Conservatism in Accounting: Definition & Principle

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Lesson Transcript
Instructor: Jay Wagner

Jay holds a Masters of Business Administration

One of the primary principles in accounting is conservatism. This principle is intended to both provide more reliable financial statements and protect the accountant from legal liability. We'll examine what this principle is and show it in action.

The Meaning of Conservatism in Accounting

An accounting instructor is covering some of the basic principles of accounting practice when he comes to the conservatism principle. A student raises his hand and asks, 'Do I have to become a conservative to be an accountant? Because my family has voted for liberal Democrats since Woodrow Wilson, and I'll change majors before I'll become a conservative Republican just to be an accountant!'

But this is just an amusing anecdote, and fortunately for this (and many other) students, the principle of conservatism has nothing to do with politics. What it does have to do with is how accountants choose between alternative possible financial measurements.

Specifically, the principle (as defined by the Financial Accounting Standards Board) holds that when faced with significant uncertainties about the solution to an accounting problem, an accountant should favor the solution that least favorably affects the income and net assets of the current period. In plain English, if there are two or more possible answers, always choose the one that looks the worst for the company.

The Financial Statements and Conservatism

The first reason for the conservatism principle is to make the financial statements of the company more useful for management, stockholders, creditors, and other users. In a way, conservatism calls for the accountant to present the worst case scenario in the financial statements. While this strategy may not always be popular with executives (who tend to be confident and optimistic - often too optimistic), when they are given the more conservative measurements, they are inclined to make more cautious decisions, which may well be better for the business.

Stockholders often vote according to financial results, so if they are being given conservative results the effect on their votes gives management an incentive to strive for the best possible performance without taking excessive risks. Creditors make credit decisions based on the company's financial statements, and they really appreciate conservatism since it reduces their risk exposure in making loans or extending credit terms on purchases.

Let's look at the conservatism principle in more personal terms. Say that you go to your bank to apply for a car loan. On your way there, you pick up a lottery ticket, figuring you can afford the price of the ticket and maybe, just maybe, you can beat the odds and win the $25 million jackpot. On the loan application, it asks for your annual income. You have a decent job making $50,000 per year, but you also have that lottery ticket. So what income do you put on the application? Obviously, you would put $50,000, because the lottery jackpot is uncertain. Congratulations, you just applied the conservatism principle in your life by reporting your likely income rather than your possible income.

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