The Principle of Conservatism

The principle of conservatism requires that accountants be allowed to recognize anticipated or potential losses, but should not be allowed the same action to be taken when considering anticipated or potential gains. For example, accountants are often required to write down assets to a value lower than their previous carrying amount if an asset becomes impaired from a loss or lack of future benefits related to that asset.

The conceptual framwork of accounting suggests that information is useful if it is both relevant and reliable. For information to be reliable, it must be complete, neutral and error free. Because neutrality (free from bias) and prudence (or conservatism) are contradictory, there exists a discussion about whether or not conservatism can aid in providing reliable information (or information that is faithfully represented). According to FASB, they do not include prudence or conservatism as an aspect of faithful representation because including either would be inconsistent with neutrality.¹

None-the-less, the principle of conservatism still underlies many rules in GAAP. According to FASB Concept Statement No. 5, this is because:

In assessing the prospect that as yet uncompleted transactions will be concluded successfully, a degree of skepticism is often warranted.A s
     a reaction to uncertainty, more stringent requirements have historically been imposed for recognizing revenues and gains as components of
     earnings than for recognizing expenses and losses. Those conservative reactions inﬂuence the guidance for applying the recognition criteria
     to components of earnings.

One example is the lower of cost or net realizable value rule for inventory. This rule states that if inventories are likely to be sold for an amount less than their carrying amount, these inventories should be written down to the amount that they are worth, not the amount that the cost to obtain. On the other hand, inventories are never written up to an amount more than their previous carrying amount.

The principle of conservatism can also be used to 'break a tie': when more than one accounting methods appear equally suited for an economic phenominon, we can justify choosing one over another based on whether or not one provides a more conservative value of revenue, gains and assets than another.  This is because "deliberately reflecting conservative estimates of assets, liabilities, income, or equity sometimes has been considered desirable to counteract the effecs of some management estimates that have been perceived as excessively optimistic".²

Therefore, while the principle of conservatism does not form a part of the explicit conceptual framework of accounting as laid out by FASB in September 2010 (because it is inconsistent with the principle of neutrality), in practice the principle is incorporated in a number of existing GAAP that accountants adhere to.

Reference:

1. FASB CON8 BC3.27
2. FASB CON8 BC3.28

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