Prudence concept (otherwise the principle of conservatism) is a fundamental accounting concept, increasing the reliability of numerical data presented in company reports, consisting in the obligation to register expenses and other liabilities as quickly as possible, while revenues only in situations where there is certainty about their implementation or a guarantee appears.
Preparation of financial statements requires professional judgment in accounting and estimation. Accountants are required to be prudent and careful when accounting for an entity's income so that they are not overstated. The optimistic attitude of the management often leads to an inflow of planned income and understatement of profits, which leads to overstating the company's profitability and lowering its debt. Prudence concept comes as help here as one of the creative accounting techniques, it prevents bias and requires caution in estimating and adopting accounting principles.
Main assumptions and goals od prudence concept
Its main purpose is prudence and objectivity, which eliminate the overestimation of revenues and assets and avoiding a disrespectful approach to losses and liabilities. Thanks to this, financial statements illustrate reality and clearly show the company's situation. It should be remembered that this rule is only a guideline and when making decisions you should also include other factors that the prudence concept assumptions do not assume.
Prudence concept convinces you to delay recognition of a revenue or asset transaction until it is uncertain. In short, prudence in this conservancy consists in this, but not recognizing profits until they arise, or at least maximally delaying their recognition until transactions are uncertain. It is also worth regularly reviewing assets and liabilities to check their value, whether it has risen or may have dropped.
Anyway, the prudence concept does not force to save the current situation in the least favorable way. This is a realistic approach to the upcoming gains and commitments and their objective evaluation.
Thanks to this type of prudence, in case of doubts regarding bills or other expenses, registering this in the report allows you to make a monetary reserve to pay for these expenses in the future.
Advantages and disadvantages
Prudence concept has many advantages, and the most important of them are:
- Ensures that the financial statements present a realistic and fair view of the company's revenues and liabilities.
- It helps in minimizing losses.
- It helps you not overestimate or underestimate the company's financial risk.
- Allows the comparability of financial information.
Unfortunately, there are also disadvantages:
- A careful accounting concept does not always consist of correct facts.
- The concept of caution cannot be applied to cultures that are outside of IFRS or GAAP.
- The company may try to create rules that are not actually required, which may result in the creation of certain secret reserves.
- BPP Learning Media, 2012, ch. 8
- Law J., 2016, p. 491
- BPP Learning Media, 2012, ch. 5
- Ryan B., 2004, p. 108
- Law J., 2016, p. 7
- Dodge R., 1997, p. 83
- Weil S., 2004, p. 178
- Weil S., 2004, p. 176
- BPP Learning Media, (2012), FIA Maintaining Financial Records - FA2 Study Text-2013, BPP Learning Media, United Kingdom.
- Dodge R., (1997), Foundations of Business Accounting, International Thomson Business Press, United Kingdom.
- Law J., (2016), A Dictionary of Business and Management, Oxford University Press, United Kingdom.
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- Weil S., Noi H., (2004), Introductory Accounting Skills: For Financial and Management Accounting Students, Juta Education, South Africa.
Author: Dominika Pszonak