Last editedOct 20212 min read
Prudence is the essence of good financial management in our personal lives. Every time we make a financial decision, we ask ourselves whether or not it’s prudent. As much as we might want to dine at a restaurant or get a takeaway because we don’t have the energy to cook, that might not necessarily be prudent. In this context, prudence means cautiousness and an awareness of the finite nature of the household’s budget.
While business finances and household budgets are far from interchangeable, they both have this in common. Prudence is an accounting concept that can help businesses be conservative in their spending, and avoid capital expenditures that could imperil their cash flow. Let’s take a look.
Prudence in accounting explained
Prudence is an accounting practice that goes beyond the common sense of being fiscally conservative. It is the practice of ensuring that the company is not overvalued by preventing the income and assets from being overstated in the company’s reporting.
The prudence principle deviates from conventional accounting as it provides for all possible losses, but does not anticipate profits. As such, the company may actually be undervalued. This may not curry favour with shareholders. However, it can create a more realistic overview of the company’s financial health than more optimistic estimates, and ensures that the company will always be able to meet its debt obligations.
It’s easy to become overconfident about your business finances if you focus too much on your top line and don’t pay attention to your bottom line. Prudence accounting prevents this from occurring by recognising revenues differently.
Revenues are only recognised when they are certain, rather than when they are probable or projected. Companies will often report prospective income from, for instance, a newly closed deal, and report both their revenue and expenses at the same time. However, this method of accounting only recognises money that’s in the company’s bank account. So you know that you are only dealing with liquid revenues and not theoretical money.
Prudence also requires that expenses be recorded accurately and in full. They can never be understated to artificially inflate your revenue. What’s more, prudence requires expenses to be logged before the payment leaves your account. When there is a likelihood of an expense, a record needs to be made of this expense in the company's books right away. This is known as a provision for an expense.
Pros and cons of prudence
Prudence can be advantageous for companies, as it prevents them from spending money that isn't yet theirs. This can prevent a potential cash flow crisis, and stave off a debt spiral. But there are also some disadvantages to this accounting method.
Let’s explore the pros and cons of prudence:
Keeps financial reporting realistic
Prevents overly optimistic income projections from providing an unrealistic overview of business finances
Can help to prevent cash flow problems
Ensures that there are enough funds to cover liabilities without resorting to high-interest bridging loans
Can be used as a comparison to other reporting methods
Can cause you to underestimate the value of your business
Best applied to internal cultures
Can paint an unflattering portrait of your business finances to employees or shareholders
May result in the creation of reserve funds. Because these will be inaccessible, this may have a negative impact on the company’s liquidity
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