Conservatism has to do with uncertainty. When uncertainty exists between two alternatives that appear to be reasonable, the accountant “breaks the tie” by picking the alternative that reports less profit and less asset amount (or more liability amount).
If there is uncertainty as to whether there was a gain, the rule says don’t record it. Because of the uncertainty and because you did not record the potential gain, there will be less profit and less asset amounts being reported.
(If there is certainty about a gain, then you do report the gain. For example, if a company sells its old delivery truck for cash and the amount received is greater than the truck’s book value, there is no uncertainty and a gain is reported.)
If there is uncertainty about whether or not there is a loss, the rule directs you to record the loss. By recording the potential loss, you will be reporting less profit and less asset amounts.
If there is a potential loss, but it is impossible to measure the amount for a journal entry, there needs to be a disclosure in the notes to the financial statements.
