Conservatism or Prudence


Conservatism concept implies that entity must select those accounting methods (among available) with least possible chances of overstating assets or income and understating liabilities or expenses of the entity in the financial statements. It is also called prudence concept.


Because of accrual basis of accounting, expenses and revenues reported in financial statements by the entity are mostly not paid or received yet. This gives the room to accountants and management to manipulate the figures in their favour that can mislead other users of financial statements.

To make the financial statements reliable and presenting realistic and fairer view of the entity’s operations, accounting frameworks uphold the concept of conservatism under which entity is required to recognize losses that occurred and make provisions for expected losses or when probability of cash outflow arises or give disclosure for losses that are less probable but not entirely remote. Whereas revenues are recognized only after entity has received or is certain in receiving the benefit or cash inflow.

As you can observe from the discussion, conservatism or prudence concept is inclined to save interests of users of financial statements in general but this must not be seen as a sting for management. Its even better for management to have the most conservative possible view of the business and put efforts to make it better. If entity survives and is still profitable under stricter accounting policies and methods, it is more prepared to overcome hardships.


Lower of cost and NRV inventory

IAS 2 requires entity to value its inventory at lower of cost or net realisable value. This is a perfect example of conservatism principle as period ending inventory is directly related to entity’s period ending profits and current assets. It helps against overstatement of incomes and assets by maintaining conservative approach for inventory valuation.

Even if entity can realize inventory for values higher than cost, units are valued at cost as entity has not realized income. And if NRV is lesser than cost then units are valued at NRV so that users are not provided with overstated values that may affect their decision.

For example if entity is keeping units that are no more in demand i.e. having zero NRV and still valuing at cost of 100,000 when total current assets including these units is 300,000 and net profit is 150,000 then it is material misstatement that must be corrected.

Provision for doubtful debts

IAS require entity to provide for expected losses so that incomes and assets (receivables) are not overstated. This is again a direct application of conservatism where no loss has actually occurred yet but an estimate is deducted from income and relevant assets to give fairer picture of entity’s operations and circumstances for better understanding of the user of financial statements.