by D. Victor

Created on: December 28, 2009   Last Updated: June 02, 2011

The prudence concept in accounting governs the recording and reporting of financial transactions, "such that the assets or income are not overstated and liabilities or expenses understated" (BPP Learning Media Ltd., ACCA Study Text). Prudence in accounting is about exercising due caution in preparing financial statements to reflect the least favourable position, particularly as accounting depends on estimates—even for simpler transactions. It is, therefore, one of the fundamental principles of financial accounting and is considered  very important by the IAS 1 (International Accounting Standard).

Often, in accounting, there is a body of methods that can be used for valuation. The different methods of estimating depreciation are a prime example. The principle of prudence holds that, where there are alternative methods or valuations, you should apply the one with the most conservative result. In deciding the value of stock for example, it would be prudent to use the cost price of the stock as opposed to the selling price. This is because the sale of that stock is merely anticipated. The derived principle from this is that where revenue is anticipated, the valuation should be conservative or cautious.

On the other hand, there are anticipated expenses and liabilities. Anticipated expenses and liabilities are treated differently under the prudence concept. They are immediately recorded or taken into account, even if the loss has not yet been experienced. An example of this concept in an everyday situation, is if you foresee that you have to make your mortgage payment at the end of the month. When you budget at the start of the month, you should anticipate that expense before it is due. When the expense is due, you would likely be in a position to cover it. Businesses ought to address devalued stock and debt servicing in the same way.

The principle of prudence also governs the handling of profit. Even though a business can expect profit, it must not be recorded before it is realized. One reason for this is that any number of factors can affect the business' profits positively or negatively. Ideally, profit should be in cash form, because of the ease of determining the value of cash. In addition, the cash value of profit from assets must be certain—within reason. An example of this is if you sell an asset and use the proceeds to buy a higher-value asset. You can only declare a profit once you purchase the higher-value asset and once it maintains a determinable value by the end of the financial period.
 
The prudence concept creates a proper platform for accounting standards and reinforces the fundamentals of financial reporting—such as the principle of Fair Presentation, which dictates that financial reports should fairly reflect the financial position and cash flows of an organisation. In addition, the prudence concept is not meant to justify withholding revenue or creating covert reserves, since this is not in keeping with the principle of Fair Presentation.

Sources

ACCA Study Text, Financial Accounting (Paper F3), BPP Learning Media Limited, Copyright 2009

http://www.blacksacademy.net/content/4011.html

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