EDUCBA

EDUCBA

MENUMENU
  • Free Tutorials
  • Free Courses
  • Certification Courses
  • 250+ Courses All in One Bundle
  • Login

Prudence Concept in Accounting

By Ratnesh SharmaRatnesh Sharma

Home » Finance » Blog » Corporate Finance Basics » Prudence Concept in Accounting

Prudence Concept in Accounting

Introduction to Prudence Concept in Accounting

Prudence concept in accounting (also known as conservatism) is a fundamental accounting concept which is based on the conservative approach of estimating the liabilities, expenses losses (i.e. cash outflow side) in a proactive manner and of estimating the assets, revenues and profits (i.e. cash inflow side) in a retroactive manner so that the liabilities are not understated and assets are not overstated.

Explanation

  • Prudence concept is the fundamental concept of accounting which states that the liabilities, expenses, and losses should never be understated.
  • Prudence states that if the liabilities are under-recorded, it may result in a huge outflow of resources at a time when the liability out-bursts. This results in an unusual movement in the income statement & cash flow statement. Thus, to avoid this situation, prudence suggests that as time passes each year, the organization should start making provision for probable liabilities, expenses, and losses in the near future. This will ensure that only a single accounting period does not suffer at a stroke.
  • On the very other hand, prudence states that the revenues, profits, and assets should not be overstated. Why so? Let’s discuss this. If you start overstating the income side, then the probable profit you at which you arrive at, will be on the higher side. Higher profits give fake confidence to investors. In the wake of higher profits, why the cash flows are still low? Year on year, it will show that the organization is incapable to recover its revenue. This also shows an inappropriate picture of current assets. So, as to avoid this situation, the assumption of prudence helps around.
  • Prudence increases the confidence of various stakeholders. It is a conservative approach of accounting since it is proactive only in respect of accounting for losses, expenses, and liabilities.
  • The concept revolves around the logic that the profits, assets & revenue should not be overstated (i.e. record it only when there is complete confidence about the recoverability of revenue, usage of assets and realization of profits) and the expenses, liabilities & losses are not understated (i.e. record these even if the chance of occurrence is low).
  • Thus, expenses should be recorded as early as possible but revenues should be recorded only when there is a certainty.

Examples of Prudence Concept in Accounting

Examples are given below:

Start Your Free Investment Banking Course

Download Corporate Valuation, Investment Banking, Accounting, CFA Calculator & others

  1. A company has the policy to give cash against unutilized credit leaves of employees as at the end of year. So, the company needs to estimate the number of leaves the company has to pay for in the near future. Prudence make sure that the company make provision for the same with corresponding recognition of expenses.
  2. A trade agreement with a customer is under process. There is a high possibility of crystalizing the agreement. Even if the agreement is finally made, prudence will make sure that the company does not recognize revenue unless it actually starts selling the products under the agreement. Also, there should be no doubt in the realization of revenue.
  3. Trade receivables reflect the amount an organization will realize in a year. But do all debtors pay in time? Can’t say so! You never know which debtor may go bankrupt in the near future. Thus, prudence ensures that the company makes provision for bad & doubtful debts.
  4. In respect of inventory valuation, the Internal Accounting Standards suggests to value the inventory at cost or net realization value, whichever is low. Say, the cost incurred till date is $ 15000 and it can be sold in the market at $ 28000 after incurring the expense of $ 3000. Thus, here the cost is $ 15000 and the net realizable value is $ 25000 (28000 -3000). The inventory is valued at $ 15000 being lower of two.
  5. A company has investments to the tune of $ 105,000 (Cost). It can be sold in the market at $ 135,000. But you cannot show the investments at $ 135,000 by recognizing the profit of $ 30,000. You cannot overstate the assets. The investments will still be presented at $ 105000 only.

Uses and Importance of Prudence Concept in Accounting

  • Prudence concept helps to delay the recognition of revenue unless there is sufficient certainty about the realization of revenue. Though this approach is restrictive in nature, it makes sure that the preparer does not unduly inflate the revenue without certainty.
  • Due to the prudence concept, the objective of financial statements (i.e. true and Fairview) is achieved.
  • If there is a probable chance of expense to occur in the near future, prudence makes sure (through accounting standards) that the appropriate provisions are made. Thus, it ensures completeness of accounting.
  • Due to the conservative approach of prudence, it ensures that financial statements are appearing less encouraging so that stakeholders do not build fake hopes. Thus, financial statements are presented on a little downside than the actual position.

