Principle of prudence

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The Principle of prudence is one of the seven principles of GAAP, and requires companies to report, on their balance sheet, the value of their assets and liabilities at their least favorable valuation. Additionally, the principle demands that income/expense recognition and projections be realistic -- i.e. revenue is not recognized unless it is certain, while expenses are recognized while they are probable.

For example, if there is a dispute about sales, the company is encouraged not to report the disputed revenue. However, if there is a lawsuit that may require the company to pay fines/fees, it has to be reported (at least in the notes).

On the other hand, investments are recorded at the value that the firm paid for it or the market value, whichever is lower. It is only after selling the position that the company recognizes any gains. Similarly, inventory of raw materials is valued at the lower of cost of purchase and market price; and inventory of finished goods are recorded at the lower of cost of production and selling price. Additionally, all real-estate assets are recorded at cost and any increase in value is not accounted for till the sale of the asset, but any significant loss of value is reported immediately. Finally, the principle requires goodwill and intangible assets to be written down gradually.

"Those with responsibility to invest money for others should act with prudence, discretion, intelligence, and regard for the safety of capital as well as income." Judge Samuel Putnum in 1830 [1] See: Prudent man rule


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