THE CONSERVATISM CONCEPT

Oftentimes, when deciding which revenues and expenses to match in a given accounting
period, accountants have a difficult time recognizing which revenues and expenses are certain
for that period. Like many people, accountants and other business professionals tend to be
overly optimistic concerning the revenues that their companies generate but tend to be more
realistic concerning the associated expenses. Thus, certain accounting principles have been
developed to offset the tendency toward optimism. These principles recognize that increases
in reported net income require stronger proof than do increases in expenses. Therefore, when
deciding which expenses and revenues to acknowledge during a given accounting period,
accountants are supposed to apply the conservatism concept. This concept has two conditions
associated with it—firms can recognize expenses as soon as they are reasonably possible, and
firms can recognize revenues as soon as they are reasonably certain.

Usually, a company applies the matching concept by being reasonably certain which items
will generate revenue and matching them with any possible expenses for those items. To
illustrate, if a company produces an item costing $100 that it later sells for $150, the company
must decide the accounting period in which it is reasonably certain to receive the $150. When
this is decided, the company must match the $100 cost with the $150 revenue as an expense,
resulting in $50 income from sales. Interestingly, not all companies take these steps in the
same order; sometimes expenses are first identified and later revenues are matched to them.

Conservatism
This requires understating rather than overstating revenue (income) and expense amounts that have
a degree of uncertainty.  The rule is to recognize revenue when it is reasonably certain and recognize
expenses as soon as they are reasonably possible.  The reasons for accounting in this manner are so
that financial statements do not overstate the company’s financial position.  Accounting chooses to
err on the side of caution and protect investors from inflated or overly positive results. 

Accounting guideline that understates assets and revenues and overstates liabilities and
expenses. Expenses should be recognized earlier than later while revenue should be
recognized later than sooner. Thus, net income will result in a lower figure. Conservatism
holds that in financial reporting it is preferable to be pessimistic (understate) than optimistic
(overstate) since there is less chance of financial readers being hurt by relying on prepared
financial statements. One can argue that pessimism is needed to counteract the optimism of
management. However, excess conservatism may result in misguided decisions.

10. If a situation arises where there are two acceptable alternatives for reporting an
Conservatism item, conservatism directs the accountant to choose the alternative that will
result in less net income and/or less asset amount. Conservatism helps the
accountant to "break a tie." It does not direct accountants to be conservative.
Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate

or disclose losses, but it does not allow a similar action for gains. For example,
potential losses from lawsuits will be reported on the financial statements or in
the notes, but potential gains will not be reported. Also, an accountant may
write inventory down to an amount that is lower than the original cost, but will
not write inventory up to an amount higher than the original cost.