The prudence concept in accounting states that a company should never overstate it's income, and it should never understate it's expenses. This means that the highest level for the expenses should be used and the lowest level of profits in making financial statements.
The prudence concept: In reporting activities, conservatism concept is used to minimize the possibility of overstating the value of assets or income in the future. Example, in determination of bad dept, conservatism approach is to expert that some dept may occur from the transactions.
Its an Accounting Principle and it means that assets and income shall not be overstated and liabilities and charges shall not be understated. However, the principle of prudence does not allow the creation of hidden reserves or undue provisions.
THE PRUDENCE OR CONSERVATISM CONCEPT For prudence, IAS 1 (1975) declared that “uncertainties inevitably surround many transactions. This should be recognised by exercising prudence in preparing financial statements. Prudence does not, however, justify the creation of secret or hidden reserves”. In the United States, ‘conservatism’ is the term used to reflect ‘prudence’. Certain US GAAP / IAS differences may be identified as rule or principle-based depending on the extent that this concept is applied. Among them are the asset impairment tests in IAS 36, provisions in IAS 37, and intangible assets in IAS 38. In IAS 36, the asset impairment test uses recoverable amount, defined as the higher of an asset’s net selling price and its value in use. The present value of expected future cash flows determines the recoverable amount and the amount obtainable in an arm’s length transaction determines the net selling price. US GAAP uses ‘fair value’ and undiscounted cash flows in the impairment test. Whether an impairment test is based on fair value rather than recoverable amount certainly is a question of which more closely relates to the basic reliability principle of prudence or conservatism. In this case, US GAAP is more conservative in that it does not recognise the reversal of an impairment loss once it is recognised. One difference leading to reporting differences for many US enterprises is that US GAAP requires a provision to be recognised when there is a probability of an outflow of resources without having to be a present obligation. IAS 37 is more specific in this case in that it specifies that, when the effect of the time value is material, the present value of the expected expenditure should be recognised. Thus, both US GAAP and IAS are conservative for recognising provisions but in different ways. Relatedly, IAS accounting is more conservative for vested past service pension plan costs which are recognised immediately under IAS but are amortised under US GAAP. For goodwill, IAS 38 provides that there is a rebuttable presumption that the useful life will not exceed twenty years from initial recognition. US GAAP had declared that goodwill does have a useful life with a maximum of 40 years for amortisation. Under the recently promulgated SFAS 142 however, goodwill is now viewed as an asset with an indefinite life, subject to impairment testing. Since the measurability of Autumn 2002 perspective 19 US GAAP / IAS DIFFERENCES: BASIC PRINCIPLES OR DETAILED RULES? Goodwill after acquisition becomes problematic, rules may have to result to provide guidance for measurability. This evident in some recent events. For example, Telefonica S.A. , Spanish company recently amended its 2001 earnings to meet the new US accounting procedures for goodwill, an adjustment from 2.11 Euro profit under Spanish rules into a 7.18 Euro loss under US rules.7 Overstatement of intangibles has been key accounting problem not only in recent years but as long ago as 1932. Of WorldCom’s US$104 billion in assets this year, about US$50 billion derived from good and other intangibles.8 Seventy years ago in the Igar Krueger scandal, the International Match Company had to write off US$27 million of intangibles, mostly recorded monopoly rights.9 In this regard, the US GAAP is more specific in pointing out that, in a business acquisition, consideration needs to be given to allocation of part of the purchase price to inprocess research and development which would be expensed in the period after acquisition. Significantly, the goodwill amortisation issue is a major cause of GAAP differences for foreign issuer adopters of IAS for reporting in the US. A recent study shows that the US principles provided for a more conservative reporting of net income and corporate equity.10 The conservative requirements for recording and amortising goodwill and other intangibles based on objectivity is ingrained in US GAAP literature and incorporated as prudence requirements in the IAS. However, the use of current values or amortisation postponement with impairment tests appears not only to be causes for reporting differences but also to create a need for more specific rules.
