Concept of Prudence
In principles of accounts POA, we often mentioned about prudence concept. The definition states that the business is not to overstate assets or understate liability. Possible losses are to be accounted for yet, possible profits are not to be accounted.
What does prudence concept meant?
Simply put, it is not only a wonderful concept to be used in accounting but it can be used in everyday life. For instance, say you are back from an exam. You know well that there is a high possibility that you could score A for the exam. Yet, when your parents were to ask you regarding your exam, you will reply saying that it was still fine. In this sense, you are being prudent as you do not want to overstate your results though there is possible high grades scored in the future.
Applying this to everyday life, it is simply “Always plan for the worst. Do not plan for the best” kind of a take in life. Some might take it as pessimism but it is rather to be always prepared for the worst result that might happened to you. Hence, life will not take you down that easily.
For businesses, it meant that financial statements should not be “exaggerated” and thus, stakeholders will not be mislead into making the wrong decisions.
In POA, it is applied to inventory and allowance for impairment loss on trade receivables. For inventory, it is applied when inventory is valued at the lower of cost or net realisable value ie. market price. Since the business adopts only the lower cost, it will not overstate its inventory value (assets) in anyway. As for allowance for impairment loss on trade receivables, by catering for the allowance account, it will not overstate its trade receivables (assets). As it “removes” the bad debtors whom might not be able to pay up, it reflect only the net trade receivables as the good debtors who will be paying up.
Want to know more of other accounting concept?
You may check out “Going concern concept applied to Hyflux Singapore Case Probe“
If you want to know the techniques to learn for learning Principles of Accounts (POA), read up Learning Principles of Accounts (POA) and Scoring As.
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