Prudence In Accounting Is Crucial For Financial Essay.

Read the following statement and answer the question:

“Prudence in accounting and financial reporting has a long-established track record. There is a considerable debate about whether International Financial Reporting Standards (IFRS), as the key global standards, should include prudence and state its importance in their conceptual framework”

The Conceptual Accounting Framework

Prudence is regarded as an important qualitative characteristic that was removed from the conceptual accounting framework in the year 2010 (M?ciuc?, 2015).   The principle of prudence refers to the exercise of caution during making decisions under the conditions of uncertainty. The prudence concept is restricting the assets and income to be overstated and liabilities to understate. As such, it leads to promoting conservatism in accounting as per which the financial statements should disclose conservative information by depicting the revenue only when it is actually realizes. IASB is presently emphasizing on including prudence again in the conceptual accounting framework for overcoming the issues of misrepresentation of financial information. There has been debate regarding advantages and disadvantages of including the principle of prudence in conceptual framework and IFRS. The debate is centered on including or excluding the principle of prudence as it is perceived to have both positive and negative impact on the financial reporting process (Soderstrom, 2007).  It has faced support and criticism from accounting experts regarding its inclusion in the conceptual accounting framework. In this context, the present essay presents a critical analysis regarding the inclusion or exclusion of prudence concept from the conceptual framework and the IFRS.

According to M?ciuc? (2015), the conceptual framework of financial reporting has developed the concepts that the basis to draft the financial statements. The major qualitative characteristics stated by the conceptual framework of accounting are understandability, verifiability, timeliness and comparability. IASB is presently emphasizing on including prudence again in the conceptual accounting framework for overcoming the issues of misrepresentation of financial information. This is mainly done for improving the quality of financial information disclosed by business entities for protecting the interests of the stakeholders. In this context, IASB has developed and established the conceptual framework of accounting that has provided the qualitative characteristics that need to be followed by business entities complying with IFRS. This is done for delivering quality financial information to the end-users of the financial reports such as investors, lenders, creditors, suppliers and others. Its re-introduction is receiving both support and criticism from accounting experts and therefore it is impotent to analyze both the arguments cited in this context for developing a consensus view regarding the introduction of this concept.

It has been stated by ACCA (2014) that IASB is emphasizing again to re-include prudence in the financial reporting process for improving the quality of financial information disclosed. The imprudent account as per various accounting experts by exclusion of prudence concept would allow measuring everything at fair value. This means that all profits whether they are realized or unrealized would be recognized as income in the financial statement. This can result in manipulating the financial information presented and thus negatively impacting the interest of the stakeholders as that occurred during the financial crisis. The use of fair value accounting is regarded to be the main reason for the occurrence of the global financial crisis. The inclusion on unrealized revenue in the financial statements supported the leading organizations such as Enron and WorldCom to deceive the interests by overstating their profitability position. As such, various accounting experts are in support of including prudence again in the conceptual accounting framework to overcome the increasing cases of corporate scandals (ACCA, 2014). The inclusion of prudence would cause the business organizations to only report the released revenues and thus helpful in protecting the interest of the investors (ACCA, 2014).

The Role of Prudence

On the other hand, according to Malley (2014) has the prudence concept was removed by the IASB form the conceptual framework as it was stated to act against the neutrality and faithful representation of financial information. The faithful presentation of financial reporting states that the information disclosed must be neutral and error-free (Oreshkova, 2017). However, the presence of prudence was believed to be inconsistent with neutrality as it directs the business entities to record a probable expenses transaction or liability and such may fail to represent the true value of economic substance. The various accounting experts still are in against the inclusion of prudence in the IFRS standards as it is believed to contradict the faithful presentation of financial information. The delay caused in recognition of profits that are to be realized in future and recording the probable expenses in a current accounting period may results in presenting biased financial information to the users. This is responsible or the criticism received by various accounting exerts on including it again in the conceptual framework of accounting (Malley, 2014).

