Prudence concept means the accountant needs to be pessimistic when showing business financial performance. It’s about being open-minded when recording liability/expenses but critical when recording assets/revenue. This helps ensure adequate financial performance is presented to the business stakeholders.  

In other words, the business must be conservative when estimating financial performance. The estimates should be more inclined towards showing reduced financial performance than inclined one.

Detailed understanding

When making estimates for the accounting record, the accountant must ensure they are not overstating revenue or profit. Instead, they must exercise due care and caution when recording revenue/assets, as these elements are expected to show inclined financial performance, which may be window dressing in reality.

Recording optimized/higher revenue and assets lead to window-dressed financial statements that might mislead financial statement users. Hence, accountants need to be pessimistic when recording revenue/assets. However, there is no harm in being optimistic when recording expenses/liability, but these items need to be genuine and true.

The theme of this concept is to remain conservative when showing financial performance. This principle is highly relevant when making accounting estimates, selecting accounting policies, and using judgment when needed.

Advantages of applying prudence concept in accounting

Following are some essential benefits of using the prudence concept in accounting.

1. Enhanced reliability of financial statements—Using the prudence concept in accounting leads to enhanced reliability/trust for financial statement users. It shows the user that the financial performance in the financial statement stands genuine/true, as controls were implemented against inflated financial performance. Higher reliability leads to higher investor confidence in the financial statement.
2. Compliance purpose—International accounting standards and regulators require companies to adhere to the prudence concept of accounting to ensure the accuracy and reliability of financial reporting.
3. Enhanced risk management—Appropriate implementation of the prudence concept ensures that the risk of overstated revenue/profit is managed to an acceptable level. It helps businesses gain the trust of stakeholders like banks, regulators, auditors, etc.

Disadvantages of the prudence concept

The following may be perceived as disadvantages of the prudence concept.

1. Being over-prudent can be challenging. Excess prudence can lead to undermined financial performance. For instance, free-hand recognition of expenses/liabilities can show deteriorated financial performance rather than reality.
2. Subjectivity in the estimating– Applying the prudence concept is a subjective matter. There is no clearly defined parameter if selecting the specific value ensures compliance with the prudence concept. Hence, it’s subjective, and being prudent can differ for different people, leading to inconsistencies when comparing businesses.
3. The concept can be confusing. When applying the prudence concept, the accountant can be over-cautious and understate the financial results. This might lead to understated profit, tax liability, and potential financial penalties from business regulators.

Areas where the prudence concept is frequently used

In the following areas of accounting, the prudence concept is frequently used.

1. Impairment testing—As per IAS 36, the business must test impairment for the assets recorded in the balance sheet. Impairment expense must be posted in the accounting books if the recoverable amount is less than the recorded cost. Hence, this accounting treatment is in line with the prudence concept.
2. NRV testing—As per IAS-2, the inventory will be valued at the lower cost and NRV. Selecting a lower value indicates that compliance with this accounting standard requires prudence application.
3. Doubtful receivable—The business must provide a provision or write off doubtful receivables. If the business is unsure about receiving funds against specific receivables, it must record bad debt expenses and remove receivables from the accounting books. Hence, removing doubtful receivables aligns with the prudence concept of accounting.
4. Recognizing claim to be received/paid—A claim to be received is only recognized when the business is highly confident. However, a claim to be paid needs to be recorded when it’s probable that the business will be required to make payment. Hence, this guideline of IAS-37 aligns with the prudence concept of accounting.

Key notes

Prudence’s accounting concept refers to being conservative when recording revenue/assets as part of a business estimate.

Compliance with this concept ensures that the risk of window dressed financial performance is reduced to an acceptable level.

Similarly, compliance with the concept leads to enhanced reliability in terms of relying on financial results and decision-making. However, this concept is subjective, and the extent to which financial statement is prudent can differ for different businesses.

This concept is in line with accounting standards such as IAS-2 (inventory valuation), IAS-37 (Provision, contingent assets & liabilities), and IAS-36 (impairment).