Financial statements have the job of ‘providing information about thereporting entity’s financial performance and financial position that is usefulto a wide range of users for assessing the stewardship of the entity’smanagement’ (Alexander and Britton, 2005, p230-231). Because of this, theinformation provided needs to be accurate, as the users of this information isnot limited to the shareholders of a business, but also potential investors.
Inthis essay, I will be discussing the role of prudence (conservatism) anddiscuss whether it should be considered a qualitative characteristic when itcomes to preparing financial statements. ‘Until 2010, prudence was included inthe International Accounting Standards Board’s (IASB) Conceptual Framework'(Cooper, 2015) and they are now considering to reintroduce it for the 2018edition. Prudence and conservatism are similar as prudence is defined as being’the degree of caution in the exercise of the judgements needed in making theestimates required under conditions of uncertainty’ (Barker, 2015, p519) andconservatism as the ‘understatement of the book value of net assets relative totheir market value’ (Beaver and Ryan, 2005, p. 269).
Management is recommendedto understate assets as some may choose to overstate to make their businessesappear better than they are. Therefore, through prudence and conservatism,businesses produce information that is more accurate and reliable, hence moreconvenient and practical for its users. The principle of conservatism comes in two forms: unconditional andconditional. Unconditional conservatism, also known as balance sheetconservatism is when there is a ‘persistent understatement’ of assets (Felthamand Ohlson, 1995 cited by M?ciuc? et al.
, 2015), meaning the business may beperforming at a higher level but through the application of caution, thebusiness remains on a safe line. Conditional conservatism, or earningsconservatism is when management is attentive and recognise losses in relationto profit, so there is an early recognition of unfavourable events and this ishighly desired when prudence is applied (Barker and McGeachin, 2015). I believethat managers and owners of businesses prefer unconditional conservatism as dueto the understatement of assets, they will be able to avoid paying high taxes.On the other hand, investors prefer conditional conservatism because they areable to see how businesses are performing financially and from there, concludeas to whether they want to invest into that firm or not. Despite them havingdifferent functions, in collaboration they ensure that the informationcollected and used within the financial statement is not biased, reachingeveryone’s needs, thus supporting the need for prudence to be considered as aqualitative characteristic.
The application of prudence also enables the information provided tohold the element of reliability, enhancing the value of the financialstatement, allowing their financial material to be credible (M?ciuc? et al.,2015). Being prudent does not allow ‘excessive provision’ to be stated (Stolowyet al., 2013, p126), meaning that things should be reported as they are.
Watts(2003, p287) found businesses that are conservative to ‘anticipate no profitbut anticipate all losses’. In other words, businesses record all expenses andliabilities that are incurred as the event arises. This strengthens thereliability of the information and causes it to be as precise as possible, aswere it not to be recorded in that moment, management may be apprehensive torecord them in the future. However, with the act of being prudent, othercharacteristics that make up a good financial statement are challenged. Forexample, Alexander and Britton (2005) recognised that the role of prudence andneutrality, when both are considered, have conflicting objectives.
To beneutral may entail of management not being prudent in that they will berequired to either overstate or understate in order to be unbiased or becomebalanced in their information. Consequently, the role of prudence has beendeleted from the International Accounting Standard Board’s (IASB) frameworkbecause it implies a lack of neutrality, (Alexander and Nobes, 2013); to supportthis, Ruch and Taylor (2015, p18) cited The Financial Accounting StandardsBoard (FASB,2010) as they explained whyconservatism is not one of the ‘qualitative characteristics of financialreporting in its conceptual framework because it believes that conservatismbiases accounting information and compromises neutrality’ therefore implyingthat the role of neutrality is more desirable than the role of prudence in thepreparation of financial statements, signifying that prudence may not be thatimportant to be considered a qualitative characteristic. Prudence was introduced in order to reduce the ‘excessive optimism’ ofmanagers (McLaney and Atrill, 2010, p60-61), as through confidence, managementwould overstate assets and understate expenses and liabilities. To support therole of prudence, M?ciuc? et al (2015, p741) found that ‘prudence counteracts anatural prejudice towards optimism’, strengthen the quality of the financialstatement. With the factor of optimism eliminated, investors, who are alsousers of financial statements, can make a clear and conscious decision as towhether they want to invest in the business or not. Prudence, in this case,acts as an advantage to management because by doing so, they are providinginvestors with authentic information, which in turn, becomes a benefit toinvestors as they will not have their time and resources wasted. The Tescoscandal of 2014 (Wood and Farrell, 2014), came about as management chose to overstate their profits by£250million, resulting in the value of the supermarket diminishing by £2bn.
Subsequently, investors chose to sell their shares, leaving Tesco’s stockprices being at its lowest of 11.5% (Wearden, 2014), the lowest it has been for10 years. This is clear evidence of how important the role of prudence is andthe dangers of overstating profits/understating liabilities. Although Tesco’smanagement may have been operating on the accrual basis, a principle that recordsevents when it occurs, not when the business has received the cash (Stolowy etal, 2013), they should have been more cautious as it appears that they had exaggeratedprofits made in that year in order to gain more investors. This explains whyliabilities are advised to be recorded in the moment and not profits because itmakes the financial statements look biased. As a result of their actions, Tescowere asked to pay an additional fine of £129million in 2017 (Ruddick andKollewe, 2017), which could have been avoided, if they had applied the role ofprudence, enabling us to conclude that prudence is a desirable quality andshould be applied in the preparation of financial statements.
The lack of prudence can also lead to the fall of a company, even so tothe point where they are unable to operate as a business. This may not directlybe a result of the lack of prudence but rather because of their imprudence, ithas led to deeper issues which could have been resolved if only they had beenprudent and honest with their current situation. This is evident in the Enronscandal, which led to the collapse of the business. As a result of thebusiness’s desire to grow, they ‘hid losses and shuffled debts’ (Ailon, 2011),in order to make themselves appear more appealing and desirable to potentialinvestors, but their lack of prudence gave rise to the collapse of the entirebusiness, elucidating the impression that prudence is indeed an importantqualitative characteristic. This also happened with Satyam, also known as the’Indian Enron’ (Bhasin, 2013).
Mr. Raju, the Chairman of the business, wrote aresignation letter explaining the errors on the Balance Sheet (Brown et al.,2014, p421) and stated that the cash recorded was ‘inflated (non-existent)’ anddue to the overstatement in the revenue that the business received, ‘it hadresulted in artificial cash and bank balances going up’.
This illustrates thatcovering up problems within the business doesn’t always work but ratherapplying unconditional conservatism will be more beneficial to management. Inboth businesses, we can conclude that they lacked materiality as they chose notto include information which they knew could potentially sway the users oftheir financial statements (Atrill and Mclaney, 2016). Furthermore, we canconclude that prudence should be a desirable characteristic in the preparationof the financial statement and that being prudent helps users of the financialstatement as they receive information as it is, complete and free from error. Overall, I believe that prudence should be considered a qualitativecharacteristic when preparing the financial statements because it savesmanagement and users of the financial statement time and resources as itapplies the rule of honesty, enhancing the credibility of the statements. Basu(1997, 8) cited by Watts (2003, p.208) stated that ‘conservatism has influencedaccounting practice for at least 500 years’, and from this, we can infer thatwithout the use of prudence or conservatism, financial statements would not bereliable. Conditional and unconditional conservatism work best in collaborationwith each other as that way, everyone’s interest is taken into consideration,to produce the best outcome for all.
Prudence has been described as a’fundamental principle’ (ACCA Global, 2018) and we can conclude that it indeedis important.