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Financial statements have the job of ‘providing information about the
reporting entity’s financial performance and financial position that is useful
to a wide range of users for assessing the stewardship of the entity’s
management’ (Alexander and Britton, 2005, p230-231). Because of this, the
information provided needs to be accurate, as the users of this information is
not limited to the shareholders of a business, but also potential investors. In
this essay, I will be discussing the role of prudence (conservatism) and
discuss whether it should be considered a qualitative characteristic when it
comes to preparing financial statements. ‘Until 2010, prudence was included in
the International Accounting Standards Board’s (IASB) Conceptual Framework’
(Cooper, 2015) and they are now considering to reintroduce it for the 2018
edition. Prudence and conservatism are similar as prudence is defined as being
‘the degree of caution in the exercise of the judgements needed in making the
estimates required under conditions of uncertainty’ (Barker, 2015, p519) and
conservatism as the ‘understatement of the book value of net assets relative to
their market value’ (Beaver and Ryan, 2005, p. 269). Management is recommended
to understate assets as some may choose to overstate to make their businesses
appear better than they are. Therefore, through prudence and conservatism,
businesses produce information that is more accurate and reliable, hence more
convenient and practical for its users. 

 

The principle of conservatism comes in two forms: unconditional and
conditional. Unconditional conservatism, also known as balance sheet
conservatism is when there is a ‘persistent understatement’ of assets (Feltham
and Ohlson, 1995 cited by M?ciuc? et al., 2015), meaning the business may be
performing at a higher level but through the application of caution, the
business remains on a safe line. Conditional conservatism, or earnings
conservatism is when management is attentive and recognise losses in relation
to profit, so there is an early recognition of unfavourable events and this is
highly desired when prudence is applied (Barker and McGeachin, 2015). I believe
that managers and owners of businesses prefer unconditional conservatism as due
to the understatement of assets, they will be able to avoid paying high taxes.
On the other hand, investors prefer conditional conservatism because they are
able to see how businesses are performing financially and from there, conclude
as to whether they want to invest into that firm or not. Despite them having
different functions, in collaboration they ensure that the information
collected and used within the financial statement is not biased, reaching
everyone’s needs, thus supporting the need for prudence to be considered as a
qualitative characteristic.

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The application of prudence also enables the information provided to
hold the element of reliability, enhancing the value of the financial
statement, allowing their financial material to be credible (M?ciuc? et al.,
2015). Being prudent does not allow ‘excessive provision’ to be stated (Stolowy
et al., 2013, p126), meaning that things should be reported as they are. Watts
(2003, p287) found businesses that are conservative to ‘anticipate no profit
but anticipate all losses’. In other words, businesses record all expenses and
liabilities that are incurred as the event arises. This strengthens the
reliability of the information and causes it to be as precise as possible, as
were it not to be recorded in that moment, management may be apprehensive to
record them in the future. However, with the act of being prudent, other
characteristics that make up a good financial statement are challenged. For
example, Alexander and Britton (2005) recognised that the role of prudence and
neutrality, when both are considered, have conflicting objectives. To be
neutral may entail of management not being prudent in that they will be
required to either overstate or understate in order to be unbiased or become
balanced in their information. Consequently, the role of prudence has been
deleted from the International Accounting Standard Board’s (IASB) framework
because it implies a lack of neutrality, (Alexander and Nobes, 2013); to support
this, Ruch and Taylor (2015, p18) cited The Financial Accounting Standards
Board (FASB,2010)  as they explained why
conservatism is not one of the ‘qualitative characteristics of financial
reporting in its conceptual framework because it believes that conservatism
biases accounting information and compromises neutrality’ therefore implying
that the role of neutrality is more desirable than the role of prudence in the
preparation of financial statements, signifying that prudence may not be that
important to be considered a qualitative characteristic.

 

Prudence was introduced in order to reduce the ‘excessive optimism’ of
managers (McLaney and Atrill, 2010, p60-61), as through confidence, management
would overstate assets and understate expenses and liabilities. To support the
role of prudence, M?ciuc? et al (2015, p741) found that ‘prudence counteracts a
natural prejudice towards optimism’, strengthen the quality of the financial
statement. With the factor of optimism eliminated, investors, who are also
users of financial statements, can make a clear and conscious decision as to
whether 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 providing
investors with authentic information, which in turn, becomes a benefit to
investors as they will not have their time and resources wasted. The Tesco
scandal 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 stock
prices being at its lowest of 11.5% (Wearden, 2014), the lowest it has been for
10 years. This is clear evidence of how important the role of prudence is and
the dangers of overstating profits/understating liabilities. Although Tesco’s
management may have been operating on the accrual basis, a principle that records
events when it occurs, not when the business has received the cash (Stolowy et
al, 2013), they should have been more cautious as it appears that they had exaggerated
profits made in that year in order to gain more investors. This explains why
liabilities are advised to be recorded in the moment and not profits because it
makes the financial statements look biased. As a result of their actions, Tesco
were asked to pay an additional fine of £129million in 2017 (Ruddick and
Kollewe, 2017), which could have been avoided, if they had applied the role of
prudence, enabling us to conclude that prudence is a desirable quality and
should be applied in the preparation of financial statements.

 

The lack of prudence can also lead to the fall of a company, even so to
the point where they are unable to operate as a business. This may not directly
be a result of the lack of prudence but rather because of their imprudence, it
has led to deeper issues which could have been resolved if only they had been
prudent and honest with their current situation. This is evident in the Enron
scandal, which led to the collapse of the business. As a result of the
business’s desire to grow, they ‘hid losses and shuffled debts’ (Ailon, 2011),
in order to make themselves appear more appealing and desirable to potential
investors, but their lack of prudence gave rise to the collapse of the entire
business, elucidating the impression that prudence is indeed an important
qualitative characteristic. This also happened with Satyam, also known as the
‘Indian Enron’ (Bhasin, 2013). Mr. Raju, the Chairman of the business, wrote a
resignation letter explaining the errors on the Balance Sheet (Brown et al.,
2014, p421) and stated that the cash recorded was ‘inflated (non-existent)’ and
due to the overstatement in the revenue that the business received, ‘it had
resulted in artificial cash and bank balances going up’. This illustrates that
covering up problems within the business doesn’t always work but rather
applying unconditional conservatism will be more beneficial to management. In
both businesses, we can conclude that they lacked materiality as they chose not
to include information which they knew could potentially sway the users of
their financial statements (Atrill and Mclaney, 2016). Furthermore, we can
conclude that prudence should be a desirable characteristic in the preparation
of the financial statement and that being prudent helps users of the financial
statement as they receive information as it is, complete and free from error.

 

Overall, I believe that prudence should be considered a qualitative
characteristic when preparing the financial statements because it saves
management and users of the financial statement time and resources as it
applies the rule of honesty, enhancing the credibility of the statements. Basu
(1997, 8) cited by Watts (2003, p.208) stated that ‘conservatism has influenced
accounting practice for at least 500 years’, and from this, we can infer that
without the use of prudence or conservatism, financial statements would not be
reliable. Conditional and unconditional conservatism work best in collaboration
with 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 indeed
is important. 

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