What is Convention of Conservatism? The convention of conservatism is an ideology of economic philosophy. In economics, it is an economic theory that anticipates the effects of taxation on economic activity. This theory leads to the assumption that taxes are good and should be used to finance public goods and services, and the associated infrastructure.
However, this conservative approach does not end there. For some, the ends do not justify the means and as such, seek means to achieve the same ends, even if it means that the means adopted are economically self-destructive. The resulting doctrine is that following transactions in the traditional manner is not only inefficient, and unfair, but also self-destructive.
In accounting, the convention of conservatism is a basic policy of minimizing future losses and maximizing future profits. This policy tends to underestimate the value of assets and potential net worth, and thus lead businesses to “play very safe” with their fixed assets and long-term liabilities. A classic example of this would be the use of a P.A.C. loan to buy long-term fixed assets with the idea that future profits would compensate for the initial loan. When these assets fail to generate income, creditors will often sell them to cover the P.A.C. debts.
A similar example would be the acquisition of costly machinery by businesses without realizing the full value of such a purchase until it is too late. Often, creditors agree to write off the cost of acquired machinery until such time that it is no longer making a net profit to the company. While such an option lowers the cost of borrowing, it also reduces future profits and, as such, damages the credit of the company. The effects of this are commonly known as “loss mitigation.”
Another example is the reluctance to depreciate costs. A company might decide to postpone capital expenditures in the past year in the hopes that the economy will improve and spend more money in the future. However, if economic conditions worsen, the investment might not be feasible in the future. For this reason, a business might delay capital expenditures in the current year so that it has more time to plan for future expenses but then incur them in the following year. This could result in excessive tax liability because the capital expenditure was not realistic in the previous year.
One way to minimize the potentially negative impact of this type of business decision is to employ what is called a “hire-purchase system.” Under this method of financing, the company makes purchases from a seller at a certain price in order to raise cash for the capital expenditures during the current year. Once the company uses the cash to make its capital expenditures during the current year, it is then able to deduct the cost of the purchases from its gross profit. Because these purchases are made when the cash is already available, this method provides the company with a way to mitigate its risk by decreasing its potential losses. The downside, however, is that the company must fund each purchase using cash, reducing its liquidity and potentially pushing up its interest rates.
One example of using a hire purchase to reduce your corporate tax liability is the case of a manufacturing firm that makes machinery. One year after purchasing the machinery, it is discovered that the majority of the machinery has low quality parts that will need to be replaced in the coming year. The manufacturing firm needs to absorb the cost of those replacement parts, but must wait until it receives its cash flow from its own operations before it can do so. It does not have the capacity to pay for the total of the replacement machineries. Thus, the employer uses a depreciation strategy to limit its exposure to the negative effects of an unfavorable depreciation cycle.
In the example presented above, the employer uses three different methods to control the number of units it needs to purchase in the coming year. These methods are a high deductible plan, a low deductible plan, and a long-term financing program. By creating a long-term financing program based on future revenue, it ensures that the firm will never run out of money to purchase the necessary machinery. Alternatively, by creating a high deductible plan that only pays out if the machinery is used in the current year, it ensures that the firm will never run out of money to replace the old equipment. On the other hand, a low deductible plan allows the firm to incur expenses for the equipment as it accumulates value through the years. Thus, it increases the firm’s profitability and avoids large short-term losses.