Definition and explanation
Prudence concept of accounting states that an entity must not overestimate its revenues, assets and profits, besides this it must not underestimate its liabilities, losses and expenses.
Prudence concept is a very fundamental concept of accounting that increases the trustworthiness of the figures that are reported in the financial statements of a business. The concept advises that the final accounts of a company must always show caution while reporting any figures specifically impacting the income and expenses. It means that the preparer must always show a conservative approach while reporting profits, revenues and assets and must only record them when they are actually realized. Simultaneously, a company must always adopt a proactive approach towards the recognition of liabilities, losses and expenses.
Another name used for prudence concept is the conservatism principle of accounting.
In simple terms, the entity must not overvalue its profits and assets until an irrefutable evidence is obtained. At the same time, it must not undervalue its losses and expenses, and must record provisions even if a possibility of their occurrence exists.
At first glance, It may seem that prudence concept requires companies to go for recording every less favorable situation, but it actually does not. The concept basically urges that financial statements must present a realistic perspective about every possible event that may impact the decision of the users of financial statements. International Financial Reporting Standards (IFRS’s) and Generally Accepted Accounting Principles (GAAPs) are two broadly used accounting frameworks and both incorporate the concept of prudence in many standards falling under their scope.
Importance/advantages of prudence concept
The key advantages of working with prudence concept are listed below:
- Prudence concept helps minimize the chances of under or overestimating the financial risk present in a particular investment or company.
- It helps present a fair and realistic view of financial statement items, like revenues, assets, losses, expenses and liabilities.
- It makes financial statements of an entity comparable with that of others operating within the industry.
- It urges to take caution in recording assets, liabilities, revenues and expenses and thus helps minimize losses.
Examples of prudence concept
Let’s take some examples to further elaborate the concept of prudence.
1. Recording of provision for bad debts
The “provision for bad and doubtful debts” is reported in the receivables section of current assets and is deducted from the final figure of debtors/receivables. This provision does not show the debtors that have resulted as bad debts. Rather, it shows the debtors that may end up as bad based on their trading history with the company or their specific circumstances, and, ultimately, the company may not recover money from them. These doubtful debtors are included in the provision under prudence concept of accounting.
2. Recording of inventory
In IAS2 (International Accounting Standard for Inventory), the inventory is always valued at lower of original cost or net realizable value (i.e., selling price less cost to sell), so that inventory may not be overvalued. The figure of inventory directly impacts the “cost of sales” figure, because “cost of sales = opening stock + purchases – closing stock”.
3. Recording of liabilities and expenses
There are many liabilities which are not certain either in terms of amount or in terms of date but they have high possibility of occurrence. In such cases, the liabilities are recorded in the statements and a corresponding expense is also recognized. This practice makes sure that both liabilities and expenses are not understated.