Conservatism

Definition

Conservatism is an accounting principle that emphasizes recognizing potential losses and liabilities as soon as possible, but not recognizing gains until they are realized. It ensures that financial statements provide a cautious view of a company's financial position.

5 Must Know Facts For Your Next Test

1. Conservatism requires accountants to record expenses and liabilities sooner rather than later if there is uncertainty about the outcome.
2. Revenue should only be recorded when it is reasonably certain, ensuring that assets and income are not overstated.
3. This principle helps protect stakeholders from overestimation of financial health by providing a more conservative estimate of profits and asset values.
4. Inventory valuation under conservatism would mean using the lower of cost or market value (LCM) rule.
5. Conservatism may result in understated net income and equity, providing a buffer against future losses.

Review Questions

• What does the conservatism principle prioritize when recording uncertain outcomes?
• When applying conservatism, how should revenue be recognized?
• In what way does conservatism impact the valuation of inventory?

Related terms

Materiality: An accounting principle that allows ignoring insignificant details which do not affect users' decisions based on financial statements.

Lower of Cost or Market (LCM): An inventory valuation method requiring inventory to be reported at the lower of its historical cost or current market price.

Going Concern: The assumption that a company will continue its operations into the foreseeable future without intention or need to liquidate.