The prudence concept

Under the prudence concept, do not overestimate the amount of revenues recognized or underestimate the amount of expenses. You should also be conservative in recording the amount of assets, and not underestimate liabilities. The result should be conservatively-stated financial statements.

Another way of looking at prudence is to only record a revenue transaction or an asset when it is certain, and record an expense transaction or liability when it is probable. Another aspect of the prudence concept is that you would tend to delay recognition of a revenue transaction or an asset until you are certain of it, whereas you would tend to record expenses and liabilities at once, as long as they are probable. Also, regularly review assets to see if they have declined in value, and liabilities to see if they have increased. In short, the tendency under the prudence concept is to either not recognize profits or to at least delay their recognition until the underlying transactions are more certain.

The prudence concept does not quite go so far as to force you to record the absolute least favorable position (perhaps that would be entitled the pessimism concept!). Instead, what you are striving for is to record transactions that reflect a realistic assessment of the probability of occurrence. Thus, if you were to create a continuum with optimism on one end and pessimism on the other, the prudence concept would place you somewhat further in the direction of the pessimistic side of the continuum.

Prudence would normally be exercised in setting up, for example, an allowance for doubtful accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an expense has not yet been identified, but a prudent person would record a reserve in anticipation of a reasonable amount of these expenses arising at some point in the future.

Generally Accepted Accounting Principles incorporates the prudence concept in many of its standards, which (for example) require you to write down fixed assets when their fair values fall below their book values, but which do not allow you to write up fixed assets when the reverse occurs. International Financial Reporting Standards do allow for the upward revaluation of fixed assets, and so do not adhere quite so rigorously to the prudence concept.

The prudence concept is only a general guideline. Ultimately, use your best judgment in determining how and when to record an accounting transaction.