What Is 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.
By applying this concept there is less change of companies to overstate their own financial health. It helps the stakeholders take an informed financial decision and predict the future prospects of the business. However, businesses should not use it to hide any kind of information or distort it in the process.
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Prudence Concept In Accounting Explained
Prudence concept 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 ensure that the company is not rightly valued.
The prudence principle in accounting is often described using the phrase “Do not anticipate profits, but provide for all possible losses.”
In other words, it considers 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 a better picture than what is.
- The prudence concept principle says that whenever you have a situation where you have some future income, you should not recognize or include that in your books of accounts.
- So, when I prepare my financial statements, my books of accounts or my balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company., or profit or loss account, I will not recognize the prospective income as part of my income for the current year’s financial records because I am acting on a conservative basis.
- This principle is not to overstate your income unless and until you have possession of that income.
- As per the prudence concept in accounting, we cannot overstate income. We cannot take into account the future income which may arise.
- At the same time, the concept of prudence principle in accounting says that you should never underestimate expenses. If there is an expectation that some expenses are likely to be incurred, you should provide it in your books of accounts.
- It would be best to 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.
Let us understand the concept with the help of some suitable examples.
- Let us assume that you have prepared 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 some income possibility would be there shortly. 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 assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. and is deducted from the final figure of debtors/receivables. This provision doesn’t show the debtors that have resulted a bad debts;Bad Debts;Bad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation. instead, it shows the debtors that may end up as bad debts based on their trading history with the company or their specific circumstances. Ultimately, the company may not recover money from these debtors. These debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. 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 cost (original cost) or NRVNRVNet Realizable Value is a value at which the asset may be sold in the market by the company after deducting the expected cost of selling the asset in the market. It is a crucial metric for determining the value of a company's ending inventory or receivables. (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 salesCost Of SalesThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. ” figure, because
“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. + Purchases – Closing stock.”
- Many liabilities are not certain either in terms of amount or 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.
The above examples give us a clear idea about how to account for various items in the financial statement by following the prudence concept in a transparent manner, which is easy to interpret and use.
Some points of importance of the financial concept are as follows:
- The prudence concept or conservatism principle is well known and used worldwide. This principle gives the companies a base on which companies could build or prepare their financial statements.
- 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. present a 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 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..
- 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. possible.
The concept also has certain disadvantages, which are as given below:
- 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 GAAPThe IFRS Or The GAAPThe International Accounting and Standards Board (IASB) issued IFRS, whereas GAAP is given by the Financial Accounting Standards Board (FASB). Though attempts are being made to bring about convergence, it becomes essential to be considerate when evaluating financial statements under the different frameworks..
- A company may try to create provisions that are not required, resulting in the creation of some private reserves.
- It lowers the earnings and profits, given the stakeholders the idea that the company is not performing well. This may reduce its value in the market and investors may back away.
- It may impact management decision because they may try to invest in opportunities that look more profitable but is risky. In order to prioritise profits and avoid losses, they may miss good opportunities.
- Since it is not accepted in all accounting standards, there is lack of standardization in financial reporting. Therefore the interpretation and application may vary.
- The concept involves some level of subjectivity which creates possibility of manipulation to meet investor’s expectations.
Thus, it is necessary to understand the advantages and limitation of any financial concept clearly so that they can be applied in the appropriate time and place for maximum value creation.
This has been a guide to what is Prudence Concept In Accounting. We explain it with examples, its importance and the various disadvantages of the concept. You may also find some useful accounting articles below –