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