Prudence And Conceptual Framework For Accounting

Internal audience Director’s Brief

Discuss about the Prudence and Conceptual Framework for Accounting.

Financial accounting has a certain concept that organizes the financial statement preparation. The most used concept for this purpose is prudence. It recommends that assets or income must not be overstated. However, liabilities or expenditure must not be understated also. The purpose of prudence is to show the least positive business position (Penman, 2013). With those who are not familiar with this concept, will not prefer to do this. Still, sometimes a good position can give a positive response to business. This concept is significant in assisting reliable representation while making sure that financial statement does not misinform and give a fake opinion to users. In essence, this concept is a basic principle of accounting, with IAS I delineating its role.

Impartiality is promoted while practising prudence. Prudence is said to be the cautiousness when judgements are made under the circumstances of uncertainty. The exercise of prudence refers to assets or revenues which are not overstated and liabilities or expenditures which are not understated. Mutually, this exercise does not entitle assets and income understatement and liabilities and expenses overstatement, it is because these type of misstatement can result to income (overstatement) or expense (understatement) in near future.

Financial statement preparers do, nevertheless, have to compete with such uncertainty that unavoidably encloses many conditions and events like the doubtful receivable collection, the expected useful life of assets and several claims of warranty that can take place. These uncertainties can be taken into account by revealing the nature and level and prudence exercise in the financial statement preparation (Malley, 2014). Prudence is inclusive of the exercise of caution and practise of judgements required in making estimation under the events of uncertainty. In such a way that, assets or revenue must not be overstated and liabilities and expenditures must not be understated (Lin, 2015). Conversely, prudence exercise does not entitle for this, for instance, hidden reserve creation or unnecessary provisions, the purpose of asset understatement, or the purpose of liability overstatement, because of no neutrality in financial statement and thus will not be reliable for the concept. On the other hand, most users pass comments regarding this issue, expressing a view that a reference to prudence must be applicable in accounting provisions of Conceptual Framework.

They provided some reasons which are enumerated as below:  

1. Standards, existing and planned, both make use of accounting treatments that some view as encouraged by approach for prudence. This, it is significant to justify prudence in the accounting provisions of Conceptual Framework so that it can be applied in a continuous manner.
2. Prudence is required to the management of counteract.
3. Investors also show concern regarding the hazardous risk than advantageous potential. Prudence assists to deal with this concern (van Mourik and Katsuo, 2014).
4. Research done by academics has suggested certain forms of conservatism, it is concept same like prudence, it has a role in financial reporting. Conversely, different viewpoints were placed regarding what form will be not useful, at what time and why.
5. Prudence exercise assists to line up the managers and shareholders interest can make a reduction in hazards (ACCA. Prudence and IFRS. 2014).
6. Financial crises had justified the requirement of prudence while making estimations.

This section is based on analysis of arguments which are against in making use of prudence in the conceptual framework. In such cases, the argument is articulated thoroughly in italics, and further, the response is provided.

Argument in favor of the re-inclusion of prudence in the new CF

Basically, prudence is not considered to be a useful method because it is formless. Particularly, this concept cannot help in questioning how much to apply in a situation. Most of the concepts are open to this similar analysis. But some do not, for instance, have an extent for the relevance measurement (Burton and Jermakowicz, 2015). In addition to, it must be kept in mind that prudence takes place at the time of uncertainty, and by considering this aspect it would theoretically incompatible to release prudence because it is too vague.  Instead, it is essentially an indistinct concept, with this ambiguity being the primary purpose for its presence in the first place as it is not a reason for the elimination of this concept from the Framework. 

Prudence is not applicable in all standards of accounting rather it is applicable in some cases. Therefore, it should not be applied in conceptual framework instead it should be applied as per the requirement at the standard measure. If prudence is said to be a concept, in developing of any specified standard, then it will be included in the framework (Gebhardt, Mora and Wagenhofer, 2014). Not every component of the framework is reliable to be considered in all aspects of the standard, but what all content of the Framework should have in common is being part of the conceptual foundation for accounting practice.  Furthermore, constant application of the concept in specified accounting standards needs a clear standard by which relevancy can be measured and evaluated, and further this conceptual standard is Framework.

