Prudence concept of accounting

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 these when they are actually realized. Simultaneously a company must always adopt a proactive approach towards the recognition of liabilities, losses and expenses. In simple terms the business must not overvalue its profits and assets until irrefutable evidence is obtained, as well as it must not undervalue its losses and expenses and must record provisions even if a possibility of occurrence exists. It may seem that prudence concept requires the company to go for every less favorable situation to be recorded, but it 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 Accounting Standards (IAS’s) and Generally Accepted Accounting Principles (GAAP) incorporate the concept of prudence in many standards.

Examples:

1. 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. The provision does not show the debtors that have resulted as bad debts rather it shows the debtors that may end up as bad debts based on their trading history with the company or their specific circumstances, and ultimately company may not recover money from these debtors. These debtors are included in the provision under prudence concept of accounting.
2. In IAS2 (International Accounting Standard for Inventory) the inventory is always valued at lower of cost (original cost) or NRV (net realizable value – selling price less cost to sell), so that inventory may not be overvalued, as the figure of inventory directly impacts the “cost of sales” figure, because “Cost of sales = Opening Stock + Purchases – Closing stock”.
3. 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 recorded. So it makes sure that liabilities are not undervalued.