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Accounting Term: What Is the Conservatism Principle?

There are tons of people who may review your client’s financial statements. They may be checking to see if your client is following regulations, preparing a bank loan, or thinking about investing in your client’s company. Regardless of how people use your client’s financial information, it’s important to try and not intentionally make the income statement look better than the actual financial position. One rule to help make this happen is called the conservatism principle.

Following the conservatism principle means you’re conservative with what you record. If your client might incur an expense, go ahead and record it. The idea is that by being conservative, nobody will be alarmed in a negative way if the expense does happen. If your client might receive revenue, the opposite is true, and you shouldn’t record the revenue. Revenue and assets are recorded only if you’re assured they will be received. Again, the worst case is your financial records are wrong, but at least they don’t make your client look like it’s in better shape.

The conservatism principle is also helpful when creating estimates. Say you’re trying to decide what your client’s allowance for bad debts should be. One member on your team thinks 3% of revenue is good enough. Another thinks 5% is more accurate. In this situation, the more conservative approach is to go with 5%. You might overstate expenses by creating an allowance that’s too big. Still, if people use your client’s financial statements to make decisions, they’ll make decisions thinking your client’s net income is lower. This reduces the risk that poor decisions will be made.

It’s tempting to want to make your client’s financial records look as great as possible. As an accountant, it’s your job to report fairly and accurately. According to accounting rules, this means being conservative when you book transactions, even if it means your client’s records look worse than what is really going on.

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