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The IASB has just published an ED of a revised Conceptual Framework for Financial Reporting. In it, the IASB proposes to reintroduce prudence as one aspect of the characteristics that make financial statements useful to investors. At first glance, this may sound an obvious and straightforward decision; prudence is, after all, long recognised as a virtue in everyday life.
Sadly, the application of prudence to the world of accounting is trickier than it is to an individual’s conduct. At the heart of the IASB’s challenge lies the definition of the word. What does ‘prudent’ mean in relation to financial reporting? Mr Cooper describes the ambiguity of the definition used in the past. The confusion caused by this ambiguity prompted the IASB to remove any reference to prudence in 2010, when the Conceptual Framework was last revised, preferring to rely on other ways of describing what the IASB means by good‑quality financial reporting.
The various dictionary definitions of prudence are all very similar, with references to synonyms such as ‘careful’, ‘cautious’, ‘wise’, ‘well judged’ and ‘circumspect’. Applying these dictionary definitions to financial reporting, however, is not so easy. Few would disagree that management should be careful and considered when arriving at the figures presented.
Good judgement is particularly important in financial reporting, because many amounts require estimation.
But it is important to understand the context within which these judgements are made. Management teams making accounting estimates are subject to many incentives that could lead them to favour either an overstatement or an understatement of financial position and financial performance (in other words, to introduce a bias into financial reporting).
For example, an overstatement of financial performance may avoid the negative consequences for management of reporting poor performance, whereas an understatement of financial performance in a good year may provide management with reserves that can be used to smooth reported profits and thereby avoid reporting poor performance in the future. For investors using financial statements to make decisions on their investment, any deliberate over- or under-statement is likely to lead to suboptimal decisions and a misallocation of capital.
It therefore seems to me that prudent and well-considered estimates should be neither overstated nor understated. Mr Cooper is sure few would support an accounting framework that allowed bias and manipulation of financial results by management.
The IASB has always recognised the desirability of avoiding a bias in the preparation of financial statements, which is why ‘neutrality’ is, and always has been, included in the IASB’s Conceptual Framework as a feature of useful information.