Why is prudence concept used when preparing a firms accounts importnt for the protection of potential investor

Question

Why is prudence concept used when preparing a firms accounts importnt for the protection of potential investor

Answer 1

Prudence Concept (aka Principle of conservatism)

Accountants must use their judgment to record transactions that require estimation. The number of years that equipment will remain productive and the portion of accounts receivable that will never be paid are examples of items that require estimation. In reporting financial data, accountants follow the principle of conservatism, which requires that the less optimistic estimate be chosen when two estimates are judged to be equally likely. For example, suppose a manufacturing company's Warranty Repair Department has documented a three-percent return rate for product X during the past two years, but the company's Engineering Department insists this return rate is just a statistical anomaly and less than one percent of product X will require service during the coming year. Unless the Engineering Department provides compelling evidence to support its estimate, the company's accountant must follow the principle of conservatism and plan for a three-percent return rate. Losses and costs—such as warranty repairs—are recorded when they are probable and reasonably estimated. Gains are recorded when realized.

Hence, if the prudence concept is followed, the potential investor will not be shown accounts which are overly rosy or misleading.