Introduction:In this essay I will critically discuss the role of prudencewithin the preparation of financial statements with arguments both for andagainst prudence within accounting standards. The word prudent means ‘actingwith or showing care and thought for the future’. There are variousdictionary definitions for prudence, all of which are similar with reference tosynonyms such as ‘careful’, ‘cautious’, ‘wise’ and ‘well judged’.Accounting transactions are sometimes uncertain however tobe relevant accountants must publish their financial reports in time.
As a result,we sometimes must make estimates. Whilst making these predictions/estimates itis important that we stay cautious and prudent. Prudence is often seen as a majoraccounting principle that ensures that assets, profit and income are not overstated,and that liabilities and expenses are not underrated.
As clear as it may seem, prudence is a desirable thing whenpreparing financial information. On the other hand, nailing down thecharacteristics of functional financial reporting has seen some debate. Until2010 prudence was included in the International Accounting Standards Board’s(IASB) framework. ‘ The Conceptual Framework for Financial Reporting describesthe objective of and concepts for general purpose financial reporting; it dealswith issues such as the definitions and measurement of assets and liabilitiesand when and how income and expenses should be recognised and presented. TheConceptual Framework also includes a discussion of the necessary (and in somecases desirable) characteristics of useful financial information.
To be useful,financial statements must provide information that is relevant and faithfullyrepresents the economic activity it depicts. Prudence is one possible componentof these characteristics and has attracted much attention.’ (IFRS, June 2015). Howevernow some continue to argue the need to place prudence back into this accountingstandard.Main body:The reason prudence is so important in accounting is becausemanagement teams who generate accounting estimates are likely to beincentivised to either overstate or understate their financial position orfinancial performance. Some may seek to be disingenuous by overstating thefinancial performance to dodge the negative consequences for reporting suchpoor performance, where as an understatement of financial performance could beused to lower the bar for future financial performance reports to avoid theconsequences of future poor performance.
This becomes problematic for investors that use financialstatements to make investment decisions as any intentional over or understatement could lead to poorer decisions and a misallocation of capital. As a result,prudent estimates should be sure to neither overstate or understate and thatthey should be as accurate as possible to create the fairest outcome for thosewithin the market.As a result, there is a clear expectation amongst most thataccountants and their accounts should therefore restrain from irresponsibly andfalsely reporting on company results.
There is an expectation that the reportedand audited numbers are to be true and that caution has been used when makingestimates and that the accompanied accounting standards reflect this. This isespecially the opinion of investors, who pay special attention to profits as abasis for bonuses and dividends. As it is where profits are overstated especiallythat accountants and their accounting standards tend to face the most scrutiny.With their being a large asymmetrical risk meaning that the risk an investorfaces is significantly different from the loss occurred by fraudulent accountants,that prudence ought to be used to address.
There is therefore an obvious risk that assets and incomeare far more likely to be overstated than understated by management whilst expensesand liabilities are to be understated. The issue arrives from companiesbenefitting from greater reported profitability due to cheaper sources offinance and a greater share price. As a result, the prudence concept is veryuseful as it helps to ensure that such bias is reversed by exercising cautionwith generating estimates and the use of accounting policies. The general rule when acting with prudence therefore is thatif you are unsure, err on the side of caution.
This does however create someissues, in revising certain chapters of framework in 2010 the IASB argued thatprudence ought to be removed as it was inconsistent with another principle, thatbeing neutrality. In their view the only way to achieve a faithfulrepresentation of transactions and balances in financial statements was forthose financial statements to be neutral and exempt from bias. As a result,prudence was found to be a form of bias. You see other investors wantmanagement to report the ACTUAL results in a manner that is neutral to bothgood or bad news. Where there may be uncertainties many investors would rather managementgave their best estimate rather than just underpredicting in order to avoid possibleconsequences of overstating profits.
This is an issue as often when managementpractice prudence by holding back profits in one year this may just result toexaggerated results in a following period. The other problem with prudence is determining how much ofan understating bias has been used between completing companies and theiraccountants. If one company has acted with more prudence than another it maylead to investors generating different opinions and as a result benefitting acompeting company. As a result, how can we be sure companies will act withprudence if it impairs them in doing so?Conclusion:As seen there are many arguments both for and against theuse of prudence in accounting standards, mainly focussing on the issues causedby user expectations when using financial information and the need for accountantsto make sure these statements remain unbiased and neutral.
Prudence is needed toensure that companies cannot mislead investors with asymmetric risk and to makesure that investors can trust the validity of financial information.Prudence should continue to be discussed in terms of how itis defined within the conceptualframework and how much prudence should be used within estimating financialinformation, however so long as it shows a fair value through honestapplication it is an important and valuable characteristic.For these reasons I believe that its role should berecognised by the conceptual framework. The use of prudence helps to ensurethat the users of the financial statement are not given falsely optimistic informationespecially to investors who may as a result misallocate capital and make poordecisions because of disingenuous estimates. I also believe that so long asprudence does not result in a gross underestimate of results in the financialstatement it will not conflict with neutrality and could help to maintainneutrality within the financial statement.