Prudence concept is a fundamentalaccounting principlewhich requires the accountant to record theexpensesandliabilitiesas soon as possible. On the other hand, prudence principle requires accountant to record revenues only when they are assured or actually realized. It is also called conservatism principle.

Prudence Concept Explanation Via Examples

In order to explain this concept more crystal clear, we will take support from examples given below:

Example 1

Alpha industry sale for the month of January is $2 million. According to an estimate, 5 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c} of the amount is not recoverable from the customers. In this case, Alpha has to account for 5 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}bad debt expensein theincome statementover the prudence concept.

Alpha industry is expecting an order on the 31st Dec, 2015. But, it could not arrive due to heavy rain in the city and destruction of internet facility from the client’s side. However, client send the order on 1st January with dated mentioned on the order as 1st January, 2016. Alpha cannot include the order in its December sale just on the basis of its expectation or estimation. According to the prudence principle, accountant cannot record revenue unless and until it is assured and actually realized.

Example 2

Z Plc is a builder and developers and has huge reputation in the construction of residential and commercial projects. One of its project in underway and has completed 25 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c} as valued by the surveyor. Surveyor has good reputation in the industry and has is in the panel of major national and international banks operating within the country. The total revenue of the project is estimated to be $5,000,000. During the construction phase, a fire damaged one side of the building under construction. As a result, the loss will have to bear by the Z Plc if not reimbursed by the insurance company. According to the negotiation with insurance companies, it is probable that insurance company will not accept the claim as it is the fault of Z Plc. In this case, Z Plc has to bear a loss of $20,000.

Required

As management accountant of Z Plc, you are required to suggest treatment of revenue and expense for the books of accounts.

Solution

According to prudence concept, expenses are recognized immediately when they are probable no matter cash is paid or not. However, revenue recognition is delayed until it gets realized or assured. In the case of Z Plc, you can see the estimated revenue is $ 5,000,000. So, Z Plc cannot record the total amount as revenue immediately. Only 25 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c} of the total revenue amount can be recognized in the books of account as revenue. This method is called stage of completion method for revenue recognition. Under this method, revenue is recognized up to the extent to which it has been completed. So, revenue that could be recognized is only $1,250,000. Similarly, the next revenue recognition will only be done only when the surveyor will do his survey and report to Z Plc.

On the other hand, though Z Plc has not paid the loss but it will have to bear the amount of$ 20,000. So, on the basis of prudence principle, Z Plc has to record this as loss expense. Prudence concept is one of the main accounting principles which is used widely and is the main root of all adjusting entries made at the end of any accounting period to ensure that financial statements give true and fair view of the financial performance and position of the company.

Advantages of Prudence

1. it is acceptable worldwide, so every financial statements is prepared on the basis of this principle.

2. it makes the comparability of financial information possible.

3. it helps in the true and fair presentation of the financial records.