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Prudence in Accounting Introduction to accounting essay...

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Prudence- Is there anything wrong with being cautious in accounting? Prudence is the ability to exercise cautiousness, good judgement and wisdom. Correspondingly, prudence in relation to accounting refers to the recording of a revenue transaction or an asset when it is certain and recording an expense transaction or liability when it is probable. Furthermore, assets are regularly reviewed to anticipate decline in value. Therefore, accountants are ‘playing it safe’ and would rather understate assets and revenue than overstate them. The concept in question has raised much debate as to what extent it should be considered useful in decision-making and whether it should be deemed a qualitative aspect. I will argue for its usefulness on the basis that it; helps to accurately present financial data, is accepted world-wide and closely relates to other vital accounting concepts. In order to assess whether prudence should be considered a qualitative aspect of accounting, we must first establish what accounting is intended to achieve. The ultimate aim is to help those using this information to make more informed decisions. According to (Cooper, S., 2015. A tale of ‘prudence’. Investor Perspectives, IFRS) prudence was already included in the international Accounting standards board (IASB) until 2010 because it was considered to serve that very purpose. Furthermore, this implementation comes as no surprise as the reported and audited numbers are expected to be ‘hard’ and good judgement is imperative when making estimations. It is common sense. Suppose a newly set-up company started selling engine parts designated to cars. A sale had never been recorded until an order came through for the end of the month. However, the customer has been unemployed for a while and the payment of £250 seemed unlikely. Prudence applied would suggest that in this case, stating a profit when it is uncertain is misleading to potential stakeholders and investors especially when it concerns tax, dividends and bonuses. An actual scenario supporting the need for Prudence occurred in 2008 which was known as the worst Financial crisis since the 1930s, (Ivashina, V. and Scharfstein, D., 2010. Bank lending during the financial crisis of 2008. Journal of Financial economics, 97(3), pp.319-338.) Many banks had failed to be prudent and could have held back excessive dividends and bonuses in hindsight and contributed less to the economic downfall. From this reasoning, it is evident to me that the Concept of Prudence should be considered a qualitative aspect of accounting. On the other hand, why then do others disagree and fail to recognise prudence as a qualitative concept? Because prudence has always been closely linked with the idea of conservatism, which is the idea that accountants require higher verifiability to recognise ‘good news as gains’ than ‘bad news as losses’. What does this entail? It means that information could be biased and only reflect positive aspects of an entity, hindering informed decisions. Therefore, the concept has come under much criticism and was removed from the international framework. So why is this relevant? Conservatism or prudence is inconsistent with the principle of neutrality which states that for accounting information to be credible, it must be free from bias and should not be manipulated to favour certain outcomes. Only then can it be faithfully represented. Analysing figure 1 of (Basu, S., 1997. The conservatism principle and the asymmetric timeliness of earnings1. Journal of accounting and economics, 24(1), pp.2) we observe how asymmetry in recognizing unrealized losses and gains affect book values of assets and ultimately, earnings. Panel A demonstrates this well as the fixed asset originally valued at 50,000 rapidly decreases in price in response to bad news which was the cutting of the life-span by 3 years. It instantaneously decreases by 30,000 following with a steady decline. However, evaluating the value of the asset once good news is received, the decline is steady, and the response is less complete and less noticeable. The original value is also

