Prudence Principle: Definition
The prudence principle of accounting, also known as the conservatism principle, states that a business should exercise a good degree of caution when booking incomes and expenses.
In particular, is considered wise to book an income only when it is realized. Alongside this, expenses should be booked as soon as a reasonable likelihood of their becoming payable is reached.
Prudence Principle: Explanation
The prudence principle of accounting is essentially the policy of “playing it safe.”
According to the principle, current assets are valued at cost or market price, whichever is less. This convention follows the rule: “Anticipate no profit but provide for all possible losses.” It demands that proper care is exercised when calculating revenues.
Revenue should only be recorded if there is reasonable certainty about its realization. Similarly, provisions should be made against all possible liabilities. This concept can also be explained using the simple statement: “Recognize all losses and anticipate no gains.”
Investments are valued at their cost or market value, whichever is less, and a similar provision is made for doubtful debts.
If we buy shares at $14 per share, a record should be added to the balance sheet at cost. Let’s assume that the shares were purchased purely for speculation purposes (i.e., in the hope that their price will rise and we will be able to sell them at a profit).
Now, let’s assume that after the date of the balance sheet, the market price of the shares has risen from $14 per share to $17 per share. In reality, a gain of $3 per share has been made, but it is unrealized because the shares have not been sold by the date of the balance sheet.
The prudence principle requires this to be ignored because it has not been realized. We should continue showing these shares in the balance sheet at $14 per share with a note given to say that their market value is higher than their cost.
However, should the value of these shares go below $14 per share on the date of the balance sheet, it would be prudent to book the loss.
For the loss case, let’s assume that on the date of the balance sheet, the shares are being sold at the stock exchange at $12 per share.
It is prudent to book a loss of $2 per share and show the shares at $12 in the balance sheet even though the loss has not really been incurred (i.e., because the shares are still held by the business and their value is likely to change in the future).