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Conservatism means early recognition of unfavorable events. It is a policy of playing safe in a world of uncertainties. There are two principal rules that are directly related to the principle of prudence: (i) the accountant should not anticipate profit and should provide for all losses. (ii) when in doubt, the accountant should choose the accountant method that will be least likely to overstate assets and income. In other words, “the working rule is: Anticipate no gains but provide for all losses and if in doubt, write it off.” When applied to business income, the convention results in the recognition o all losses that have occurred or liable to occur and to admit the gains only when they have been realized. Conservatism is inherent in the practice for valuing stocks or inventories at the lower of the cost or market value rule. Thus if the values of inventories have gone down in the market, they would be written down to the extent of reduction in value. But no ‘write ups’ would be followed if the market shows an upward trend unless the gain is actually realized. There is a strong plea that the understatement of earnings and assets is less dangerously misleading than the overstatement. Generally the conservatism affects principally the assets held for short time i.e., stock of goods, debtors, marketable securities. Thus the convention of conservatism requires the accountant: (a) Make provision for bad debts in respect of doubtful debts. (b) Value the stock in hand at lower of cost or market value. (c) Create investment fluctuation reserve. (d) Treat small amounts of capital expenditure items like crockery as expenses. (e) Amortize intangible assets like goodwill, patents, trade, marks etc. as early as possible. (f) Never provide discount on creditors. (g) Provide for the loss on the issue of debentures when the same are issued at par but redeemable at premium. (h) Show the joint life policy at surrender value on the assets side of the Balance Sheet. Further, it is argued that if goods have been for sale at predetermined price in terms of a legal contract and the seller is entitled to claim liquidated (pre-determined) damages in the event of default by the buyer, it would be quite logical to value stock-in-hand at the contract price rather that at cost.

It is claimed that sometimes the income is deliberately understated as a result of excessive depreciation charges, creation of unwanted provisions etc. The excessive application of conservatism could result in the creation o secret reserves, a practice contrary to the policy of full disclosure. Conservatism when carried beyond what is warranted can make the business appear to be in poor financial condition when such is not the case. The confidence of the prospective investors would be shaken and investments would be discouraged, if the business appears to be less valuable than what it is. As stated above the defendants maintain that erring in the direction of conservatism has less serve effects than erring in the direction of overstating net income and overvaluing the assets. In contrast with the earlier intentional understatements of net assets and income, conservative procedures are now utilized in circumstances where the accountant is unsure of the proper measure to use.

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