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Why the Conservatism Concept is So Important In Accounting

Kindly note the word “conservatism” in accounting has absolutely nothing to do with whether you vote conservative, liberal, or NDP! Ok, now I’ve got that out of the way, let’s define what it means in accounting.

Conservatism in accounting simply means this – that revenue is recognized only when it is assured of being realized (you could say in simple business terms – will I get paid?), and expenses are recognized sooner when there is a reasonable possibility they will be incurred (in other words, you will be liable to pay).

In other words, a cautionary approach is taken which creates more reliable financial statements for users.

Which is why I hate deferred expenses, as I wrote about in a prior Blog. People rationalize deferring expenses (putting on the Balance Sheet as an asset, rather than expensing on the Profit and Loss Statement) by applying (mis-applying?) the matching principle.

As a refresher, let’s talk about what a deferred expense is. A deferred expense (as opposed to a prepaid expense which is different. I will explain later) is an expense that was incurred now, that you think will have a future value in your business. So, you move it off your Income Statement to your Balance Sheet. In other words, you “defer” it to a later date. Sometime in the future, you will expense it.

When you don’t apply the “conservatism” principle in accounting what happens is you end up creating financial statements that cannot be relied upon. They end being full of assumption-based not fact-based.

Let us see how this works by examining a Balance Sheet…

Every Item on Your Balance Sheet Tells a Story

If you were to go through every line item on your Balance Sheet you could tell me a story about it.

Really, you could. The story would either be a true story, based on verifiable facts, or it would be a made-up story, a fairy tale based on assumptions and projections or crystal-ball gazing.

The true stories you could verify. The fairy stories you would have to spin a tall tale.

Let’s go through some examples…looking just at the asset section of your Balance Sheet.

First, what is an asset?

An asset is something you own, something that has value. I could add more distinctions, however, let’s keep it simple for now.

Cash in the Bank

Together as we go through a Balance Sheet we start with “Cash in the Bank”. You unpack the details about this account, in other words, you tell a story.

You inform me that you own that bank account. It is in your company name. You can show me documented proof that you own it.

Is it the correct amount? You could pull out a bank reconciliation showing me your balance in the bank on that date, less cheques that haven’t cleared the bank yet, and deposits of cheques that haven’t been deposited at that time.

All facts, all clear. We can all agree on those facts.

Next, Accounts Receivable

Now you show me a number on your Balance Sheet that says – “this is how much my customers owe my business”.

Again, is this a true story? I don’t know yet. So, to back it up, you show me your accounts receivable list and that includes all the details of each customer and how much they owe you.

You also tell me that you have reviewed each item carefully and determined that they are good payers, and they all will actually pay you.

I may ask some questions – especially about the ones over 90 days.

Why?

Because it is well known that the older the account the less likely it will be of being collected.

Yet all of these are verifiable facts. I could see over the next few weeks how these accounts receivable are converted into cash.

Inventory

What is inventory?

Inventory is stuff on hand that you either bought from a supplier or built yourself that you will re-sell.

You show me how much your inventory is valued at.

Is it a true number or a phony number?

I don’t know. You need to show me your inventory. Show me the details – how many of this item and how many of that item? What did you either pay for it or what did it cost you to manufacture?

Can you sell it for that much I ask?

You tell me that yes, plus a profit, and that you even reduced the cost on some items to the actual sales value you believe you will get.

Do you start to see how this story is a story you can check up on by asking for more documents or even looking on shelves of widgets and count them?

Can you also see, that by writing things down, this becomes a conservative story?

When I say conservative, I mean you have taken the trouble (this is an accounting principle, by the way) to reduce the cost of certain items of inventory that you feel are worth less than what their cost is.

It is kind of like “under-promising” and “over-delivering”.

Fixed or Capital Assets

Next, I look on your Balance Sheet and see you have bought some capital items – things that do have a future value.

Why do they have a future value? Because they are things that will last longer than 1 year.

We can all agree that usually computers, cars, buildings and furniture do last more than 1 year.

You can show me these physical assets. You can pull out legal purchase agreements for what you bought. You can show me invoices.

You will also be depreciating those assets over the next few years based on your estimate of how many years they will last.

Although, the number of years they will last is unverifiable in reality, you, again, have taken a conservative approach. You have reduced their value by your estimate of the wear-and-tear, and reduction in value that occurs over time.

Goodwill and Other Intangibles

The next items in the asset section of your Balance Sheet are intangible items, like goodwill.

Goodwill – what’s that?

Great question! If you made it up, as in, this is the extra value my business has over and above it’s net assets that I can sell it for, then it is a real fairy story you are telling me.

If, on the other hand, you bought that goodwill, you actually paid for it to a third party, that is another matter altogether.

Now, you are able to show me purchase agreements and dollar figures.

Does it mean that it is worth what you paid for it? Sorry to say so, but likely not.

However, it is verifiable in that I can see an actual invoice.

To determine its actual real-life value, I would hire a business valuator to come in and assess the entire business and let him or her place a value on the goodwill.

Deferred Charges

Ok, dear reader, you have been very patient, and now for my rant…

Deferred charges are what exactly? Again, they are things that you would normally expense, however you have decided to defer them to some point in time in the future when you will write them off.

How did you determine this?

By assumptions. Now, the story takes a left turn.

For all the other items above you can show me verifiable documents for what you purchased. You can show me physical stuff even. You can show me bank statements, customer lists, and so on.

Now, you are telling me that these items – these deferred charges, or expenses, have some future value.

How did you determine that value? You tell me that you invested extra labour that will result in higher customer retention and that that cost can be matched to future revenue.

You have no agreements, no proof, no ability to validate the actual time frame involved.

Will it benefit business for 5 years? 10 Years? 1 year? You get to say because it is not based on anything real.

This is the opposite of the conservatism principle.

This is inflation. Inflating your assets to show a value that you cannot prove.

Increasing your income by reducing your expenses.

This is why a non-conservative approach to accounting creates monkey business. And it can defraud lenders and investors.

By the way, there are times you would defer expenses by following the conservatism principle. An example would be start-up development costs when a building is under construction. These would be capital costs in nature, and rightly placed on the Balance Sheet.

So, the moral of the story in this: whichever political party you support, in accounting always be conservative, and know that every number tells a story!

Thanks for reading…