“Prudence in accounting and financial reporting is a concept which has been subject to much recent discussion in the academic and professional literature”. Prudence can be define as careful, cautious, wise, well-judged or circumspect (IFRS 2015). Prudence concept is a key accounting principle which sure that assets and income are not overstated and liabilities and expenses are not understated. Prudence is one of the desirable thing when preparing accounting and financial information. It is always controversial and difficult by using prudence in proving useful financial statements. Prudence is also long recognised as a virtue in everyday life. However, application of prudence to the world of accounting is always trickier than to an individual’s conduct. Should prudence be considered as a qualitative characteristic of financial reporting?
Prudence in accounting can be viewed both as something that should be embedded in the standards themselves, but then also exercised by preparers when applying those standards Martin (2014). For example: Supreme Office had in his running franchise business some antique office equipment. This had been bought for £10,000. It had never sold and is sitting in his store and in reality the equipment is worth nothing. Prudence would say that the value of the office equipment should be worthless. Based on it, there will be many considerations in making accounting estimations by management teams including favours either an overstatement or an understatement of financial position and financial performance. They will bias into either way of financial reporting. This idea has been taken further by IFRS (2015) that overstatement of financial performance may avoid the negative consequences for management of reporting poor performance. However, an understatement of financial performance may provide management with reserves that can be used to smooth reported profits and avoid poor reporting performance.
For example: when inventory is recorded at the lower cost or net realizable value (NRV) rather than the expected selling price. This will ensure only profit on the sale of inventory is only realized when the actual sale takes place. Revenue and profits are not anticipated, profits are also only recognised when it is realisable. Jan (2013), on the other hand also have a view that bad debts are also probable in many businesses. They create a special contra-account to accounts receivable which called allowance for bad debts, which brings the accounts receivable balance to the amount which is expected to be realized and hence it will also prevent overstatement of assets. An expense called bad debts expense is also booked to stop net income from being overstated. The application of prudence should eliminate bias from financial statements but its application should not reduce the reliability of the information.
Clearly, there are ‘good’ and ‘bad’ prudence. It might be difficult to draw between them. For instance, how much prudence should be use in measuring the assets between company A and its competitor company B? Certainly, when profits and revenue are overstated but not when they are understated , accounts, accountants and accounting standards will have received the most criticism based on it. According to Martin (2014), for example the financial crisis in 2008/9, more prudent accounting by banks might have restrained excessive bonuses and dividends, made for more resilient banks and provided greater financial stability to the whole economic system.
Furthermore, some liabilities are contingent upon future occurrence or non-occurrence of an event such a law suit, etc. We judge the probability of occurrence of that event and if it is more than 50%, we record a liability and corresponding expense at the most likely amount. Hence, we stop liability and expense from being understated by using prudence as based on Jan (2013). The other example is that periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it does exceed, the impairment of fixed asset is recorded by reducing its carrying amount. This can also prevent from being overstated of account as based also on Jan (2013).
Based on Steven (2013), prudence could also exercise in using an allowance of doubtful accounts or a reserve for obsolete inventory. In both cases, when the cause of expense has not yet been identified, prudence will be used to record a reserve in anticipation of a reasonable amount of these expenses that will rise at some point in the future.
The benefits of application of prudence seems to be widely agreed upon. The chairman of the IASB has also described the definition of prudence in the IASB’s former framework as ‘sheer common sense’ (Martin 2014). However, there are also arguments against prudence. The main arguments has concerned about the neutrality and conservative accounting through prudence. For example: Chartered Financial Analysts (CFA) wants the management team to report actual results in a neutral way and to be biased against any good or bad news. They would also make the management team to estimate uncertainties with the appropriate disclosures.
Based on Martin (2013), IASB has proposed an exposure draft to reinstate the concept of prudence and also define prudence in a manner that is consistent with neutrality. It is often discussed that prudence might restrain the profit. Prudence might hold back the profits in one year .This restrain may simply lead to their release in a subsequent period which as a result will show exaggerated results. There is a view that when making estimates of assets and profit can be just as damaging for investors. It does not only give investors poor information in the current period, but it can be used by management to mask a deterioration in the business in future periods IFRS (2015).
It will be hard to determine whether it is a ‘good’ or ‘bad’ prudence. When companies have transferred to be more transparent, in some cases by including prudence under International Financial Reporting Standard (IFRS), companies will turn out to be relatively small. For example, in countries that have been including prudent accounting, such as Germany and Switzerland pre-IFRS, investors and creditors could supposing knowing there were hidden reserves and they should know that companies will turn differently by including prudent in the company accounts and when company tend to be more transparent.
On the other hand, if prudence is considered as biased towards understatement of assets this will be regarded as more desirable characteristic of financial statements. It would always presumably be preferred even if it is less relevant to the investors. Furthermore, prudent would also lead asset to a depreciation over a useful life that is shorter than it is usually expected. The only way to ensure the useful life is not longer would be presumably to use a useful life of zero and immediately recognise all assets as an expense.
In conclusion, including prudence as a qualitative characteristics in financial reports could be controversial until now. Prudence could be used to compensate over-optimistic of managers. Furthermore, it is a practical way of dealing with uncertainty. However, management team need to be cautious when making estimations to counter uncertainty of financial reporting. Financial reporting should be a reliable source for users and not to be biased against any way of overstatement or understatement of financial position. Even though including prudence could restrict profits, it is also clear that prudence can be seem to be widely accepted now. To sum up, prudence can be a ‘good’ or ‘bad’ prudence and it depends on the circumstances and cases. It is still controversial that prudence should be a qualitative characteristic in financial reports. A ‘good’ prudence can lead to lesser uncertainty. However, a ‘bad’ prudence may be result to a restrain in profits.