Conservatism concept is one of the accounting concept dealing with the recognition of increase or decrease in equity. Normally, the increase of equity derives from the sale of goods or the provision of services to customers while the decrease of equity derives from the expenses incur at each reporting period. So what is conservatism concept?
Similarly to realization concept, this concept covers the recognition of revenues and expenses when earn or incur. Each entity shall recognize revenues and expenses conservatively. This means that the items of revenues and expenses shall be recognized when it is clearly indicated that such revenues are completely earned and such expenses are actually incurred.
So in order to understand clearly about this vital concept, we will illustrate two meaningful scenario as follow:
Scenario 1: In January 2019 early at the end of the month, ABC Company has agreed with its corporate customer (D Company) to sell ten Laptops, US$1,500 per unit. During the price quote before placing the order, both entities agreed that the delivery will take place in early March 2019 due to the special order from overseas store.
In this scenario, there is possibility that the customer may change his mind and cancel the order or that customers may reduce to only certain numbers.
Hence, in accordance with the conservatism concept, as the sales of those ten laptops in January is uncertain, thus, ABC cannot recognize as sale revenue in January 2019. The sales revenue shall be recognized only when the delivery is made and satisfy with all conditions and requirements. This is a conservative way of revenue recognition.
Scenario 2: Let’s further continue from scenario 1 from the perspective of customer who bought such laptops, if the delivery has taken place in March 2019, however, a month later, one of those laptops was stolen. In this case, the management of D Company has decided to wait until April 2019 so that they can do full investigation in order about the loss before they are able to recognize such loss in its financial statements
In this scenario, D Company shall recognize the loss immediately in March 2019 where it is reasonable possible and does not need to wait until the investigation is finished. This is because it is already clear that the laptop is loss as somebody has stolen. D Company shall not wait unit they finish the investigation.
In accordance with the conservatism concept, it requires that the company shall recognize the decrease in equity when it is reasonably possible; which is in March 2019.
We shall recognize the increases in equity only when it is reasonably certain and recognize the decrease of such equity as soon as it is reasonably possible.