The Controversy Of Reintroducing ‘Prudence’ In The Conceptual Framework For Financial Reporting

Background of the Proposed Change

The conceptual framework (CF) made for the purpose of financial reporting has been revised as well as improved time and again in the past years. However, from the general understanding, CF is particularly formulated to outline the fundamental concepts related to the financial reporting of the firms on the basis of international standards. It also guides the Boards of firms to develop appropriate International Financial Reporting Standards (IFRS). Moreover, the main goal is to ensure that the standards are to be consistent conceptually so that useful information relating to the firms can be accessed by the external parties such as lenders, investors, and creditors (IFRS, 2017). This has been evident even in the scenario that CF is an important consideration. In addition, it has also been observed that ‘prudence’ is the oldest and a well-known concept within the domain of financial accounting in the IFRS. The term ‘prudence’, which is also known as conservatism is defined as differential verifiability, which is required for profit recognition when it is compared to losses. This implies that prudence has been playing a significant role but in 2010, International Accounting Standards Board (IASB) removed references to this concept such as definitions stating that it conflicted with the objectives of unbiased representation and neutrality (M?ciuc?, Hlaciuc, & Ursache, 2015).

In this context, there has been a debate among the members of the Board of Directors of Big Phore Partners, especially the Executive Director of Audit and Executive Director of Corporate Advisory. Both the person had their own opinions relating to the inclusion/exclusion of the concept of prudence. In this context, the Executive Director of Audit stated that cautiousness/prudence is the main foundation stone of financial reporting. On the other hand, the Executive Director of Corporate Advisory stated that rather than prudence, providing correct information to the stakeholders such as investors is highly essential for making appropriate decisions. As a result of these arguments, the Executive Chairman decided to have an internal debate for settling the conflicts of opinions. Furthermore, it has been decided by the company to send a formal submission with respect to the outcome of this debate to the IASB through a letter. Hence, it can be taken into consideration for the betterment of the standards along with the companies complying with it.

Understanding the aforementioned case overview, the background of the proposed change is further outlined in a brief manner. The difference in the opinions among the members of the board raised a serious issue with respect to the re-inclusion of ‘prudence’ in the new CF. In this context, a serious as well as a heated debate has occurred in the organization, which must be solved immediately. One of the members stated that it is imperative to provide precise information to the investors so that they can be able to take decisions accordingly. Another member argued that prudence is more important, especially when it comes to preparing financial reports. After the conversation of both the board members, Executive Chair Dr. Coopers decided to solve the underlying issue with the support an internal debate and the result of which will be submitted to the IASB. This can help in ensuring that future considerations will be taken into the account while developing the standards of the new CF. In brief, this was the context of change i.e. the re-inclusion of prudence that may or may not is considered in the new CF. Hence, this changing context has been evident in the comprehensive Exposure Draft (ED) published by IASB.

Proposed Changes Made by IASB

According to Deloitte (2015), IASB proposed to reintroduce a certain reference of prudence in the new CF. It was further stated that prudence supported “neutrality”, thereby defining it as the exercise of caution, which needs to be considered by the companies. This is mostly at the time of making crucial judgments during uncertain conditions. This changed was proposed to be included in the second chapter, which provided standards relating to qualitative characteristics of the financial information (Deloitte, 2015). This proposed change was considered in the year 2018 Conceptual Framework by the IASB. However, the effective date has not been finalized and so the companies have not yet considered prudence and associated concepts at the time of financial reporting (Deloitte, 2018). Therefore, only after the actual implementation of the new CF, its effectiveness can be analyzed so that the IASB, in addition to the companies can further enjoy benefits. Thus, in order to understand the impact of re-inclusion of “prudence”, arguments are set by analyzing both the aspects outlined in the internal debate of Big Phore Partners.

Some of the members including Mr. Price, the Executive Director of Audit, stressed the importance of prudence in the financial reports. He further stated that it is the “cornerstone” of the financial reports. Similar opinions were also presented by IFRS (2015) that although there were certain flaws in the previous inclusion of prudence, which were eliminated in the year 2010. However, it has been proposed to be reintroduced with respect to the preparation of financial reports. The IASB further made sure that the inclusion of prudence yielded better outcomes for the companies. Hence, it did so, by making prudence as one of the important aspects for preparing financial statements. It has been proposed to be one of the characteristics, which helps in making financial reports of the companies use for mainly for the investors. Moreover, it has been identified as one of the virtues in the daily life hence, proving its importance. It has further been defined that in the financial accounting context, prudence is “cautiousness”. This implies that prudence encourages good judgment, which is highly crucial vital for financial reporting. This is due to the fact that various estimations have to be made while preparing these statements (IFRS, 2015). Similarly, Oreshkova (2017) stated that it is highly necessary for prudence to be re-introduced in the CF. The main aspect highlighted for including it was that there is certain information, which cannot be disclosed by the companies for safeguarding certain sources of income. This phenomenon is termed as capital preservation, for which the principle of prudence comes into consideration (Oreshkova, 2017).

