The prudence concept ensures that expenses and liabilities are noted as soon as incurred but revenue is documented only when attained
The prudence concept ensures that expenses and liabilities are noted as soon as incurred but revenue is documented only when attained (Business Dictionary, n.d), thereby making certain that there is a “degree of caution” in implementing policies whilst maintaining going concern for the company (ACCA, 2014, p.3). However, precipitated by the financial crisis in 2008, several accounting academia have scrutinised prudence as an inadequate way of assessing assets and income because of its rigidity in undervaluing them (HMRC, 2013). In addition, traditionalist critics also argue it impedes neutrality (ACCA, 2014b). Contrastingly, some adopt the consensus that the demotion of the concept to desirable quality in financial reporting in 2010 as opposed to a core concept in the IFRS 18 (Christodoulou, 2010) consequently caused the downfall of the economy. Also, citing that prudence coordinates the interest of shareholders with the objectives of management (Macuica, 2015).
Traditionally, prudence was viewed as a key concept in the conceptual framework as conveyed by Van Hulle in Prudence: a principle or an attitude?, a necessity in the Fourth EU Directive (Van Hulle,1996). The IASB justified its decisions by arguing prudence was still prevalent in the revised accounting standards (Omiros, n.d.) but its presence as fundamental influenced the neutrality of financial reports. Professional investors such as the CFA echo the argument presented in Omoris’ paper, positing the quality of information is impaired as it allows for subjective estimates by management (ACCA, 2014c). According to Reed’s Investors oppose prudence in reporting, in a survey conducted in 2014 by CFA’s members, only 31% preferred prudence in financial information, stating that implementing it would mean an adjustment of data to cater for “conservative bias” thereby implying, the CFA is resistant to the inclusion of the prudence concept (Reed, 2014, p.1). The hesitance is further reiterated by Hans Hoogervorst, Chairman of IASB who argues in The Concept of Prudence: dead or alive? that “excessive conservatism” led to cookie jar accounting – creating reserves during good financial period for bad financial periods thus smoothing out the trend (Investopedia, n.d.) – therefore hinting that the financial crisis was collateral damage of using prudence as opposed to the general consensus aforementioned above (Hoogervorst, 2011, p.3) . This “excessive conservatism” is in probable reference to Daimler Benz who admitted in their restatement that the frequent unpredictability of bank loans during financial periods forced them to release understated profit from one period into another (Kobrak and Wilkins, 2012), thereby demonstrating that there appears to be ambiguity to the level of prudence needed for entities to use. Finally, the argument to exclude prudence from the conceptual framework and IFRS is conveyed through the idea that it does not recognise the incline in value of an asset except when sold, this in turn demonstrates a lack of prudence as the possibility of this amount seems to not have been taken into consideration. Additionally, Richard Barker’s Conservatism, Prudence and the IASB’s Conceptual Framework also explains that it forces an incomparability of financial statements as the “manipulation and abuse of financial statements” differs from period to period depending on the level of prudence on each, separate accounting manager (Barker, 2015, p.12). Therefore suggesting that the inclusion of prudence in the conceptual framework will instead harm the nature of financial reports and opposed to rectifying it.
However, institutional investors like Eumedion argue that prudence as a key concept would prohibit over-optimism or prevent extreme bias in uncertain financial periods in The role of prudence in financial reporting by Geanina Macuica. Omoris’ paper furthers the argument by stating that prudence allows for competent stewardship by management and directors as it also works in tandem with Company Law (Omoris, n.d. c). Michel Prada in Interview: Michel Prada defends IFRS Foundation governance initially defends Hoogervorst’s insistence on not introducing prudence but adds that if prudence makes the public comfortable in knowing that companies are adopting faithful representation, then it is paramount that prudence be reintroduced into the conceptual framework, therein suggesting that not only does the inclusion of prudence result in greater trust – by the information users – in eliminating bias, but it also unifies the legal obligation of an entity with international financial reporting standards. In Langworth’s Battle of the Accountants, Steve Smith, an accountant argues that prudence underpins the international standards as well as the nature of accounting. Smith further explains that the debate between neutrality and prudence should rather be reduced to which concept would be better depending on the information available and the specific situation, thus concluding that prudence is just as important as neutrality, refuting the argument that one disqualifies the other. Finally, it is known that it is mostly in overstating profits that accountants are most criticised, demonstrated by the uproar by British taxpayers who learned about the large bonuses bank executives were given during the financial crisis. Willemjin de Jong argues in Regulating bankers’ bonuses that “bonuses stimulated excessive risk-taking”, this is possibly since it demands for extreme attention on short term earnings which would result in managers most likely manipulating accounting standards to achieve earning objectives (De Jong, 2013, p.1). It could be said that if the PRA had existed during this period, more financial firms would have practised prudence extensively which would have curtailed, if not, prevented the financial crisis (BBC News, 2013).
In conclusion, it appears that there is considerable debate about whether the IFRS should include prudence and state its importance in their conceptual framework. On the one hand, some critics argue that its inclusion in the conceptual framework affects the neutrality of reports – a fundamental qualitative characteristic – and leads to excessive prudence which in turn results in accounting malpractices. Those that adopt this view also highlight the issue that prudence creates in only recognising the incline in value of an asset when it is sold. Whilst others suggest that prudence is principal in governing true, representations of a company’s financial performance and position through financial periods. Such critics further the argument by stating how important of a role prudence would have played in preventing the financial crisis, eliminating over-optimism or extreme bias as well as ensuring the public’s needs are addressed first. Ultimately, prudence should be included in the conceptual framework of the IFRs because it correctly assesses the stewardship of management which is crucial in maintaining objectivity of reports and going concern of the entity. It also facilitates transparency for potential investors and could prevent global financial risks.