Accounting Concepts

Prudence Concept

Definition

Prudence requires that profits are not anticipated and are only recognised when realised, but that losses are recognised as soon as they become foreseeable — even before they crystallise.

Where there is uncertainty, err on the side of caution: understate assets and income; do not understate liabilities and expenses.

Applications of Prudence

1. Provision for Depreciation

• Non-current assets lose value over time; this loss is recognised as an expense each year rather than waiting until the asset is sold
• This prevents assets from being shown at an overstated value on the SFP

2. Provision for Doubtful Debts (PDD)

• Not all trade receivables will pay; a proportion is estimated as potentially irrecoverable
• The PDD reduces the value of trade receivables on the SFP to a more realistic figure
• Double entry: DR Increase in PDD (expense) / CR Provision for doubtful debts

3. Inventory Valuation — Lower of Cost and NRV

Inventory must be valued at the lower of:

• Cost — the purchase price of the inventory
• Net realisable value (NRV) — the estimated selling price minus any costs still needed to complete and sell the item

NRV formula: NRV = Selling price − Costs to complete − Selling costs

If NRV < Cost: the inventory is written down to NRV. The write-down is an expense in the IS. If NRV > Cost: inventory remains at cost. Prudence prevents recording an unrealised profit.

NRV Calculation Table

Items B and D are written down: write-down = (300 − 240) + (420 − 330) = £60 + £90 = £150 extra expense.

Key Point

Prudence and realisation work together: you recognise a loss when foreseeable (prudence) but only recognise income when earned (realisation). This asymmetry is deliberate — it prevents overstatement of profit.