The concept of prudence and its use, or non-use, in financial reporting has been the cause of much angst and the subject of swirling debates in recent years, says CPA Australia chief executive Alex Malley
Outside of accounting and legal circles, prudence, like so many other words of another era is a descriptor, if not a concept, on the wane. It refers to the exercise of good judgment, informed by intelligence and good character. Prudence requires the consideration of long term choices and implications of decisions, and the avoidance of biases that make us focus on the here and now.
For decades, the concept of prudence had been part of financial reporting frameworks. It was recognised as part of the qualitative characteristic of "reliability" within the International Accounting Standards Board’s (IASB) conceptual framework until 2010, when the IASB decided to replace it with the concept of neutrality.
In order to better understand the IASB’s decision to remove prudence from the conceptual framework, let us first look at its pre-2010 definition of the word, which was "the inclusion of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated".
While some argue that there is nothing wrong with this definition, in practice there have been some real issues with interpretation, particularly as it can cause a bias towards conservatism in financial reporting. Or worse, as the IASB chairman put it in a 2012 speech "many felt that in practice the concept of prudence was often used as a pretext for cookie jar accounting".
As professionals, we strive to remove bias from our everyday actions – why should financial reporting be any different?
Prudence causes bias in financial reporting through introducing a degree of conservatism that diverges from the presentation of unbiased or neutral financial reports. There is no doubt that prudence and conservatism were perhaps more important concepts in a time when the accounting standards and frameworks were less well developed, to encourage the exercise of caution by financial report preparers when there was no clear guidance or requirement set out to tackle a particular financial reporting issue.
However, in more recent times, accounting standards and frameworks have become much more well developed, obviating the need for the concept. As an interesting aside, support for the concept of prudence appears to be stronger in jurisdictions where the financial reporting function has links to the ‘capital maintenance concept’ and the protection of creditors. The International Financial Reporting Standards promulgated by the IASB, with their focus on the provision of information related to financial performance to allow investors to make appropriate economic decisions, do not have the same objectives.
Whilst the meanings and interpretations of the concept of prudence within financial reporting may have become too warped over time to redefine and reintroduce, there is no doubt a place for its true meaning in other everyday actions of an accounting professional.
Prudence requires an open-mindedness that is a necessary trait for accountants. As accountants we need to be able to perceive possibilities, as strategic thinkers and as creators and assurers of information. We need to actively seek information that contradicts our preconceptions and seeks to promote the common good, the public interest.
Let us look at the development of the framework for Integrated Reporting <IR> for example, an initiative that I ardently support and seek to foster. In the last two decades, there have been instances where the Annual Report has been used as a tool to promote an entity’s brand, often a brazen marketing initiative. <IR> seeks to bring discipline into the preparation of annual reports, introducing an emphasis on the discussion of the business model, the risks a business faces, value creation and value depletion, all in a structured manner. One might argue that the introduction of such a discipline is synonymous with the exercise of prudence.
So I think we should not exclude prudence from our toolkit of virtues, but understand it and embrace it for what it really is-not bias or conservatism in financial reporting that it was previously associated with, but unbiased long term intelligent thinking.
Malley”s previous article: Cracking open professional scepticism