Prudence Concept in Accounting

Prudence Concept in Accounting

Prudence Concept or Conservatism principle is a key accounting principle that makes sure that assets and income are not overstated and provision is made for all known expenses and losses whether the amount is known for certain or just an estimation i.e expenses and liabilities are not understated in the books of accounting.

Explained

Prudence concept is a concept that has been put in place to ensure that the person who is making the financial statements makes sure that the assets and income are not overstated to make sure the company is not overvalued. The expenses are not understated to make sure that the company is not rightly valued.

The prudence principle in accounting is many times described using the phrase “Do not anticipate profits, but provide for all possible losses.”

In other words, it takes into consideration all prospective losses but not the prospective profits. The application of the prudence concept ensures that the financial statements present a realistic picture of the state of affairs of the enterprise and do not paint the better picture than what is.

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Recognizing Revenues

Recognized Expenses

  • At the same time, the concept of prudence principle in accounting says that you should never underestimate the expenses, which means if there is an expectation that some expenses are likely to be incurred, you should provide it in your books of accounts.
  • You should make a provision today in your book of accounts for the above mentioned future claims. In the future, you have to make the payment, and effectively this claim is in respect of whatever income you have made to date, i.e., till the date you are preparing your balance sheet (in this case till 31.03.2018).
  • In this case, the prudence concept in accounting says that you should never underestimate the expenses, and if there is a likelihood of expenses, we call it a provision. We should make a provision for expenses in your book of accounts.

Examples

          “Cost of sales = Opening StockOpening StockOpening Stock is the initial quantity of goods held by an organization during the start of any financial year or accounting period. It is equal to the previous accounting period's closing stock, valued in accordance with appropriate accounting standards based on the nature of the business.read more + Purchases – Closing stock.”

  • Many liabilities are not certain either in terms of amount or in terms of date, but they have a 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.

Advantages

  1. The prudence concept or conservatism principle is well known and used worldwide. It gives a base to the companies on which companies could build or prepare their financial statements according to this principle.
  2. Prudence principle in accounting ensures that the financial statementsThe Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more present the realistic and fair picture of a company’s revenue and liabilities.
  3. It helps in the minimization of losses.
  4. It helps in not overestimating as well as not underestimating the financial risk of a companyFinancial Risk Of A CompanyFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more.
  5. The Prudence concept makes the comparability of financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more possible.

Disadvantages

  1. The prudence concept in accounting doesn’t always necessarily consist of correct facts.
  2. You cannot apply the prudence concept to cultures that are outside of the IFRS or the GAAP.
  3. A company may try to create provisions which are not required that may result in the creation of some secret reserves.

This has been a guide to Prudence Concept in Accounting. Here we will look at the overview of Prudence Principle, its meaning along with practical examples, advantages, and disadvantages. You may also find some useful accounting articles below –

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