What is the Prudence Concept of Accounting?

prudence in accounting

Instead, what you are striving for is to record transactions that reflect a realistic assessment of the probability of occurrence. Thus, if you were to create a continuum with optimism on one end and pessimism on the other, the prudence concept would place you somewhat further in the direction of the pessimistic side of the continuum. When the expense for the same is recorded, the corresponding liability should also be recognized. Let’s assume that the shares were purchased purely for speculation purposes (i.e., in the hope that their price will rise and we will be able to sell them at a profit). However, complying to the prudence principles can be easily done in a financial modelling tool and can ease your manual workload. A tool like Brixx can ensure that the financial forecasting for your business is reported on with ease – simply needing a few data entries to be entered throughout the software.

For the accounting profession, an association with prudence was beneficial because it provided what Abbott (1988, p. 185) refers to as “legitimation,” identifying accountants not only with technical expertise but also with culturally approved moral virtues. By claiming ownership of the idea of prudence, the accounting profession was able to promote itself as the provider not only of technical assistance but also of neutral wisdom to the business community. The prudent accountant was, in effect, discharging his professional duties to society (Maltby, 2000).

What is the difference between prudence and conservatism?

Finally, we discuss historical debates concerning the concept of prudence in philosophy, legal theory, and economics. In specific terms, we address whether prudence constitutes a moral virtue or whether it is merely a technique for deciding between alternative courses of action. The primary argument of the chapter is that prudence has been an important moral virtue and a component of commercial and accounting practice throughout history, even though accounting standards setters have now relegated it to secondary importance. This chapter has explored the concept of prudence from multiple perspectives, including accounting theory and the history of ideas. The chapter has demonstrated that the concept of prudence has been pervasive throughout history and that it has played an important role in the evolution of social and economic life. The tension between a cautious view of prudence and an asymmetric view of prudence has also been discussed, a distinction which was introduced by the IASB (2015).

prudence in accounting

Overall, while the prudence concept can be useful in ensuring that financial statements accurately reflect potential losses and liabilities, it is important to consider the potential disadvantages and to apply it in a consistent and transparent manner. The prudence concept is subjective, and the extent to which a company should be conservative in its financial reporting can vary depending on the circumstances. This can lead to inconsistency in financial reporting and make it difficult for stakeholders to fully understand the company’s financial position. In other words, under the prudence concept, a liability should be recognized in the financial statements of an organization if there is a reasonable possibility that it exists, even if its occurrence is uncertain.

Asset impairment

Consequently, both the ancient Greek and Medieval philosophers considered prudence to be a moral virtue that provided the basis for deciding the best course of action among alternatives (for further discussion, see Hariman, 2003). The prudence Principles of Accounting is applied by recording all revenues, costs, and expenses only when they are likely to be realized or result in a liability. One must remember that the concept of prudence is concerned with being cautious, which means realizing revenues only when they are likely to be realized and booking losses as soon as the loss becomes likely to occur.

  • This means that if an expense is anticipated but not yet incurred, it should be visible in the financial statements.
  • The term “conservatism” was used to denote this third meaning, but the word “prudence” continued to be used because it was a way of giving moral sanction to conservatism.
  • Many actions in social settings may cause risks to others (e.g., driving an automobile), and unless the activity is to be completely forbidden, it would only be when the risk was unreasonably excessive (e.g., driving above the speed limit) that legal liability would be imposed.
  • Contingent assets are recognized only in rare circumstances, whereas contingent liabilities must be recognized if they are “more likely than not” to occur (ACCA, 2014).

The prudence Principles of Accounting is one of the most widely used and accepted criteria for preparation and reporting of Financial Statements. According to this principle, a business fully exercises good degrees of caution while booking incomes and expenses. Prudence would normally be exercised in setting up, for example, an allowance for doubtful accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an expense has not yet been identified, but a prudent person would record a reserve in anticipation of a reasonable amount of these expenses arising at some point in the future.

Why You Can Trust Finance Strategists

The German concept of vorsicht (prudence) is related to imparitätsprinzip (principle of imparity). This principle requires that gains be treated differently from losses, thus reflecting a preference for asymmetric prudence. There was also an emphasis on the protection of creditors as the main providers of finance (Evans, 2000).

prudence in accounting

Similarly, when a company owes money to another party, it must record the liability on its balance sheet. However, if there is any doubt about the future payment of the liability, the accountant should again play cautiously and record a higher value for the liability. This is because recording a lower value could understate the company’s liabilities and make it appear more financially stable than it actually is.

Recognition of expenses

Utilitarianism is an ethical theory that distinguishes between right and wrong actions based on the consequences of choosing a particular action rather than another action. In act-utilitarianism, the assessment of whether a given act is good or not good is applied to each alternative action when faced with a situation of choice. The correct rules are those which achieve the best results for the greatest number of people (Driver, 2014). Prudence, therefore, involves a capacity to act correctly with respect to the things that are beneficial for the furtherance of the good life. In the Medieval Period, Thomas Aquinas also discussed prudentia, which he described as the “right reason” (Aquinas, 1984).

Book Chapters

While the prudence concept is intended to prevent companies from overstating their profits, it can also be used to manipulate financial statements in the opposite direction. Companies may use the prudence concept to recognize potential losses or liabilities that may not actually materialize, which can create a false impression of financial health. The prudence concept can result in financial statements that are overly conservative, which may not accurately reflect the financial health of the company.