Conservatism Concept – Conservatism states that the accountant should not anticipate income and should provide for all possible losses. When there are many alternative values of an asset, an accountant should choose the method which leads to the lesser value. Later on we shall see that the golden rule of current assets valuation – ‘cost or market price’ whichever is lower originated from this concept.
Conservatism concept states that when alternative valuations are possible, one should select the alternative which fairly represents economic substance of transactions but when such choice is not clear select the alternative that is least likely to overstate net assets and net income. It provides for recognising all known expenses and losses by best estimates if amount is not known with certainty, but does not allow recognising revenues and gains on the basis of anticipation.
The Realisation Concept also states that no change should be counted unless it has materialised. The Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain but it is desirable to guard against all possible losses.
For this concept there should be atleast three qualitative characteristics of Financial statements, namely,
- Prudence, i.e., judgement about the possible future losses which are to be guarded, as well as gains which are uncertain.
- Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as well as to exclude uncertain gains,
- Faithful representation of alternative values.
Many accounting authors, however, are of the view that conservatism essentially leads to understatement of income and wealth and it should not be the basis for the preparation of Financial statements.
- Provision for doubtful debts is created at the end of the year.
- Stock is valued at Cost or NRV, Whichever is less.