Prudence gets a revival

Should "prudence" go back into the conceptual framework?

Ever since the International Accounting Standards Board decided to remove the term “prudence” from its conceptual framework in 2010 and replace it with “neutrality", there has been a strong push from some quarters to get this term reinstated.

The IASB has paid heed to these voices and tentatively decided to reintroduce prudence into the conceptual framework at its recent meeting in May 2014.

Voices from the European Union (EU) have perhaps been the loudest.

The United Kingdom Financial Reporting Council (UK FRC) has been at the forefront of the push to seek reinstatement of prudence within the conceptual framework that forms the basis of the International Financial Reporting Standards (IFRS).

Giving evidence at a recent House of Lords Economics Affairs Committee hearing, the UK FRC Chief Executive Stephen Haddrill stated that the UK FRC has been lobbying the IASB hard to get prudence reinstated as a concept.

Reasons for reinstatement of prudence as a concept include:

  • Prudence is used in both existing and proposed IFRS and therefore it is important to explain it in the conceptual framework
  • Prudence is needed to counteract a natural bias towards optimism in financial statements
  • Prudence helps address investor concern about downside risk rather than upside potential
  • Exercise of prudence helps align the interests of shareholders and management

Those arguing against reinstatement of prudence have cited reasons including:

  • A lack of clear understanding of the term that could lead to different interpretations and inconsistent application
  • Exercising prudence could lead to bias in financial statements that is inconsistent with the concept of neutrality
  • Inappropriate application could lead to “profit shifting” or “cookie jar accounting”, the undesirable practice of understating good performance in some years to hide bad performance in future years.

The previous decision by the IASB to remove prudence from the conceptual framework was subjected to extensive due process and was agreed with the United States Financial Accounting Standards Board (FASB).  Reintroducing the term now could also mean divergence from the approach taken by FASB.

The IASB’s tentative decision to reintroduce prudence into the conceptual framework is supported by recommendation and analysis set out in an IASB staff paper.

In making their recommendation to the IASB to consider reintroducing prudence, the IASB staff believes that the concept of neutrality can be reconciled with the exercise of prudence, both by preparers of financial statements, and by the IASB in setting standards.

The staff recommendations to the IASB include:

  • Describing prudence as the exercise of caution when making judgements under conditions of uncertainty to ensure that assets or income are not overstated and liabilities or expenses are not understated
  • Explaining that prudence is consistent with neutrality and does not allow for the deliberate overstatement of liabilities or expenses or understatement of assets or income

In tentatively deciding to reintroduce prudence, the IASB has also stated “…developing a global standard means that we also need to listen to the views of more than 100 countries that now mandate the use of IFRS, and those views are not always consistent”.
Ram Subramanian is CPA Australia’s policy adviser – reporting & audit.