Prudenceis defined in the dictionary as caution with regard to practical matters; discretion.1 This is the whole concept behind financial prudence beinga desirable quality when it comes to financial reporting. It is the idea that,when making financial reports, the accountant in question should base hisactions on the ‘prudent man.’ This basically means that accountants should erron the side of caution for when making budgets and so forth. This was outlinedas a framework or guidelines for financial statements followed by organizationssuch as the IASB(International Accounting Standards Board ).2 For example, when a company is in progress of theirbalance sheet, they should take extra precautions not to overestimate assetsthat are coming in and not to underestimate liabilities coming out.
This is putthere as a sort of safety guideline for businesses to be ‘sensible’ and nottake unnecessary risks. This is especially a factor for PLC’s as they actuallyhave large amounts of other people’s capital in escrow. Since then prudence has beendiscussed in many literature articles as to whether it should be a quality thatis enforced. In this passage the role of prudence in when preparing financialstatements will be elaborated and whether there is need for it to be a setframework in financial reporting.To start, we will explore how financialprudence has been implemented in the modern world of accounting.
An example of a law passedspecifically for the idea to have display more prudence in the corporate worldwas the 1974 Employment Retirement Income Security Act (ERISA) topreserve and protect the pension plans of millions of American workers.(LAWUPENcite)3.This was because there was a wave of business failures as they hadoverestimated their incomings- the revenue generated from being in business and,underestimated their outgoings- the pensions that they had promised theirworkers. The ERISA set out minimum standard for private businesses when settingout pension and health plans for employees. This law meant that there were setnumbers when preparing a financial statement which helps both businesses andbuyers. This is because when budgeting it is harder to underestimate losses asthere is now a benchmark loss so businesses would have to budget according tothese new figures. This now kept businesses safer as well as their manystakeholders. Even though there may evidence that suggests that the law had adirect impact on businesses, from the article “””4 itsuggests that prudence is inherent in business accounting.
This is becausebusiness accounting, unlike economic accounting, doesn’t take into account thehuman side of the business but instead is strictly the monetary value ofassets. This then brings to question that, in a field that is dealing with theincomings and outgoing of a business, prudence has always been an unsaidquality that is necessary for this nature of work. Linking back to ERISA, itmay not have been that the businesses had failed because they were not beingconservative and basing their budgets and actions on a prudent man, it may justhave been that the businesses had a problem elsewhere that led to them becomingbankrupt. With prudence being a qualitative conceptualframework in business accounting, there have been issue that have arisen. Oneof these issues is the opportunity for individuals or businesses to embellishfunds and keep unnecessary reserves. This is because the companies now have aformat to change numbers. For example, in 2002 Nortel was found to be holding$300 million in reserves through following the guidelines.5 Someof their employees didn’t release this excess into the income of the companystatements and rather used them as overstated liabilities which actually endedup being fabricated to show that Nortel was operating at a loss instead.
Itthen can be argued that from prudence being a qualitative measure, businessesnow have easier ways to doctor financial reports what could then bring doubtupon the reliability of a businesses financial statement. Leading on from theidea of a business having questionable reliability, the use of prudence as aframework could lead to more tampering in order to protect individuals,departments, or businesses themselves. An example of this is when companies usethe prudent guidelines to exaggerate profits and make losses lesser. This getsrid of the transparency in business statements as the statements should beneutral and not biased to get favourable results6.This is because if a business is in a time of uncertainty they should judgetheir budget on what they think is the most possible outcome at the time notwhat they will think will please shareholders. This closely links to the ideaof “”conditional conservatism””7again from basu where the author distinguishes the difference betweenunconditional and conditional conservatism. As deduced from the article,prudence is under the term of unconditional conservatism which is conservativein every way. If a business was to use conditional conservatism it would meanthat they would have to take into account everything at the time the statementis being prepared and also they would have to be prudent as according to theirbest judgement.
The IASB is completely independent from businesses which makesit hard to lay a blanket rule set down for all businesses to follow as thereare so many. With conditional conservatism it makes businesses be as prudent asthey need to be in order to grow. Linking back to the example of businessesholding unnecessary reserves, with prudence just being a quality of a business Nortelwould have had to use their judegment as to what they decide was prudent whichwould lead them to having to use all their funds to make a proper financialstatement as they wouldn’t have set numbers to work around and manufactureprofits or losses for the benefit of a few.
This may add a bigger degree oftransparency when it comes to preparing financial reports. Saying that, Basudid also lay out that an negative earnings changes have more chance ofreversing in the next year in comparison to positive earnings changes. Thiscould mean that the work of financial prudence framework is effective in waysof it seems that businesses are using the figures to reverse their performance.8In summary some of the main key factors towhether there is a need for a financial prudence as a conceptual framework areapparent.
The ERISA act could be a clear indication as to financial prudence,when enforced, is a key to healthy business growth and in turn a healthiereconomy. All that being said there are strong arguments to why financialprudence should be more of a desired quality than a framework such as “””argument that prudence or conservatism is actually inherent to running abusiness and that there is no need to tell a business exactly how to becautious as there isn’t a definitive set of rules. Also Basu shows that adifferent approach of prudence may been in need which is conditional. Mostimportantly the use of prudence as a framework seems to shroud the what ismeant to be the transparency of business statements so it may actually be doingmore harm than good. So, in conclusion, The discussion in literature mostlyseem to indicate that these frameworks may be outdated and from the points mentionedabove it may be time to- not completely get rid of the conceptual framework-but to adjust them enough to allow a manageable amount of uncertainty sobusinesses can adjust their statements accordingly and more transparently.1 http://www.dictionary.
com/browse/prudence2 https://www.accountingweb.co.uk/business/financial-reporting/the-iasb-conceptual-framework-an-introduction3 https://www.
dol.gov/general/topic/retirement/erisa4Barker, R., (2015). Conservatism, prudence and the IASB’s conceptual framework.Accounting and Business Research, 45, pp. 514-538.5highered.
pdf7 http://www.scirp.org/(S(351jmbntvnsjt1aadkposzje))/journal/PaperInformation.aspx?PaperID=70733 8 http://www.scirp.org/(S(351jmbntvnsjt1aadkposzje))/journal/PaperInformation.
aspx?PaperID=70733Watts, R.L. (2003b).
Conservatism in Accounting PartII: Evidence and Research Opportunities. Accounting Horizons, 17(3), pp. 287-30