how accounting conservatism works
generally accepted accounting principles gaap insist on a number of accounting conventions being followed to ensure that companies report their financials as accurately as possible one of these principles conservatism requires accountants to show caution opting for solutions that reflect least favorably on a company s bottom line in situations of uncertainty accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures it is a method of accounting that provides guidance when uncertainty and the need for estimation arise cases where the accountant has the potential for bias accounting conservatism establishes the rules when deciding between two financial reporting alternatives if an accountant has two solutions to choose from when facing an accounting challenge the one that yields inferior numbers should be selected a cautious approach generally presents financial statement in the least optimistic light there is a danger that assets and revenue would be overstated so where the accountant has two acceptable options the principle of conservatism would recommend presenting the lower of the two options there is a danger that liabilities and expenses on the other hand will be understated conservatism dictates that if it is more probable than not that the loss will be incurred accountants are encouraged to record it immediately regardless of whether it has actually been paid out yet in contrast if there is a possibility of a gain coming the company s way they are advised not to record it in the financial statements until virtually certain of receiving some benefit since there is a danger that companies will manipulate revenue numbers to record higher profits there are very stringent rules around revenue recognition there are many ways in which revenue could be manipulated that lie in an accounting gray area recording legitimate revenues before they are really true sales is one such risk for this reason before a sale can be recorded there are several criteria that must be met the fulfillment of the performance obligations is an example of conservatism in action no revenue should be recorded before these events take place even if business managers are very sure that a customer is going to want products or services advantages of accounting conservatismunderstating gains and overstating losses means that accounting conservatism will always report lower net income and lower financial future benefits painting a bleaker picture of a company s financials actually comes with several benefits most obviously it encourages management to exercise greater care in its decisions it also means there is more scope for positive surprises rather than disappointing upsets which are big drivers of share prices like all standardized methodologies these rules should also make it easier for investors to compare financial results across different industries and time periods disadvantages of accounting conservatismon the flip side gaap rules such as accounting conservatism can often be open to interpretation this means that some companies will always find ways to manipulate them to their advantage another issue with accounting conservatism is the potential for revenue shifting if a transaction does not meet the requirements to be reported it must be reported in the following period this will result in the current period being understated and future periods being overstated making it difficult for an organization to track business operations internally using accounting conservatismaccounting conservatism may be applied to inventory valuation when determining the reporting value for inventory conservatism dictates the lower of historical cost or net realizable value is the amount that should be included on the balance sheet as an asset estimations such as uncollectable accounts receivable ar and casualty losses also use this principle if a company expects to win a litigation claim it cannot report the gain until it meets all revenue recognition principles however if a litigation claim is expected to be lost an estimated economic impact is required in the notes to the financial statements contingent liabilities such as royalty payments or unearned revenue are to be disclosed too 