When applied to the balance sheet, the conservative approach results in understatement of assets and capital and overstatement of liabilities and provisions. The principle of conservatism, however should be applied cautiously. If the principle is stretched without reservations it results in the creation of secret reserves which is in direct conflict with the doctrine of full disclosure. Since the main aim of published accounts is to convey and not to conceal the information, the policy of secrecy is being abandoned in favour of the modern and more logical policy of disclosure.

Conservatism in Balance Sheet

Conservatism is a principle in accounting that requires accountants to prepare financial statements with caution and prudence. When applied to the balance sheet, conservatism dictates that companies must understate their assets and overstate their liabilities, rather than overstating assets and understating liabilities. This principle ensures that financial statements are reliable and credible.

Understatement of Assets

The concept of conservatism when applied to the balance sheet results in the understatement of assets. This means that companies should report the value of their assets at a lower amount than their actual value. For instance, if a company has a piece of machinery that costs $10,000, but its market value is $15,000, the company should report the value of the machinery as $10,000.

Reasons for Understatement of Assets

Conservatism is based on the principle of prudence, which means that accountants should always err on the side of caution when reporting financial statements. There are several reasons why companies should understate their assets, including:

1. Unexpected losses: If a company overstates its assets, it may have to write them down in the future, resulting in unexpected losses.

2. Fraud prevention: Understating assets can help prevent fraud by reducing the temptation for fraudsters to inflate the value of assets.

3. Credibility: Financial statements that are conservative and cautious are more credible to investors, creditors, and other stakeholders.

Conclusion

In conclusion, conservatism is an important principle in accounting that requires companies to prepare financial statements with caution and prudence. When applied to the balance sheet, conservatism results in the understatement of assets, which helps ensure that financial statements are reliable and credible.

Correct reason not mentioned in this answer, in my opinion reason is if closing stock is valued at cost price or market price whichever is lower generally cost price shows lower balance when compared to market price closing stock value reflects both the income statement as well as position statement. if closing stock value is low balance sheet assets side total also understated.