The Bruce Column — Being prudent about prudence

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03 Oct 2013

The concept of prudence is, on the surface, a simple one. But, as our regular resident columnist Robert Bruce explains, that is why it needs to be better defined.

‘Dear Prudence’, the Beatles once sang before launching into a song about sunshine, blue skies and birds singing. And that is the problem with prudence. The word, the concept, is lost in such a haze of vaguely positive feelings that it is hard to pin it down and define what it really means. Small wonder that when accountants try to work out an acceptable definition of the concept of prudence as it applies in the field of financial reporting they find it both almost impossible and contentious.

Outsiders can’t really see what the fuss is about. If they have any idea where prudence fits in they tend to feel that accountants should be more likely to emphasise bad news than good news, more likely to recognise losses than to push up the profits. Or as the original version of the IASB’s conceptual framework put it: ‘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, such that assets or income are not overstated and liabilities or expenses are not understated.’

The problem with this is that prudence can lead accountants a bit of a dance. Historically prudence became the oldest trick in the book. You cite ‘extra’ prudence one year and then, marvel upon marvel, discover that you can feed the fruits of that prudence into a bumper crop of profits the next year.

This, as the IASB points out in the latest discussion paper on the conceptual framework, means that the financial statements concerned ‘would not be neutral and therefore, not have the quality of reliability’. Instead the IASB decided in 2008 that the problem of precisely defining the application of prudence meant prudence should be dropped and the idea of neutrality introduced instead. Neutrality would effectively cover the admirable aspects of prudence but not the more problematic and worrying downsides. The pursuit of neutrality, it was felt, would be more effective than prudence at ridding the process of bias.

But the word prudence is emotive and a significant number of people mourn her loss and refuse to accept the IASB concept that she is still alive and well and can be found in the standards. ‘Some would prefer financial statements to show a bias towards conservatism and reject the notion of neutrality’, explains the discussion paper.

The rationale for the IASB’s views on neutrality and prudence is that a systemic bias towards conservatism undermines the value of earnings as a performance indicator, but the on-going debate proves that this view is not universal.

The IASB also realises that fans of ‘a bias towards conservatism’ would not accept its definition of the good lady as ‘the exercise of caution when making estimates and judgements under conditions of uncertainty.’ EFRAG noted in its Bulletin ‘Prudence’ (April 2013) that there is a view that ‘prudence is compatible with neutrality and request that, as prudence is important, the Framework needs to explicitly acknowledge it, because otherwise it will be incomplete.’  EFRAG concludes that, given that not everyone ‘exercises the degree of “caution” in the same way,’ the Framework should discuss the role of prudence explicitly.

There is an opportunity during the discussion of the conceptual framework to acknowledge that, while the idea of prudence should be all around financial reporting, we need to be more explicit about how it influences it. Or as the Beatles put it: ‘Dear Prudence see the sunny skies, the wind is low, the birds will sing, that you are part of everything’.

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