The term ‘conservatism’ is also used in place of prudence. Hence, in order to understand its importance, a distinctive definition must be used in the CF. This would facilitate to make sure that its precise essence can be highly depicted. It is only then that the companies can make optimal use of the principles relating to prudence, especially in favor of the investors. This is mostly due to the fact that the concept of prudence is essential to adhere to the standards such as “IAS 36 Impairment of Assets” and “Contingent Liabilities and Contingent Assets”. Therefore, if it is reintroduced, balanced (reasonable) judgment can be done in uncertain situations, thereby enabling the companies to estimate fairly at the time of valuation (Oreshkova, 2017). On the other hand, ACCA (2014) stated that “prudence” is a concept, which must be embedded in the accounting standards and at the same time, it must be effectively exercised by the companies preparing financial reports. However, many companies might misuse or misinterpret the meaning of prudence. Hence, in the new CF, it is highly essential to understand the requirements as well as the extent to which firms can utilize it set for implementing the guidance (ACCA, 2014). Similar observations are made by Kronbauer, Marquezan, Barbosa, & Diehl (2017) that even though prudence may lead the companies to have tax burden if used wisely, low-profit levels at the time of uncertainty can reduce it.

Arguments for the Reintroduction of Prudence

According to Narayanan & Burkart (2005), prudence in accounting is an essential aspect for making the system of corporate governance to be effective and efficient. In this context, ‘good corporate governance’ is positively related to the high-level implementation of conservatism i.e. prudence. However, in the case of the IASB, it has been highly observed that prudence must not be overused, as it may mislead the investors (Narayanan & Burkart, 2005). Similarly, P?tra?cu (2014) stated that the principle of prudence has been widely researched in the past history. This is mostly due to conflicting interests. However, prudence can be effectively considered as a part of ‘credibility’, is necessary for the financial reporting, thereby allowing the investors for providing a rational judgment at the time of uncertainty (P?tra?cu, 2014). Hence, although the application of prudence while preparing financial reports can lead to a certain level of biases. However, various estimations are to be considered so it must be reintroduced in the CF due to its significance.

On the contrary to the abovementioned opinions, Dr. Waterhouse, the Executive Director of Corporate Advisory stated that providing “right information” should be considered. This is to make sure that the investors take correct decisions rather than being cautious. Authority of the Accounting Standards (ANC) (2015) further asserted that the value of prudence in accounting can vary according to the firms and countries. Hence referring to the Australian political environment, it was reported by AASB (2015) that it is essential to clarify the role of prudence at the time of financial reporting in the CF. The main reason for this is that if a company uses a high level of prudence in its financial accounting, it makes the information less pertinent. Hence, more prominent definitions are to be provided in the CF so that the usage of prudence can be done in a positive manner by the Australian companies. It further highlighted the issue of reintroducing the concept of prudence in an explicit manner. In this context, the IASB proposed that prudence must be described as the act of being cautious while making judgments in uncertain situations. It was also found that it stated the importance of prudence towards the achievement of neutrality. However, this exercise indicated that the income as well as assets must not be overstated whereas the expenses and liabilities must not be understated. This also reflected that the understatement of income and assets are not allowed and an overstatement of liabilities as well as expenses is also not allowed. These limitations must be considered in the new CF and then the only misstatement of information can be avoided. If these limitations are not considered by the IASB and the complying companies, then the incomes can be overstated and expenses can be understated in future circumstances (AASB, 2015 a; AASB, 2015 b). This is the key drawback of reintroducing the notion of prudence in the CF.

Similarly, according to Mora & Walker (2015), it was asserted that one of the reasons for removing prudence from CF was that it was used mainly as the pretext for the purpose of managing extra earnings. Moreover, at times this concept was used as a conditional conservatism in which the firms applied lower cost/market value while conducting inventory valuation. As a result, inventory value decreased sooner than the amount to be increased. This enabled a considerable amount of biases in the financial information. Moreover, contracting costs are incurred, which acts as an essential determinant of conditional conservatism’s demand. This displays that other drivers of conservatism must also be identified in a view to properly report accounting earnings in the financial statements, in turn, eliminating the biased information (Mora & Walker, 2015). Furthermore, ACCA (2017) observed that the proposed CF involved proper identification of values/costs of liabilities and assets, which must be measured in an attainable manner. The proposed changes were also regarding the probability criterion regarding the information that was beneficial for the companies as it exceeded the cost of its provision (ACCA, 2017).

