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 so as to make sure the company is not overvalued and the expenses are not understated so as 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 actually is.
Recognizing Revenues
- Now, what’s the prudence concept principle say is that whenever you have a situation where you have some prospective income, you should not recognize or include that in your books of accounts.
- So, when I am preparing my financial statements, my books of accounts or my balance sheet or profit or loss account, I will not recognize the prospective income as a part of my income for the current year’s financial records because I am acting on a conservative basis.
- The idea behind this principle is not to overstate your income unless and until you actually have the possession for that income.
- As per the prudence concept in accounting, we cannot overstate income. We cannot take into account the prospective income which may arise.
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 that in case some claim like the above comes in tomorrow, you have to make a payment and effectively this claim is in respect of whatever income you have made till 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
- Let us assume that you prepare your company’s financial statements for 31.12.2018. So as the balance sheet date which is 31.12.2018 you get additional information stating that the company may earn $1 million from a particular contract. As you are closing your financial statements you know in advance that there is some income possibility which would be there in the near future. At the same time, let’s assume that there is also a possibility that some claim may come which may result in an expense of say $500,000.
- There is a “provision for bad and doubtful debts” which is reported in the receivables section of current assets and is deducted from the final figure of debtors/receivables. In this provision, we don’t 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 the prudence concept in accounting.
- 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”
- There are many liabilities that 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
- 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.
- Prudence principle in accounting ensures that the financial statements present the realistic and fair picture of a company’s revenue and liabilities.
- It helps in the minimization of losses.
- It helps in not overestimating as well as not underestimating the financial risk of a company.
- The Prudence concept makes the comparability of financial information possible.
Disadvantages
- The prudence concept in accounting doesn’t always necessarily consist of correct facts.
- You cannot apply the prudence concept to cultures that are outside of the IFRS or the GAAP.
- A company may try to create provisions which are actually not required that may result in the creation of some secret reserves.
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