The conservatism principle directs an accountant who is faced with two alternatives. To illustrate, let's assume that a company has an inventory with a cost of $15,000. However, the marketplace has changed dramatically and now the inventory can be sold for only $14,000 if the company spends an additional $2,000 to package and ship the goods.
For the next balance sheet the accountant is faced with 1) continuing to report the inventory at its cost of $15,000 or 2) to 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 $14,000.) Expressed another way, on the next income statement the accountant is faced with 1) ignoring the loss in inventory value until the goods are actually sold, or 2) reporting the loss immediately.
The concept of conservatism directs the accountant to 1) report the inventory at the lower NRV of $12,000 and 2) to report immediately a lower net income due to the inventory write down $3,000 on its income statement. (The $3,000 loss is the write down from the cost of $15,000 to the NRV of $12,000.)
The conservatism principle does not say that accountants are to be super conservative. Accountants should be fair and objective. The conservatism principle says if there is doubt between two alternatives, the accountant should opt for the one that reports a lesser asset amount or a greater liability amount, and a lesser amount of net income.
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