Prudence principle

What it means

The prudence principle is an accounting principle under which a company, when valuing assets and liabilities, takes into account all foreseeable risks, losses and impairments relating to the period, even if they have not yet occurred. Profits, by contrast, are recognised only when realised, not when merely expected.

The principle is asymmetric. An expected loss is booked immediately, for example through an impairment allowance on a doubtful receivable or a provision for a lawsuit, whereas an expected gain, such as a rise in property value, is generally not recognised in profit until the asset is sold.

Its aim is to protect creditors and other users of the financial statements from an inflated picture of the company. The Accounting Act requires it expressly, and together with principles such as substance over form it underpins the true and fair view.

How it works in practice

At year-end we go through the risks that should be reflected with clients: overdue receivables, slow-moving or damaged stock, pending disputes, warranty repairs and untaken holiday. For each we look for a reasonable accounting estimate.

Prudence also covers information arriving after the reporting date. If, say, it emerges in February that a customer was already insolvent in December, the loss on the receivable belongs to the old year as an event after the reporting date confirming the year-end position.

For tax purposes, remember that not all allowances and provisions are deductible. Prudence in the accounts therefore often creates a difference between accounting and taxable profit, handled through add-backs and possibly deferred tax.

What to watch out for

Prudence does not mean creating hidden reserves. If a company deliberately understates assets or overstates liabilities, for example to lower profit in a good year, it breaches the true and fair principle just as much as if it overstated them. Estimates must be supported.

A common failing in small companies is ignoring prudence altogether and carrying receivables from long-defunct customers at full value for years. The statements then show assets that do not really exist, and a bank or investor gets a surprise at the first in-depth review.