Arguments Against the Reintroduction of Prudence

Hence, these considerations have the potential to improve the standards as well as benefit all the involved parties without creating any misinterpretation for the investors. In accordance to Wagenhofer (2015), cautious prudence has been examined, which further highlighted that neutral accounting neglected the requirement of measuring all liabilities and assets at their fair value. Moreover, it did not prohibit assets’ impairment that was measured at cost (Wagenhofer, 2015). Hence, it can be stated that the reintroduction of this concept needs to be highly considered to the flaws that it had earlier so that every party can benefit from its implementation in the financial reporting. Even though prudence had negatively affected the financial standards, especially in the Australian context but ethically considering this concept can be highly beneficial.

Conclusion

Based on the study findings can hence be concluded from the above examination that re-inclusion must be incorporated in the new CF in the second chapter of the ED)/2015/3. Thus, on the basis of the overall understanding of the entire report, it can be recommended that the reintroduction of prudence is important, as it can have cost benefits to the companies that implement these standards during financial reporting. However, there must be a limit on the implementation and hence proper description and definition of this concept have been suggested for eliminating any future misinterpretation as was in the earlier CF’s case. Moreover, it must also be noted that ethical consideration of this notion must be done by the companies so that the information provided by the financial reports can ensure correct decision-making of the investors. 

References

AASB. (2015 a). AASB comment letter CF EDS (final). The Australian Accounting Standards Board. Retrieved September 27, 2018, from https://www.aasb.gov.au/admin/file/content106/c2/AASB_Comment_Letter_CF_EDs_(final).pdf

AASB. (2015 b). Conceptual framework for financial reporting. AASB Exposure Draft. Retrieved September 27, 2018, from https://www.aasb.gov.au/admin/file/content105/c9/ACCED264_06-15.pdf

ACCA (2017). The IASB’s conceptual framework is being renovated, says Adam Deller, and is turning out to be a bigger task than anticipated. IASB restructures its Conceptual Framework. Retrieved September 27, 2018, from https://www.accaglobal.com/in/en/member/discover/cpd-articles/corporate-reporting/deller-mar17.html

ACCA. (2014). Prudence and IFRS. Association of Chartered Certified Accountants. Retrieved September 27, 2018, from https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-prudence.pdf

ANC. (2015). Policy paper a(nother) look at prudence/conservatism in frameworks, in standards, in practice and in academia. Paul André & Andrei Filip – ESSEC Business School. Retrieved September 27, 2018, from https://www.anc.gouv.fr/files/live/sites/anc/files/contributed/ANC/3.%20Recherche/D_Etats%20generaux/2015/PP_Prudence_P%20Andre%20VE.pdf

Deloitte. (2015). IASB publishes exposure draft of a new conceptual framework. News. Retrieved September 27, 2018, from https://www.iasplus.com/en/news/2015/05/cf-ed

Deloitte. (2018). IASB publishes revised conceptual framework. News. Retrieved September 27, 2018, from https://www.iasplus.com/en/news/2018/03/cf

IFRS. (2015). A tale of ‘prudence’. Investor Perspectives. News. Retrieved September 27, 2018, from https://archive.ifrs.org/Investor-resources/Investor-perspectives-2/Documents/Prudence_Investor-Perspective_Conceptual-FW.PDF

IFRS. (2017). Conceptual framework for financial reporting. IFRS Foundation. Retrieved September 25, 2018, from https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/

Kronbauer, C. A., Marquezan, L. H. F., Barbosa, M. A. G., & Diehl, C. A. (2017). Analysis of the effects of conservatism in accounting information after the 2011 change in the basic conceptual pronouncement. Review of Business Management, São Paulo, 19 (65), 453-468.

 M?ciuc?, G., Hlaciuc, E., & Ursache, A. (2015). The role of prudence in financial reporting: IFRS versus Directive 34. Procedia Economics and Finance, 32, 738-744.

Mora, A., & Walker, M. (2015). The implications of research on accounting conservatism for accounting standard setting. Accounting and Business Research, 45(5), 620-650.

Narayanan, S., & Burkart, M. (2005). The role of accounting conservatism in a well-functioning corporate governance system. Munich Personal RePEc Archive, 4458, 2-15.

Oreshkova, H. (2017). The debate on prudence in accounting. CBU International Conference on Innovations in Science and Education, 5, 343-360.

P?tra?cu, D.R. (2014). The importance of accounting principles in the accounting profession. Social Economic Debates, 3 (2), 47-50.

Wagenhofer, A. (2015). The never ending story of prudence and IFRS. Business Reporting. Retrieved September 27, 2018, from https://www.ifac.org/global-knowledge-gateway/business-reporting/discussion/never-ending-story-prudence-and-ifrs

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