However, Deller (2017) stated that the inclusion of prudence principle again in the IFRS and the conceptual framework can be regarded as necessary for ensuring the protection of interest of investors. This is because IASB itself has asserted that the concept of neutrality can be reconciled with prudence to provide true and fair view of economic value of an entity to the end-users (Soderstrom, 2007). The current accounting framework has amended the terms that defines their recognition criteria for assets and liabilities. As per the recent framework of accounting, an asset and liability will only be recognized if it the information results in providing more benefits in comparison to the cost. The removal of probability criterion from their recognition criteria has provided a pathway for the inclusion of prudence again in the conceptual framework of accounting. IASB has introduced the term cautions prudence for ensuring that neutrality is supported by the exercise of prudence. It requires the developers of financial statements requiring that the assets and liabilities should not be either overstated or understated for reducing the ambiguity related with the term (Deller, 2017).

The inclusion of prudence concept helps in true and fair representation of all financial figures in the financial statements. The prudence concept helps not to over estimating and underestimating the financial risks which helps to avoid the financial losses in future (ACCA, 2014). In addition to advantages of prudence there are many disadvantages or cons that need to be addressed while including the prudence concept in conceptual framework. Inclusion of prudence concept leads to overstating of liabilities and understating the assets which critically impacts the financial statements (Oreshkova, 2017). The wrong valuation of assets and liabilities creates the false impression of entity as it leads to a situation of worse financial position but in real it is not so. Investors will not invest in company that has negative position but in actual it is not. It creates a situation where the financial statements are no longer neutral.

Debate Surrounding the Inclusion of Prudence

Therefore, it can be said from the arguments stated for inclusion and removal of prudence and also as per the views of Cooper (2015) that it is perhaps the most important concepts in the accounting standards and framework. However, at the time of its exclusion by IASB in the year 2010 from the financial reporting process the accounting framework was less developed. Thus, it was not able to ensure the exercised of caution in the financial reporting by developers of financial statement due to lack of clear guidance for resolving particular accounting issue. However, it can be stated that the accounting framework has been developed to large extent in present time and has clarified the ambiguity that exists in relation to the identification and recognition of assets and liabilities. Therefore, it can be stated that the application of cautious prudence will help in overcoming all the issues that have caused the removal of prudence from the conceptual framework. The development of new and improved versions of the accounting framework provides enough guidance to the accounting experts during the conditions of uncertainty for recognizing the assets and liabilities. As such, the presence of prudence concept as a qualitative characteristic of financial information will help in proving true and fair view of the firm to the end-users of the financial reports (Cooper, 2015).

Conclusion

Thus, it can be stated from the discussion held in the context of prudence inclusion in the conceptual framework and IFRS that the principle is necessary to maintain quality in the financial disclosures. However, it should be applied in consistency with the faithful presentation of information so as to not contradict the neutrality principle of financial reporting. Thus, on the basis of the overall critical discussion I support the inclusion of prudence in the conceptual framework and the IFRS.

References

ACCA. 2014. Prudence and IFRS. [Online]. Available at: https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-prudence.pdf [Accessed on: 20 October 2018].

Cooper, S. 2015. A tale of ‘prudence’. [Online]. Available at: https://archive.ifrs.org/Investor-resources/Investor-perspectives-2/Documents/Prudence_Investor-Perspective_Conceptual-FW.PDF [Accessed on: 20 October 2018].

Deller, A. 2017. The IASB's Conceptual Framework is being renovated, says Adam Deller, and is turning out to be a bigger task than anticipated. [Online]. Available at: https://www.accaglobal.com/africa/en/member/discover/cpd-articles/corporate-reporting/deller-mar17.html [Accessed on: 20 October 2018].

M?ciuc?, G. 2015. The role of prudence in financial reporting: IFRS versusDirective 34. Procedia Economics and Finance 32, pp. 738-744.

Malley, A. 2014. Opinion: is prudence still a virtue? [Online]. Available at: https://www.theaccountant-online.com/news/is-prudence-still-a-virtue-4276220/ [Accessed on: 20 October 2018].

Oreshkova, H. 2017. The Debate on Prudence in Accounting. CBU International Conference on Innovation in Science and Education, pp. 22-24.

Soderstrom, N. 2007. IFRS Adoption and Accounting Quality: A Review. European Accounting Review 16 (4), pp. 675-722.