The principle of inventory valuation – “cost or net realisable value, whichever is lower” is based on :

Correct — D, (d) Convention of Conservatism. The rule 'cost or net realisable value, whichever is lower' is the textbook application of conservatism, also called prudence.

Conservatism is the convention that an accountant should not anticipate profits but should provide for all possible losses. Applied to stock, it produces exactly the asymmetry the quoted rule contains. Suppose an item cost ₹ 100 and could now be sold for ₹ 130. The unrealised gain of ₹ 30 is NOT recognised — the stock stays at ₹ 100 — because the profit has not been earned and will be recognised when the goods are sold. Suppose instead the same item can now be sold for only ₹ 80. The loss of ₹ 20 IS recognised at once, and the stock is written down to ₹ 80. Upward movements are ignored, downward movements are booked immediately. Only a rule that treats gains and losses differently can produce that result, and conservatism is the rule that does.

The convention is not merely a textbook one. Accounting Standard 2, Valuation of Inventories, states in terms that inventories should be valued at the lower of cost and net realisable value, and defines net realisable value as the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. AS 1, Disclosure of Accounting Policies, lists prudence as one of the three major considerations governing the selection and application of accounting policies, alongside substance over form and materiality, and explains it as making provision for all known liabilities and losses even though the amount cannot be determined with certainty while not recognising profits on an anticipatory basis.

That is why the answer is a convention and not one of the three concepts offered beside it. Accrual, matching and money measurement all tell you WHEN or WHETHER to record something; conservatism tells you WHICH of two possible measurements to choose when the outcome is uncertain, and it tells you to choose the one that does not flatter the accounts.

Why the others are wrong

• (a)Accrual Concept — The accrual concept fixes the TIMING of recognition, not the amount at which an asset is carried. It requires revenues and costs to be recognised as they are earned or incurred rather than as money is received or paid, and to be recorded in the accounting period to which they relate. It is what makes outstanding expenses, accrued income, prepaid expenses and income received in advance necessary at the year end, and it is one of the three fundamental accounting assumptions in AS 1. Accrual has nothing to say about choosing between two possible values for the same asset. It would be satisfied equally by valuing stock at cost, at net realisable value, or at the higher of the two — so it cannot be the basis of a rule that specifically picks the lower.
• (b)Matching Concept — The matching concept requires the expenses of a period to be set against the revenues of that same period, so that profit is measured on a like-for-like basis. It is the reason depreciation is spread over an asset's useful life rather than charged in full on purchase, why closing stock is carried forward rather than written off, and why a provision for doubtful debts is made in the year the sales were recognised. It explains why unsold stock is carried forward as an asset at all, and to that extent it is in the neighbourhood of this question — but it does not say at WHAT VALUE. Matching is satisfied by carrying stock forward at cost; the further instruction to write it down where net realisable value has fallen below cost comes from conservatism alone. Note the paper prints this option again as Q97's option (a), with a lower-case c, where it is the answer to a different question.
• (c)Money Measurement Concept — The money measurement concept says that only transactions and events capable of being expressed in money are recorded in the books of account. It is the concept that keeps the skill of the workforce, the quality of management, the loss of a key customer and the entry of a new competitor out of the ledger, however important they may be to the business. It has consequences of its own — accounts are incomplete as a picture of an enterprise, and the assumption of a stable monetary unit ignores inflation — but it operates at the point of deciding WHETHER something enters the books at all, not at the point of choosing between two money measurements of an item that is plainly there. Stock passes the money-measurement test at cost and at net realisable value alike.

Accounting is built on a layer of assumptions and a layer of conventions, and questions of this kind reward keeping the two apart. The three FUNDAMENTAL ACCOUNTING ASSUMPTIONS in AS 1 are going concern, consistency and accrual: they are presumed to have been followed unless a departure is disclosed. The CONCEPTS — business entity, money measurement, accounting period, cost, dual aspect, revenue recognition, matching, full disclosure — describe what is recorded and when. The CONVENTIONS — consistency, full disclosure, materiality and conservatism — describe how judgment is exercised where the rules leave room. Conservatism, or prudence, is the convention that governs uncertainty: anticipate no profit, provide for all possible losses. Its everyday applications are the ones worth listing together, because a question can be built from any of them — valuing inventory at the lower of cost and net realisable value under AS 2; creating a provision for doubtful debts and a provision for discount on debtors while creating no corresponding provision for discount on creditors as a matter of routine; charging depreciation even in a year of loss; and appending a note for a contingent liability while ignoring a contingent gain. Its limits matter too. Conservatism deliberately understates, so an accountant who applies it too enthusiastically creates secret reserves and reports a profit that is as untrue as an inflated one; AS 1 therefore couples prudence with the other two major considerations, substance over form and materiality, rather than letting it run alone.

Key facts

• The convention of conservatism, or prudence, is stated as: anticipate no profit, but provide for all possible losses.
• AS 2, Valuation of Inventories — inventories should be valued at the lower of cost and net realisable value.
• Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
• AS 1 lists prudence, substance over form and materiality as the three major considerations governing the selection and application of accounting policies.
• AS 1's three fundamental accounting assumptions are going concern, consistency and accrual — conservatism is not among them.
• Other applications of conservatism: provision for doubtful debts, provision for discount on debtors but not on creditors, depreciation charged even in a loss year, and disclosure of contingent liabilities but not contingent gains.
• The accrual concept governs the timing of recognition; the matching concept sets expenses against the revenues of the same period; the money measurement concept limits the books to what can be expressed in money.
• Excessive conservatism creates secret reserves and understates profit, which is why AS 1 balances prudence against the other considerations.

Common traps

• Choosing matching because closing stock is carried forward. Matching explains the carry-forward, not the choice of the lower figure.
• Treating conservatism as a fundamental accounting assumption. AS 1's three assumptions are going concern, consistency and accrual.
• Confusing net realisable value with market value or replacement cost. AS 2 defines it as estimated selling price less costs to complete and to sell.
• Applying conservatism symmetrically. It recognises losses immediately and gains only on realisation; that asymmetry is the whole point.

• practice — not a real PYQ

  Making a provision for discount on debtors but not for discount on creditors is an application of :

  • (a)The matching concept
  • (b)The convention of conservatism
  • (c)The money measurement concept
  • (d)The going concern assumption

  Answer(b) The convention of conservatism

• practice — not a real PYQ

  Under AS 2, net realisable value means :

  • (a)The current replacement cost of the inventory
  • (b)The historical cost of the inventory less accumulated write-downs
  • (c)The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale
  • (d)The price at which the inventory was last purchased

  Answer(c) The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale