![]() Generally Accepted Accounting Principles incorporate the prudence concept in many accounting 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. 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 at some point in the future. Prudence would normally be exercised in setting up, for example, an allowance for doubtful accounts or a reserve for obsolete inventory. 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. Instead, what you are striving for is to record transactions that reflect a realistic assessment of the probability of occurrence. 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!). ![]() 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. Also, regularly review assets to see if they have declined in value, and liabilities to see if they have increased. In addition, 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. The result should be conservatively-stated financial statements.Īnother way of looking at prudence is to only record a revenue transaction or an asset when it is certain, and record an expense transaction or liability when it is probable. Also, one should be conservative in recording the amount of assets, and not underestimate liabilities. This caused them to overstate its income and overstate these assets.Under the prudence concept, do not overestimate the amount of revenues recognized or underestimate the amount of expenses. In changing the useful life and salvage value of its assets, Waste Management was able to reduce the amount of depreciation expense hitting the income statement. The expense recognition principle requires that deprecation is recognized over its useful life. In your description, please identify a journal entry that may have been used by Waste management to commit the fraud. Based on the case information provided, describe specifically how Waste Management violated the expense recognition principle. This also affected the balance sheet by overstating their assets. ![]() This affected the income statement and increased the carrying value of their assets. Considering that Waste Management was increasing the useful life and salvage value of its assets, they were deferring expenses such as depreciation and overstating its revenues. This principle is important for users of financial statements because matching revenues with expenses gives users an accurate picture of the company's profitability. The expenses need to match the period in which the income was generated, regardless if cash was received when the work was substantially completed in that period. The expense recognition principle, also known as the matching principle, is a generally accepted accounting principle which states that expenses need to be recognized in the period in which they incurred. Define the expense recognition principle (sometimes referred to as matching principle) and explain why it is important to users of financial statements. ![]() Consider the principles, assumptions and constraints of Generally Accepted Accounting Principles (GAAP). ![]()
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