Definition of Prudence Concept (Convention, Principle) or Conservatism Concept of Accounting:
Prudence concept (convention, principle) of accounting is also well known as conservatism concept. This concept defines and emphasizes that “the accountants are cautious people. Preparation of financial statements need good professional command and exact estimates of future by the accountants”.
Traditionally, accountants do not anticipate profits, however, provide for all losses. Incomes are not accounted for until they are earned. However, the accountants provide for all likely losses and expenses, when there is a reasonable possibility that such losses and expenses will occur in future.
Explanation, Use and Application of Prudence Concept:
A typical use and application of prudence concept is to value inventories at lower cost or net realizable value. In case of reduction in market value then the “anticipated loss” should be provided for but if the price in the market is higher than cost which is usually the case then ignore the “anticipated profits”.
Prudence concept states that accountants should select the one, out of the possible accounting treatments, that shows less encouraging financial results for the business. The accountant, however, should not be over conservative as it might eventually distort the financial results.
Solved Example 1:
A customer who owes the business $1000 at the end of an accounting year appears to be in financial difficulty and is in danger of going bankrupt. However, no-one knows certainly whether or not this will happen.
The prudence convention of accounting requires that the potential bankruptcy is taken into account and that the balance sheet is adjusted to reflect this. The likelihood is that the business will make a provision for doubtful debts.
Solved Example 2, (Calculation of Net Realizable Value of an Inventory):
The cost of a particular inventory item is $12 having its current scrap price $6 and replacement cost is $11. However, it can be sold at normal selling price of $20 after incurring expenses of $11.
At how much price should the item be valued in the balance sheet?
As inventory is recorded at net realizable value or cost whichever is lower. Net realizable value of an inventory can be calculated by using the formula, as:
Cost is $12 and net realizable value is $9, so inventory should be valued at $9 which is lower of the two.
Scrap price is ignored as business has an option to sell the same inventory at higher value.