prudence

7.1 Accounting Principles – Prudence ⚖️

What is Prudence?

Prudence, also known as conservatism, is the rule that says you should never over‑estimate what you own or what you earn, and never underestimate what you owe or might lose. Think of it as putting a safety net under a tightrope walker – you want to be safe, not just show a big smile.

Why It Matters 📉📈

• Protects users of financial statements from over‑optimistic pictures.
• Helps managers plan for worst‑case scenarios.
• Builds trust with investors, creditors and regulators.

Prudence in Numbers

The principle can be expressed with simple formulas:

• Assets: $A = \min(C, M)$ – record at the lower of cost (C) or market value (M).
• Liabilities: $L = \max(A, E)$ – record at the higher of actual liability (A) or estimated liability (E).
• Profit: $P = R - E$ – revenue (R) minus all expenses (E), no future gains added until earned.

Prudence in Practice – A Quick Table 📊

Prudence Checklist ??

1. Are all assets valued at the lower of cost or market?
2. Are all liabilities recorded at the higher of actual or estimated amounts?
3. Is any potential loss already reflected in the accounts?
4. Are future gains only recorded when they are realised?
5. Have we set aside a reserve for unexpected events?

Quick Quiz 🎓

1. Which of the following best illustrates prudence?
   • A company records a $10,000 gain on a sale before the sale is completed.
   • A company records a $10,000 loss on a sale after the sale is completed.
   • A company records a $10,000 gain only after the sale is completed.
2. When valuing inventory, you should use the lower of cost or net realizable value. If the cost is $5,000 and the market value is $4,000, what value should you record? $5,000 or $4,000?
3. True or False: Prudence means you can overstate assets to make the company look stronger.