How is the prudence assumption related to stock valuation?

The prudence assumption in accounting states that assets and income should not be overstated, while liabilities and expenses should not be understated. This principle is particularly relevant to stock valuation as it promotes a conservative approach when assessing the value of inventory.

When valuing stock, the prudence assumption leads to the guideline that stock should be valued at the lower of cost or net realisable value. This means that if the market value of the stock (net realisable value) falls below the cost incurred to purchase or produce the stock, the inventory should be recorded at this lower value. This prevents the potential overstatement of assets and offers a more accurate picture of the financial position of the business.

In this context, stock at cost reflects the price paid for it, while the net realisable value is the expected selling price minus any costs of completion and selling. By applying the lower of these two values, businesses adhere to the prudence assumption, ensuring that they do not inflate their assets on the balance sheet.

This approach effectively protects stakeholders by presenting a conservative estimate of the company's financial health, avoiding risks associated with potential future losses that could arise if the stock does not sell for more than its carrying cost.