Introduction
It is one of the important accounting principles and is the basis of many accounting requirements set out in either of generally accepted accounting principles or alternatively International financial reporting standards. This principle and the principle of the accrual concept may confuse you; however, there is a substantial difference between the two principles. The conservatism principle calls for the cautious approach in relation to the recognition of the incomes and gains whereas the accrual concept requires the transactions to be reported on the basis of the actual occurrence.
Conservatism principle is also commonly referred to as the prudence concept and it requires the accountants to recognize the losses as soon as there is a hint of their occurrence, however, in relation to the gains and income, their recognition is deferred until it is certain with regard to their occurrence. This way financial statements can be protected from misleading for the stakeholders of the same, however, at the same time, there is probability that the principle is abused for consistently under recording of the incomes and gains and thus would lead to tax evasion. For instance, a certain organization may in the name of the conservatism principle pass adjusting entries that decrease the expense, whereas the real purpose of decreasing the expense was to avoid the income taxes.
Explanation
Conservatism principle is a kind of control over the management which has the affinity for showing more profits and thus assets and gain qualification for the incentives and bonuses. The application of the conservatism principle thus establishes the fairness and truthiness in relation to the financial statements.
Application of the conservatism concept
The concept of the conservatism has wide application in relation to the financial statements. For instance, the conservatism principle is the very foundation of the famous rule that lower of cost or market. The rule of the lower of cost or market states that report the assets at the cost which is lesser of the actual historical cost or alternatively the market value. This way we are writing down the value which actually should not be part of the asset and thus the financial statements are fairly presented.
Making of the estimates is pretty important to the making of the financial statements. Making of the statements calls for the management judgment. Conservatism principle assists the management in the making of those estimates. For example, let's take the case of the allowance for the doubtful debts which is based on the estimates. The sales department is of the view that 5% is the reasonable estimate of the allowance for the doubtful debts whereas the collections department advocates 7% as the reasonable estimates. The conservatism principle will favor the greater of the two estimates in relation to the assessment of the allowance for doubtful debts. In this way, conservatism principle helps the management in the making of the estimates.
Conservatism principle goes against the objectives of the taxation and duties authorities. The conservatism principle favors that delaying of the recognition of the gains, however, advocates immediate recognition of the losses which decreases the threshold of the taxable income and thus appeals lower slabs of the tax rates which is against the spirit of the taxation authorities.
Conclusion
In the nutshell, Conservatism principle, stated differently, the prudence concept and it requires the accountants to recognize the losses as soon as there is a hint of their occurrence, however, in relation to the gains and income, their recognition is deferred until it is certain with regard to their occurrence. This way financial statements can be protected from misleading for the stakeholders of the organization in the short-term as well as long-term.
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