Course Outline
Join PRO

What is the conservatism principle?

Author:
Harold Averkamp, CPA, MBA

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 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).

Join PRO to Track Progress

Advance Your Accounting and Bookkeeping Career

Must Watch image

  • Perform better at your job
  • Get hired for a new position
  • Understand your small business
  • Pass your accounting class
Watch the Video
Certificates of Achievement

Earn Our Certificates of Achievement

Certificates of Achievement
  • Debits and Credits
  • Adjusting Entries
  • Financial Statements
  • Balance Sheet
  • Income Statement
  • Cash Flow Statement
  • Working Capital and Liquidity
  • Financial Ratios
  • Bank Reconciliation
  • Accounts Receivable and Bad Debts Expense
  • Inventory and Cost of Goods Sold
  • Depreciation
  • Payroll Accounting
View PRO Plus Features

Join PRO or PRO Plus and Get Lifetime Access to Our Premium Materials

Read all 2,866 reviews

Features

PRO

PRO Plus

Features
Lifetime Access (One-Time Fee)
Explanations
Quizzes
Q&A
Word Scrambles
Crosswords
Bookkeeping Video Training
Financial Statements Video Training
Flashcards
Visual Tutorials
Quick Tests
Quick Tests with Coaching
Cheat Sheets
Bookkeeping Study Guide
Managerial Study Guide
Business Forms
All PDF Files
Progress Tracking
Earn Badges and Points
Certificate - Debits and Credits
Certificate - Adjusting Entries
Certificate - Financial Statements
Certificate - Balance Sheet
Certificate - Income Statement
Certificate - Cash Flow Statement
Certificate - Working Capital
Certificate - Financial Ratios
Certificate - Bank Reconciliation
Certificate - Accounts Receivable and Bad Debts Expense
Certificate - Inventory and Cost of Goods Sold
Certificate - Depreciation
Certificate - Payroll Accounting
Motivational Badges
Motivational Points
Medal Rankings
Activity Streaks
Custom Public Profile Page of Achievements

About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

Read 2,866 Testimonials

Take the Tour Join Pro Upgrade to Pro Plus