| 5 | Many believe that prudence contributes to the credibility of financial statements, especially as it provides a high degree of confidence that the net assets represented in the balance sheet are at least as great as their reported amount, and that all reported profits are certain. |
| 6 | However, just as prudence has a long history, so does the debate about it. The main objection some raise is that prudence introduces bias into reporting, which conflicts with the neutral (or unbiased) view that financial statements should provide. In particular, they argue that prudence may be used to artificially smooth income, reducing profits in good years to provide a cushion that may camouflage the results of poor years, making it dif cult to understand the entity's performance. Because it is often dif cult for users to detect the exercise of prudence, and to quantify its effect, prudence may impair, in their view, the transparency of financial information. |
| 7 | In contrast, others believe that the application of prudence results in an earlier reflection of existing risks in the financial statements, preventing the recognition of profits which are not yet realised. They see prudence as the opposite of imprudence, which concept may result in recognising illusory profits and an overstatement of income, and can lead to ill-based economic decisions. In their view, prudence is clearly linked to pro t distribution, as noted in paragraph 1, in particular in jurisdictions where legislation has established a direct link between net income and dividend distributions. |
| 8 | In response to the objection described in paragraph 6, standard-setters, and more specifically the FASB and the IASB, in developing their Conceptual Frameworks, were careful to distinguish between: |
| (i) | the deliberate understatement of assets and profits, or overstatement of liabilities and expenses; and |
| (ii) | the adoption of a cautious approach in making the judgements necessitated by uncertainty so that assets and income are not overstated and liabilities and expenses are not understated. |
| 9 | The Frameworks frown upon the former of these and approve the latter. This is the approach to prudence reflected in FASB's Concept Statement 2, which was issued in 1980, and Frameworks issued in the 1980s and 1990s by the Australian standard-setter and the UK ASB. In these Frameworks, prudence is addressed as an aspect of reliability rather than as a 'qualitative characteristic' in its own right. The same approach was adopted in the Framework issued by the IASC in 1989. |
| 10 | Academic literature also distinguishes conditional conservatism that results in asymmetric timeliness in the recognition of good and bad news (the latter recognised earlier) and unconditional conservatism, which results in systematic understatement of net assets. According to some academic literature, users find early recognition of losses useful, as they are less frequently anticipated by the market than gains. There is a general agreement on the usefulness of conditional conservatism, while unconditional conservatism is more contentious. |
| 11 | There now seems to be widespread acceptance of the distinction between 'bad' prudence (prudence as deliberate misstatement, which is generally rejected) and 'good' prudence (prudence as caution, which is generally supported). Hans Hoogervorst, the Chairman of the IASB, has recently described it as 'plain common sense'.1 It is playing a role in the IASB's current work, for example in its projects on revenue recognition and impairment of financial assets. However, even though there is wide agreement that prudence should not go beyond bringing an appropriate level of "caution", there remain quite divergent views as to what the appropriate level of "caution" is, since it is not a defined term in the Framework. Hence some argue against recording, for example, financial assets at fair value and including the resulting gains in pro t when there is no observable price in the market or when the activity in a market is low, as, in their view, this would not reflect an appropriate level of "caution". |
| 12 | Both the criticism of prudence as a smoothing device and the acceptance of prudence as 'a degree of caution' have a common foundation in the demand that financial statements are based on sound verifiable information that users can depend upon, and thus be assured that the financial statements faithfully portray the economic position of the company, which would make them relevant for users of the financial statements of the company. |
| 13 | However, some consider that faithful representation, under the application of the prudence concept, means that the recognition of gains should be subject to a high probability realisation threshold. The definition presented in paragraph 8 considers only the understatement and not the overstatement of income. Finally, they believe that the definition of prudence cannot only be based on the objective of reducing earnings management. |
| 1 'The Concept of Prudence; dead or alive?' Speech given at the FEE Conference on Corporate Reporting of the Future, Brussels, Belgium, Tuesday 18 September, 2012. |
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