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The conservatism principle helps an accountant decide between two alternatives. Forexample, if an item in inventory has a cost of $20, but it can be replaced for $15, the

conservatism principle directs the account to report the item in inventory at $15 and toimmediately report the loss of $5. For an asset such as inventory it means reporting the lower

asset amount on the balance sheet and the lower net income amount on the income statement.From the conservatism principle comes the accountants the lower of cost or market rule for

inventory valuation.

The conservatism principle does notsay that accountants are to be conservative. Accountantsshould be fairand objective. The conservatism principle is used to break a tie between tworeasonable options. It is not intended to motivate accountants to beat down a companysearnings and assets.

Conservatism has to do with uncertainty. When uncertainty exists between two alternativesthat appear to be reasonable, the accountant breaks the tie by picking the alternative thatreports less profit and less asset amount (or more liability amount).

If there is uncertainty as to whether there was a gain, the rule says dont record it. Because of

the uncertainty and because you did not record the potential gain, there will be less profit andless asset amounts being reported.

(If there is certainty about a gain, then you do report the gain. For example, if a companysells its old delivery truck for cash and the amount received is greater than the trucks bookvalue, 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 theloss. 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.

The conservatism concept According to this concept,

revenues should be recognised only when they are

realized,

while expenses should be recognized as soon as they are

reasonably possible. For instance, suppose a firm sells

100

units of a product on credit for Rs.10,000. Until the

payment is received, it will not be recorded in the

accounting books. However, if the firm receives

informationthat the customer has lost his assets and is likely to

default the payment, the possible loss is immediately

provided for in the firms books.

Conservatism

This requires understating rather than overstating revenue (income) and expense amounts that have

a degree of uncertainty. The rule is to recognize revenue when it is reasonably certain and recognize

expenses as soon as they are reasonably possible. The reasons for accounting in this manner are so

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that financial statements do not overstate the companys financial position. Accounting chooses to

err on the side of caution and protect investors from inflated or overly positive results.