Prudence that ‘there is a false pretence that

Prudence
is a concept that preparers of financial statements should exercise when making
judgements about uncertain items such as doubtful debts, assets lives, etc. It
is deemed as one of the qualitative characteristic of accounting information
and refers to the inclusion of a degree of caution in accounting judgements
under conditions of uncertainty.  According to the framework, ‘information
included in financial statements should be prudent’. The aim of using prudence
is to avoid the overstatement of assets and under-statement of liabilities as both
would lead to an over-statement of profit. In my essay, I will discuss the role
of prudence and whether it should be characterised as a qualitative
characteristic.

One positive of prudence comes from The IASB who
state that ‘there is a false pretence that prudence is inconsistent with
neutrality.’ Instead, it can be argued that it could be a mechanism for
ensuring neutrality exists. Neutrality is a term included in the IASB’s
conceptual framework and is deemed important when assessing financial
information. The role of neutrality is to remove bias
by ensuring financial information is not weighted, emphasised, de-emphasised or
manipulated to increase the probability that such information will be received favourably
or unfavourably by the users. It is a necessary component for providing faithful
representation. An example of prudence being consistent with neutrality is when
measuring the depreciation of an asset. It is ethically important that any potential
investors are not only aware of the estimates calculated but also that these
estimates are realistic and without bias. In this instance, prudence is consistent
with such estimates and the need for neutrality. On the other hand, despite The
IASB’s Framework (para37)stating, ‘the exercise of prudence does not allow,
for example, the creation of hidden reserves or excessive provisions, the
deliberate understatement of assets or income, or the deliberate overstatement
of liabilities or expenses, because the financial statements would not be neutral
and, therefore, not have the quality of reliability’, prudence was still used
inappropriately by Nortel in November 2002 (USSEC Press Release November
2010). The report shows that ‘In November 2002, three senior managers of
Nortel learned that Nortel was carrying over $300 million in excess reserves and
did not release these excess reserves into income as required under US GAAP. Instead,
they concealed their existence and maintained them for later use to avoid
posting a profit’. These reserve manipulations helped to erase Nortel’s pro
forma profit for the fourth quarter of 2002 and caused it to report a loss
instead. This allowed the company to delay paying bonuses to its stakeholders
such as shareholders and employees. This clearly demonstrates a lack of consistency
between neutrality and the use of prudence and it is also an example of how
prudence can work against a number of stakeholders. For example, for investors
who use financial statements to make decisions on future investments. Any over-
or under-statement within the statement could lead to substandard decisions and
a misallocation of capital.

 

 

 

 

 

 

“It
therefore seems to me that prudent and well-considered estimates should be
neither overstated nor understated”. (Steve Cooper pg1, 2015). The problem
with prudence lies with the definition of the word. It can often be difficult
to understand its relation to financial reporting. It is this confusion that led
to the IASB to remove any reference to prudence in 2010.  SPEAK ON HOW THE FRAMEWORK REMOVED PRUDENCE
IN 2010

For
instance, prudence has also been defined as ‘Conventional prudence’ (Barker
2015). This type of prudence places more focus on the verifiability of gains
compared to losses. “The accountant’s tendency to require a higher degree of
verification to recognise good news as gains compared recognising bad news as
losses” (Basu 1997, pg7). This is also known as accounting conservatism. The consequence,
as Barker claims, is a lower carrying amount of net assets compared to IASB
prudence. This is an issue because by understating within the financial
statement in the current period, this could lead to an over-statement of
earnings in future periods by causing an understatement of future expenses. There
has been empirical research on conservatism that comes to the conclusion that accounting
has become more conservative in the last 30 years (Watts 2003, pg. 208).  The usefulness of conventional prudence
however, depends on whether it implies a downward bias in net asset value and whether
it is therefore consistent with neutrality. The concept of conventional
prudence applies only where there exists significant uncertainty in
measurement, and even then, only when the uncertainty concerns gains as opposed
to losses. Conventional prudence in principle does not allow either a
deliberate understatement of gains in the absence of uncertainty or under any
circumstances, the deliberate overstatement of losses (Barker 2015). Based on
this context alone, there isn’t really any strong difference between IASB prudence
and conventional prudence. Instead, the purpose of conventional prudence is to
defer the recognition of gains that are subjectively estimated (i.e. ‘uncertain’)
at the balance sheet date and that therefore can neither be verified nor relied
upon, and it is in this context only that conventional prudence differs from
IASB prudence