It is a policy of playing safe. For future events, profits are not anticipated, but provisions for losses are provided as a policy of conservatism. Under this policy, provisions are made for doubtful debts as well as contingent liability; but we do not consider any anticipatory gain.
For example, If A purchases 1000 items @ Rs 80 per item and sells 900 items out of them @ Rs 100 per item when the market value of stock is (i) Rs 90 and in condition (ii) Rs 70 per item, then the profit from the above transactions can be calculated as follows:
|Sale Value (A) (900×100)||90,000.00||90,000.00|
|Less – Cost of Goods Sold|
|Less – Closing Stock||8,000.00||7,000.00|
|Cost of Goods Sold (B)||72,000.00||73,000.00|
In the above example, the method for valuation of stock is ‘Cost or market price whichever is lower’.
The prudence however does not permit creation of hidden reserve by understating the profits or by overstating the losses.