Prudence principle

Accounting has a built-in bias, and it is deliberate: when in doubt, do not count a gain you have not yet banked, but do count a loss you can already see coming.

That bias is the prudence principle. Applied to open equity index and stock derivative positions, it means an anticipated loss must be provided for in the accounts, while an anticipated profit is simply not recognised until it is actually realised.

Chapter 9 applies prudence to two ledger accounts:

• Mark-to-Market Margin Account (futures): a debit balance (net payment made — an anticipated loss) must be provisioned for, by a debit to the profit and loss account. A credit balance (net amount received — an anticipated profit) is ignored; no credit is taken to the profit and loss account for it.
• Options premium accounts: for the buyer/holder, a provision is made for the amount by which the premium paid exceeds the premium prevailing on the balance sheet date — a fall in value, provisioned as a loss. If the market premium instead exceeds what the buyer paid, that gain is not recognised. For the seller/writer, a provision is made for the amount by which the premium prevailing exceeds the premium received — a rise in the cost to buy back the option, provisioned as a loss. If the premium received instead exceeds the prevailing premium, that gain is not recognised either.

Provisions are worked out stock-wise or index-wise, combining all series and all open options of the same stock or index together, and any bought and sold positions in that stock or index are netted first — only a net loss triggers a provision; a net gain is ignored.

A trader bought an option paying a premium of Rs 40. At the balance sheet date, the same option is trading in the market at a premium of Rs 55.

This Rs 15 rise represents an anticipated gain to the trader — and under the prudence principle, it is not recognised; no credit is taken to the profit and loss account.

Now suppose instead the market premium had fallen to Rs 28. The trader's position shows an anticipated loss of Rs 12 (40 − 28), and prudence requires a provision of Rs 12 to be created, debited to the profit and loss account — even though the loss has not been realised by actually closing the position.

Chapter 9 invokes the prudence principle explicitly, both for the Mark-to-Market Margin Account on futures and for provisioning on open options positions at the balance sheet date. Expect a question testing whether an anticipated gain or an anticipated loss should be recognised — the answer is always: provide for the loss, ignore the gain.

• Anticipated losses are provisioned; anticipated profits are never recognised — this asymmetry is the whole principle, and reversing it is the most common error.
• Provisioning is done stock-wise or index-wise, with all series of the same underlying combined, not contract by contract.
• Bought and sold positions in the same stock or index are netted first — the provision responds to the net result, not to each individual open position separately.