The prudence concept in financial accounting
In financial accounting, there are basic concepts that govern the preparation of financial statements. Prudence is one of several basic concepts used for that purpose. It suggests that assets or revenue should not be overstated. On the flip side, liabilities and expenses should not be understated either.
The aim of the prudence concept is to reflect the least favourable position of a business. To those unfamiliar with the concept, it might seem strange to want to do this. After all, a healthy position can work in a business’ favour sometimes. This principle is important in facilitating faithful representation – ensuring that financial statements do not mislead or give false optimism to their various users. As such, the prudence concept is a fundamental accounting principle, with the first International Accounting Standard (IAS I) outlining its role.
In accounting, there are sometimes many routes to one result. For example, you can value an asset according to Net Realisable Value or Replacement Cost. Or you have different ways of evaluating stock and estimating depreciation of an asset. In cases such as these, the prudence concept suggests that the chosen method should provide the most conservative result. This is seen in stock valuation, where stick is valued at cost and not revenue potential.
Where expenses and liabilities are concerned, prudence suggests the opposite. A liability or expenses need only be expected or anticipated to be recorded. For instance, assume that a business has to pay insurance costs at the end of the calendar year. However, if the financial statement is prepared, it should take account of that expected expense. Organizations should deal with devalued stock and debt servicing accordingly.
This fundamental principle also applies to handling of profit or losses. A profit cannot be reported unless it is realized. For example, assume that a business purchases an asset. Overnight, the asset value soars; if the business sells the asset now, it would make a profit. However, unless it actually sells the asset for a profit, it should not be documented. In addition, profit should be in cash form (this makes it determinable) and should also be reasonably certain (to avoid speculative profits).
The prudence concept can conflict with other fundamental concepts – like the accruals basis of accounting. Accruals recognize transactions that have not yet been completed – like a hire purchase sale or prepaid expenses. In such cases, one principle (in this case, accruals) should prevail.
Prudence, along with other fundamental principles, creates a sound platform for accounting. However, note that it is no excuse for an organisation to withhold revenue or create hidden reserves. After all, that conflicts with the principle of Fair Presentation.