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What is the prudence concept in accounting?
Under the prudence concept, you should not overestimate the amount of revenues that
you record, nor underestimate the amount of expenses. You should also be
conservative in recording the amount of assets, and not underestimate liabilities. The
result should be conservatively-stated financial statements.
Another way of looking at prudence is to only record a revenue transaction or an asset
when it is certain, and to record an expense transaction or liability when it is probable.
Another aspect of the prudence concept is that you would tend to delay recognition of
a revenue transaction or an asset until you are certain of it, whereas you would tend to
record expenses and liabilities at once, as long as they are probable. Also, you should
regularly review assets to see if they have declined in value, and liabilities to see if
they have increased. n short, the tendency under the prudence concept is to either not
recogni!e profits or to at least delay their recognition until the underlying transactions
are more certain.
The prudence concept does not "uite go so far as to force you to record the absolute
least favorable position #perhaps that would be entitled the pessimism concept$%.
nstead, what you are striving for is to record transactions that reflect a realistic
assessment of the probability of occurrence. Thus, if you were to create a continuum
with optimism on one end and pessimism on the other, the prudence concept would
place you somewhat further in the direction of the pessimistic side of the continuum.
You would normally exercise prudence in setting up, for example, an allowance for
doubtful accounts or a reserve for obsolete inventory. n both cases, a specific item
that will cause an expense has not yet been identified, but a prudent person would
record a reserve in anticipation of a reasonable amount of these expenses arising.
&enerally Accepted Accounting 'rinciples incorporates the prudence concept in many
of its standards, which #for example% re"uire you to write down fixed assets when
their fair values fall below their book values, but which do not allow you to write up
fixed assets when the reverse occurs. nternational (inancial )eporting *tandards do
allow for the upward revaluation of fixed assets, and so do not adhere so rigorously to
the prudence concept.
The prudence concept is only a general guideline. Ultimately, you must use your best
+udgment in determining how and when to record an accounting transaction.
http://accountingexplained.com/financial/principles/prudence
Prudence Concept
Accounting transactions and other events are sometimes uncertain but in order to be
relevant we have to report them in time. ,e have to make estimates re"uiring
+udgment to counter the uncertainty. ,hile making +udgment we need to be cautious
and prudent. 'rudence is a key accounting principle which makes sure that assets and
income are not overstated and liabilities and expenses are not understated.
Examples
1. Bad debts are probable in many businesses, so they create a special
contra-account to accounts receivable called allowance for bad debts
which brings the accounts receivable balance to the amount which is
expected to be realied and hence prevents overstatement of assets.
!n expense called bad debts expense is also boo"ed to stop net
income from being overstated.
#. $ome liabilities are contingent upon future occurrence or non-
occurrence of an event such a law suit, etc. %e &udge the probability of
occurrence of that event and if it is more than '() we record a liability
and corresponding expense at the most li"ely amount. *ence, we stop
liability and expense from being understated.
+. ,eriodic evaluations of assets are made to ma"e sure their carrying
value does not exceed the benefits expected to be derived from the
asset, and if it does exceed, the impairment of fixed asset is recorded
by reducing its carrying amount.