What is Convention of Conservatism?
It is also known as ‘doctrine of prudence’. Convention of Conservatism states to anticipate all the future losses and ignore gains.
The managers who are responsible for running the business successfully are also human beings. They always try to give a favorable report for the business they are handling. But as Financial Accounting Standards Board says, “prudent reporting based on a healthy skepticism builds confidence in the results, in the long run, best serves all of the divergent interests. This reporting has results in the birth of conservatism concept.
This concept underestimate the profits and gains and overestimate the losses. Hence, inventory records in the books of account whichever is lower between acquisition cost and current market cost.
Two Aspect of Conservatism Convention
- Recognize revenue only if they are certain.
- Recognize expenses as soon as they are reasonably possible.
Conservatism Concept Example
Case 1 – In December 2016, Karan agrees to buy an automobile from Ram & Sons Motors, Inc for delivery in January 2017. This is a good news from the Ram & Sons point of view. But it is also possible that some unfortunate happens and deal gets broken.
Therefore, as per convention of conservatism, revenue is not recognized in the books of accounts till the actual delivery does not happens.
Case 2 – Suppose an uninsured automobile disappears from Ram & Sons on December 2010. It could be possible that it get stolen and will get recovered never. So, the conservatism concept requires this will be treated as expense and will be recognize in the month of December 2010 itself.