A possibility of probable loss in future is to be considered for but a possibility of future profit of revenue is not to be considered. Such a concept is known as Prudence or Conservation concept. According to this concept of prudence, an accountant does not take into account anticipated gain or profit to be received in future but provides for all anticipated losses. For example, closing stock is valued at cost price or market price, whichever is less.
Similarly, in the accounts, provision for bad debts on debtors, discount reserve on debtors, provision for repairing reserve, taxation provision, investment fluctuation fund, etc. are made based on the principle of prudence only. In accounting for sale under “sale or return” basis also income is not recognized based on this principle only. The sale income is recognized only when confirmation is received from the buyer for having accepted the sales.
According to the concept, in case of accounts for long term contracts also when the work completed is very less, entire profit of that year is reserved by transfer to work in progress account. (It means the profit is not taken into account). However, if there is loss, the same shall be taken into account. According to this concept, all research and development expenses are debited to the Profit and Loss Account of the year in which they are incurred even if the benefit of such expenses is derived in future. In this way, utmost care is to be taken while preparing the books of accounts. Such a concept is called as Prudence concept or Conservations concept.
According to this principle, there may be any possibility that the net profit of the business might be lesser than the actual profit, due to which the goodwill of the unit is maintained, Because of this principle, in the form of company organisation, the possibility of unfairly excess distribution of dividend, decreases. This concept also violates the concept of full disclosure.
In the present age, the use of this concept is increasing day by day. For the Profit and Loss Account to show true profit or loss and the Balance Sheet to show a fair financial position of the business, it is required to use this concept. From the accounting point of view, it is not fair to conceal the true profit and financial position of the business by creating more than the required provisions.
