Do you know what the prudence concept means? Hopefully you will have a better understanding
after watching this video!
I’m Thomas Harwood and Welcome to The Accounting Student, where we create free and short videos
so that you can learn about accounting.
Today’s video is looking at what is the prudence concept.
Firstly, there are a number of concepts or rules of accounting. They are referred to,
by many, as the accounting concepts.
These concepts and rules are fundamental in preparing the final accounts of an entity.
It can be said that to a certain extent the accounting concepts help to make the final
accounts relevant and trustworthy to its users.
Overall, there are ten main accounting concepts, of which the fifth one that we will look at
in this video is the prudence concept.
The prudence concept states that the final accounts should always report conservative
and cautious figures. This includes the figure for the profit and the valuation of assets.
Additionally, the business should not overvalue its profits or assets nor should it understate
losses or liabilities. Also profits are not to be anticipated but recognised when they
can be reliably measured.
When there is any doubt of valuing an item, the concept suggests that the item is recorded
at a “prudent” amount, in other words, it should reflect as a conservative and cautious
amount in the accounts.
The concept is applied to the accounts of a business in many ways.
The most common use of the prudence concept is the creation and application of the provision
for depreciation. In short, the provision is a book entry to reduce the value of an
asset over its lifetime; as a result the asset book value and profits are reduced to make
these values more prudent.
Another main use of the concept is the practice of the provision for bad debts or doubtful
debts. The provision again is a book entry which reduces the amount of debts owed to
the business this results in the debtors figure being reduced and therefore the amount reflected
is more conservative and cautious.
Lets give an example to illustrate the concept.
Ray owns and runs a second-hand shop which sells goods from living room furniture to
sports memorabilia. He recently bought a rare painting for £2,000, after buying the painting
Ray’s friend told him that a similar painting sold for £2,500 at an auction. Ray is thinking
of valuing the painting at £2,500 in the accounts, is he correct?
Well, in this situation, Ray would be incorrect. By following the prudence concept, Ray should
not value the painting at the current market price, i.e. the auction price, because it
will cause the profits and value of assets, more specifically the painting, to be overstated
in the accounts.
Furthermore, the auction price is also an estimate value of the painting at the current
time. The concept disagrees with estimating the value of items because they should only
be recognised when they can be reliably measured.
Therefore Ray should record the painting as the amount it cost the business which will
be £2,000, this results in the profits and values being “prudent”.
So that was the definition of the prudence concept. If you enjoyed it, press the like
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