Convention of Conservatism

Also known as doctrine of prudence the Principle of Conservatism is one of the major accounting principles and concept listed under GAAP which states to minimize the overstatement of revenue and assets and to understate the liabilities and expenses.

The Convention of Conservatism states that “anticipate no profit, provide for all losses.” This implies that an accountant must always be cautious and record the lowest possible value for assets and revenues and the highest values for liabilities and expenses. As per this concept, revenues or profits should only be recorded whey are realized with reasonable certainty.

However, Conservatism should not mean understating of earnings or assets. Both overstatement and understatement of earnings and assets are bad. Understatement in one year will mean overstatement in the subsequent year. For example, if closing stock of a year is understated, it will reduce the profit of that year.

The closing stock of that year will become opening stock of next year so it will increase profit because trading account will be debited with a lower figure.

ADVANTAGES OF CONSERVATISM PRINCIPLE

  • The principle motivates the management to execute better care when making decisions.
  • Accounting conservatism also leads to objective book values that are prepared based on the Generally Accepted Accounting Principles (GAAP), making it easier for investors to compare performance across different markets and periods.
  • The  conservatism approach provides an accurate measurement of the risks involved.

DISADVANTAGES OF CONSERVATISM PRINCIPLE

  • This method underestimates the future value of the company.
  • This method might mislead the stakeholders or investors as the value is not estimated accurately.
  • This principle promotes revenue shifting which means a transaction can be deferred into the next period if it does not meet the reporting requirements of the current period.
  • Since the profits of the company are understated , the actual taxation liabilities of the firm may not  be reflected.

 

Thus in simple words, the Convention of Conservatism is an important accounting principle that requires company accounts to be prepared with caution and high degrees of verification

Accounting & Finance for Banking

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