Definition of Conservatism Principle
In accounting, the conservatism principle (or accounting constraint) directs an accountant , who is faced with doubt between two possible alternatives, to choose the alternative that will result in one or more of the following:
- Less profit
- Less asset amount
- Greater liability amount
The conservatism guideline does not direct the accountant to be super conservative and beat down a company's profits. The accountant is to be fair and objective. However, if that objectivity reveals two possible ways for recording a transaction, conservatism means recording the transaction or situation in a manner that results in less profit, less asset amount, and/or a greater liability amount.
Example of Conservatism in Accounting
One example of conservatism is the 游戏电竞线上外围APP v5.2 accounting rule for reporting inventory on a company's balance sheet. The accounting rule requires inventory to be reported at the lower of its cost or its net realizable value (NRV) . The amount of the inventory write-down is reported on the current income statement.
To illustrate, assume that a company has inventory with a cost of $15,000. However, the market for the goods has declined. As a result, the goods in inventory can be sold for $14,000, but only if the company spends an additional $2,000 to package and ship the goods .
If the inventory is not sold, the accountant is faced with two alternatives for the company's next balance sheet:
- Report the inventory at its cost of $15,000
- Report the inventory at its net realizable value (NRV) of $12,000. (NRV is equal to the estimated sales value of $14,000 minus $2,000 of expenses necessary to get the goods sold for $14,000.)
The concept of conservatism results in the accounting rule requiring 1) the inventory to be reported on the balance sheet at the lower NRV of $12,000, and 2) the income statement to report the write-down loss of $3,000 (even though the goods have not yet been sold).
