Financial statements are important to a range of user groups, such as shareholders, banks, employees and suppliers. Prudence is important because overstated assets or understated liabilities could mislead potential or current investors. However, excessive cautiousness means that the financial performance and position of an entity is not faithfully represented. The IASB proposes to amend the Framework in order to reintroduce the concept of prudence and to stress its importance in relation to the faithful representation of financial information (IASB 2014). Where expenses and liabilities are concerned, prudence suggests the opposite. A liability or expenses need only be expected or anticipated to be recorded. For instance, when a business has to pay insurance costs at the end of the calendar year. However, if the financial statement is prepared, it should take account of that expected expense. Organizations should deal with devalued stock and debt servicing accordingly.
The IASB has announced an intention to re-insert prudence as part of the current revision (IASB 2014).
Financial information presented in financial statements needs to have some key qualities which make it useful for the users. Generally accepted accounting standards normally outline such standards in their frameworks. IASB Conceptual Framework categorizes these into fundamental qualitative characteristics and enhancing qualitative characteristics. Relevance Materiality Faithful representation Comparability Verifiability Timelines Understandability . Prudence had always been a controversial qualitative characteristic, and its deletion was also controversial amongst standard-setters (Nobes and Stadler, 2015, p. 11-12). IAS 8.23 allows an exception when that is ‘impracticable’. Despite this, in our data, there are nine cases of disclosed but unexplained changes which were said to have no material effect. In the IASB’s ‘bound volume’ of standards for 2011 onwards, footnotes have been added to IAS 1 and IAS 8 which mention that a revised ‘Conceptual Framework’ has been issued, but these footnotes have not been through ‘due process’ and are not in the EU-endorsed or the Australian versions of the standards (EU countries and Australia comprise six of the ten countries in our empirical analysis). The 1989 Framework by the predecessor committee to the International Accounting Standards Board (IASB) included prudence alongside neutrality as a desirable quality of financial reporting. In joint work with the US Financial Accounting Standards Board (FASB), The IASB continued the Framework project without the FASB and produced a discussion paper in 2013, in which it stood firm with its previous decision to exclude prudence, and tried to prevent further discussion by indicating an unwillingness to reopen the debate. Prudence eliminated from the accounting conceptual framework in 2010. The IASB removed prudence from the Framework because of its conflict with neutrality. This decision was made after long and controversial debates. This is because reducing assets in one period is likely to lead to the overstatement of financial performance in the next period. There is an argument that has sometimes been used in favor of excluding prudence from the Framework ‘Prudence is not applied to all accounting standards but instead only in certain instances. It should therefore not be in the Framework but instead should be applied as needed at the standards level.
According to the Framework information included in financial statements should be prudent. The Framework defines prudence as ‘the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets and income are not overstated and liabilities and expenses are not understating (Thomas and Ward, 2015, pp. 88).
This essay is about the role of prudence in the preparation of financial statements, whether and in what form prudence should be considered as a qualitative characteristic. In this essay, I’m going to show the importance of prudence concept and why prudence is regarded a qualitative characteristic of financial information and how it enhances the usefulness of information provided to various users to help them in their decision-making. In financial accounting, there are basic concepts that govern the preparation of financial statements. Prudence is one of several basic concepts used for that purpose. Prudence is historically one of the fundamental accounting concepts. Prudence- a word that describes that you should be careful about your financial situation. Is also means not being unspecified about having money until you defiantly have the knowledge that you will be getting in it. Prudence is an accounting principle which is used by an accountant while preparing financial reports to record liabilities and expenses as soon as they occur, but revenues to be recorded only when they actually occur or are about to occur in other words is the exercise of caution when making judgements (Kaplan Publishing, 2016, pp. 29). There is a rationale behind prudence. For a company, the value of an asset should not be recognized higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid in its respect in the future. Exaggerate liabilities (provisions) and expenses, particularly in years when the entity performed well is one of the reasons that prudence is used in the past. The Framework makes particular reference to this by stating ‘the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability’ (Thomas and Ward, 2015, pp 88). The main purpose of prudence is to reflect the least favorable position of a business, avoids the recording of unrealized gains and to be prepared for the losses that are likely to arise. In simple words, prudence lets to recognize profits or to delay their recognition until the core transaction is more certain to occur(Weygandt, Kimmel, Kieso, 2015, p. 103-104). For instance, Bad debts are probable in many businesses, so they create a special contra-account to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized and hence prevents overstatement of assets. An expense called bad debts expense is also booked to stop net income from being overstated. Under this concept, fixed assets are recorded when their Fair Values Fall below their book value and not when the reverse occurs.