Applications of Prudence Concept in Accounting

Prudence concept in accounting is used in various accounting conventions and figures in the financial statements.

Few of the applications are enlisted below:

1. Recognition of Revenue

As per prudence, prospective income should not be recognized unless there are transactions (and not just events) that justify the certainty of the realization of revenue. This ensures that the revenue (so does the profits) are not overstated unduly without a base.

For example, a company deals in the manufacture and sale of sanitizers. It is expected to receive a sales order from the federal government department and so a tender is submitted. As on the closing date, no tender is approved, no agreement is made, no manufacturing order is started, no advance is received, no supply arrangements are made for, etc. If you see, nothing has flourished till the end of the year. Thus, the company can not recognize that revenue unless the sale of sanitizers has actually started.

2. Recognition of Expenses

Prudence works in favour of expenses by not understating the same. It ensures that if there is possibly for expenses to be incurred, it makes sure that the organization provides for such expense.

For example, the employees of the organization will retire 10 years from now. At the time of retirement, few retirement benefits are ought to be given as per the labor laws. Thus, the organisation is required to make provision at the end of every year no scientific basis.

Popular Course in this category
Sale
Business Valuation Training (16 Courses)16 Online Courses | 80+ Hours | Verifiable Certificate of Completion | Lifetime Access
4.5 (9,560 ratings)
Course Price

View Course

Related Courses
Equity Research Training (17 Courses)Project Finance Training (8 Courses with Case Studies)

3. Recognition of Assets

Prudence make sure that assets are not overstated. Thus, the value of the asset should reflect the cost or near about value of realization

For example, Inventory valued at cost or net realizable value, whichever is low. Provisions are made for bad & doubtful debts and shown as the reduction from the gross figure of trade receivables.

4. Recognition of Liabilities

As per prudence, liabilities should not be understated. Thus, the value of liabilities will always be on a higher side than what it should be. For example, employees are about to retire. When the expense for the same is recorded, the corresponding liability should also be recognized.

Advantages and Disadvantages

Below are the advantages and disadvantages :

Advantages

Some of the advantages are given below:

  • It ensures the correct measuring of expenses
  • It ensures completeness in estimating the liabilities of the organization.
  • Prudence is a fundamental accounting, which is the base for the financial statements.
  • It helps the financial statements to show a more realistic picture of the expenses, assets, liabilities, and revenue.
  • It helps in proactive recognition of expenses and liabilities. This helps the organization to envision the future & prepare for it today.
  • Due to lower profits, it helps increasing the cash reserves.
  • Provisions for business expenses are allowed under income tax laws and thus, it reduces the tax liability.

Disadvantages

Some of the disadvantages are given below:

  • It doubts the revenue-collecting ability of the organization and thus it fears to record the revenue.
  • When the provisions are no more required, the other accounting conventions suggest for writing off the provision in a certain year. This inflates the income side & increases tax liability in certain years.
  • Prudence is favoured only towards the liabilities and expenses side.
  • Provision is a matter of management judgment and thus, they may reflect excess provisions even if not required though.

Conclusion

“Expecting the worst to happen” is different than “preparing for the worst if it happens”.

Being prudent means preparing for the worst if it happens. The concept makes sure that you honour liabilities first irrespective of expectations for the revenue side. Thus, it ensures you to have appropriate provision at the end of each year. Prudence has the capacity to change the whole picture of the financials & thus, it has wide importance in the preparation of final accounts.

Recommended Articles

This is a guide to Prudence Concept in Accounting. Here we also discuss the uses and importance of prudence concept in accounting along with advantages and disadvantages. You may also have a look at the following articles to learn more –

  1. Relevance in Accounting
  2. Accounting Cycle
  3. Types of Accounting
  4. Conservatism Principle of Accounting

All in One Financial Analyst Bundle (250+ Courses, 40+ Projects)