In case net assets are understated in the existing period of accounting, then the financial position might be overstated in near future, which will not be considered as prudent. If profits are removed when they are vague further they will be unavoidably reported in future when they will be certain (Craig, Smieliauskas and Amernic, 2017). In the test of prudence, gains are realized just once and they can be demonstrated, further, this can be considered as prudent. Point to be noted is that, at no point are net assets over-stated (van Mourik and Katsuo, 2014).   The main question arises is in if or if not an investors will prefer to assess of financial performance that is trustworthy against to one that they cannot.

If the conceptual framework entitles bias and an exit from neutrality, further this approach will make an individual eligible for abusing and window-dressing of financial statements (Chaudhry and et.al, 2015). There are two defences in opposition to this argument. It is depended on the IASB on how to make use of Framework while setting standards and its provided in standard applicability that the policy decisions are decided by preparers themselves. Next is that traditional prudence can in any case by stated as consistent with neutral and fair, and the reasons for this were mentioned above.

Prudence would lead to unrealised profit prohibition. The meaning of conventional prudence does not rely on realisation but on uncertainty. Further an unrealised gain not required to be uncertain.

Prudence would enable an enterprise to estimate an asset to an extent that must be less than the unbiased estimate. This argument misses the point with regards to uncertainty. In case the amount is uncertain, then it will be misled in respect of biases (Craig, Smieliauskas and Amernic, 2017).

XYZ company Sydney 3500 Date: Mr Price Executive Director of Corporate Advisory Corporate Advisory Group Re: draft submission letter to the IASB Respected board The term ‘prudence’ in accounting is utilised in different ways having a different sense. In particular, there are two primary divergent perceptions of prudence which are prominent in the debate on the conceptual framework. In accordance with the IASB; prudence is consistent with neutrality and essential for interpretation for careful judgement in accounting. Second perception in accordance with the traditional understanding of prudence in accounting practice which states that prudence is the solicitation of a complex threshold of verifiability for the acknowledgement of gains in comparison to losses.  The International Accounting Standards Board recently issued an Exposure Draft of a new and revised framework regarding Financial Reporting. For this, IASB tends to re-establish prudence that will make financial statements more useful (Zhang and Andrew, 2014). On the face of it, this sounds like a clear-cut decision, after all, prudence is recognized as an asset on daily basis of life. Although, prudence application to accounting provisions is complex than it is to a conduct of an individual.  This vagueness has created confusion in order to remove any reference to prudence in 2010, during the last revision of the Conceptual Framework, choosing to depend on other ways of defining good quality in terms of financial reporting (Gebhardt, Mora and Wagenhofer, 2014). In divergence with this indistinctness in 1989 and 2010, the reinstatement of prudence in the 2015 ED was noticeably in the form of ‘IASB Prudence’.  Without categorical acknowledgement of the manifestation of uncertainty. However; the cited approach is profoundly flawed.  It is because; this concept familiarises a ‘concept’ into the Framework which is not a viable theory at all because it leads to significant confusion.  The problem in the concept of prudence is in its substance of definition which does not make contributions to the objective of neutrality. Further; conceptual framework already provides a definition of neutrality thus nothing will be attained from the institution of an additional ‘concept’ which does not have any distinctive meaning (Craig, Smieliauskas and Amernic, 2017).  This argument does not imply that neutrality and prudence are exactly similar; undeniably, neutrality is a wider concept in comparison prudent approach of IASB.  Due to this factor; the existence of two approaches and definitions having similar conceptual outcome summonses unescapably unproductive endeavours to comprehend why and how each concept differs from the other. In addition to this concept of ‘prudence’ have a different meaning to different people, thus ‘reintroduction’ of the concept of prudence will make an increase in misunderstanding as an accommodating response by the IASB to hassles that the Conceptual Framework should entrench prudence as conventionally assumed.  On the basis of this aspect my viewpoints are as below: ·         The conduct of prudent in IASB must be dropped because it has no useful intention and has risks in itself. ·         The existing treatment of prudence must be replaced by; prudence is the application of maximum limit of verifiability for asset realisation that of liabilities. ·         The above-mentioned meaning must be enhanced with a clear picture of the main core of the conceptual framework. The above-specified text in the core of framework must be enhanced with a clear picture in terms of conceptual justification for prudence, inclusive of the fundamental role of; measurement uncertainty and time, irregularity of information and financial incentives among investors and management. I don’t think, it is sensible to re-establish the basis of its use can come into different from what it was before. Just not the term prudence is acceptable, but also to use this in a different manner is illogical (Bauer, O’Brien and Saeed, 2014). While talking about other factors of financial information, these both prudence and neutrality are completely different features and are used at a threshold, equally while benefiting the information. However, one cannot be used to back the other. From my point of view, the most suitable way to make use of prudence can be defining the framework for the purpose of financial information (Investor perspectives. A tale of prudence, 2015). Take it in another way; I don’t think it’s conventional understanding must be changed. Instead of that, the accounting aspects of conservatism and irregularity must be maintained, but it some degree of scope. Thank you for providing me with the opportunity to express a viewpoint on the concept of prudence. If you have further queries in future please contact on +61(3) 1111 1111 or on [email protected] EYX Executive chair

