There has been much discussion on the prudence principle in accounting, as many hold contrasting views on its role in financial reporting. This essay aims to critically discuss my perspective the role of the prudence concept in accounting and to what extent it is considered as a qualitative characteristic of financial reporting. In saying this, I will be considering the pros and cons, as well as, role of prudence in preparation of financial reporting.
Qualitative characteristics in accounting aim to faithfully represent and provide a clear representation of a company’s financial performance and position, they consist of understandibility which is taking into consideration users understanding of the information recorded on the financial statements, relevance includes the predictive and confirmatory value of information and how relevant the information produced and recorded is. Reliability is one of the main qualitative characteristics of accounting as it states information must faithful represent a company’s financial health, be neutral, free from material error and be complete and prudent. Comparability includes consistency and disclosure of financial information. The prudence concept is considered a fundamental concept in accounting, it highlights that assets and revenues should not be overstated, and liabilities and expenses should not be understated.
It causes an asymmetry in the accounting for assets and liabilities as it requires a higher degree of certainty before recognition of assets than of liabilities. Furthermore, the prudence principle advises that preparers of financial information have ‘prudent’ views when making decisions about uncertain occurrences and aim to record transactions that mirror a realistic assessment of the probability of occurrence, by anticipating no profit and anticipating all losses. In practice prudence proclaims that all expenses and revenues linked to those revenues must be realised and reported in the period in which they incurred, irrespective of when they are paid. Prudence plays a crucial role in recognising the assets and liabilities of a company by establishing the circumstances in which specific expenditures can be realised as assets and by requiring a sufficient consideration of foreseeable liabilities, as well as, potential losses. It also plays a significant part in terms of valuating assets, even though the basic rule of the concept is that assets should be valued at historical cost. In Accounting the use of comparability and consistency is required whilst dealing with past events, a key reason as to why transactions in accounting must be recorded at historical cost.
Historical cost refers to the resource value given up or any liabilities that have incurred to gain an asset or service during the time in which the liability occurred or time the resource was given up. The principle requires that they are presented at a lower value accountable to them at the date shown on the balance sheet. One of the main criticisms regarding the prudence principle is that the profits are only recognised and recorded when realised, this, therefore means the entity’s financial representation will not be as accurate providing a skewed visual of the company’s financial health.
The reasoning behind prudence is that a company should avoid recognising an asset which holds a greater value than the amount expected to be recovered from its use. This can be ascribed to the situations of uncertainty in business and places challenges and pressure in financial decision making. This is further clarified in the IASC Framework 1989, an operating guideline in the preparation of financial statements for external users, as they define prudence as “the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.” (1) The prudence concept is, after all, an estimation of the financial information of the company and therefore provides temptations to overestimate or underestimate accounts, projecting them in a superior light. In other words, the prudence concept introduces bias which conflicts with ‘neutrality’. The result of this is investors making wrong decisions and misallocating capital. There is an innate risk that the income and assets of an entity are more likely to be overstated than understated by the management whereas liabilities and expenses are more likely to be understated. A case in point could be during transfer of ownership/sale of a company and also in stock market trading.
The risk arises from the fact that companies often benefit from better reported profitability and lower gearing taking form from a cheaper source of finance and greater share price. Subsequently, the use of prudence may impact the ‘timeliness’ of earnings as the concept delays the inclusion of assets and revenues on the financial statement and overstates the amount of liabilities. ‘Timeliness’ is a qualitative characteristic of accounting, referring to financial information being provided to users in time for them to make decisions and take action. An inherent flaw of the prudence principle relates to neutrality and the inability to make comparisons of financial statements. The Chartered Financial Analysts (CFA) propagates that management should report the actual results in a transparent fashion and free from bias, giving both good and bad news equally. In the event of uncertainties, they would like best estimates to be referenced with appropriate disclosures providing the basis on which this was made. Any questions on the tendency and desirability of exercising restraint in showing profits are often counter -argued that any profits held back in one year will be reflected in the following years leading to exaggerated results. This can be seen illustrated in the case of Daimler Benz the German Car Maker when they listed in the New York Stock exchange where they simply restated their profits from the prudent German accounting guidelines considered be conservative to the US GAAP (generally accepted accounting principles) principle.
The Spanish banks did something similar during the economic crisis by provisioning reserves, masking the underlying reasons as market conditions changed, delaying remedial action at the source of the problem. (ACCA) However, due to the risks involved in economic activities, prudence should be exercised in accounts to provide a balanced perspective of the company’s financial position. Clearly, there is an obligation for accountants to exercise restraint in reporting the company’s financial information.
This is tied to the belief that the use of the concept exercises caution when making certain estimates on the financial position of a company. This viewpoint is endorsed by the general public as well as major companies and professional investors, it aids companies that utilise profits as a basis to work out dividends payable. A more recent example highlighting this is the lack of exercising restraint in disclosing financial affairs of entities during the financial crisis of 2008/9.
Had the companies responsible for the collapse of the global economic system exercised more prudence and shown transparency in their financial affairs, this would have prevented the economic downturn and provided greater stability to the global economy. Turkey could also be given as an example of exercising prudent and conservative banking principles, helping their economy recover rapidly in comparison to its western counterparts, solely due to less liquidity in their market and financial discipline. The usefulness of the embracing prudence in applying standards is perhaps more widely agreed upon. For instance, the chairman of the international accounting standards board (ISAB) has defined prudence in the IASB’s framework as “sheer common sense”. It is accepted globally in the preparation of financial information and it also assists in the comparison and fair presentation of financial data.
Accounting transparency is demonstrated in the prudence concept as it means offering a concise and balanced view of your company’s financial situation to shareholders. The importance of accounting transparency grew after several prominent businesses and accounting scandals and heightened government regulations that require companies to comply with specific reporting standards. The use of prudence can be good for investors looking to invest in a company as it gives them the ability to plan ahead due to transparency in the financial statement and also in decisions in terms of investing as the prudence concept provides information on any risk of liabilities that the company may have and therefore helps give a picture of the company in general.
On the other hand, the prudence concept may be bad for the company as it doesn’t realise assets of the company but overstates liabilities which therefore puts the company in a negative light, therefore repelling any investors looking to invest in the company. Prudence is not only a qualitative characteristic of accounting but a time- tested principle which is makes it especially relevant in today’s uncertain economic times. There may be elements of bias which may be present in its application but constrained bias cannot be detrimental if provides insights to corporate risk assessment. It is a reliable measure, however, there needs to be a degree of uniformity across global accounting standards to be more well received by all.
This is because the world economy in its current form is very inter- dependant place and companies trade globally, therefore are not insulated against risks in another part of the world. There have been various debates about its use of the name ‘Prudence’ but with common standards in its application and in tandem with other characteristics such as reliability, understandibility, relevance, comparability and regulations. To summarise, the prudence concept in accounting can in fact be regarded as a qualitative characteristic as prudence comes under the qualitative characteristic of reliability stating that all financial info provided in the reports, in order to be reliable must be exercise prudence.