Prudence concept

Prudence concept
See also
Accounting Convention Accounting policies Non operating asset Comparative statements Materiality principle Creative accounting Conservatism principle Reporting entity Stock-taking

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.

International Accounting Standards (IAS) and Generally accepted accounting principles (GAAP) take into account the concept of prudence in many standards.

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.

Example of prudence concept use

Let's say a company purchases a machine for $100,000 with the intention of using it for 10 years. Under the prudence concept, the machine must be recorded as an asset on the balance sheet, but the cost of the machine must be depreciated over the 10-year life of the machine. This means that the company will record the purchase of the machine as an asset for $100,000, but over the 10-year period, the company will record the cost of the machine at a rate of $10,000 per year as an expense. This ensures that the company's financial statements are accurate, reliable and free from bias.

Main assumptions and goals of prudence concept

Fig.1. The accounting principles

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.

Arguments for importance of prudence concept

• Reliability: The prudence concept ensures that financial statements are reliable and free from bias. This is because only those transactions and events that are certain are included in the financial statements.
• Transparency: The prudence concept requires that all transactions are recorded in a transparent manner. This allows for the financial statements to be easily understood by the users and helps to ensure that all information disclosed is complete, accurate and verifiable.
• Comparability: The prudence concept ensures that the same accounting principles are applied across all entities. This helps to ensure that the financial statements are comparable and reliable.
• Objectivity: The prudence concept encourages the use of objective data when preparing financial statements. This helps to ensure that information is reliable and free from bias.
• Timeliness: The prudence concept ensures that financial statements are prepared in a timely manner, as information is not delayed for uncertain events. This allows for more accurate and up-to-date financial information to be available.

Benefits of prudence concept

• Timeliness: The prudence concept ensures that financial statements are prepared in a timely manner, as information is not delayed for uncertain events. This allows for more accurate and up-to-date financial information to be available.
• Accuracy: The prudence concept helps to ensure that financial statements accurately record the financial position of entities. This is because only transactions and events that are certain will be included in the financial statements.
• Transparency: The prudence concept requires that all transactions are recorded in a transparent manner which allows for the financial statements to be easily understood by the users. It also helps to ensure that all information disclosed is complete, accurate and verifiable.
• Objectivity: The prudence concept encourages the use of objective data when preparing financial statements. This helps to ensure that information is reliable and free from bias.
• Consistency: The prudence concept ensures that the same accounting principles are applied across all entities. This helps to ensure that the financial statements are comparable and reliable.

Limitations of prudence concept

• Overly Conservative: The prudence concept can lead to financial statements that are overly conservative. This is because only transactions and events that are certain will be included in the financial statements. As a result, potential gains can be understated.
• Lack of Flexibility: The prudence concept can lead to a lack of flexibility when recording transactions as only those that are certain can be included. This means that entities may be unable to record certain transactions that may be beneficial in the long term.
• Subjectivity: The prudence concept can lead to subjectivity when recording transactions, as some judgement may be required to determine whether a transaction is certain. This can lead to errors in the financial statements if the judgement is incorrect.
• Discourages Risk Taking: The prudence concept may discourage entities from taking risks as potential losses are recorded as soon as they occur. This may lead to entities being overly conservative in their decision making.
• Reduced Cash Flow: The prudence concept may reduce the cash flow of entities as potential gains are not recorded until they are realized. This can lead to a lack of funds for entities to invest in growth.

Other accounting principles

• Accrual Principle: This principle requires that revenue and expenses are recorded in the period in which they are incurred, rather than when cash is received or paid.
• Matching Principle: This principle requires that expenses be matched with the related revenue for the same period.
• Going Concern Principle: This principle assumes that the business will continue to operate for the foreseeable future.
• Cost Principle: This principle requires that assets are recorded at their original cost.
• Full Disclosure Principle: This principle requires that all relevant information is disclosed in the financial statements.
• Relevance Principle: This principle requires that information provided in the financial statements is relevant and reliable.
• Materiality Principle: This principle requires that only transactions and events that are material are recorded in the financial statements.

References

• 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.
• Ryan B., (2004), Finance and Accounting for Business, Thomson Learning, United Kingdom.
• Sangster A., Wood F., (2018), Frank Wood's Business Accounting, Tom 1, Pearson Education Limited, United Kingdom.
• Weil S., Noi H., (2004), Introductory Accounting Skills: For Financial and Management Accounting Students, Juta Education, South Africa.

Author: Dominika Pszonak