What is the Prudence Concept?

Under the prudence concept, do not overestimate the amount of revenues recognized or underestimate the amount of expenses. Also, you should be conservative in recording the amount of assets, and not underestimate liabilities. The result should be conservatively-stated financial statements.

Another way of looking at prudence is to only record a revenue transaction or an asset when it is certain, and record an expense transaction or liability when it is probable. In addition, you would tend to delay recognition of a revenue transaction or an asset until you are certain of it, whereas you would tend to record expenses and liabilities at once, as long as they are probable. Also, regularly review assets to see if they have declined in value, and liabilities to see if they have increased. In short, the tendency under the prudence concept is to either not recognize profits or to at least delay their recognition until the underlying transactions are more certain.

The prudence concept does not quite go so far as to force you to record the absolute least favorable position (perhaps that would be entitled the pessimism concept!). 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.

Generally Accepted Accounting Principles incorporate the prudence concept in many accounting standards, which (for example) require you to write down fixed assets when their fair values fall below their book values, but which do not allow you to write up fixed assets when the reverse occurs. International Financial Reporting Standards do allow for the upward revaluation of fixed assets, and so do not adhere quite so rigorously to the prudence concept.

The prudence concept is only a general guideline. Ultimately, use your best judgment in determining how and when to record an accounting transaction.

Examples of the Prudence Concept

Emerson Fittings sells a variety of home maintenance parts to contractors. It does so mostly on credit, so it has built up a substantial amount of accounts receivable. Some of the contractors who buy from it are not in the best financial condition, and are more likely to not pay Emerson’s invoices. The prudence concept would dictate that Emerson’s bookkeeper set up an allowance for doubtful accounts. The intent is to create a reserve against those contractor invoices that are probably not going to be paid, even though the bookkeeper cannot yet specifically identify which invoices will not be paid.