Prudence in Accounting: Concept Overview

Introduction to Prudence

Prudence in accounting also referred to as the principle of conservatism suggests that overestimation of revenues and underestimation of liabilities should be avoided (Jennings, 2001). This principle also suggests that the expenses and liabilities should be recorded in the books, the moment they happen. However, the revenue should be recorded only when they are received (McKeith and Collins, 2013). Thus, it can be said that prudence in accounting emphasises on recording the actual values of revenues and expenditures and not over exaggerating them. However, there is a never-ending debate on whether a lack of prudence in the IFRS helps create the over-exuberance of expansion, unrealised profits, unjustified bonuses and dividends or its inclusion will really be beneficial to stop the exaggeration (ACCA, 2014).

Arguments favouring Prudence

As per IAS18 of IFRS, the revenue is recorded at fair value only after it has been received. This means that the amount will be realised only when the goods have been delivered to the beneficiary (IFRS, 2017). This example specifies that IFRS has involvement of Prudence to some extent. Another example for expenditure /loss can also be considered to check whether prudence is applicable or not. Considering the case of an obsolete inventory, there is no identification of a specific item due to which loss will be incurred. Thus, while using the concept of prudence a reserve would be defined under the name of the loss which is certain to occur at some point of time in future. This amount would lie within a reasonable range of value and would not be underestimated (Oreshkova, 2017). However, it becomes difficult to estimate that reasonable amount. Hence, it is clear that the role of prudence is no doubt beneficial for accounting, but it is yet to be decided to what extent prudence should be included in IFRS. Also, as per the description provided in the previous framework of IFRS, prudence has been stated as an act of ‘Sheer Commonsense’.

Georgiou (n.d.) debated that prudence should be included in the accounting principles of IFRS with other accounting concepts like reliability. It is evident that the concept of prudence is more applicable to profits/revenue, rather than loss/expenses. As the concept of prudence avoids overstating of assets and revenues and understating of liabilities and losses, This means that the profits realised on the balance sheet date should only be recorded. Conservatism, as it is generally called, is an ancient and important principle of accounting.

Supporting the use of prudence in IFRS, Oreshkova (2017) suggested that it would bring more transparency in the recording the financial report. This is possible as prudence seizes any opportunity of an organisation being unrealistically realistic. He also, suggested that credibility and verifiability should be restored in the authorities responsible for publishing the reports. Those in favour of prudence felt that overstated revenues and losses might lead to an economic imbalance in case of the financial crisis as it is clearly evident from the financial crisis of 2008-09. During that period had the banks followed the concept of prudence accounting, it would have been easier for them to deal with the financial crisis. As the balance sheets were over exaggerated excessive dividends to the shareholders and bonus to the employees was given (Elliott and Elliott, 2017). It is evident from the example that overstating of the revenues results in exaggerating profits and in turn leads to increased expenditure. However, the concept of prudence could have helped the banks avoid the occurrence of a financial crisis (Jennings, 2001).

Arguments against Prudence

In contrast to IAS18, under IAS37, it has been stated that whether or not the goods have been delivered a full provision is required to be made for the same (IFRS, 2017). Those in against of prudence state that, recording revenue at the time of realisation can prove to be erroneous (ACCA, 2014). It implies that if the revenue is generated in one financial year and realised in the following year, then according to the concept of prudence it will be recorded in the following year. There are chances that including prudent reverses temporarily mask the weaknesses of the company and may delay remedial action. This implies that the profits of the following year would be exaggerated. The basic rule of accounting states that any decline in the value of assets is recorded as impairment or depreciation. However, an increase in the value of the asset can only be recorded when they are sold. This concept is denied through the use of prudence, by recording asset’s increased value in the year it is sold. This will show a rise in the profits of the year it is sold and not in the year when it actually rises. Thus, it can be said that including prudence may result in exaggerated results. Moreover, it is believed that management should be transparent and neutral in reporting both good and bad news (Charted Financial Analysts, (CFA)). That is, in case of uncertainty, there should be appropriate disclosure with best estimates. Thus, in addition to exaggerated results and masking weaknesses, the concept of including prudence in IFRS may have a concern with the neutrality and comparability. This means that the accounting books would be free from errors or missing entries along with the application of accounting principles (Jennings, 2001).

Conclusion

Thus, it can be seen that the concept of prudence is both useful and harmful for the accounting process. For example, in case of investment in land/property the payment is made in the current year, but the profit will be earned only in the year it is sold (Elliott and Elliott, 2017). This will over exaggerate the profits of that year, and hence, the concept of prudence is not applicable. However, in the case of inventory, the profits are realised in the same year. Thus, the concept of prudence can be applied fully. Hence, it is not false to say from the above discussion that the concept of prudence needs to be revised and then incorporated in IFRS. It may include provisions in which prudence is more applicable for profits/revenues and less for loss/expenditure. Overall, there are various arguments in favour of and against the use of prudence in IFRS. By providing a proper definition of prudence, it is possible to incorporate the revenues that have been generated in one year while realised in the consequent years. The level of transparency has to be revised and properly followed by the organisations recording financial statements. Thus, before incorporating prudence in IFRS, the concept of prudence should be revised to overcome its weaknesses.

References

Jennings, A.R. (2001). Financial accounting. Thomson

Georgiou, O. (n.d.). The Removal and Reinstatement of Prudence in Accounting: How Politics of Acceptance Defeats Financialisation. Alliance Manchester Business School.

Oreshkova, H. (2017). The debate on prudence in accounting. CBU international conference on innovations in science and education.

Craig, D., Ward and Marie, A. (2013). Financial accounting and reporting: an international approach. Essential.

McKeith, J and Collins, B. (2013). Financial accounting & reporting. Essential.

Elliott, B and Elliott, J. (2017). Financial accounting and reporting. Essential.

IFRS. (2017). IAS 18 Revenue.