50,000 and we can see a more stable decline in 5,000 increments, indicating less activity in terms of value. The losses would affect the business at the time than reduce earnings in the future. In short, it is evident that bad news is recognized more often in a business and unrealised losses are more predominant which is biased and does not truly represent accounting data. Therefore, linking it back to the question, it has more to do with the balance of prudence regarding being good (non-biased) and bad (biased) than the concept itself. The data from the source supports the allegations that prudence can be bias and therefore, should not be considered a qualitative aspect of accounting. On the other hand, people may argue against the point that prudence/conservatism is bias as there are practical issues with measuring financial data and distinguishing losses from profits. Referencing (Barker, R., 2015. Conservatism, prudence and the IASB's conceptual framework. Accounting and Business Research), economic resources may not always be easily identifiable, and it may be unclear at times whether costs are recoverable or whether assets will truly yield profit/earnings. This counters the idea that prudence or conservatism is always bias as the value of assets and costs are constantly subject to change and unforeseen occurrence. This now leads on to how prudence enhances financial data to aid in decision-making. Prudence, as mentioned earlier, focuses on exercising good judgement about uncertain items such as provisions for doubtful debts, assets and estimates. Furthermore, as a result, amounts entered in the financial statement will be the highest figure of probable loss and the lowest figure of a gain. This enhances the quality of the data because it allows for comparability and for another party to properly assess the businesses financial position, performance, and any changes that occur. However, this argument can be countered because if accountants were ‘too’ prudent, liabilities could be overstated/exaggerated and deter potential investors as the information is no longer reliable. An example where prudence was used inappropriately occurred in 2002, when 3 senior managers of Nortel learned the business was carrying over $300 million in excess reserves. They concealed and maintained it for later use instead of releasing it into income and added a further $151 million in excess reserves. When the irregularities in the statements came to light, Nortel was forced to pay of tens of millions to return to profitability as it was clear the intent was to avoid pay-outs and bonuses. Therefore, we can gather from this example that there is also a risk of excessive prudence. The former IFRS framework went on to say, “the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions” which relates to the case of Nortel. Martin R, MR. (2014) Prudence and IFRS https://secure.accaglobal.com/content/dam/acca/global/PDF-technical/financialreporting/tech-tp-prudence.pdf Another argument against the usefulness of prudence in accounting is that it conflicts with another vital concept of accounting, Accruals. The Accrual concept states that a revenue and expenses should be recorded as soon as they are recognised, regardless of whether cash is received or not. In contrast, prudence stresses the recording of transactions only when cash is certain. According to the framework, the relevance of information is affected by its nature and materiality. If specific figures were omitted, it could influence decision-making on a large scale causing many to place more value on Accruals as it is seen to be more complete and in the end, more reliable. However, it can be argued that prudence is more beneficial if it were to be seen from a different perspective, away from neutrality. (Professor Fearnley S. (2015) Perspective on Prudence https://economia.icaew.com/en/features/july-2015/perspective-onprudence) says “What’s neutrality? Accounts can never be neutral because there are so many judgements in them.” If we were to dwell on this view, Prudence would have little resistance being re-introduced into the framework for accounting standards.

In conclusion, prudence should be reintroduced as a qualitative characteristic in accounting based on its wide use and effective results concerning financial data. Subsequently, prudence is already embedded in the existing IFRS and used on a worldwide scale. Hence, it is one of the reasons accountants are notorious for being pessimistic, cautious and making effort to refrain from errors. The main reasons justifying my stance on this matter being that Prudence is now high in demand in terms of accounting requirements. Hui et al. (2012) found that suppliers and customers demand more prudent accounting, which increases with bargaining power, length of trading relationship, and asset-specificity. It can also be explained consistently with conservatism demands from other stakeholders in terms of asymmetry in information and payoffs. Furthermore, it is common sense to carefully judge accounts and estimates in order to ensure information is accurate and free from errors that could cost much future loss or potential investors. Prudence is therefore very useful in enhancing financial information should be reconsidered in the framework for accounting standards. Reference list 

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Martin R, MR. (2014) Prudence and IFRS https://secure.accaglobal.com/content/dam/acca/global/PDF-technical/financialreporting/tech-tp-prudence.pdf . (Professor Fearnley S. (2015) Perspective on Prudence https://economia.icaew.com/en/features/july-2015/perspective-on-prudence) (Cooper, S., 2015. A tale of ‘prudence’. (Ivashina, V. and Scharfstein, D., 2010. Bank lending during the financial crisis of 2008. Journal of Financial economics, 97(3), pp.319-338.) (Barker, R., 2015. Conservatism, prudence and the IASB's conceptual framework. Accounting and Business Research) (Basu, S., 1997. The conservatism principle and the asymmetric timeliness of earnings1. Journal of accounting and economics, 24(1), pp.2) Hui et al. (2012)...