What is meant by the accounting term “Conservatism”?
Conservatism is the prudence exercised in financial reporting as a result of the uncertainties surrounding business and economic activities. when faced with accounting alternatives accountants tend to choose those that are least likely to overstate assets or income.
For historical reasons, an accountant is always motivated to record business transactions in such a way that the profit is never overstated. In the initial stages of accounting, some anticipated profits which were recorded did not materialize, resulting in a considerable lack of acceptance of the accounting data by end-users.
Based on such experiences in the past, the accountants follow the principle “anticipate no profit and provide for all possible losses.” The most important accounting procedure that arises because of this concept is that the value of the inventory of a business enterprise is recorded at “cost or market, whichever is lower.” In this context, it is a clear modification of the earlier cost concept.
Many people are now challenging the validity of the conservatism principle, especially on the ground that it detracts from the disclosure of the true and fair financial position of the business enterprises and the fair determination of profits. For instance, if goods have been produced for sales at a predetermined price in terms of a legal contract which provides for liquidated damages in case the buyer does not take delivery in such a situation, it would be quite appropriate to value inventory at the contract price rather than at cost.
Thus, although the usually accepted method of valuation of goods is cost or market (realizable) value whichever is lower, it does not make sense to value inventory at anything other than the price which has the protection of the law behind it. This example only points up the fact that there are possibilities for intelligent differences of opinion in this context.