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What is the prudence concept?


The prudence concept is another fundamental accounting concept. It basically means we count count our chickens before they hatch. In other words, when presented with options,  the prudence concept would dictate we err on the side of caution.  In practice, this means we should not overstate income, understate expenses, over-value assets or understate liabilities. To give an example, inventory is valued at the lower of cost or net realisable value (which is more or less what something sells for). While there are detailed accounting rules on inventory valuation, this is an example of the prudence concept at work. So, if the net realisable value was less that cost, inventory would be stated on the books at below cost. Another example is providing for bad and doubtful debts. For example, a business might think 2% of its customer debt will not be paid. This might not actually happen, but it is prudent to assume it will.

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