References

Books and journals

André, P., 2014. Towards a New Conceptual Framework: Here We Go Again!.

Bauer, A.M., O’Brien, P.C. and Saeed, U., 2014. Reliability makes accounting relevant: a comment on the IASB Conceptual Framework project. Accounting in Europe, 11(2), pp.211-217.

Burton, G.F. and Jermakowicz, E.K., 2015. International Financial Reporting Standards: A Framework-Based Perspective. Routledge.

Chaudhry, A., Coetsee, D., Bakker, E., Varughese, S., McIlwaine, S., Fuller, C., Rands, E., de Vos, N., Longmore, S. and Balasubramanian, T.V., 2015. Conceptual Framework. 2015 Interpretation and Application of International Financial Reporting Standards, pp.29-37.

Craig, R., Smieliauskas, W. and Amernic, J., 2017. Estimation Uncertainty and the IASB’s Proposed Conceptual Framework. Australian Accounting Review, 27(1), pp.112-114.

Gebhardt, G., Mora, A. and Wagenhofer, A., 2014. Revisiting the fundamental concepts of IFRS. Abacus, 50(1), pp.107-116.

Gebhardt, G., Mora, A. and Wagenhofer, A., 2014. Revisiting the fundamental concepts of IFRS. Abacus, 50(1), pp.107-116.

Lin, H., 2015. Discussion about conceptual framework. International Business Research, 8(6), p.191.

Penman, S., 2013. Accounting standard setting: Thoughts on developing a conceptual framework. China Journal of Accounting Studies, 1(3-4), pp.157-167.

van Mourik, C. and Katsuo, Y., 2014. The IASB and ASBJ conceptual frameworks: Same objective, different financial performance concepts. Accounting Horizons, 29(1), pp.199-216.

Zhang, Y. and Andrew, J., 2014. Financialisation and the conceptual framework. Critical perspectives on accounting, 25(1), pp.17-26.

Online

ACCA. Prudence and IFRS. 2014. [PDF]. Available through <https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-prudence.pdf>. [Accessed on 30^th September 2017].

Investor perspectives. A tale of prudence. 2015. [PDF]. Available through <https://www.ifrs.org/-/media/feature/resources-for/investors/investor-perspectives/investor-perspective-jun-2015.pdf>. [Accessed on 30^th September 2017].

Malley A., 2014. [Online]. Available through <https://www.theaccountant-online.com/news/is-prudence-still-a-virtue-4276220/>. [Accessed on 30^th September 2017].