Under the prudence concept, you should not overestimate the amount of revenues that you record, nor underestimate the expenses. You should also be conservative in recording the amount of assets, and not underestimate liabilities. Another way of looking at prudence is to only record a revenue transaction or an asset when it is certain, and to record an expense transaction or liability when it is probable. Another aspect of the prudence concept is that you would tend to delay recognition of a revenue transaction or an asset until you are certain of it, whereas you would tend to record expenses and liabilities at once, as long as they are probable. In short, the tendency under the prudence concept is to either not recognize profits or to at least delay their recognition until the underlying transactions are more certain. The prudence concept does not quite go so far as to force you to record the absolute least favorable position (perhaps that would be entitled the pessimism concept!). Instead, what you are striving for is to record transactions that reflect a realistic assessment of the probability of occurrence. Thus, if you were to create a continuum with optimism on one end and pessimism on the other, the prudence concept would place you somewhat further in the direction of the pessimistic side of the continuum. You would normally exercise prudence in setting up, for example, an allowance for doubtful accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an expense has not yet been identified, but a prudent person would record a reserve in anticipation of a reasonable amount of these expenses arising. Generally Accepted Accounting Principles incorporates the prudence concept in many of its standards, which (for example) require you to write down fixed assets when their fair values fall below their book values, but which do not allow you to write up fixed assets when the reverse occurs. International Financial Reporting Standards do allow for the upward revaluation of fixed assets, and so do not adhere so rigorously to the prudence concept. The prudence concept is only a general guideline. Ultimately, you must use your best judgment in determining how and when to record an accounting transaction.
What is a going concern qualification?
The going concern principle is that you assume a business will continue in the future, unless there is evidence to the contrary. When an auditor conducts an examination of the accounting records of a company, he has an obligation to review its ability to continue as a going concern; if his assessment is that there is a substantial doubt regarding the company's ability to continue in the future (which is defined as the following year), then he must include a going concern qualification in his opinion of the company's financial statements. This statement is typically presented in a separate explanatory paragraph that follows the auditor's opinion paragraph. There are no specific procedures that an auditor must follow to arrive at a going concern opinion. Instead, he derives this information from the sum total of all other audit procedures performed. Indicators of a potential going concern problem are:
Negative trends. Can include declining sales, increasing costs, recurring losses, adverse financial ratios, and so forth. Employees. Loss of key managers or skilled employees, as well as labor difficulties of various types. Systems. Inadequate accounting record keeping. Legal. Legal proceedings against the company, which may include pending liabilities and penalties related to environmental or other laws. Intellectual property. The loss of a key license or patent. Business structure. The company has lost a major customer or key supplier. Financing. The company has defaulted on a loan or is unable to locate new financing.
The auditor's going concern qualification can be mitigated by management...