What is conservatism?

Conservatism is an accounting convention requiring that when different valuation methods are available, the alternative having the least favorable immediate financial impact must be chosen.  It calls for the understatement of assets and revenues, the overstatement of liabilities, the early recognition of expenses and losses, and the later recognition of revenues and gains.  The general concept of conservatism, which underlies much of financial reporting, requires that assets representing claims to cash not be reported at amounts exceeding that which will ultimately be collected.

The conservatism convention holds that in financial reporting it is better to be pessimistic (understate) than optimistic (overstate), it being argued that pessimism is needed to balance the optimism of management, thus protecting the users of financial statements.  Conservatism is generally considered only when other principles affecting a choice of alternatives are neutral.  Examples of conservatism are the lower-of-cost-or-market method to value inventories, the accrual of expected expenses and losses, and the deferral of anticipated revenues and gains.  Conservatism requires losses to be recognized at the earliest date of occurrence, while realization stipulates that gains are not recognized until actually realized.

The lower-of-cost-or-market (LCM) principle, which is based on the conservatism concept, requires that assets be valued at either the lower of their historical cost or their current replacement cost.  It is used for individual asset items or groups of like items and typically applied to inventories or marketable securities, but may also be used for other assets.  When certain accounts are restated at the lower of their historical cost or current replacement cost, an unrealized loss is shown in the financial statements.