Accounting prudence principle is a type of principle that is commonly used in accounting and finance. It is based on the concept of dealing with uncertainty. In essence, it advocates for making conservative accounting decisions, particularly in the area of asset, income, and disclosure valuation. The goal of adopting this principle is to ensure that the financial statements that are produced are true and fair. This means that all presented transactions are recognized smoothly and accurately.
Accounting prudence principle works by recognizing assets and liabilities in the presence of uncertainty or doubt. Generally, it is focused on forestalling losses while avoiding unreasonably optimistic reasoning or anticipations. Although in some instances this may result in relatively conservative results, it is important to remember that it is always better to enjoy certainty. In case of doubt, it is better to wait until the situation is clarified instead of committing to investments too soon. For instance, when attempting to determine the fair value of asset, if the market is too volatile to provide a reliable approximation, the appropriate accounting policy necessitates having a more conservative value. This prevents understating the asset’s value, by having a likelihood of overstating the value instead.
In relation to income and expenditure, accounting prudence principle also focuses on having a conservative approach. In this case, as soon as income is associated with a transaction, it should be displayed in the financial report, even if the sale has not been actualized. This is because deferring recording the income could be riskier than recognizing it promptly. When it comes to expenditure, the same strategy is applied, in that it should be instantly recognized.
The emphasis of recognizing the effects of transactions in present, as opposed to the future, is attributable to the notion that the incapacity to estimate future activities safely and appropriately will only lead to arbitrary recognition. For this reason, alternative methodologies of revenue recognition is discouraged as it creates too much speculation in relation to revenue. It is also applicable in multiple facets of finance, such as construction contracts, investment securities, dividend operations and capital asset renewals.
In addition, the accounting prudence principle also provides the support for the disclosure of uncertain liabilities, such as future unsettled leases, contingent liabilities, and potential commitments. This means that even the potential of a transaction that may take place in the future should not be omitted from a financial report. It is best to disclose each and every possibility for a liability that may be encountered in the future, rather than downplaying the possibility of it taking place.
Finally, the accounting prudence principle is important to note since it creates a far better view of the financial situation on a company by creating much more accurate and reliable financial reports. This lowers the risk of misuse of assets and liabilities which may arise due to over estimation or underestimation of values. It is based on the premise that it’s better to be safe, than sorry, and so it basically works to such an effect.
