3. Conservatism in accounting

Conservatism plays an important role in financial reporting. The constraint of conservatism was developed in the early days of accounting. During that time the major users of accounting information were creditors, who didn’t want the borrowers to overestimate the assets and underestimate losses.  Generally speaking, creditors preferred the understatement of assets to their overstatement: the deliberate understatement of assets was acceptable. Also, conservatism allowed the recognition of all losses but didn’t allow the anticipation of profits.

Over time, the constraint of conservatism has changed in order to reflect the interests of creditors and investors. Today, conservatism could be defined as follows:

Conservatism refers to the accounting practice of prudence when there is business uncertainty.

There can be many situations when a business decision is essentially based on personal judgment:

• Several equally acceptable accounting methods
• Accounting estimates (e.g., useful life)
• Uncertain activities or events (e.g., theft, fire, future legal requirements and economic conditions) 
• Uncertain financial results (e.g., gains, losses, income)

Under uncertainty, the most conservative method should be chosen. Such a conservative method would be least likely to:

• Overstate assets
• Overstate income
• Anticipate or disclose losses, but not gains

Conservatism, however, doesn’t imply that assets and income should be understated! Understating assets and income in financial statements would not represent the true financial position of a company: the financial statements would not be reliable in this case. For instance, an understatement of income in the current period (by overstating current expenses) could result in the overstatement of earnings in the future period (due to the understatement of expenses in that period).

Examples of conservative accounting practices include the following (non-exhaustive list):

• Reporting inventory at lower-of-cost or market
• Using LIFO method during inflation
• Using accelerated depreciation methods for plant assets
• Recognizing probable loss contingencies (but not probable gain contingencies)
• Timely disclosure of losses
• Recognizing high estimates for reserves and allowances (e.g., bad debt, warranty, returns)
• Expensing advertising and marketing expenditures

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