Prudent Cost Concept
The financial accounting term prudent cost concept refers to a process that allows accountants to place a value on an asset that is different than historical cost. The prudent cost concept applies when a company is unaware of the asset’s true value and the acquisition price is too high. When this occurs, the recommended course of action is to charge a loss in the current period.
Generally, the price paid for assets is their valuation as they are acquired. This is referred to as historical cost. Donated assets are one of the few exceptions to this guideline.
The prudent cost concept states that if a company is unaware of an asset’s true value, and overpays for it, the company should capitalize the true value of the asset and take a loss on the excess cost in the current accounting period. This is not the same concept as the lower of cost or market, which is an inventory valuation approach.
If the company acquired an asset at a price that is considerably below its true market value, the company would not recognize a gain in the current accounting period. The guidance of recognizing only losses is aligned with the conservatism constraint, which states that companies should report information that does not overstate income or assets, or does not understate expenses or liabilities.
The prudent cost concept is seldom used by companies since the subject matter experts involved with purchases and acquisitions rarely make an error that results in overpayment.