Updated July 20, 2023
Introduction to Prudence Concept in Accounting
Prudence concept in accounting (also known as conservatism) is a fundamental accounting concept that is based on the conservative approach of estimating the liabilities, expenses losses (i.e. cash outflow side) in a proactive manner and of estimating the assets, revenues, and profits (i.e. cash inflow side) in a retroactive manner so that the liabilities are not understated and assets are not overstated.
Explanation
- The prudence concept is the fundamental concept of accounting which states that the liabilities, expenses, and losses should never be understated.
- Prudence states that if the liabilities are under-recorded, it may result in a huge outflow of resources at a time when the liability out-bursts. This results in an unusual movement in the income statement & cash flow statement. Thus, to avoid this situation, prudence suggests that as time passes each year, the organization should start making provisions for probable liabilities, expenses, and losses in the near future. This will ensure that only a single accounting period does not suffer a stroke.
- On the very other hand, prudence states that revenues, profits, and assets should not be overstated. Why so? Let’s discuss this. If you start overstating the income side, then the probable profit which you arrive at will be on the higher side. Higher profits give fake confidence to investors. In the wake of higher profits, why the cash flows are still low? Year after year, it will show that the organization is incapable to recover its revenue. This also shows an inappropriate picture of current assets. So, as to avoid this situation, the assumption of prudence helps around.
- Prudence increases the confidence of various stakeholders. It is a conservative approach to accounting since it is proactive only in respect of accounting for losses, expenses, and liabilities.
- The concept revolves around the logic that the profits, assets & revenue should not be overstated (i.e. record it only when there is complete confidence about the recoverability of revenue, usage of assets, and realization of profits) and the expenses, liabilities & losses are not understated (i.e. record these even if the chance of occurrence is low).
- Thus, expenses should be recorded as early as possible but revenues should be recorded only when there is certainty.
Examples of Prudence Concept in Accounting
Examples are given below:
- A company has the policy to give cash against unutilized credit leaves of employees at the end of the year. So, the company needs to estimate the number of leaves the company has to pay for in the near future. Prudence makes sure that the company makes provision for the same with corresponding recognition of expenses.
- A trade agreement with a customer is under process. There is a high possibility of crystalizing the agreement. Even if the agreement is finally made, prudence will make sure that the company does not recognize revenue unless it actually starts selling the products under the agreement. Also, there should be no doubt about the realization of revenue.
- Trade receivables reflect the amount an organization will realize in a year. But do all debtors pay on time? Can’t say so! You never know which debtor may go bankrupt in the near future. Thus, prudence ensures that the company makes provisions for bad & doubtful debts.
- In respect of inventory valuation, the Internal Accounting Standards suggest valuing the inventory at cost or net realization value, whichever is low. Say, the cost incurred to date is $ 15000 and it can be sold in the market at $ 28000 after incurring the expense of $ 3000. Thus, here the cost is $ 15000 and the net realizable value is $ 25000 (28000 -3000). The inventory is valued at $ 15000 being lower by two.
- A company has investments to the tune of $ 105,000 (Cost). It can be sold in the market at $ 135,000. But you cannot show the investments at $ 135,000 by recognizing the profit of $ 30,000. You cannot overstate the assets. The investments will still be presented at $ 105000 only.
Uses and Importance of Prudence Concept in Accounting
- The prudence concept helps to delay the recognition of revenue unless there is sufficient certainty about the realization of revenue. Though this approach is restrictive in nature, it makes sure that the preparer does not unduly inflate the revenue without certainty.
- Due to the prudence concept, the objective of financial statements (i.e. true and Fairview) is achieved.
- If there is a probable chance of expense to occur in the near future, prudence makes sure (through accounting standards) that the appropriate provisions are made. Thus, it ensures the completeness of accounting.
- The conservative approach of prudence ensures that financial statements are appearing less encouraging so that stakeholders do not build fake hopes. Thus, financial statements are presented on a little downside than the actual position.
Applications of Prudence Concept in Accounting
The prudence concept in accounting is used in various accounting conventions and figures in financial statements.
A few of the applications are enlisted below:
1. Recognition of Revenue
As per prudence, prospective income should not be recognized unless there are transactions (and not just events) that justify the certainty of the realization of revenue. This ensures that the revenue (so does the profits) are not overstated unduly without a base.
For example, a company deals in the manufacture and sale of sanitizers. It is expected to receive a sales order from the federal government department and so a tender is submitted. As of the closing date, no tender is approved, no agreement is made, no manufacturing order is started, no advance is received, no supply arrangements are made, etc. If you see, nothing has flourished till the end of the year. Thus, the company can not recognize that revenue unless the sale of sanitizers has actually started.
2. Recognition of Expenses
Prudence works in favor of expenses by not understating the same. It ensures that if it is possible for expenses to be incurred, it makes sure that the organization provides for such expenses.
For example, the employees of the organization will retire 10 years from now. At the time of retirement, few retirement benefits are ought to be given as per the labor laws. Thus, the organization is required to make provisions at the end of every year with no scientific basis.
3. Recognition of Assets
Prudence makes sure that assets are not overstated. Thus, the value of the asset should reflect the cost or near about value of realization
For example, Inventory is valued at cost or net realizable value, whichever is low. Provisions are made for bad & doubtful debts and are shown as the reduction from the gross figure of trade receivables.
4. Recognition of Liabilities
As per prudence, liabilities should not be understated. Thus, the value of liabilities will always be on the higher side than what it should be. For example, employees are about to retire. When the expense for the same is recorded, the corresponding liability should also be recognized.
Advantages and Disadvantages
Below are the advantages and disadvantages :
Advantages
Some of the advantages are given below:
- It ensures the correct measuring of expenses
- It ensures completeness in estimating the liabilities of the organization.
- Prudence is a fundamental accounting, which is the base for financial statements.
- It helps the financial statements to show a more realistic picture of the expenses, assets, liabilities, and revenue.
- It helps in the proactive recognition of expenses and liabilities. This helps the organization envision the future & prepare for it today.
- Lower profits help increase cash reserves.
- Provisions for business expenses are allowed under income tax laws and thus, it reduces the tax liability.
Disadvantages
Some of the disadvantages are given below:
- It doubts the revenue-collecting ability of the organization and thus it fears recording the revenue.
- When the provisions are no more required, the other accounting conventions suggest writing off the provision in a certain year. This inflates the income side & increases tax liability in certain years.
- Prudence is favored only towards the liabilities and expenses side.
- Provision is a matter of management judgment and thus, they may reflect excess provisions even if not required though.
Conclusion
“Expecting the worst to happen” is different than “preparing for the worst if it happens”.
Being prudent means preparing for the worst if it happens. The concept makes sure that you honor liabilities first irrespective of expectations for the revenue side. Thus, it ensures you have appropriate provisions at the end of each year. Prudence has the capacity to change the whole picture of the financials & thus, it has wide importance in the preparation of final accounts.
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