Conservatism Constraint

Definition

The financial accounting term conservatism constraint refers to an accounting constraint that states when in doubt, report information that does not overstate income or assets or does not understate expenses or liabilities.

Explanation

Constraints accounting is a financial reporting approach that is consistent with the framework outlined by the Financial Accounting Standards Board (FASB).  The Conservatism constraint is used when all other accounting theory, principles, assumptions, and constraints fail to provide the accountant with guidance.

The conservatism constraint provides final guidance to an accountant when higher level concepts fail.  This constraint states when in doubt, report information that does not overstate income or assets or does not understate expenses or liabilities.  This is sometimes interpreted to mean assets and income should always be understated, which is not correct.  When there is no doubt how to accurately account for an asset or expense, then this constraint is not applied.

Examples

One of the often cited examples of the conservative constraint has to do with the valuing of inventory.  When in doubt as to its value, it's better to use the lower of market or cost.  Another example would be the classification of some operating costs as a balance sheet item (asset) or an income statement item (expense).

Related Terms

FASB, cost benefit constraint, industry practices, materiality, lower of market or cost, prudent cost concept