumstances, in order to accelerate the recognition of taxable income.