Definition & explanation
Conservatism or prudence principle of accounting stats that a business should display a good degree of caution in booking incomes and expenses. It is considered wise to book an income only when it is realized but to book an expense as soon as a reasonable likelihood of it becoming payable is reached.
This is the policy of “Playing Safe”. According to this Conservatism or prudence principle, current assets are valued at cost or market price whichever is lesser. This convention follows the rule, “anticipate no profit but provide for all possible losses”. This Convention requires that proper care should be kept while calculating the revenues.
Revenue should only be recorded if there is reasonable certainty about its realization. Similarly, provisions should be made against all possible liabilities. This concept can also be explained by using a simple statement, “Recognize all losses and anticipate no gains.” Investment is valued at their cost or market value whichever is lesser similarly a provision is made for doubtful debts.
Let us take an example to understand conservatism or prudence principle. If we buy some shares in a company whose shares are sold at the stock exchange at say $14 per share, we should show them in our balance sheet at cost. Let us assume that these shares are purchased purely for speculation purposes, i.e., in the hope that their price will rise and we will be able to sell them at a profit.
Now let us also assume that on the date of balance sheet their market price has risen from $14 per share to $17 per share. In reality, a gain of $3 per share has been made this gain has not been realized because the shares have not been sold by the date of the balance sheet. The prudence principle would require us to ignore this because it has not been realized. We should continue showing these shares in the balance sheet at $14 per share with a note given to say that their market value is higher than their cost.
However should the value of these shares go below $14 per share on the date of the balance sheet, it would be prudent to book the loss. Let us assume that on the date of balance sheet these shares are being sold at the stock exchange at $12 per share. It would be prudent to book a loss of $2 per share and show the shares at $12 in the balance sheet even though this loss has not really been incurred as these shares are still held by the business and their value is likely to change in the future.