Conservatism leads to a doctrine of prudence within financial accounting. It involves the anticipation of future losses that may occur without taking into consideration the potential for future gains. This policy tends to create an understatement in the net income and net assets of an organization. Some might describe this approach as a way to play it safe.
When taking the conservative approach to accounting, this principle states that when you have 2+ solutions from which to choose, then the one you select should be the option that offers the least chance of overstating income or assets. Expected losses are treated as reality, while expected gains are ignored.
This approach plays an essential role in several accounting rules that are followed today, including the lower of cost or market rule and the allowance for doubtful debts.
Here are some of the other pros and cons of conservatism in financial accounting to consider as well.
List of the Pros of Conservatism in Financial Accounting
1. Negative revenues fully reflect the entire profit during the time they occur.
When working under the principle of conservatism in financial accounting, there is an asymmetric timeline of profits. The “bad news” that occurs for an organization with its books will be reflected on the profits earned faster than any “good news.” That means the negative revenues will fully reflect the entire profit during the period they represent for the agency. Then the positive earnings dividends reflect a partial period, creating a result that is closer to the movement of share prices.
2. It can improve the measurement of cash flows.
Using the conservative approach with your accounting method makes it easier to measure the cash flows which occur when there are asymmetric receivables involved in the calculation. Because losses are assumed, anything that is overdue in the receivables department is not counted as a potential profit. This process creates a realistic approach to the various cash flows that occur in the organization. It gives you an opportunity to plan for the worst, but then hope for the best when dealing with liquidity.
3. If offers a positive measure of book value compared to market value.
The conservatism approach in financial accounting will typically reduce the net book value of a company to its actual economy value. If the ratio of book value is then reduced to the ratio of market value, you can see with reasonable surety that this approach is in place throughout the organization. That means there is more surety in the stability of other factors when examining the overall health of a company – especially as an investor.
4. It helps stakeholders to determine what their absolute bottom line will be.
When there are times of economic uncertainty, stakeholders in an organization will want to know if survival is a possibility. By taking the conservatism approach in financial accounting, everyone can see what the bare minimum outcome will be. If these figures indicate that a loss is probable, then members can begin to take actions that will improve the situation. Although it doesn’t account for changes in potential profit that may come through, the evaluation of losses compared to guaranteed income helps to create a realistic plan for the future.
5. It provides an accurate measurement of the risks involved.
When you take the conservatism approach in financial accounting, then you can obtain a better idea of what the risks will be as you progress forward into the next evaluation period. There is always a clear picture of what losses may occur because each one becomes part of the equation. By evaluating these factors as a way to determine where investments should go, it becomes possible to improve the growth of future profits because you have a clear picture of what your liabilities happen to be.
6. There is an allowance available for doubtful accounts with this option.
Let’s say that you are operating as a credit card lender. When you look at your books, then you can see that 90% of your customers pay at least the minimum monthly payment on-time every month. When you look at the other 10%, then you need to figure out what is collectible and what is not. Your collections staff thinks that 3% of the receivables are bad debt because of the history they see with these accounts. At the same time, your senior managers believe it will be 6% because the economy is teetering on the edge of a recession.
Using the conservatism approach in financial accounting would require that you take the latter figure when creating your budget. If the collections staff are correct, then great! Your budget in this area just got 3% better. If they were wrong, then you’re not stuck trying to balance things because the anticipated 3% is suddenly gone.
7. It offers more flexibility than other methods.
When conservative principles are what dictate an approach to accounting, then it allows a corporation to respond faster to rapid changes that can occur in the business environment. If you are stuck following a specific set of rules to reflect your overall value, then it could be several years before you receive meaningful advice on how to handle the situation you face with a new type of transaction.
8. Conservatism encourages professional judgment.
When accountants must follow specific rules when going through their books, then it is a chore that anyone can perform if they go through the proper training courses. When you have the chance to include principles more often when evaluating your financial health, then it requires people to dig deeper into the substance of each transaction. It encourages each person to use their sound financial judgment when gauging the quality of each possible gain or loss to determine a potential outcome for the organization.
List of the Cons of Conservatism in Financial Accounting
1. It always underestimates the future value of an organization.
Using the conservatism approach in financial accounting means that you are always logging a potential loss and never recognizing the possibility of a future gain. Even if you know with certainty that a payment is coming through for you, this principle dictates that you do not count it on your books until you have it in your hands. Since debts occur faster than profits for most organizations, there is always less future value when looking at a company. Although this offers a sense of “realism,” it is important to remember that not all future debts become reality either.
2. You must immediately write down the value of assets.
Let’s say that there is an asset owned by an organization which involves inventory. The company purchase the items at $100 per unit. Now it is six months later, and the items are available at $45 per unit instead. Using the conservatism approach in financial accounting, this business must immediately write down the value of the asset to reflect the lower cost of market.
This approach does not work in the opposite way. If you have the inventory at $100 per unit and the market price rises to $145 per unit, then you do not get to record the assets until you’re able to sell the assets in question.
3. Provisions must be made for every liability.
There are no exceptions to consider when following the conservatism approach in financial accounting. You must make provisions for all liabilities, losses, and expenses that may occur during the period under examination. It doesn’t matter if they are certain or uncertain. You must always record a loss whenever it appears in your contingencies. Although this process can help a business to stay safe during times of economic difficulty, it may also create challenges in the future when it is time to start scaling upward.
4. It may not be reflective of your tax liabilities.
When you take a conservative approach to your financial situation, then the emphasis on losses will always create lower profits that you would report. That design runs counter to what the tax authorities in most countries need because the lower income levels create less in tax receipts at the end of the year. There may be specific rules in place for some organizations where this approach is not permitted for official reporting purposes, even if this is the method that is used within the company.
5. This option may not be suitable for American accounting rules.
The International Financial Reporting Standards in accounting tends to employ more principle-based approaches, such as the conservatism approach discussed here. Corporations in the United States typically use the Generally Accepted Accounting Principles method instead, which focuses more on rule-based standards. You can still take a conservative approach when looking at your transactions and forecasts, but U.S.-based companies must follow complex evaluations regarding their present value in GAAP compared to what is available in IFRS.
6. It reduces options for comparability.
When you follow the conservative approach, then your judgment might be a little different than what someone else might see. There may not be any consistency present in the logging of losses because different groups may see each transaction in a different way. Rules are a better option when comparability is necessary because there is no variability in the process. If you’re only following principles, then two companies with the exact same assets could present them differently on their published balance sheets.
7. Enforcement of principles is more challenging.
Companies are often accused of misstating financial information because they follow principles instead of rules when going over their books. Asking a jury or judge to look over the books when they have no experience with the conservatism approach in financial accounting could create even more problems for an organization. Because the conservative approach reduces the emphasis on profits, it will always seem like a company is understating their revenue when using this approach – which could create liabilities in a rules-based environment.
A Final Thought on the Pros and Cons of Conservatism in Financial Accounting
When examining the pros and cons of the conservatism approach in financial accounting, it is essential to remember that the goal is not to report the least amount of profits possible. You are working to reduce any over-statement in what the future profits could be for an organization. This approach helps stakeholders see what the actual value happens to be with certain assurances of a minimum bottom line. If you can achieve more after this baseline, then the healthier revenue levels help to make everyone happy.
This approach is only a guideline. Accountants use their best judgment every day when evaluating financial decisions. The goal is to record a transaction in relation to the data you have in that moment.
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