250+ Online Courses

40+ Projects

1000+ Hours

Verifiable Certificates

Lifetime Access

Learn More

0 Shares
Share
Tweet
Share
Primary Sidebar
Finance Blog
  • Corporate Finance Basics
    • BPO vs KPO
    • C Corporation
    • Brick and Mortar
    • Business Entity Concept
    • Bounced Check
    • Capital Maintenance
    • Bridge Financing
    • Business Exit Strategy
    • Callable Bonds
    • Affiliated Companies
    • Certified Check
    • Chattel Mortgage
    • Contingent Beneficiary
    • Debt Collector
    • Closed Corporation
    • Cumulative Voting
    • Consumer Loan
    • Commercial Loans
    • Collateralization
    • Commercial Credit
    • Collection Agency
    • Classification of Financial Markets
    • Class Action Lawsuits
    • Prudence Concept in Accounting
    • Calmar Ratio
    • Asset Classes
    • Audit Evidence
    • Contingent Liability
    • Employee Stock
    • Financial Liabilities
    • Incurred Cost
    • Partial Income Statement
    • Deferred Tax Asset
    • Tax Fraud
    • Non-Operating Income
    • Variable Costing
    • Mixed Cost
    • Prime Cost
    • Regressive Tax Examples
    • Unqualified Opinion of Auditor
    • Bonds Payable
    • Class A Shares
    • Contingent Liability Example
    • Contingent Shares
    • Contributed Capital
    • Brownfield Investment
    • Internal Audit
    • Indirect Taxes
    • Fund Management
    • Fixed Cost
    • Debt Equity Swap
    • Cash Flow Hedge
    • Risk Shifting
    • High Yield Investments
    • General Obligation Bond
    • Forward Market
    • Box Spread
    • Fixed Income Trader
    • Trade Discount
    • Quick Assets
    • Notes Payable
    • Revenue Bonds
    • Euribor
    • Settlement Date
    • Short Covering
    • Short Selling
    • Dividend Examples
    • Time to Market
    • Junior Accountant
    • Commodity Derivatives
    • Flash Report
    • Idle Time
    • Leasehold Improvement
    • Product Portfolio
    • Risk Parity
    • Branch Accounting
    • Credit Enhancement
    • Basis Trading
    • At the Money
    • Accounts Receivable
    • Long Term Investments
    • Negative Goodwill
    • Recourse Factoring
    • Residual Value
    • Short Term Loan
    • Tax Exempt
    • Audit Report Format
    • Cash Investment
    • 457 Plan
    • Audit Procedure
    • Audit Materiality
    • Audit Committee
    • Asset Allocation
    • Non-Cash Expenses
    • Dividend Policy Types
    • Credit Terms
    • Dividend Payable
    • Profit Center
    • Absorption Costing
    • Final Dividend
    • Hybrid Securities
    • Other Current Assets
    • Simple Random Sample
    • Dependency Ratio
    • Effective Duration
    • Loan to Value Ratio
    • Inventory Turnover Ratio
    • Advantages of Ratio Analysis
    • Loss Ratio
    • Delaware Corporation
    • Articles of Incorporation
    • Negative Covenants
    • Statutory Liquidity Ratio
    • Leverage Ratio for Banks
    • Accrued Liabilities
    • Activity Ratio
    • Debt Service Coverage Ratio
    • Return on Investment Ratio
    • Turnover Ratios
    • Cash Conversion Cycle
    • Lumion vs V-Ray
    • Capital Intensive
    • Voided Check
    • Negotiable Instruments
    • Portfolio Optimization
    • 401k Plan
    • Non-Marketable Securities
    • Stock Certificate
    • Treasury Stock
    • Appropriate Retained Earnings
    • Stockholder
    • Share Vesting
    • Shares Issued
    • Preferred Shares
    • Share Buyback
    • Shareholder Types
    • Tax Loss Harvesting
    • Statutory Audit
    • Audit Risk
    • Fund of Funds
    • Accredited Investor
    • Cost Centre
    • Lessee
    • Golden Handcuffs
    • Ordinary Shares
    • Restricted Stock Units
    • Goodwill Valuation
    • Share Classes
    • Lessor
    • Preferred Dividends
    • LIFO Liquidation
    • Dilutive Securities
    • Restructuring Cost
    • Non-Cumulative Preference Shares
    • Pass Through Entity
    • Management Discussion and Analysis
    • Premium on Stock
    • Leveraged Loans
    • Dividend
    • Dividend Policy
    • Financial Reporting Objectives
    • Financial Reporting
    • Internal Controls
    • Capital Investment
    • Debt to Equity Ratio
    • Dividend Growth Rate
    • Market Capitalization
    • Deal Origination
    • Importance of Working Capital
    • SWOT Analysis
    • White Knight
    • Root Cause Analysis
    • Realized Gain
    • Return on Operating Assets
    • Offshore Investments
    • Transfer Price
    • Times Interest Earned Ratio
    • Debt Coverage Ratio
    • Dividend Discount Model
    • Combined Ratio
    • Merger Arbitrage
    • Gordon Growth Model
    • Advantages of Joint Venture
    • Interest Coverage Ratio
    • Reserve Requirements
    • Asset Turnover Ratio
    • Price to Rent Ratio
    • Ratio Analysis Types
    • Debt Ratio
    • Business Risk
    • Financial Leverage
    • Dividend Payout Ratio
    • Mistakes in DCF
    • Risk/Reward Ratio
    • Full Form of FIPB
    • Financial Risk
    • CAPE Ratio
    • Overcapitalization
    • Systematic Risk
    • Hedge Ratio
    • Full Form of NHB
    • Sensitivity Analysis
    • Current Ratio
    • Corporation Examples
    • Asset to Sales Ratio
    • Balance Sheet Ratios
    • List of Financial Ratios
    • Coverage Ratio
    • Forward PE Ratio
    • Interpretation of Debt to Equity Ratio
    • Capitalization Ratio
    • Importance of Ratio Analysis
    • Quick Ratio Interpretation
    • Corporate Finance Basics
    • PEG Ratio
    • Corporate Finance Interview Questions
    • Price to Earnings Ratio
    • Structured Note
    • Limitations of Ratio Analysis
    • NPV vs IRR
    • IRR vs ROI
    • Imputed Interest
    • Full Form of HR
    • Shareholders Agreement
    • Earnings Per Share
    • Corporate Finance Jobs
    • About Corporate Finance
    • Corporate Finance Theory & Practices
    • Career in Corporate Finance
    • Simple Interest Rate vs Compound Interest Rate
    • Stocks vs Shares
    • Bonds vs Debenture
    • Bull Market vs Bear Market
    • Mortgagee vs Mortgagor
    • Horizontal Integration vs Vertical Integration
    • Money Market vs Capital Market
    • Leveraged vs Unleveraged
    • Dividends vs Capital Gains
    • Present Value vs Net Present Value
    • Qualified vs Ordinary Dividends
    • ROE vs ROA
    • Bond vs Loan
    • Stock Dividend vs Stock Split
    • Audit vs Assurance
    • Coupon Rate vs Interest Rate
    • Growth Stock vs Value Stock
  • Accounting fundamentals (658+)
  • Asset Management Tutorial (198+)
  • Banking (44+)
  • Credit Research Fundamentals (6+)
  • Economics (44+)
  • Finance Formula (382+)
  • Financial Modeling in Excel (13+)
  • Investment Banking Basics (120+)
  • Investment Banking Careers (26+)
  • Trading for dummies (67+)
  • valuation basics (27+)
Finance Blog Courses
  • Online Business Valuation Training
  • Equity Research Certification
  • Project Finance Course
Footer
About Us
  • Blog
  • Who is EDUCBA?
  • Sign Up
  • Live Classes
  • Corporate Training
  • Certificate from Top Institutions
  • Contact Us
  • Verifiable Certificate
  • Reviews
  • Terms and Conditions
  • Privacy Policy
  •  
Apps
  • iPhone & iPad
  • Android
Resources
  • Free Courses
  • Investment Banking Jobs Offer
  • Finance Formula
  • All Tutorials
Certification Courses
  • All Courses
  • Financial Analyst All in One Bundle
  • Investment Banking Training
  • Financial Modeling Course
  • Equity Research Course
  • Private Equity Training Course
  • Business Valuation Course
  • Mergers and Acquisitions Course

