# Accounting Conservatism: Definition, Advantages and Disadvantages

> **Definition**
>
> Accounting conservatism is a principle that mandates companies report financial information with a great level of care and factor in the worst-case scenarios of their financial futures.

## What Is Accounting Conservatism?

In financial reporting, accounting conservatism plays an important role by requiring companies to act cautiously and have strong evidence before claiming profits, which helps maintain accuracy and prevent overstating financial health.

The general concept is to factor in the worst-case scenario of a firm’s financial future. Uncertain [liabilities](https://www.investopedia.com/terms/l/liability.asp) are to be recognized as soon as they are discovered. In contrast, [revenues](https://www.investopedia.com/terms/r/revenue.asp) can only be recorded when they are assured of being received.

### Key Takeaways

*   Accounting conservatism urges businesses to be careful and thorough when recording financial information, ensuring all figures are well substantiated before being reported.
*   All probable losses are recorded when they are discovered, while gains can only be registered when they are fully realized.
*   If an accountant has two solutions to choose from when facing an accounting challenge, the one that gives the least optimistic view of the situation should be selected.

![Accounting Conservatism](https://www.investopedia.com/thmb/m-t0The8zPWk02GKyVJDhVR9USA=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Term-a-accounting-conservatism_Final-e501ce15a804454a959b3f860a90daf9.png)

*By prioritizing caution, accounting conservatism can influence how businesses make decisions and manage their financial expectations over time. — Ryan Oakley / Investopedia*

## How Accounting Conservatism Works

[Generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) insist on a number of [accounting conventions](https://www.investopedia.com/terms/a/accounting-convention.asp) being followed to ensure that companies report their financials as accurately as possible. One of these principles, conservatism, requires accountants to show caution, opting for solutions that reflect least favorably on a company’s [bottom line](https://www.investopedia.com/terms/b/bottomline.asp) in situations of uncertainty.

Accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.

Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.

A cautious approach generally presents financial statements in the least optimistic light. There is a danger that [assets](https://www.investopedia.com/terms/a/asset.asp) and revenue would be overstated, so where the accountant has two acceptable options, the principle of conservatism would recommend presenting the lower of the two options. There is a danger that liabilities and [expenses](https://www.investopedia.com/terms/e/expense.asp), on the other hand, will be understated.

Conservatism dictates that if it is more probable than not that the loss will be incurred, accountants are encouraged to record it immediately, regardless of whether it has actually been paid out yet. In contrast, if there is a possibility of a gain coming the company’s way, they are advised not to record it in the financial statements until virtually certain of receiving some benefit.

### Recording Revenue

Since there is a danger that companies will manipulate revenue numbers to record higher profits, there are very stringent rules around revenue recognition. There are many ways in which revenue could be manipulated that lie in an accounting “gray area.” Recording legitimate revenues before they are really true sales is one such risk. For this reason, before a sale can be recorded, there are several criteria that must be met:

*   There must be a customer contract.
*   Accountants must identify performance obligations within that contract to break down clearly what goods will be sold and what services will be rendered.
*   Determine the transaction price for goods sold and services rendered.
*   Allocate the transaction price to the different parts of the contract, identifying what the customer should pay for goods and services if both are being sold.
*   Recognize revenue when you’ve fulfilled each performance obligation and not before. For goods, this is when they are transferred, and for services rendered, this is when the service is performed.

The fulfillment of the performance obligations is an example of conservatism in action. No revenue should be recorded before these events take place, even if business managers are very sure that a customer is going to want products or services.

## Advantages of Accounting Conservatism

Understating gains and overstating losses means that accounting conservatism will always report lower [net income](https://www.investopedia.com/terms/n/netincome.asp) and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.

Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.

## Disadvantages of Accounting Conservatism

On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. This means that some companies will always find ways to manipulate them to their advantage.

Another issue with accounting conservatism is the potential for [revenue shifting](https://www.investopedia.com/terms/i/incomeshifting.asp). If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods being overstated, making it difficult for an organization to track business operations internally.

## Using Accounting Conservatism

Accounting conservatism may be applied to [inventory valuation](https://www.investopedia.com/articles/02/060502.asp). When determining the reporting value for inventory, conservatism dictates the lower of [historical cost](https://www.investopedia.com/terms/h/historical-cost.asp) or net realizable value is the amount that should be included on the balance sheet as an asset.

Estimations such as uncollectable [accounts receivable (AR)](https://www.investopedia.com/terms/a/accountsreceivable.asp) and [casualty losses](https://www.investopedia.com/terms/c/casualty-loss.asp) also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all [revenue recognition](https://www.investopedia.com/terms/r/revenuerecognition.asp) principles.

However, if a litigation claim is expected to be lost, an estimated economic impact is required in the [notes to the financial statements](https://www.investopedia.com/terms/f/footnote.asp). [Contingent liabilities](https://www.investopedia.com/terms/c/contingentliability.asp) such as royalty payments or [unearned revenue](https://www.investopedia.com/terms/u/unearnedrevenue.asp) are to be disclosed, too.

## What Does Accounting Conservatism Take Into Account?

Accounting conservatism records all probable losses when they are discovered and registers gains only when they are fully realized.

## What Does Accounting Conservatism Provide?

Accounting conservatism provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias. It establishes the rules when deciding between two financial reporting alternatives. The one that yields inferior numbers should be selected.

## Does Accounting Conservatism Have a Bright Side?

It does. Accounting conservatism encourages management to use greater care in decision making. It also means more scope for positive surprises instead of disappointing upsets, which drive share prices. Finally, it also makes it easier for investors to compare financial results across different industries and time periods.

## The Bottom Line

Accounting conservatism is a set of bookkeeping guidelines. It requires company accounts to be prepared with caution and high degrees of verification. The point is to factor in the worst-case scenario for a company’s financial future.