Concept of Prudence in Accounting and Financial Reporting

Summary of Prudence in Accounting Concept

Prudence in accounting, also known as the prudence concept or prudence convention, is a fundamental principle that guides accountants to adopt a cautious and conservative approach when preparing financial statements. The core meaning of prudence in accounting is to avoid overstatement of assets and income and to ensure that liabilities and expenses are not understated. This principle requires accountants to anticipate and recognise potential losses as soon as they are foreseeable, while only recognising gains when they are certain and realised.

The prudence concept applies in several key areas:

• Revenue recognition: We recognise revenue only when we earn it. Ergo, there’s reasonable certainty of receipt, preventing premature or overly optimistic reporting.
• Expense recognition: We need to record expenses and liabilities as soon as they are likely to occur. That’s true even if payment has not yet been made, ensuring we don’t overstate profits.
• Asset valuation: Assets require conservative valuation, typically at the lower of cost or net realisable value, to avoid inflating a company’s financial position.
• Provision for losses: Provisions for bad debts, inventory write-downs, and contingent liabilities are made to reflect potential future losses realistically.

The prudence accounting approach enhances the reliability and accuracy of financial statements, supporting better risk management and building investor confidence. By prioritising caution, the prudence concept ensures that financial reports provide a true and fair view of a company’s financial health, even if this sometimes results in a more understated or conservative portrayal of profitability and asset values.

Introduction

“Prudence in accounting and financial reporting has a long-established track record. There is a considerable debate about whether International Financial Reporting Standards (IFRS), as the key global standards, should include prudence and state its importance in their conceptual framework” (ACCA, 2014*).

Critically discuss the debate about the inclusion of the prudence concept in the conceptual framework and IFRS.

1.1 Introduction

Conceptual framework is a coherent system which considers the theoretical and conceptual issues which arise in financial reporting. The International Accounting Standards Board’s (IASB) framework requires financial report’s to comply with key concepts to ensure there is minimal or no bad accounting practises which will triumph over the good accounting practises.

1.2 Introduction to the Prudence in Accounting concept

For years, accountants would exercise the prudence concept on important matters in order to wisely and cautiously make judgements. Prudence historically is a key qualitative characteristic of ‘reliability’ within the IASB framework until 2010 when ‘neutrality’ overtook it. Neutrality in accounting is to prepare the financial statements free from bias, not preparing them with the purpose to influence certain decisions of the users. The pre-2010 definition of prudence is the inclusion of caution in making judgements with the purpose to make sure that assets, along with income are not overstated and liabilities and expenses are not understated.

The debate of the removal of prudence from the framework began due to the conflict with neutrality, as they both conflict with one another. When prudence leaves the conceptual framework, the concept of prudence and neutrality receive join development (Mackintosh, 2010). Thus the prudence concept never really leaves the framework, but rather combines as one in order to avoid the conflict.

2. Argument: Against the inclusion of prudence

Chartered financial analysis (CFA) want clearer results which isn’t biased. Where there are uncertainties they would like management’s best estimate with the appropriate disclosures of the basis on which this has been made. The inclusion of prudence is not necessary as it contradicts other accounting assumptions. As discussed earlier, the debate came about due to the conflict with neutrality.

Prudence ultimately conflicts with neutrality. As Smith (2010) explained, a ‘prudent accountant would make provisions in the accounts for the potential bad debts and then notify superiors’ therefore adjusting books in bias and recovering the monies, whereas a ‘neutral accountant would wait until the matter unfolds before taking any action’.

Thus keeping both prudence and neutrality in the framework will only lead to confusion and misrepresentation of the truth in the accounts. Furthermore, other areas of the framework such as faithful representation also clash with the concept of prudence, as the information decisions which are made under the prudence concept do not always represent transactions faithfully, leading to information not being fully reliable.

Therefore, as long as financial statements are as accurate as possible and represent the reality of the accounts as much as possible following the other frameworks, prudence is not needed.

3. Argument: For the inclusion of prudence

Accounts are a parallel representation of a company’s results. This view is agreed upon by professionals along with the public. As a company’s financial conditions are major concerns to both investors and creditors, it is important for there to be true image of a company’s finance. Underestimating a company’s profits may put off investors, reversely, overestimating a company’s expenses may worry creditors.

Therefore, prudence is an important factor in recording financial statements as it where both assets and profits have been overstated to an extent where accountants felt was necessary, and where liabilities and expenses are understated to provide a sense of stability to a firm’s accounts. If accountants are to overestimate losses on business, the company’s income will look much worse than it actually is. Underestimation has the reverse effect, where income looks much better than its reality. Furthermore, there is an ideology that audited numbers are ‘hard’, this being exercised during estimates upon looking at previous frameworks.

Estimates, by their nature, tend to overstate and understate a company’s performance. Thus, best way to avoid misstatement is to follow the standard accounting principle of prudence and be cautious when making judgment’s on under conditions of uncertainty. The reintroduction of prudence will only support other accounting frameworks, working side by side to create a real image of accounts which can be used in order to make the best decisions by users.

4. Argument: Against the inclusion of prudence

Showing contrast, many may argue that in circumstances where assets and profits have been overstated, accounts, accountants and accounting standards are most criticized due to the result their actions and decisions have had on financial reports. There is an obvious risk in prudence that it can cause bias in financial reporting as it introduces a degree of conservatism that diverts the reports from unbiased and/or neutral.

Thus, many accountants saw the disappearance of the prudence concept as a positive outcome, as it discouraged the ‘cookie jar’ accounting that concealed volatility. When challenged over the desirability of restraint in profit recognition it is often pointed out that while prudence may hold back profits in one year, such restraint may simply lead to their release in a subsequent period which as a result will show exaggerated results (cookie jar accounting). Spanish banks and dynamic were provisioning during crisis. They used their prudent reserves, by understating profit and creating reserves in good years temporarily to mask the underlying weaknesses in subsequent years as factors changed, further delaying progressive action.

5. Conclusion

Writes Malley (2014):

‘Prudence requires an open mindedness that is a necessary trait for accountants’.

It is required by accountants regardless of whether it is included in the framework or not. Inherited from the early years, it is recognisable by everyone that the prudence concept is a key principle in financial accounting by being a characteristic of past standards, existing and future standards.

To conclude my argument, I believe it isn’t necessary for the conceptual framework to receive recognition. This is due to the fact that it further enhances precaution in financial accounts. The application of precaution helps the financial misstatements and can give a false optimism to the information’s users. That’s especially true for investors who make decisions owing to the information they have to hand. Companies use the precautionary principle of prudence to retain revenues or create hidden reserves in financial reporting. However, this distorts true, realistic figures which can affect the decisions information users make.