As per the prudence concept in accounting, a firm should not overestimate its revenues, assets, or profits, nor should it underestimate its obligations, losses, or expenses.
The prudential principle is a fundamental accounting concept that increases the dependability/usability of a company’s financial statements. In the final accounts of a firm, all data that significantly impact the company’s income and expenses should always be presented with care. This means that while reporting profits, sales, and assets, the preparer must always be careful and record them only after they have been realized.
A proactive approach to recognition
In terms of recognizing commitments, losses, and expenses, a business must always adopt a proactive posture. Simply put, the corporation must not undervalue its losses and expenses and must record provisions even if there is a possibility that they may materialize. Unless sufficient evidence is acquired, it must also not overstate its profits and assets. Although it may seem that the concept of caution requires the organization to record all less-than-ideal conditions, this is not the case. The concept essentially calls for financial statements to offer a true perspective on every conceivable event that might impact the decisions of financial statement readers. Numerous International Accounting Standards (IAS) and Generally Accepted Accounting Principles (GAAP) standards include the concept of caution.
Recognition of Assets
Prudence prevents assets from becoming overvalued. The asset’s value should thus resemble its cost of realization.
For example, inventory may be valued at either its cost or its net realizable value, whichever is lower. Provisions for bad and doubtful debts are made and subtracted from the overall amount of trade receivables.
Also read, what is NRV testing.
Recognition of liabilities
Good judgment dictates that liabilities must not be underestimated. Consequently, the value of liabilities will constantly exceed what it should be. For example, employees are preparing to retire. The accompanying obligation must be recorded concurrently with the associated expenditure.
Advantages of prudence concept
Listed below are some of the advantages:
- It ensures precise cost measurement.
- It ensures the correctness of the organization’s obligation calculations.
- Prudent accounting is the basis of accounting, upon which the financial statements are constructed.
- It contributes to a more accurate representation of expenses, assets, liabilities, and revenue in the financial statements.
- It helps to identify expenses and liabilities early on. This assists the company in anticipating the future and preparing for it immediately.
- Reduced earnings lead to an increase in cash on hand.
- The income tax code allows deductions for business expenses, therefore reducing the tax liability.
Disadvantages of prudence concept
The following are some disadvantages:
- It is hesitant to report the revenue because it is concerned about the organization’s ability to collect funds.
- Other accounting methods recommend wiping off the provision in the year in which it is no longer required. This increases the income and, in certain years, the tax liability.
- Only on the assets and expenses side is prudence advised.
- Provisions are subject to management discretion; therefore, they may indicate excess even if they are unnecessary.
Being careful requires anticipating the worst-case situation. Despite expectations for the revenue side, the concept guarantees that debts be paid off first. Therefore, it ensures that you will have sufficient funds at the end of each year. Prudence can modify the whole financial picture, making it essential when preparing final accounting.