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5ACCN004W Financial Accounting and International Reporting Standards

Question

Learning outcomes:

LO1: understand the impact of international standardisation on reporting practices.

LO2: demonstrate an understanding of contemporary measurement issues in financial reporting and their application in practice.

Read the following statement and answer the question:

“Prudence in accounting and financial reporting has a long-established track record. There is a considerable debate about whether International Financial Reporting Standards (IFRS), as the key global standards, should include prudence and state its importance in their conceptual framework” (ACCA, 2014*). 

Critically discuss the debate about the inclusion of the prudence concept in the conceptual framework and IFRS.

Answer

Introduction:

Over the past decade, the European nations have encountered significant financial reporting changes. There has been considerable debate whether “International Financial Reporting Standards (IFRS)”, as the significant international standards, need to include prudence and its significance in the conceptual framework. However, prudence has been eliminated after the global financial crisis as a part of the conceptual framework introduced in 2010. Prior to that period, prudence has been included in the framework of IASB in the description of the qualitative characteristics of reliability (Accaglobal.com, 2018). However, in 2015, the prudence concept has been reinitiated in 2015, which has further aggravated the debate. Therefore, the current paper aims to discuss the arguments for and arguments against the inclusion of prudence in the conceptual framework.

Arguments for and against the inclusion of prudence in the conceptual framework:

Arguments for the inclusion of prudence in the conceptual framework:

The arguments in favour of the prudence theory are seen among various types of the users (accountants) who should be restrained on anticipated increased exuberance in the results of an entity. This is further depicted to be closely attached to the expectation of both audited and reported figures which are difficult to be ascertained for certainty and need to be exercised with caution. This is identified to be exercised as per referring to former framework of the accounting standards and supporting the viewpoints of the same. This view is not only depicted to be opined by the public but also by the professional investors those which are particularly linked with paying the bonuses and dividends (Tracey, 2015).

This is identified as the area in which the assets and profits are seen to be overstated as per the various types of the considerations which are understood with accounting standards, accounts, accountants and criticisms. The asymmetrical risk aspect has further led to addressing the significant problems of GFC 2008/9. The benefits of this are further identified with the application of the standards which are widely agreed upon. For instance, IASB chairperson has defined prudence in terms of former framework of IASB as sheer common sense (Watts and Zuo, 2016).

The different types of the arguments which are against the concerns of prudence needs to be identified with comparability and neutrality which are having a specific impact on the financial statements. The different types of the professional investors such as CFA desire the management to report the actual results to be revealed in a more transparent manner which is not biased to both bad and good news. In addition to this, there are several types of the uncertainties arising as a result of the disclosures made by the management. At the time of evaluating the challenges such as desirability and restraint in profit recognition after pointing out the prudence concerns, which held back the profits showing exaggerated results (Sutton, Cordery and Van Zijl, 2015). The restatements of Daimler Benz’s have shown several types of the profit records which were prudent from the German accounting to other accounting standards such as US GAAP. The overall depictions of the results revealed that the there is significant smoothing effect in terms of prudence. The Spanish banks are further depicted to be having a dynamic effect on defining the provision at the time of the crisis and this can be cited as the underlying weakness with the changing conditions (Zhang and Andrew, 2014).

Arguments against the inclusion of prudence in the conceptual framework:

Prudence is not a valuable concept from the practical perspective, as it is too vague. More precisely, it does not assist with the issue of the amount of prudence to be applied in any particular situation. This is because there is no scale of measuring relevance. In addition, it needs to be kept in mind that the prudence case takes place during uncertainty and for this reason; it would be inconsistent conceptually for dismissing prudence, as it is not precise in application (Barker, 2015). Instead, it is a vague concept and this uncertainty is the reason behind its existence initially. In reality, determining the technique and the way of applying prudence becomes a judgemental matter at the level of standards and the framework’s role is to develop the underlying concept.

Secondly, it is not possible to apply prudence in all the standards of accounting; rather it could be applied only in particular circumstances (Bauer, O'Brien and Saeed, 2014). Therefore, it need not be included in the framework; instead, it could be applied at the standards level, when necessary. However, all component frameworks are pertinent to considering all aspects of various standards. Moreover, the steady application of a concept through any provided number of accounting standards needs a clear yardstick against which it becomes possible to ascertain and analyse consistency and the place for that conceptual yardstick is the framework.

Finally, if there is understatement of net assets in the existing period, there is chance of overstating the financial performance in upcoming periods, which could not be adjudged as prudent. In case, gains are not considered at the time of uncertainty, they would then be reported in an upcoming period after gaining certainty (Macve, 2015). If the prudence test is that there is recognition of gains only after verification, then it could be explained as prudent. It is noteworthy to mention that at no point, there is overstatement of net assets. The main question here is whether the investors would like a financial performance measure they could trust in contrast to the ones that could not be trusted. Thus, if there is scope of bias and shift from neutrality in the conceptual framework, it could pave the path for abusing and manipulating the financial statements.

Conclusion:

It can be depicted that arguments in favour of the prudence theory are seen to be closely attached to the expectation of both audited and reported figures which are difficult to be ascertained for certainty and need to be exercised with caution. This is  depicted to be exercised as per referring to former framework of the accounting standards and supporting the viewpoints of the same. On the other hand, the different types of the arguments which are against the concerns of prudence needs to be identified with comparability and neutrality which are having a specific impact on the financial statements.

References:

Accaglobal.com. (2018). [online] Available at: https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-prudence.pdf [Accessed 12 Nov. 2018].

Barker, R. (2015). Conservatism, prudence and the IASB's conceptual framework. Accounting and Business Research, 45(4), 514-538.

Bauer, A. M., O'Brien, P. C., and Saeed, U. (2014). Reliability makes accounting relevant: a comment on the IASB Conceptual Framework project. Accounting in Europe, 11(2), 211-217.

Macve, R. (2015). A Conceptual Framework for Financial Accounting and Reporting: Vision, Tool, Or Threat?. Routledge.

Sutton, D. B., Cordery, C. J., and Van Zijl, T. (2015). The purpose of financial reporting: The case for coherence in the conceptual framework and standards. Abacus, 51(1), 116-141.

Tracey, E. (2015). Discussion of ‘Conservatism, prudence and the IASB's conceptual framework’by Richard Barker (2015). Accounting and Business Research, 45(4), 539-542.

Watts, R. L., and Zuo, L. (2016). Understanding practice and institutions: A historical perspective. Accounting Horizons, 30(3), 409-423.

Zhang, Y., and Andrew, J. (2014). Financialisation and the conceptual framework. Critical perspectives on accounting, 25(1), 17-26.

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