I don’t understand the conservatism principle. Why do losses get recorded but not gains?
Conservatism has to do with uncertainty. When uncertainty exists between two alternatives that appear to be reasonable, the accountant “breaks the tie” by picking the alternative that reports less profit and less asset amount (or more liability amount).
If there is uncertainty as to whether there was a gain, the rule says don’t record it. Because of the uncertainty and because you did not record the potential gain, there will be less profit and less asset amounts being reported.
(If there is certainty about a gain, then you do report the gain. For example, if a company sells its old delivery truck for cash and the amount received is greater than the truck’s book value, there is no uncertainty and a gain is reported.)
If there is uncertainty about whether or not there is a loss, the rule directs you to record the loss. By recording the potential loss, you will be reporting less profit and less asset amounts.
If there is a potential loss, but it is impossible to measure the amount for a journal entry, there needs to be a disclosure in the notes to the financial statements.
Learn more about Accounting Principles.
Learn more about the Lower of Cost or Market.
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Conservatism principle is the principle used by accountants when there are no clear policy in connection with the realization of income on some cases wherein accountants choose to apply methods resulting to lesser income. (conservative)
The reasoning is that where judgement is concerned the accountant should risk overstating losses or understating income in order for judgemental error to have the most favoreable impact on the decision makers or stakeholders relying on the financial reporting of the accountant.
The accountant’s job is to be fair and objective and report “what is”, and to that end must not be allowed to be “tempted” to report unsubstatiated favorable conditions. However, where there exists a potential or probable unfavorable condition, it must be reported in order to provide decision makes the opportunity to react. In the case that the unfavorable condition either doesn’t materialize or is abated without intervention, the result will be a more favorable outcome.
Therefor the impact of mis-judgement by the accountant would most likely lead to favorable outcomes, rather than unfavoreable outcomes.
This is the “conservative” principle… the mitigation of risk that mis-judgement will lead to financial hazard.