The principle of conservatism gives guidance on how to record uncertain events and estimates. The principle of conservatism states that you should always error on the most conservative side of any transaction. Most of the time this means minimizing profits by recording uncertain losses or expenses and not recording uncertain or estimated gains.
Since accounting standards and GAAP are always concerned with the usefulness of financial data to financial statement users, you can understand why the FASB doesn’t want financial information to over estimated or error on the high side. This could sway users’ decisions.
The principle of conservatism also applies to estimates. Generally, a more conservative estimate should always be used. When estimating allowance for doubtful accounts, casualty losses, or other unknown future events you should always error on the side of conservatism. In other words, you should tend to take the position that is records the most expenses and least income. This is the main principle behind the lower of cost or market concept for recording inventory.
Remember when there is a event with an uncertain outcome, you want to recognize revenues when they are actually earned and recognize expenses when they are reasonably probable.
Examples
– Assume Gold Guitar, Inc. is in the middle of a patent lawsuit. GGI is suing Blue Guitar, Inc. for patent infringement and anticipates winning a large settlement. Since the settlement is not certain, GGI does not record the gain on the financial statements. Why? Because of the GGI might not actually see this gain. It might not win, or they might not win as much as it expected. Since a large winning settlement might skew the financial statements and mislead the users, the gain is left off the books.
– Assume the same example above except GGI anticipates losing the lawsuit instead of winning it. If Blue Guitar, Inc. expects to lose the suit; they should record the loss in the footnotes of its financial statements. This would be the most conservative approach because financial statement users want to know if the company will have to pay out a large some of money in the near future.
– Red Brick Records is getting ready to release a new album and is unsure as to whether it owes a few artists on the record royalties due to contracts and legal disputes. Red Brick should report the contingent liability in the footnotes of the financial statements. If the record is a hit, the record label could owe a large amount of money to its artists. To be conservative, this should be shown in the notes.
