It is normal in accounting that in certain areas, uncertainties are involved which require the management to make estimates, so that income and expenses are recorded in the period to which they relate. While making these estimates, accountants are required to make judgements to choose between available alternatives. Prudence concept requires that a relatively cautious approach should be adopted in making accounting estimates and judgments, so that income and assets are not overstated, and expenses and liabilities are not understated.
Prudence concept, which is also known as conservatism principle, requires that if there are two or more available alternatives, accountants should choose the alternative which will result in lesser net income. Purpose of this concept is to keep the business on a safer side and record expense and losses when it is anticipated that the company will have to bear economic outflow of benefits, but don’t record anticipated income and gains as they can have an adverse impact on the business if the anticipation is not realized.
Let’s take a look at the following examples to get a better picture of prudence concept.
- A lawsuit against an entity is pending adjudication in which it is anticipated that the entity might have to pay the penalty of $40,000. Being prudent, provision for potential loss in the form of penalty should be recorded as an expense.
- An entity has filed a lawsuit against a supplier in which it is anticipated that the entity might receive $40,000 as compensation from supplier. Being prudent, it should NOT be recorded as an income and the entity should wait until the case has been decided in the favour of the entity and its right to receive the amount has been established.
- Recoverability of trade receivables is often scrutinized and an allowance or provision is created for doubtful debts so that assets are not overstated. This is also as per prudence concept of accounting.
- At the reporting date, an entity’s finished goods inventory is carried at a cost of $10,000. Due to change in market conditions, inventory’s net realizable value has dropped and it is expected that it will only be sold at $8,000. Being prudent, inventory is written down and a loss of $2,000 is recorded at the reporting date.
- At the reporting date, an entity’s finished goods inventory is carried at a cost of $10,000. It is expected that it will be sold for $15,000 or more. Being prudent, potential gains are NOT recorded and inventory will be carried at its cost of $10,000.
- Similarly, fixed assets and intangibles are periodically evaluated for impairment, to ensure that fixed assets and intangibles are not overstated (represented at more than their recoverable amounts).