Prudence has been described as “a degree of caution” Hans Hoogervorst. (18 Sep 2012) when making estimates required under circumstances of uncertainty. This means when preparing financial statement assets shouldn’t be overstated and liabilities shouldn’t be understated in order to make sure financial statements show what actually happened at the end of the accounting period. Therefore, this can be interpreted that any losses should be recorded immediately in the financial statement to show the current position and performance of the business at any time for the stakeholders for decision making purposes for example whether to invest in the business.
There is an ongoing debate about whether it was the right decision for the International Accounting Standard Board to exclude the prudence concept in the conceptual framework in 2010. The IASB removed prudence in 2010 because it conflicted with neutrality. Also, Prudence was removed when discussions began with the FASB on convergence because “US GAAP did not have a definition of prudence.” Hans Hoogervorst. (18 Sep 2012). The decision to remove the prudence concept when revising the 2010 conceptual framework in favour of neutrality regarding the qualitive characteristic has sparked controversial views.
The current debate of IASB replacement of prudence with neutrality received mixed views and criticism for example that neutrality cannot be achieved as the main purpose of financial reporting statements is to aid decision making, so it cannot actually be neutral. Also, when preparing financial statements there are always unexpected circumstances which occur for example the “financial crisis in 2008/9 is the latest example more prudent accounting by banks might have restrained excessive bonuses and dividends” Richard Martin.(August 2014) and could have led to a decrease in the chance of a financial crisis and many people losing shares and trust in the financial sector. Therefore, if there is a stronger emphasis on prudence there’s less of a chance of something like this happening again in the future.
Arguments for not including the prudence concept in the conceptual framework and IFRS argue that the prudence concept does not need to be stressed as much as it is indirectly applied through other standards. According to, Hans Hoogervort (2012) argued “if in doubt, be cautious”. Hans Hoogervorst. (18 Sep 2012) was still applied in other accounting standards. Therefore, there is no need to reintroduce prudence as the meaning is already there and because the standards emphasised strongly on neutrality as being free from bias and error and prudence will make no difference.
A member of the IASB commented suggested reintroducing prudence will have no effect on how financial statements are prepared because the conceptual framework already emphases the concept neutrality and therefore nothing will change introducing another concept that has no “distinctive meaning”. Stephen Bouvier. (22 March 2016).
Further, critics opposed to prudence argue that prudence produces bias as it “artificially smooth income”, dropping profits in good years to provide a “cushion” (European Financial Reporting Advisory Group. (April 2013). that can cover up when the company has low profits by using profits from previous years which has been reserved. Therefore, not representing the actual performance of an entity. This is also known as ‘cookie jar accounting’. Steven Bragg. (March 28, 2018). This is misleading a company’s performance and doesn’t protect potential investors as incorrect information is being presented as hidden reserves from previous years are being used to cover up losses in poor years and this goes against the fact that financial statements should be transparent on what they report and disclose. It also goes against the concept that financial statements should represent a faithful representation.
Prudence contributes to the credibility and reliability of financial statements because investors can look at the financial statements and look at any risks and concerns that may arise from the entity before investing. However, the absence of prudence has had a negative effect on investors and shareholders because it has meant that the company can hide the actual performance from external stakeholders because external users cannot select specific financial information, they must rely heavily on the statements provided. Therefore, these statements should show what has actually happened when the business was running.
While shareholders claim companies are not regulated to prepare their financial statements at a good enough standard, they also argue auditors dont have much of a say when regulating an entity. The prudence concept has been “stripped away” UKSA. (2012) when all these accounting standards have come to place which has restricted auditors in assessing or questioning an entity on what they have been up to. In the eyes of shareholders prudence is seen as “absolutely essential”. Roger Collinge FCA. (July 2015). They argue there’s less restriction on accountants to report assets and liabilities as soon as they occur.
Also, prudence can help achieve neutrality in selecting and applying accounting policies. Including prudence in the conceptual framework allows tighter restrictions on what a business can do when valuing their assets for example if prudence was not included this will give the opportunities for companies to choose how they will value their assets from a selection of choices even if the auditors do not agree with it and consider their decision to be “imprudent”. UKSA UK Shareholders’ Association. (July 2011). Therefore, in order to make sure assets are being measured reliably in order to show a true picture of the company’s position and worth at any time, there needs to be prudence.
To conclude, I believe prudence should be reintroduced in the conceptual framework and in IFRS because the main reason financial reports are produced is to provide reliable information to those who are most likely to benefit from it and use it to make decisions. There have been many accounting scandals in the past years and one reason these scandals occurred was because businesses understated their liabilities and overstated their assets. Also, the financial crisis in 2008 which many people lost trust in investing in businesses, accountants and the financial sector. If there was a stronger emphasis on prudence maybe hundreds of people wouldn’t have lost their jobs when the cooperation’s went bankrupt. If external stakeholders do not trust the statements provided, they are less likely to invest in the business and some businesses need shareholders investments in order to grow and develop in business. I believe there’s so much pressure on how financial statements should be prepared in order to please all stakeholders that prudence should be emphasised in order to make sure no more accounting scandals occur and prevent another financial crisis but also to build back the trust in the financial sector.