There has been a heated debate on the matter of prudence in financial accounting over the recent years. Some people have argued that financial accounting is a conservative practice that requires accountants to be cautious. Others believe that accountants should be neutral when applying the principles of the International Accounting Standards Board (IASB) so that there is a faithful presentation during financial reporting. There are inherently many risks attached to the application of prudence in financial accounting. One of the main items that often fall into the trap of prudence is the valuation of assets (Barker, 2015). It is usually common to find that the book value of assets being less than the economic value of the same assets. Because of these differences, there are both practical and conceptual reasons for the outcome when neutrality or prudence concepts are applied. If an accountant uses the prudence principle to value an entity’s assets, there would be information asymmetry bias which might lead to a conservative outcome of the financial statements being presented (Holt, 2018). This saw the need for the update of the IASB’s 1989 Framework for the Preparation and Presentation of Financial Statements to remove the concept of conservatism and prudence in financial reporting. This paper seeks to make an outline of the initial discussion paper draft for the Board of Directors of Big Phore Partners detailing the context of the change and the arguments for and against the inclusion of the matter of prudence in the new Conceptual Framework by IASB. This paper is also intended to prepare a letter of the draft to be submitted to the IASB in regard to the firm’s position on the issue of re-including prudence in the Conceptual Framework.
The Context of the Change
We can all attest to the fact that financial accounting is not a subject for the neutral measurement and recording of the economic value of items of the financial statements. We also all know that the book value and the economic value of items are conceptually different because of the issue of conservatism (Dichev, 2015). This issue of inherent conservatism seems to have been overlooked by the IASB and other critics. The decision of IASB to remove prudence from the Framework for the Preparation and Presentation of Financial Statements has sparked a lot of criticism from practitioners and academia (Barker, 2015; Tracey, 2015). Although it can be argued that the challenge of the new framework is being implied by adopting an agency –based, contracting demand for prudent accounting, critics of this principle believe that the actual problem, for the most part, does not exist.
What appears to be the truth of matters is that, most investors today, desire that the management through the accountants of an organization will avail ‘‘the right information’’ for them to make the right decisions. As a comment to this new Conceptual Framework, we can suggest as a company (Big Phore Partners) to ask IASB not to re-include the principle of prudence and conservatism as it is against the desires of most investors. But because Mr Price (the company’s executive director) believes that prudence is the cornerstone of financial reporting, we have to look at the arguments for and against the re-inclusion of the principle of prudence in the Framework for the Preparation and Presentation of Financial Statements during financial reporting.
Prudence in financial accounting and reporting has had a long-established track record. Since the prudence matter was done away in 2010, there has been a heated debate on whether to re-include it or not. As the body mandated to review and update accounting standards and frameworks, the International Financial Reporting Standards (IFRS) should consider these arguments for and against the matter of prudence before making a decision on the same.
There has been a general, clear and acceptable expectation that has been placed among accountants by users of financial statements over a long time. These users have always believed that accountants should restrain themselves from a situation of anticipated over-exuberance of the management when it comes to the preparation and presentation of a company’s financial statements. Some users also usually believe that the reported and audited financial statements are usually hard and that most certainly some estimates might have been made cautiously by the accountants during the preparation of such numbers (“Conceptual Framework”, 2018). This scenario was being referred to by the previous framework as prudence where accounting standards supported it. The view of caution during the preparation and presentation of financial statements is not only held by the general public but also by professional investors, accounting researchers and organisations stakeholders. Investors are particularly interested in this area because of the profits figure they desire for payment of dividends and bonuses.
It is most certainly possible that where assets and profits have been overstated rather than being understated, the accountants, books of account and the underlying accounting standards would receive more criticism than the later. There are many asymmetrical risks that are associated with being non-prudent (Hogarth, 2015). The latest example that can be attributed to non-prudent behaviour is the 2008/2009 financial crisis that hit most banks in the US and Australia. During the financial crisis, the more prudent banks and firms who might have restrained excessive dividends and bonuses are the ones which became resilient and thereby provided financial stability to the whole economic system. The application of prudence in entity ensures that cases of changing accounting policies, changing reals’ variables of the accounts, timing of new accounting standards, managing discretionary accruals and timing of transactions to suit the interest of the company does not occur.
Many proponents of the re-inclusion of the principle of prudence believe that its application is more widely agreed upon than its rejection (https://www.accaglobal.com, 2018). According to the chairman of IASB, the inclusion of the concept of prudence in the International Accounting Standards Board’s is a way of promoting a sheer common sense across the accounting profession where professional accountants would have to choose a ‘‘wise” option of conservatism rather than being overly optimistic. An example of a sheer common sense scenario is where the accountant has to ensure that revenues are not overstated while expenses should not be understated. Prudence should, therefore, be re-included to guide accountants to judge situations more wisely.
Proponents for the re-inclusion of the concept of prudence in the conceptual framework have argued that the current conceptual framework does not include an explicit reference to substance over and conservatism as it used to be before. They argue that adding the practices of conservatism and substance explicitly would add more clarity to reporting. The IASB Exposure Draft that was released for public opinion in 2015 proposed changes among them being the issue of application of the concept of substance over form and faithful recognition and representation when it comes to recording, summarizing and presenting the results of economic phenomenon of an entity (M?ciuc?, Hlaciuc & Ursache, 2015). The 2015 IASB’s Exposure Draft therefore proposed in favour of conservatism way of accounting rather than merely providing economic information about the legal existence of items of an entity. The most important reason behind this outcome is that even if accounting is done in accordance with the legal form of items and or relevant disclosures, the faithful representation cannot occur when the economic substance of an organization is reported with a lot of optimism (Positive Accounting).
Positive accounting and or optimistic accounting is a recent practice that has been accused of trying to seek to predict and explain the accounting practices rather than deriving and prescribing a normative or optimal accounting standard. Optimistic accounting, as opposed to convertism accounting, usually tries to make things look good by making ‘‘positive” theories aimed at explaining the real economic substances of an entity and translating them into accounting transactions (Sutton, Cordery & van Zijl, 2015). The application of the prudence concept, therefore, is a way of trying to adhere to normative accounting theories and hence reducing overly optimistic reporting.
Proponents of the anti-inclusion of the prudence matter in the “Framework for the Preparation and Presentation of Financial Statements argue that the principle of prudence is against prudence and faithful presentation (Bouvier, 2018). When IASB made an update to the Framework for the Preparation and Presentation of Financial Statements, it removed the reference made to prudence and conservatism on grounds that prudence lack consistency when it comes to the issue of neutrality. Neutrality and faithful presentation are the core practices and principles that should underlie the preparation and presentation of financial statements (Cuguerr-Escofet & Rosanas, 2016). IASB, therefore, would have no option to re-include the concept of neutrality when developing and revising its principles.
While prudence has been desired because of its restraint when it comes to profit recognition overstatement, it is often found that prudence may hold back profits in one year (restraint) and release them in the subsequent fiscal periods. This situation will result in exaggerated results over time. Dimler Benz’s is a company that was once affected because of prudence (“Daimler-Benz Reports Loss”, 2018). The profits were restated using the German accounting standards to the US Generally Accepted Accounting Standards (USGAAP) for it to be listed in New York. This restatement was duped as ‘smoothing’ effect of the prudence principle. In other cases, prudence has also been accused of causing a crisis to the Spanish Banks where the prudence concept was used to provide strategic provisioning during the period. Because of these factors, prudence has been accused of providing a temporary reservation to an entity’s weakness as the conditions change causing a delayed remedial action.
References
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