What Does the Prudence Concept Mean in Accounting?

The prudence concept, also known as the conservatism principle, is an accounting principle that requires an accountant to record liabilities and expenses as soon as they occur, but revenues only when they are assured or realized. The prudence concept requires the accountants to be cautious in the adoption of policies and estimations in such a way that the entity's income and assets are not overstated and the entity's expenses and liabilities are not understated.

Under the prudence concept, the company should not recognize a particular asset at a value higher than the amount that can be recovered from its use or sale. In the same way, liabilities should not be recognized by the company at a lower value than the amount they are expected to be paid for in the future.

The application of the prudence concept in accounting eliminates bias from financial reports and statements; however, it should not affect the reliability of the presented information. For example, inventory is recorded in the financial records of a company at the net realizable value, or NRV, and not the actual expected price of selling. This ensures that the profit from the sale is realized when the sale takes place.