Business transactions and other events are sometimes uncertain and presenting them in financial statements requires making estimates. Making estimates involves exercise of judgement. Use of judgement requires prudence. Prudence is a key accounting principle which ensures that assets and income are not overstated, and liabilities and expenses are not understated. At the same time, it does not allow deliberate understatement of assets and income and overstatement of liabilities and expenses. Prudence is critical to achieve neutrality which is one of the preconditions of faithful representation.
Traditionally, the prudence concept has been used to mean a deliberate attempt not to overstate assets and income or understate liabilities and expenses. However, more recently, the accounting frameworks adopted by IASB and FASB have linked prudence with neutrality. At the framework level, exercise of prudence means achievement of neutrality which in turn means neither positive nor negative bias in estimates. In other words, exercise of prudence requires neither understatement nor overstatement of any element of financial statements. This is important because just like an overstatement of assets or income and understatement of liabilities and expenses, a deliberate understatement of assets or income or overstatement of liabilities and expenses is not desirable because it would overstate (understate) the values in future years.
While some accounting standards might apply the prudence concept in the traditional sense, i.e. in attempting deliberately not to overstate assets/income and understate liabilities/expenses, at the framework level, the boards attempt to achieve neutrality.
- Bad and doubtful debts occur in many businesses which sell on credit. They often create a special contra asset to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized. This prevents overstatement of assets. An expense called bad debts expense is also booked so that income is not overstated. Even though no loss has been incurred, it is prudent to recognize potential bad debts expenses arising from existing receivables. However, bad debt charge must not be higher than what is justified from past experience and future expectations because this would mean understatement of future expense.
- Some liabilities are contingent upon occurrence or non-occurrence of a future event such as lawsuit, etc. We judge the probability of occurrence of that event, and if it is more than 50%, we record a liability and corresponding expense at the most-likely amount. This prevents overstatement of liability and expense from being understated.
- Periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it does exceed, the impairment of assets is recorded by reducing the asset’s carrying amount.