Definition Definition

What Is Conservatism Principle? Understanding Conservatism Principle with Example

What is Conservatism Principle?

Conservatism Principle is a theory that entails that profit should be documented only if they are likely to occur, but all prospective costs, even the ones with a tiny possibility of occurring, should be acknowledged.

Understanding Conservatism Principle

The conservatism principle directs how to capture doubtful occurrences and estimations. In the majority of cases, this involves limiting earnings by documenting uncertain costs or liabilities while ignoring questionable or projected benefits.

Because accounting rules and Generally Accepted Accounting Principles (GAAP) have always been engaged with the useful accounting records to cash flow statement consumers, it's easy to see why the Financial Accounting Standards Board (FASB) does not want the financial statements to be exaggerated or inaccurate. This could influence user choices.

Calculations are also subject to the conservatism principle. In most cases, a more conservative estimate should be employed. Generally, companies should err on the side of caution when calculating allowances for suspect records, collateral damage claims, or other unforeseeable events. To put it another way, they should choose the records that have the most expenditures and the minimum income. The lower expense or market idea for stock management is based on this notion.

Practical Example

HK Limited has merchandise worth $20,000 in stock. The demand for the items, on the other hand, has suddenly shrunk. As a consequence, the stock products can be offered for $18,000, but only when the corporation pays an extra $3,000 on packaging and shipping.

If the stock is not delivered, the accountants have two options over the next financial statements of the company.  Record the item at its $20,000 cost. Calculate the inventory's net realizable value (NRV) of $15,000 and inform it. (NRV is $18,000 projected sales price less $3,000 in expenditures required to sell the products for $18,000.)

The bookkeeping rule requires:

  1. Inventories to be represented on the financial statements at the reduced NRV of $15,000, and
  2. Cash flow statement to record the $1,000 write-down cost is based on the conservatism principle.

In Sentences

  • The accounting conservatism principle is a concept that requires companies to construct their financial statements with sensitivity and a high level of verification.


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