'It is said that reserves are set aside to meet the known or unknown contingency in future'. Let me explain the meaning of this statement. Let us take the example of an average household. For example if a man is getting Rs.50000 as salary and out of this he is regularly putting Rs.10000 in Fixed Deposit with the bank. Why is he saving? He is saving because in future he may have to pay for higher studies of his children or may be for his old age or to meet sudden medical expenses etc. Similarly a business also puts aside a part of its profits for its future growth needs or to meet some unknow contingencies like slow down of business or stoppage of business due to accidents like fire and earthquake etc. (future is always uncertain).
First I would like to point out that Concept of Prudence or Concept of Conservatism are the two names of the same principle. This principle states that while valuing assets, assets should be valued at lower of cost price or market price whichever is less. Similarly while reporting income, income should be recognised only when realised and expenses/losses should be recognised even if their chances of occurring are not so high.
Here I would like to mention that a business creates reserves to safeguard its future and in this concept of conservatism or prudence has no role to play.