Prudence only aware of the estimates calculated but

Prudence is a concept that those who create
financial statements would use when making judgements about uncertain items
such as doubtful debts, assets lives, etc. It is seen by many as one of the
qualitative characteristic of accounting information and refers to the
inclusion of a degree of caution in accounting judgements under conditions of
uncertainty.  According to the framework,
information included in financial statements should be prudent. The aim of
using prudence is to avoid the overstatement of assets and under-statement of
liabilities as both would lead to an over-statement of profit. In my essay, I
will discuss the role of prudence and whether it should be characterised as a
qualitative characteristic.

One positive of prudence comes from The IASB who
state that “there is a false pretence that prudence is inconsistent with
neutrality”. Instead, it can be argued that it could be a mechanism for
ensuring neutrality exists. Neutrality is a term included in the IASB’s
conceptual framework and is deemed important when assessing financial
information. The role of neutrality is to remove bias
by ensuring financial information is not weighted, emphasised, de-emphasised or
manipulated to increase the probability that such information will be received
favourably or unfavourably by the users. It is a necessary component for
providing faithful representation. An example of prudence being consistent with
neutrality is when measuring the depreciation of an asset. It is ethically
important that any potential investors are not only aware of the estimates
calculated but also that these estimates are realistic and without bias. In this
instance, prudence is consistent with such estimates and the need for
neutrality. On the other hand, despite The IASB’s conceptual framework 1989 stating,
“the exercise of prudence does not allow, for example, the creation of hidden
reserves or excessive provisions, the deliberate understatement of assets or
income, or the deliberate overstatement of liabilities or expenses, because the
financial statements would not be neutral and, therefore, not have the quality
of reliability” (PWC report Anna Schweizer 2016), prudence was still used
inappropriately by Nortel in November 2002 (USSEC Press Release November
2010). The report shows that ‘In November 2002, three senior managers of Nortel
learned that Nortel was carrying over $300 million in excess reserves and did
not release these excess reserves into income as required under US GAAP.
Instead, they concealed their existence and maintained them for later use to
avoid posting a profit’. These reserve manipulations helped to erase Nortel’s
pro forma profit for the fourth quarter of 2002 and caused it to report a loss
instead. This allowed the company to delay paying bonuses to its stakeholders
such as shareholders and employees. This is evidence of a lack of consistency
between neutrality and the use of prudence and it is also an example of how
prudence can work against a number of stakeholders. For example, for investors
who use financial statements to make decisions on future investments. “Any
over- or under-statement within the statement could lead to substandard decisions
and a misallocation of capital” (Steve Cooper pg2. 2015). Therefore, the use
off prudence and estimates with regards to financial statements should neither
be understated or overstated (Steve Cooper pg1. 2015).

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Prudence has also been defined as ‘Conventional
prudence’ (Barker 2015). This type of prudence places more of its focus on the
verifiability of gains compared to losses. “The accountant’s tendency to
require a higher degree of verification to recognise good news as gains
compared recognising bad news as losses” (Basu 1997, pg7). This is also known
as conservative accounting. The consequence, as Barker claims, is a lower total
value of net assets within the financial statements compared to IASB prudence. This
is an issue because by understating within the financial statement in the current
period, this could lead to an over-statement of earnings in future periods by
causing an understatement of future expenses (Watts 2003, pg. 208). For
example, as stated above, in 2002, whilst Nortel understated its accounts, by
2003 the senior managers “directed the release of at least $490m of excess
reserves in order to boost earnings and fabricate profit” (USSEC Press Release,
November 2010).  In doing so, this
presents a problem. For instance, what may look like a huge growth in profits
may in fact seem a lot smaller than it actually is. This presents a number of problems,
as whilst senior managers are getting a pay rise, it could lead to a wider pay
gap between other employees creating a bad environment, it could falsely
attract any potential investors, or lead to current shareholders who are
unaware of the real growth in earnings demanding more in dividends. As a
result, it is important that businesses produce accurate financial statements
by ensuring prudence is used the way it was intended to and not deliberately
alter any financial statements. The usefulness however, of conventional
prudence, is that it is only applicable where there are significant uncertainties
in measurement, and even then, only when the uncertainty concerns gains as
opposed to losses. Conventional prudence theoretically does not allow neither a
deliberate understatement of gains in the absence of uncertainty or under any
circumstances, the deliberate overstatement of losses (Barker 2015). Based on
this framework alone, there isn’t really any strong difference between IASB
prudence and conventional prudence/conservative accounting. Instead, the
purpose of conventional prudence is to defer the recognition of gains that are
subjectively estimated at the balance sheet date and that therefore can neither
be verified nor relied upon, and it is in this context only that conventional
prudence differs from IASB prudence. Another positive of conservative accounting
is that because it simply focuses on the businesses relevant and certain
information, it safely ensures the business can look at the financial statement
information which would better help distribute and determine dividend payment
towards shareholders, bonuses to employees, etc, then it would have, had assets
been overstated. Thus, those who believe in conservative accounting, argue that
the “asymmetry of consequences should drive an asymmetry of accounting”. (Cooper
pg. 4, 2015)

It’s clear from above, that
the problem with prudence as a qualitative characteristic for financial
accounting lies with the definition of the word. It can often be difficult to
understand its relation to financial reporting. It is this confusion and
prioritising ‘neutrality’ over ‘prudence’ (Lesley Meall 2015), that led to the removal
of any reference to prudence from the conceptual framework in 2010 by the IASB,
which was previously drawn up in 1989. With the removal of prudence, the IFRS
were not able to be certain what profits had been realised into cash. As a result,
the IFRS had a lot of issues with companies who would carry out inappropriate
strategic and operational decisions (Kieran Quinn et al 2015). Tesco for
instance saw more than £2bn being wiped off its value as a result of
overstating its profits by £250m (Graeme Wearden 2014). This shows the
importance of prudence as it is unlikely that this would have occurred had
prudence remained in the conceptual framework. Fortunately, in 2015 the IRFS
published a revised comprehensive Exposure Draft (ED), which reintroduced the
concept of prudence stating that it does support neutrality. Within the ED,
prudence is now defined as “prudence is the application 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” (PWC report by Anna Schweizer
April 2016). This will ensure that deliberate overstating or understating
of assets and liabilities do not occur as it did previously and ensures that
the qualitative characteristic of prudence complies with neutrality, what with
the confusion over the definition in the past. On the other hand, it may also
be seen as flawed (Barker 2015). This is because the definition of prudence is vague
and with the addition of a ‘new concept’ it could potentially lead to even more
confusion. Furthermore, there remains the question as to whether a business
could apply prudence and neutrality together.

In conclusion, I believe that prudence is an important
qualitative characteristic due to its ability to drastically alter financial
statements. Without this characteristic, financial accounts are likely to mean
less as companies would have the ability to overstate or understate in order to
suit their agenda at a certain point of time. Whilst it was clear that the 1989
definition of prudence was difficult to interpret, the introduction of the Exposure
Draft improved the concept clarifying what the IRFS expect. The issue that
remains however is whether entities can be both neutral and prudent. Despite
this, overall, I do believe prudence should be considered as a qualitative characteristic.