Introduction
According to the International Accounting Standards Board (IASB), the purpose of general financial reporting is to provide vital monetary information concerning the reporting of business operations. The information is useful to lenders, potential and existing investors, and creditors in terms of enabling them to make wise decisions concerning resource provision and utilization in the business. However, in advanced financial accounting, the basic knowledge gained in general accounting is expounded. Besides the usual analysis of statements of financial position and records of comprehensive income for both a partnership and Limited Liability Company, a new financial statement that analyses the cash position of the business is also included. Therefore, although the primary function of financial accounting is to measure and identify fiscal information, advanced financial accounting addresses the communication of this information to the accounting information users. To produce reliable, relevant, comparable, and understandable financial information, the information must be well communicated by its users to make proper business decisions. Specifically, this essay analyses the principle of prudence in financial reporting.
Principle of Prudence
Establishing the properties of useful financial reporting has not been easy since time immemorial. Previously, the principle of prudence was vouched for until 2010 when it was scrapped by the IASB (Cooper 2015). The prudence concept is an accounting code that recommends the recording of expenses and liabilities as early as possible. However, the rule advises that the documentation of profits or revenues should be done only when they are guaranteed. Hence, the number of expenses projected should not be underestimated. Similarly, the profits or revenues realized should never be overestimated. Assets are recorded with surety whereas liabilities are recorded on a probability basis (Deegan 2009). In this regard, the principle of prudence has been considered an enthusiastic approach (Ebert & Wiesen 2014). For example, in the case of reserves for obsolete machinery as an inventory, a prudent accountant will record the raw materials in anticipation of the rising expenses (ICWAI 2010).
Another example that shows that the prudence principle is essential is that persons are not allowed to write up fixed assets when their fair value is higher compared to their book value, although it is a requirement to write down the fixed possessions when the turn round occurs (Lewis & Pendrill 2004). The IASB proposed to reintroduce prudence as an element of the properties that demonstrate the importance of financial statements to investors. Hence, according to the conceptual accounting framework, investors and stakeholders expressed their desire to have accounting standards based on the prudence concept, which is addressed in the Exposure Draft of 2015. In the principle of conservatism, when allowed to choose between outcomes where the occurrences or probabilities are equal, the prospect that leads to a lower profit amount should be considered. Similarly, when faced with a similar dilemma regarding the value of an asset, the transactions that result in a lower asset valuation are examined. Consequently, in case of any loss or an event of uncertainty, the loss should be received (Elliott & Elliott 2008). However, if a profit is tentative, it should not be documented.
The principle of conservatism creates the foundation for the market rule where inventory should be recorded at the lower margin of its purchase cost or its current market rate. The principle infers that when one is not sure of the value, the accounting option that is unlikely to overstate the income and assets should be opted for (Schroeder, Clark, & Cathey 2005). Taxing authorities are disadvantaged by the principle of conservatism since the amount of taxable income is relatively lower during the initial phases. Hence, minimal taxes are collected. Arguments in favor of the principle of conservatism are that the school of thought reduces litigation cost because net assets are understated to the extent of reducing the probability of the firm being sued for warranty claims. In addition, when reporting and taxation are linked, conservatism leads to delayed tax payment, which, in turn, improves the value of the firm. Lastly, for regulators, it is safer if a firm understates its net assets, as opposed to their exaggeration. Hence, conservatism lowers the political cost that is imposed on regulators by avoiding an asset overstatement for a firm. Opponents of conservatism argue that it results in non-conservative future income statements. For instance, when valued through conservative principles, an appreciating property such as land will add value later. However, it will not be conservative during the period when the appreciation occurs. The aim of conservative accounting is not to generate conventional earnings but rather a conformist value of net assets. According to Ebert and Wiesen (2014), the most influential and important principle of valuation in accounting is conservatism.
Another concept that is related to the principle of prudence is a faithful representation, which states that the generated financial statements should precisely reflect the prevailing conditions of an enterprise. The concept can also be defined as the necessity for uniformity of financial reports and claims made in financial statements and the real monetary status of the firm (Narayanan 2005). Therefore, the requisite information that readers require for them to come to a conclusive and concise opinion of the financial position, results, and cash flows must be incorporated into the financial statements. Moreover, the financial statements should have no errors. Hence, the statements should represent the true state of the business without any maneuvering, which is done to coerce prospective buyers to pay more for the firm. Conversely, the financial statements may also be manipulated to look worse to reduce the income tax associated with the firm.
Conceptual Framework
A conceptual framework refers to a theoretical network of linked principles, rules, and assumptions that support the established ideas to create a broad concept. The IFRS framework acts as a guide to finding solutions to accounting problems that are not addressed accordingly in the International Accounting Standard or the IFRS (Gebhardt, Mora, & Wagenhofer 2014). In the absence of this requisite standard that is necessary for a transaction, the management is required to use its analysis to develop and further incorporate an accounting policy that leads to relevant and reliable information (Deloitte 2010).
In March 2010, the ‘Exposure Draft: Framework for Financial Reporting’ presented a unique definition of a ‘reporting entity’. The FASB and the IASB defined such entity as an area of economic activity whose financial information has the potential of being used by the prospective and existing investors, including lenders and creditors who cannot manage to gather the direct information they require in decision-making. Such decision-making is vital during resource allocation in the business and/or analyzing whether the board of governors or the management has used the resources provided effectively and efficiently (ASB Exposure Draft 2015). The primary reason for the revised conceptual framework is to help the IASB in pointing out concepts that the body (IASB) will apply during the development and amendment of the IFRS.
Other than the IASB, the conceptual framework may also assist diverse parties to interpret and understand the existing International Financial Reporting Systems (IFRS). Such parties also stand a better chance to establish accounting policies where they (policies) do not exist or where they apply to a particular transaction in case a new standard is developed (Burton & Jermakowicz 2007). Hence, the new financial reporting standards help the shareholders by shelving them from the probability of high litigation costs in warranty claims, higher tax payments, and sure profits with the application of the principle of prudence (IFRS Foundation 2013). In very few cases, to meet the main objective of financial reporting, the IASB can agree to issue a new or revise the old standards, which disagree with the aspect of the conceptual framework. For such cases, the IASB always elaborates the reasons for departure from the feature of the theoretical structure in the conclusion based on the standard. For the current Exposure Draft of 2015, the IASB proposes neutrality to be enhanced when prudence is exercised.
Conclusion
Reinstatement of the principle of prudence has been appreciated and criticized in equal measure. Some people reiterate that it was right to remove it in 2010 due to its complicated interpretation. Hence, they refute the reinstatement by claiming the move is a negative step that will create more confusion. Other people suggest that the IASB has not delved deeper into the new Exposure Draft and that the definition of prudence should create an allowance for a degree of conservative bias in financial reporting. However, in advanced financial accounting, the principle of prudence is highly important. Hence, it has also been considered in the Exposure Draft where it is termed as the exercise of caution when making judgments under uncertain conditions.
References
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