The Accounting Concept of Prudence

THE ACCOUNTING CONCEPT OF PRUDENCE

The accounting concept of prudence states that Profits must not be Overstated and the value of the Assets must not be Overvalued. Also, the Losses must not be Understated and the value of the Liabilities must not be Undervalued.

The accountant’s duty is to ensure that all accounts are reliable, in other words the accountant needs to produce a reliable set of reports that are free from errors and also free from bias.

Example of accounting concept of prudence

Never Overvalue Assets[pic 1]

For e.g.  a delivery company purchased a truck for worth $30,000 to deliver goods to its customer at the beginning of the financial year. At the end of the year, it is estimated that the truck will be depreciated or lost $10,000 in value and it is due to the result of using this asset in the business to deliver the goods to the customers. So, the value of the asset in the balance sheet would be $20,000. Therefore, the asset should not be overvalued in the balance sheet and pretended it was worth $30,000 just because that was the amount that the delivery company paid for it at the time of purchase.  

Never Undervalue Liabilities

[pic 2]

For e.g. a credit company (creditor) lends $100,000 to a small-scale manufacturing company (borrower). The borrower was hoping that the creditor will give them a promotional discount of $10,000. The borrower can’t show $90,000 in the balance sheet as the reason being the liability should never be undervalued so the borrower should show the creditor value in the balance sheet as $100,000 not $90,000. The borrower can only put $90,000 into the balance sheet as the value of the creditor once the borrower has received the bill or the invoice from the creditor in which it stated that the borrower owed $90,000 to the creditor.

Never Overstate Profits[pic 3]

For e.g.  a company had calculated that they have made a net profit of $100,000. If the company ignored $10,000 of its unpaid electricity bill, then they would be overstating the value of their profit. In other words, they would be pretending that their profits were $10,000 more than they actually were. So, the correct treatment would be to subtract $10,000 to give a correct net profit of $90,000 ($100,000 - $10,000 = $90,000) which was not overstated or over emphasized.

Never Understate Losses

If the same company made a net loss of $50,000 and this loss would be understated if they ignored the unpaid electricity bill of $10,000 so the correct treatment was to subtract $10,000 from the net loss of $50,000 to give a correct net loss of $60,000 [($50,000) - $60,000]. [pic 4]

When we discuss about assets and liabilities we always talk about values, so we say overvalued asset or undervalued liability. Also, when we discuss about profits and losses we use the term overstated to mean too much and understated to mean too low.