Principle of Prudence- Understatedness in Accounting

We’ve all heard of or know people or companies that flaunt their wealth, pretty annoying, right? For companies that might come from executives or talking heads looking to boost the brand’s image, but accountants are a different story. Keep reading to find out how and learn about the principle of prudence.

As we said before, accountants aren’t like other departments or employees of a company. What they report and say should be measured and backed up. That’s where the principle of prudence comes into play, the principle of prudence says that accountants are expected to be conservative with their reporting of things like total assets and predicting future gains and losses. Instead of overestimating those indicators, they underestimate them, leading the business to, in turn, make conservative financial decisions.

Principle of prudence is one of the ten GAAPs, Generally Accepted Accounting Principles, meaning that they’re the base of how any accountant works and functions. They allow all accountants to have a common framework so they all understand each other. Without them everybody would have their own way of doing things, and nobody would understand each other.

It should be said that GAAP is only for the US, but the principle of prudence is pretty universal. Other countries have different accepted principles like the IFRS, International Financial Reporting Standards.

Let’s say the accountant were to overestimate the assets that a company has, and then the executives of that company overextend themselves, leading to major losses or some other catastrophic event. This is exactly what the principle of prudence aims to prevent.

Think of it like this, when you underestimate something, you always have room to grow and go above targets or objectives set. However, if you’re overshooting and not realistically stating your assets or future gains or losses, you can only be disappointed.

Like the other GAAPs, the principle of prudence is there to provide accountants with a solid base and philosophy on which to base their work. As we’ve said before, without it accountants in the US wouldn’t be able to understand each other’s numbers, people wouldn’t know which numbers are right and which aren’t.