Accounting Conservatism
What it is:
Accounting conservatism is one of the four accounting conventions, which are standards, customs or guidelines regarding the application of accounting rules.
How it works/Example:
There are four widely recognized accounting conventions that guide accountants:
- Be conservative. In other words, play it safe.
- Disclose in full.
- Be consistent. In other words, use the same method for calculating and reporting similar events.
- Report everything that is important. This is also known as the materiality convention. In other words, an item or event is material (and thus should be disclosed) if knowledge of the event or item might reasonably influence the users of the financial statements.
Generally Accepted Accounting Principles (GAAP), which are updated regularly to reflect the latest accounting conventions and specific rules, are the definitive source of accounting guidelines that companies rely upon when preparing their financial statements. Specific GAAP rules are sometimes subject to different interpretations, and unscrupulous companies often find a way to bend or manipulate them to their advantage. This first principle, conservatism, dictates that accountants must make cautious estimates, must not make or apply speculative interpretations of accounting rules or, in more frank terms, play fast and loose with the rules.
Why it matters:
Accounting conservatism, along with the other accounting conventions, provides a standardized methodology (or, more realistically, an ethical guideline) that creates reliable financial statements. In turn, accounting conservatism creates a reliable means of comparing financial results from industry to industry and from year to year.