Definition: The conservatism principle is a concept that suggests a less than optimal estimate should be used when given and option. In other words, when there is an uncertain event, accountants should error on the side of caution and moderation. This generally means in a situation where income and expenses are uncertain, less income is recorded and more expenses are recorded. This isn’t always the case, but minimizing profits is generally more conservative that maximizing them.
What Does Conservatism Principle Mean?
GAAP requires that accountants view estimates and uncertain business events with skepticism. Management will almost always lean toward the most optimal and opportunistic outcome in any situation. It’s the accountant’s job to look at the reality of the transaction and record it with a less than optimal outcome.
Remember, the conservatism principle doesn’t say that we always have to estimate outcomes unfavorably. Accountants just have to choose the most conservative outcome if two different outcomes are available.
Let’s take a look at an example.
Bishop’s Toy Company manufacturers children’s toys and accessories. Over the last year, Bishop has been manufacturing a toy with defects that have caused several choking hazards for small children under the age of three. Since the defective toys have become known, Bishop recalled them and stopped production.
The families of the children who choked on the toys are now suing the company for damages, neglect, and improper labeling. It isn’t certain whether Bishop will lose the liability suits, but the estimated damages will amount to over $10M if they do.
There are a number of GAAP rules and guidelines dealing with contingencies and lawsuits, but we will just look at this situation according to the conservatism principle. According to the principle, the company should take the least optimistic approach to the situation, assume they will lose the cases, and adjust the financial statementsaccordingly.