1.11

CONSERVATISM

PRINCIPLE

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The Rules of Accounting

Relevance

Reliability

Comparability

Understandability

Entity

Historical cost

Going concern

Reporting period

Monetary unit

Conservatism

Consistency

Qualitative Characteristics Accounting Principles

1.11 CONSERVATISM PRINCIPLE

© Michael Allison. Author’s permission required for external use.

Conservatism Principle

1.11 CONSERVATISM PRINCIPLE

Definition:

Caution must be used when preparing financial reports

• Losses are recorded when they are expected to occur

• Gains are only recognised once they are certain to happen

(i.e. they have been earned)

This is done so:

• Assets and revenues are not overstated (too high)

• Liabilities and expenses are not understated (too low)

© Michael Allison. Author’s permission required for external use.

Conservatism Principle

Example: applying conservat ism to

losses.

A business owns inventory that was

bought for $12,000. It has gone down in

value and is now worth just $8,000 e.g.

winter coats in January

Should it recognise this loss and value

the inventory at $8,000?

Answer: yes, the loss is expected to occur

Balance Sheet

Non-Current Assets $

Inventory 12,000

Balance Sheet

Non-Current Assets $

Inventory 8,000

Income Statement

Expenses $

Stock write down 4,000

1.11 CONSERVATISM PRINCIPLE

This is done so the value of an Asset

(inventory) is not overstated (too high)

© Michael Allison. Author’s permission required for external use.

Conservatism Principle

Example: applying conservat ism to

gains.

A business owns a building that

originally cost $500,000.

But growth in the property market

means the building is now valued at

$600,000 if it were to be sold.

Should the firm value the building at

$600,000 and record a revenue

(gain) of $100,000?

Answer: no, conservatism states that

this gain should not be recorded until it

is certain to occur, i.e. when the building

is sold

This is done so the value of an Asset

(building) and a revenue are not

overstated (too high)

Balance Sheet

Non-Current Assets $

Building 500,000

1.11 CONSERVATISM PRINCIPLE

© Michael Allison. Author’s permission required for external use.

Conservatism Principle

1.11 CONSERVATISM PRINCIPLE

Balance Sheet

Non-Current Assets $

Inventory 12,000

Balance Sheet

Non-Current Assets $

Inventory 8,000

Balance Sheet

Non-Current Assets $

Building 500,000

Relevant?

Reliable?

Balance Sheet

Non-Current Assets $

Building 500,000

YES

NO

Relevant?

Reliable?

NO

YES

© Michael Allison. Author’s permission required for external use.

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