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are going to learn concept which is
known as the conservatism principle of
accounting as you can see in the blue
box is something written over here let's
read that conservatism principle is a
concept in accounting under the GAAP
which recognizes and records the
expenses and liabilities certain or
uncertain in nature and as soon as
possible but recognizes revenue and
assets when they are assured of being
received so there is like you know a
partially with that is happening
between the liabilities and the revenues
well it's it's quite simple over here
the expenses and liabilities are
recorded whether it is certain or
uncertain with the biggest example like
the bad debts or resolves for the
doubtful debts and the revenues and the
assets are recognized when they are
actually been assured because of these
standards they say that you know the
revenue should be recognized only when
it is certain and the recovery of the
amount is certain so all those critical
things has to be in marked so as to
recognize revenue and assets let's
understand this in complete detail
conservative principle is basically a
concept that is accounting under GAAP
right and that recognizes and records
expenses and liabilities certain on
certain nature as soon as possible but
recognizes revenue assets when they are
assured of being received so it gives a
clear guidance for recording cases of
uncertainty in estimates now the
principle of the conservatism is one of
the major accounting accounting
principles and guidelines under it under
under UK gaap which is regulatory body of principle and standards of accounting
that all the accountants across the
globe need to follow while reporting the
financial activity to business now the
principle of the conservatism is mostly
concerned with the reliability of the
statement of business entity now the
conservatism principle example that we
are going to take so that we understand
let's make an assumption that a company
which is known as the kg Inc is
embroiled in an patent lawsuit KG inc
is suing a B Inc for patent infringement
and is expecting in a large settlement
now since the settlement is not surety
is not in surety he kg inc does not
record the gain in the financial
statement now the question why doesn't
why does it not record in the financial
statement the answer is that the KG Inc
may win or it may not win right the
amount is expected by the winning of the
settlement now since a large winning
settlement amount may lead to
complexities in the financial statement and
also mislead thus to the users so this
this gain is not recorded in the books
again taking the same example if a be
limited or A B Inc expects to lose this
suit then they must record if they lose
they must record in the footnotes of the
financial statement now this will be the
most conservative approach because the
users will want to be aware of the
company will have to pay out a large sum
of settlement right in the coming days
this was the example number 2 example
number 1 now we'll take example number
two to understand in again a good
fashion suppose let's say an asset is
owned by an entity like inventory and it
was bought for let's say $120 but
can now be bought for 150 can can it be
bought for 50 my question then the
company must immediately write down the
value of the asset 250 so
the company must immediately write down
the value 50 that is you know the lower
of the cost of the of the market this is
basically the cost this is let's say the
NRV the net realizable value it's cost
of NRV whichever it is lesser but if
the inventory was bought for let's say
120 and now we'll the cost will be of
the company will be 150 right
it must be still shown the cost now is
at 150 and the NRV is standing at 120
then we should record it at 120
whichever is less so the gain is only
recorded when the inventory or the asset
is sold now let's understand the impact
of the conservatism principle of the
financial statement now conservative
conservatism principle of the accounting
always says that one should always error
on the most conservative side on the
financial statement or the transaction
sorry second it is done by minimizing
the profits who invites by stating
uncertain losses or expenses and not
mentioning the uncertain estimated gains
and it always States more conservative
estimate should always be followed third
while doing an estimate for allowance
regarding it out full accounts casualty
losses or other unknown future events
one should one should always error on
the side of the conservatism I will just
write over your allowance regarding
doubtful debts now alternative we can say that you know an accountant should
record the most expenses and and the
least incomes so the principle of the
conservatism forms the main backbone
okay of the lower of the cost or the
market value so whichever is lower right
in recording the inventory part
which we just understood conservative
principle of the accounting states that
you know that the accountant must choose
the most conservative outcome when the
two outcomes are available to them so
the main logic behind this of the
principle of the conservatism is that
when the two reasonable possibilities
for recording a transactions are
available one must error on the
conservative side so this means that one
has to record uncertain losses while
staying away from recording the
uncertain gains right so when the
conservative principle of accounting is
followed lower asset amount is recorded
on the balance sheet and lower net
income is recorded you can say on the
income statement right so there to
the principle results in lower profits
being recorded in the statement now why
to follow the principle of conservatism
why this is the question why do we use
conservatism see while recording of
business entities gains or losses I mean
why do we use conservatism while
recording business entities gains or
losses see we must keep in mind that the
principle of conservatism does not mean
making the recording recorded earnings
as low as possible
this principle basically helps us to
break a tie with when an accountant has
to deal with equal probable outcomes for
a transaction so when interested users
or investors are going through company's
financial statement they must get an
assurance that the profit of the company
that the profits of the company are not
misleading or if it is or estimated it
will be misleading for the company
stakeholders so when the conservatism
principle of accounting is followed prep
people they are Pro or potential
business investor or partner gets more
clear and realistic picture of the
company financial standing and and the
future
trajectory of the company so the two
main aspects of the conservatism
principle of the accounting are and
recognize the revenue recognize revenue
only if there they are certain and
recognize the expenses as soon as they
are reasonably possible I hope you have
got a clearer insight regarding this
very topic so that's it for this
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