© 2022 - EDUCBA. ALL RIGHTS RESERVED. THE CERTIFICATION NAMES ARE THE TRADEMARKS OF THEIR RESPECTIVE OWNERS.

EDUCBA
Free Investment Banking Course

Corporate Valuation, Investment Banking, Accounting, CFA Calculator & others

*Please provide your correct email id. Login details for this Free course will be emailed to you

By signing up, you agree to our Terms of Use and Privacy Policy.

EDUCBA
Free Investment Banking Course

Corporate Valuation, Investment Banking, Accounting, CFA Calculator & others

*Please provide your correct email id. Login details for this Free course will be emailed to you

By signing up, you agree to our Terms of Use and Privacy Policy.

EDUCBA Login

Forgot Password?

By signing up, you agree to our Terms of Use and Privacy Policy.

Let’s Get Started

By signing up, you agree to our Terms of Use and Privacy Policy.

EDUCBA

*Please provide your correct email id. Login details for this Free course will be emailed to you

By signing up, you agree to our Terms of Use and Privacy Policy.

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy

Loading . . .
Quiz
Question:

Answer:

Quiz Result
Total QuestionsCorrect AnswersWrong AnswersPercentage

Explore 1000+ varieties of Mock tests View more

Special Offer - Online Business Valuation Training Learn More