Where the term 'prudence' means being responsibly cautious, the same meaning transfers when applied to the world of accounting. The so-called prudence concept in accounting is a useful way of quantifying caution to achieve more accurate figures. This is why we've compiled this short guide to what the prudence concept is, its application to accounting and finance, as well as its advantages and disadvantages.
Prudence Concept Definition
The prudence concept refers to a crucial principle used in accounting to ensure that income and assets are not overstated in financial statements. Alternatively known as the conservatism principle, it also makes sure that liabilities are not understated and provisions are made for income and losses.
The prudence principle is, for example, applied when a company is expecting bad or doubtful debts. Here, the business creates a special contra asset to accounts receivable called allowance for bad debts. This ensures that the accounts receivable balance shows a realistic figure of anticipated profits or losses. The accounting prudence concept can also be helpful if there are certain liabilities of a company that are very likely to occur, but not certain. In this case, it is possible to try and judge the probability of this liability occurring, and if that is more than 50%, to record a liability and corresponding expense.
What Is The Prudence Concept in Accounting and Financial Planning?
In accounting and financial planning, the prudence concept is applied to ensure that profits are not anticipated and all possible losses are provided for. This ranges from contracts not yet won by a company to bad and doubtful debts. As one of the generally accepted accounting principles, the prudence concept does differ from traditional accounting, as it does not anticipate profits. While it may undervalue a company's profits and therefore not excite shareholders, it can help create a more realistic picture of a company's financial health. The prudence concept is recognized in many international accounting standards.
The preparer of a business's financial statements (e.g., balance sheet or income statement) must choose a conservative approach when looking at prospective income, but proactively recognize and identify any potential liabilities, losses, and expenses.
This may sound like the prudence concept asks business owners and accountants to be overly pessimistic, but it does not. When running a business there are lots of numbers to take into consideration. Some of these will be based on physical cash available but some will be based on projections and forecasts. The prudence concept simply means you are only taking into account the money available at the time of reporting.
What Are The Advantages of the Prudence Concept?
There is a number of advantages in working with this key accounting principle:
- It ensures that a company's financial reporting is realistic.
- It stops projections and forecasts from being unrealistic.
- It paints a cautious and realistic picture of a company's market value.
- It helps prevent cash flow issues.
- It helps create a situation where a company is not relying on high interest and bridging loans to cover their expenses and liabilities.
- It helps prevent unexpected large expenses that may cause a business to go into bankruptcy.
- It helps to not overestimate or underestimate the company's financial risk.
What Are The Disadvantages of Prudence Concept Accounting?
However, there is also a number of disadvantages to be aware of when applying the prudence concept to your company's financial statements:
- It can sometimes make a profit look less profitable than it is which can look unattractive to investors and alarm shareholders.
- It can cause inconsistency in reporting numbers if you switch to this method after another has been established - after all, the caution applied to recording profits can make financial statements look very different.
- Low numbers can distort the image of your company's financial health and possibly worry your employees.
- It may result in the creation of reserve funds and because these will be inaccessible, this may have a negative impact on your company’s liquidity.
- The prudence concept does not always lead to correct figures.
Prudence Concept FAQs
- What is the importance of the prudence concept in accounting?
The prudence concept in accounting helps create a realistic picture of a company's financial position. It ensures that income and assets are not overstated and liabilities are not understated in financial statements as well as that provisions are made for income and losses.
- What are recognized revenues?
The revenue recognition principle ensures that revenues are recognized when realized and earned, not when the cash is received.
- What are recognized expenses?
According to the principle of expense recognition, any expense should not be recognized until any related revenue is also recognized.
- What is the prudence conservatism concept?
The prudence conservatism concept, also known as the prudence concept ensures that income and assets are not overstated and liabilities are not understated in financial statements.