Before as well as producing examples of
Before discussing the role of Prudence, it is importantthat the role of Prudence is understood. Many people tend to confuse Prudencewith Conservatism; believing that they are synonyms (Barker, R 2015). When in fact, prudencefalls under the accounting characteristic of conservatism. They are two concepts that are used byaccountants when creating financial statements. Conservatism refers to anymethod of accounting that leads to book value being less than economic value (Barker, R 2015). Economic value is anestimate of future cash flows and worth after discounting.
Some argue that conservatismis an intrinsic system property as accountants following the framework shouldalready be focused on valuing assets at appropriate values. Prudence concept isthe accounting term used to define the characteristic that allows one to actwith or show care and thought for the future. Prudence arises from acautious response to Uncertainty (Barker, R 2015). Prudence is fundamentalin financial accounts as it makes financial accounts relevant and useful (Barker, R 2015). Financial accountsshould always aim to produce conservative and cautions figures in order toproduce the best financial interpretations of any business (Barker, R 2015). In this essay, I will be discussing the effectprudence has on the preparation of financial statements. Whether Prudenceshould be considered as a qualitative characteristic in the accountingframework. How prudence plays a role in decision making as well as producingexamples of how prudence can successfully be applied when calculating financialstatements.
A good example of how Prudence can successfully beapplied when calculating financial statements is in the case of inventories. Based onprudence, the accounting standard states that inventories should be valued forthe purposes of the financial statements at cost or net realisable value,whichever is lower. By so doing, the entity is recognising the possibility ofthe loss likely to arise due to drop in the selling price of the commodity.Therefore portraying a realistic financial picture of the value of theinventories.There are many advantages of the effect prudence has onthe preparation of financial statements. Firstly, Prudence has developed a clear expectation among many users thataccountants should put a restraint on the anticipated over-exaggerations ofmanagement in reporting a company’s results. (Prudence and IFRS – ACCA Global).
This means that the results of financial statements are more likely to have amore truthful representation. In doing so, Prudence really helps to achieve abetter balanced image of the businesses successes and shortcomings inaccordance with any externalities the business may face which management maynot want to display but need to accept.Secondly, Prudencecertainly fixes where profits and assets have been overstated – and not wherethey have been understated. This iswhere accounts, accountants and accounting standards have received the mostcriticism. (Prudence and IFRS – ACCA Global) The main use of financial statementsis to take a transparent image of the business and prudence ensures that a businessdoes not appear to have over valued assets. This is why provisions have to bemade when formulating financial statements.A great examplewould be “The financial crisis in 2008/9”.
This is the most recent example ofhow a more prudent approach to accounting by banks might have restrainedexcessive bonuses and dividends; making banks more resilient. It also providedgreater financial stability to the whole economic system that was going throughthe effects of this financial crisis (Prudence and IFRS – ACCA Global). Prudenceforces accountants to think about the way figures are represented.Prudence isultimately a fairly easy concept to follow as the benefits of the exercise ofprudence in the application of the standards are perhaps more widely agreedupon. For example the chairman of the IASB has described the definition ofprudence in the IASB’s former framework as ‘sheer common sense’ (Prudence andIFRS – ACCA Global). Prudence can be easily understood as not overestimating assetsand in the same respect underestimating expenses.
However, theexercise of prudence does not allow, the creation of hidden reserves orexcessive provisions, the deliberate understatement of assets or income, or thedeliberate overstatement of liabilities or expenses (Prudence and IFRS – ACCAGlobal). One could say Prudence dramatically contributes to a production ofethical financial statements. This Is done in order to not distastefully deceivethose who gather information from financial statements.However there aresome well-developed arguments against prudence in the accounting industry.
Manyexperts see Prudence in a transparent manner that is not biased but neutral toboth good and bad news (Prudence and IFRS – ACCA Global). Essentially thiscontradicts the use of Prudence as through “transparency”there is possibility for a lack of truthfulness in the financial statementscreated.Another disadvantage is the desirability ofrestraint in profit recognition. As it is often pointed out that while prudencemay hold back profits in one year, such restraint may simply lead to theirrelease in a subsequent period which as a result will show exaggerated results (Prudenceand IFRS – ACCA Global). Exaggerated results at a later date also contradictsthe use of accounting concepts as they go against a truthful representation ofthe business’ financial position.Furthermore, this can gravely effect the waydecisions are made by accountants. Accountants can use Prudence as a way tohide discrepancies within the business when producing financial statements.
Forexample, the Spanish banks and the dynamic provisioning during the crisis arecited as a further case in point – prudent reserves temporarily masked theirunderlying weakness as conditions changed, and delayed remedial action (Prudenceand IFRS – ACCA Global). The other main issue with the role of Prudence isthat it is a concept that cannot be measured. The problem with prudence isdetermining how much downward bias has been used in measuring the assets byCompany A compared with its competitor B (Prudence and IFRS – ACCA Global).
Forexample, Apple and Samsung. Both successful companies would strive to use therole of prudence to their advantage. As they are both Plc.’s both of these companieswould want to keep their competitive advantage and not disclose a transparent,truthful picture of their companies’ financial positions through financialreporting.However, some may argue that the problem does notlie with prudence but rather prudential regulators (Prudence and IFRS – ACCAGlobal). Financial reporting is used to capture a truthful, transparent financialpicture and therefore prudence is a necessary concept. Perhaps if there wasmore efforts placed with prudential regulators then these financial picturescould be managed in a conducive format.
In the conclusion, the aim of the use of Prudenceis to make sure that any financial statements produced show a truthful representationof the business’ financial position. I have discussed in depth what effectsPrudence can have on the appearance of a business such as deception and bias.Furthermore, I have also discussed how Prudence can support a truthfulrepresentation of a business and influences accountants to think of theirethical responsibilities when completing financial statements. Prudence should be considered as aqualitative characteristic in the accounting framework. Especially as it cannotbe directly measured or quantifiable. Although the main subject of this essay isPrudence, I believe that as long as the concept of conservatism is practiced inthe accounting industry then there is some leeway to remove Prudence from theconceptual framework.
As at the very least a business is taking into accounteconomic values. I can also appreciate the ethical standpoint Prudence holds.
