The prudence concept is a principle used within accounting. It is a principle which always understates assets and overstates liabilities in order to produce conservative and prude financial statements. Therefore when final accounts are published, this principle shows the business in a less favourable position this in order to counteract unrealistic surges in profit and to shield against potential losses. As the name ‘prudence’ suggests, it means that one is acting carefully to guard against potentially unwanted situations.However, there has been some discussion over the years whether the prudence concept should be considered as a qualitative characteristic. Qualitative characteristics are attributes that financial statements must have in order to be useful to those reading them. These characteristics are things such as
· Reliability – The reports should not contain errors and mistakes or be misleading.
· Understandability – Easily understandable for readers
· Relevance – Must be relevant to the area recorded
· Comparability – Must be able to compare to other companies
· Verifiability – The reports must be verified
· Timeliness – Must be a timescale, which allows time for decision-making
throughout this essay I will discuss whether prudence should be considered as a qualitative characteristic when preparing financial statements.
When producing financial statements, the introduction of prudence presents each report with a level of bias. This is because numbers are being understated and overstated. This is particularly highlighted by neutrality. Neutrality is a very important concept within accounting, and is when information is presented with no bias, no overstating or understating, just a balanced view of the figures of the business. In 2010 prudence was removed from the IASB’s conceptual framework. One of the reasons it was removed was because there was lots of confusion regarding the definition of prudence in the conceptual framework released before 2010. An example of this from the original draft of the pre 2010 conceptual framework from the IASB which I have taken from Barker (2015) “Such uncertainties are recognised by the disclosure of their nature and extent and by the exercise of prudence in the preparation of financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty” However, the same article later goes on to state that “However, 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.” Here is a clear example of a rather blurry and unclear statement from the IASB which inevitably led to confusion as one one hand it seems as though they understand that some figures may be altered and excercised by the prudence concept, yet on the other hand does not allow the deliberate uunderstating and overstating of assets and liabilities. Therefore there is a lack of understandability regarding prudence, which therefore could present the argument that it cannot be considered a qualitative characteristic of financial reporting.
Prudence can also be viewed negatively for investors as it means that they do not get a true image of the company’s accounts. As a result of this, figures which may not be truly reflective of the company’s performance are published and therefore as Cooper (2015) suggests those investors who use the financial statements to make decisions on their investment is likely to lead them to make sub-optimal decisions and to potentially allocate capital into the business where it may not be needed. This could therefore also potentially lead investors to pull out of the business, perhaps if assets are understated, which could give the impression that the company is not as profitable as predicted and may be going downhill. This therefore means that the prudence concept may have a detrimental effect on the decision making of investors. With regards to qualitative characteristics it can be said that because the prudence concept does not always demonstrate a true reflection of the companies accounts, that it has a lack of reliability, which is a fundamental characteristic of accounting. As a result of this it could be said that the prudence concept may not be considered a qualitative characteristic because the reports could potentially be misleading.
However it could be argued that conservative financial statements are useful as they can provide better stability for a business because they help plan for uncertainty in times ahead. For example, if a company did not use the prudence concept and submitted financial reports that were more neutral there is likely to be a higher risk of financial problems when paying shareholders dividends. Which is suggested by Cooper (2015) when he uses the example that if a company pays out dividends to shareholders and then it turns out (using hindsight) that the business was in fact undercapitalised, the company may then struggle to find the extra capital needed to compensate.
To conclude I feel that the arguments against the prudence concept being considered as a qualitative characteristic when producing financial reports heavily outweigh the arguments for.
Although it can be said that the the prudence concept helps guard against financial uncertainty, the fact that it holds a bias when reporting immediately sends warning signs. As reported earlier under and overstated figures can not only present the company in a unrealistic light, but can also give investors the wrong impression of the way the company is moving forward, or backward. As Cooper (2015) also suggested earlier, these figures could lead investors and potentially management to nake sub-optimal decisions. As I understand this could place any company in jeopardy as decisions are being made using data which is not neutral. Is it worth making decisions which can alter the future of a company based on financial reports that are not necessarily representative of the true financial state of said company? Taking all this in, and analysing factors such as understandability and reliability, I do not think that the prudence concept should be considered as a qualitative characteristic when preparing financial reports.