the conservatism principle

The Conservatism Principle

Conservation is humanity caring for the future.

Nancy Newhall

The Conservatism Principle actually is a guideline used in financial accounting when recording transactions on the company’s books. But after learning about this principle, I could see how this can and should be used in personal money management as well.

The Conservatism principle, when used in accounting, states that a company should always anticipate on future losses, but never on future gains. This to prevent the company, as well as investors, from acting upon overly positive financial reports, only to find out at a later stage that those anticipated gains were never realized. This ultimately affects the owners and investors negatively. So how does the conservatism principle help with our personal finances?

The conservatism principle & personal finance

Before I go into depth, I’d like to share a story which will highlight a mistake I used to make. When I was planning a trip to Montreal, Canada, and making the calculations for how much money was needed, I included income which I had not received yet. Among the included income would be my tax return and items I had put up for sale, but not yet sold.

Neither of these incomes had been realized at the time of departure. To account for my costs during the trip, I used my paycheck, which mostly was meant for other purposes. After my trip I noticed how hard you get hit when income which you anticipated on, isn’t collected. Until I finally received my tax return, I was forced to live incredibly frugal.

Of course, everyone can see that in this example I handled quite stupidly, if I might say so myself, although it does paint a clear picture. It shows how I was anticipating on future income, and it shows the impact this way of money management can have.

However, many people make these kind of calculations: they divide their future income according to the upcoming purchases they are planning to make. The future income is already “used up” in their heads. But when these incomes aren’t realized or unexpected costs come along, it messes with your finances.

Even the most obvious of incomes, your salary, shouldn’t be anticipated on. A company could have financial challenges which might lead to a decision where salaries will be paid out later, or in two parts. Or worse, a company could go bankrupt. When certain gains aren’t realized, you suddenly have to find another way to make up for the amount that you are quickly in need of. 10 out of 10 times this is nearly impossible, causing stress that could have been prevented.

Anticipate on future expenses instead

In contrast, anticipating on future expenses will prepare you for what is yet to come. Once you reckon certain expenses have to be accounted for, you will do good setting money aside until these have to be paid. Might any of these expected expenses resolve for whatever reason, I would recommend you to either save or invest that particular amount you had put aside. If you choose to spend it on anything else really, you will miss out on an opportunity to get ahead financially.

A way that could help you anticipate on future expenses, even without expecting any, is to create a financial buffer. Also knows as an emergency fund. With an emergency fund, you will always be prepared for any expenses that are yet to occur.

Recap

The Conservatism Principle should help considerably in making wise monetary decisions. Never include yet to be earned income in any calculations, and always be aware of expenses that might be around the corner.

Lots of love,

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