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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.

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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.

Legal Liability and Conservatism

Had you reported the $25 million jackpot as your income (and had the banker not checked your income, which is highly unlikely), you probably would have been offered any size loan you wanted. Instead of the used Chevrolet Caprice that you had planned to buy, you might have decided to take a much bigger loan to buy a new Rolls Royce Phantom with every possible option. If you didn’t win the lottery, your gross overstatement of your income wouldn’t excuse you from your obligation to repay the loan.

Besides protecting the company from liability for bad financial decisions (like borrowing more money than they can really repay), the conservatism principle protects the accountant from legal liability. We live in a society where people will sue anyone any time for anything, and if an accountant chose to overstate a company’s income, and a creditor or investor suffered financial harm because of a decision based on that overstatement, they might well sue the accountant, and they would almost certainly win that suit. The only real defense an accountant has from such suits is that he or she applied the conservatism principle. This doesn’t mean that the accountant purposely tried to understate the income, but that the income was reported at its lowest probable value in accordance with generally accepted accounting principles (GAAP).

Lesson Summary

The principle of conservatism has to do with how accountants choose between alternative possible financial measurements. As defined by the Financial Accounting Standards Board, the principle states 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.

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. When given the more conservative measurements, companies are inclined to make more cautious decisions. It also serves as an incentive to strive for the best possible performance without taking excessive risks. The legal reason behind conservatism is to protect the company from liability for bad financial decisions and protect the accountant from legal liability.

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