Question

Explain in a paragraph about  Conservatism in term of Accounting . Also writes its Pros And Cons.

Answer 1

Principle of Conservatism

Conservatism is a principle of accounting. It also known as doctrine of prudence. Generally, accounting principles are of two types; concepts and conventions. Accounting concepts are some assumptions that we use while preparing our accounts. Accounting conventions are some generally accepted rules that we should follow while preparing accounts. Conservatism is a convention, so it is known as convention of conservatism.

               The convention of conservatism states that we should anticipate and account for all the possible future losses but not future gains. We should anticipate each and every possible losses and can make a provision to cover these losses. There are some accounting practices originated based on this convention. Provision for bad and doubtful debt is a best example. At the same time it clearly says that we should not consider any anticipated profits. It simply means that when we are left with two choices the possibility of occurrence of these two are equally likely, we should recognize one which results in lower amount of profit or which will overstate the assets or income at the minimum. So under this convention, all the expected losses are losses that we should take necessary precautions, but profits are not profits.

It cannot eliminate the future loses fully. But it can reduce the intensity of the losses by helping us to take the necessary precautions like providing provisions. So it helps an organisation to escape from sudden future threats or losses. Experts says that it has a lot of advantages as well as disadvantages.

Pros of Conservatism in Accounting

>An approach to play it safe-

             Convention of conservatism helps to anticipate all future losses. So we can make necessary precautions and reduce the intensity of losses.

>Helps the stakeholders to understand their absolute bottom line-

              Future is uncertain.So the stakeholders of an organidsayion will be keen to know their possible outcomes and position in these uncertain sistuations.Conservatism will help to anticipate all losses and expect at the minimum.

>Measurement of risk involved-

              Convention of conservatism helps the management as well as owners to understand the future losses and the maximum amount of risk involved in it so that they can make arrangements to face these risks.

>Allowance available for doubtful accounts-

              You may find from the past that all your debtors may not pay the amount in full. If two of your managers expect that there will be a bad debt of 3%, 6% respectively. Then they can take 6% as bad and provide provision. If it is actually 6% it’s ok that you provided provision to cover that. If the bad debt is 3%,then you can be happy that you got more than expected.

>Offers flexibility-

              It offers an organisation to respond quickly to rapid changes which may not be possible with the absence of this.

>Realistic measurement of cash flows-

              It takes into account all the future losses and avoids all the uncertain profits. So it helps to prepare a more realistic cash flow.

Cons of Convention of Conservatism Accounting

>It always understate the income of an organisation-

              According to this convention, we takes into account all the future losses but do not consider future profits. Profits are taken into account only when it is received. So it always understate the profit or income of an organisation.

>Immediate write down of asset value-

              If you purchase an asset for 6 lakhs and after few months the market value of that asset fell down to 5 lakhs. Then you should reduce the book value of your asset to 5 lakhs. But it does not happen when the opposite happens.

>Provisions must be made for every liability-

              An organisation should anticipate each and every future losses and should provide provision for it which may be difficult some times.

>The Tax liability may not change-

             Sometimes the net profit that you get after providing all provisions for future losses may not be enough for Tax purposes. We may need to prepare an extra statement of income for Tax purposes.