You do your own bookkeeping like a pro but every now and then you might encounter an accounting concept that extends beyond your accounting knowledge. Not too worry. We’re here to help. Case in point: the conservatism principle.
Let’s dig into it…
Accounting for Uncertain Events
Sometimes when you need to record a transaction on your company’s books, whether it’s an expense or revenues earned, there will be some uncertainty about the amount you should record. Maybe you’re not sure whether a payment will be received in full or maybe you’re not sure what an upcoming expense might actually cost. The conservatism principle (also called the conservatism concept or the prudence concept) helps you make a decision about the amount to record on the books in uncertain cases. The main idea behind this principle is that when faced with two reasonable possibilities for recording a transaction you should err on the side of being conservative. This means recording uncertain losses while refraining from recording uncertain gains.
How does this play out on your financial statements? Generally speaking, when you follow the conservatism principle you end up recording lower asset amounts on your balance sheet and lower net income on your income statement. Overall, adhering to the conservatism principle leads to lower (more conservative) profits being recorded on your statements.
Why Be Conservative?
What is the purpose behind being conservative about recording your company’s gains and losses? Bear in mind that following the conservatism principle does not mean seeking to make your recorded earnings as low as possible. More than anything, this principle is used to help you “break a tie” when dealing with equally probable outcomes for a transaction.
When interested parties are looking at your company’s financial statements, they will want to assure themselves that you’re not overestimating the profit your business is bringing in. That would be misleading for those with stake in the company. When the conservatism principle is being used, those who need to know—say your tax prep pro or a potential business partner—can get a more realistic picture of the business’s financial standing and possible future trajectory.