What is Conservatism Convention in Accounting

Conservatism conventionConservatism is one of the accounting conventions which shows accountant how to deal with uncertainty and estimates of the financial information. Conservatism is a method that produces financial result in a way that is least likely to overstate the assets and net income.

When the accountant is in a circumstance that they have to choose between the two reasonably acceptable uncertainty, they should choose the one that is least likely to result in an overstatement of the assets and net income.

In conservatism convention, net income should never be overestimated while a provision for losses should always be made.

However, the objective of conservatism is not to produce the lowest net income and the asset value. Its objective is to provide guidance when there are uncertainties that accountant faces.

When there are likely that a loss will happen, accountant should recognize and record it immediately, however, a gain should only be recognized when it is fully realized. We only record gain when there is enough appropriate evidence.

It is a principle that requires accountants to be caution and demand a high degree of verification when preparing financial accounts.

One common application of the conservatism convention is the measurement of the carrying value of inventory, in which the inventory is required to be measured at the lower of cost or market in US GAAP (or lower of cost or net realizable value in IFRS).

For example, no matter how much greater the inventory’s value is in the market today compared to its cost, the company still needs to recognize the inventory value at its original cost.

On the other hand, if the market value of the inventory is below the original cost, the company needs to recognize the loss immediately. They need to write down the inventory cost to market value.