The conservatism principle.

The conservatism principle helps an accountant decide between two alternatives. For example, 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 to immediately 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 not say that accountants are to be conservative. Accountants should be fair and objective. The conservatism principle is used to “break a tie” between two reasonable options. It is not intended to motivate accountants to beat down a company’s earnings and assets.

Learn more about Lower of Cost or Market.