EFRAG and the National Standard-Setters of France, Germany, Italy and the UK published the first three Bulletins on the IFRS Conceptual Framework, dealing with Prudence, Reliability of financial information, and Uncertainty. Comments are invited by 5 July, 2013.
Prudence
It has long been established that the idea of prudence (or ‘conservatism’) plays a major part in financial reporting. It is recognised in the EU Accounting Directives which were agreed in the 1970s (see paragraph 3), but its history can be traced back much further. The origins of prudence may, in part, reflect the use of financial statements in showing the amount of profit that is available for distribution.
The essence of prudence is that assets and income are not overstated and that liabilities and expenses are not understated. The application of prudence ensures that gains are reported only if they are highly probable or reasonably certain (often not until realised) but that (expected) losses are recognised as soon as they are identified. Prudence also causes an asymmetry in the accounting for assets and liabilities, as it requires a higher degree of certainty before recognition of assets than of liabilities. Prudence may affect the accounting policies that determine whether transactions and events are recognised; the measurement of assets and liabilities that are recognised; and the presentation of gains and losses. It may play a role both in the development of accounting standards and, in practice, the preparation of financial statements based on these standards.
The Fourth EU Directive on Company Law of 1978 requires that “valuation must be made on a prudent basis” and that, in particular, only profits made at the balance sheet date may be included, whereas account must be taken of all losses related to the financial year or to a previous one. This may reflect the view that prudence is necessary to counter the overstatement of income.
Consistently with the objective of general purpose financial reporting set out in the IASB’s Framework, this Bulletin discusses prudence in the context of financial statements, which are prepared to fulfil the needs of investors and others in making decisions about providing resources to the entity and assessing how efficiently and effectively the entity’s resources have been used. It does not address financial information that may be useful for other purposes such as supervision of financial institutions or monitoring compliance with contracts.
Reliability of financial information
This Bulletin addresses the issue of reliability of financial information. Until the Conceptual Framework was revised in September 2010, the IASB (and FASB) acknowledged that relevance and reliability were qualitative characteristics that could conflict, in which case financial reporting should aim at achieving an appropriate balance among them. This was known as the trade-off between relevance and reliability.
In the 2010 revision of the Framework, the IASB (and FASB) replaced ‘reliability’ by ‘faithful representation’, and eliminated all references to a potential trade-off between these two qualitative characteristics.
This Bulletin considers whether the replacement of reliability with faithful representation and the loss of the idea of the trade-off between relevance and reliability is appropriate or whether there is an ongoing need for such ideas in the Framework. This matters because a clear understanding and consensus on the extent to which amounts in financial statements can be regarded as reliable is vital to their use.
The Bulletin tentatively concludes that reliability (including the idea of verifiability) needs to be reinstated as a fundamental characteristic of information in financial statements and should continue to be a recognition criterion, with further discussion on how reliability should be assessed, and what level of reliability is needed for information to be useful.
This Bulletin explores whether the replacement of reliability with faithful representation and the lack of discussion of a trade-off between the two removes a necessary part of the assessment of whether financial information is useful.
Uncertainty
This Bulletin addresses the issue of uncertainty. Almost all assets and liabilities have some level of uncertainty relating to their inflows or outflows of economic benefits. In the current Framework that uncertainty is referred to in defining elements (inflows and outflows have to be expected) and in the recognition criteria (inflows and outflows must be probable). Uncertainty also inevitably affects the measurement of assets and liabilities. Some IASB projects have indicated that the IASB may be thinking that uncertainty is best dealt with solely as a matter of measurement. This Bulletin considers that view, and an alternative view that uncertainty should continue to also play a role in either or both the definition of an element and the recognition criteria.
The way in which uncertainty is dealt with matters because it affects which assets and liabilities are recognised. If uncertainty is dealt with only as a matter of measurement, assets and liabilities that are unlikely to give rise to cash flows will be included in the statement of financial position. If a specified level of certainty is included in either the definition of assets and liabilities or in a recognition criterion, some assets and liabilities will be excluded from the statement of financial position.
The Bulletin tentatively concludes that a probability-based threshold in some form should continue to exist, and notes some different ways that this might be done.
Press release
© EFRAG - European Financial Reporting Advisory Group
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