BAC304 Advanced Accounting Theory

This article explores the debate on the inclusion of prudence in the new conceptual framework (CF) for financial reporting. It provides arguments for and against the re-inclusion of prudence in the CF. The article analyzes the impact of re-inclusion of prudence and its significance in financial reporting. The article is relevant to BAC304 Advanced Accounting Theory course.

1BAC304 Advanced Accounting Theory
Running head: BAC304 ADVANCED ACCOUNTING THEORY
Advanced Accounting Theory
Author’s Name
Institutional Affiliation
Author’s Note:
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Table of Contents
Part 1: Internal Audience Directors’ Brief.......................................................................................3
Case Overview.............................................................................................................................3
The Context of Change................................................................................................................4
Arguments For.............................................................................................................................5
Arguments Against......................................................................................................................7
Arguments Against......................................................................................................................7
Part 2: IASB Audience Exposure Draft Submission.......................................................................9
Conclusion.....................................................................................................................................10
References......................................................................................................................................12
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Advanced Accounting Theory
Part 1: Internal Audience Directors’ Brief
Case Overview
The conceptual framework (CF) made for the purpose of financial reporting has been
revised as well as improved time and again in the past years. However, from the general
understanding, CF is particularly formulated to outline the fundamental concepts related to the
financial reporting of the firms on the basis of international standards. It also guides the Boards
of firms to develop appropriate International Financial Reporting Standards (IFRS). Moreover,
the main goal is to ensure that the standards are to be consistent conceptually so that useful
information relating to the firms can be accessed by the external parties such as lenders,
investors, and creditors (IFRS, 2017). This has been evident even in the scenario that CF is an
important consideration. In addition, it has also been observed that ‘prudence’ is the oldest and a
well-known concept within the domain of financial accounting in the IFRS. The term ‘prudence’,
which is also known as conservatism is defined as differential verifiability, which is required for
profit recognition when it is compared to losses. This implies that prudence has been playing a
significant role but in 2010, International Accounting Standards Board (IASB) removed
references to this concept such as definitions stating that it conflicted with the objectives of
unbiased representation and neutrality (Măciucă, Hlaciuc, & Ursache, 2015).
In this context, there has been a debate among the members of the Board of Directors of
Big Phore Partners, especially the Executive Director of Audit and Executive Director of
Corporate Advisory. Both the person had their own opinions relating to the inclusion/exclusion
of the concept of prudence. In this context, the Executive Director of Audit stated that
cautiousness/prudence is the main foundation stone of financial reporting. On the other hand, the
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Executive Director of Corporate Advisory stated that rather than prudence, providing correct
information to the stakeholders such as investors is highly essential for making appropriate
decisions. As a result of these arguments, the Executive Chairman decided to have an internal
debate for settling the conflicts of opinions. Furthermore, it has been decided by the company to
send a formal submission with respect to the outcome of this debate to the IASB through a letter.
Hence, it can be taken into consideration for the betterment of the standards along with the
companies complying with it.
The Context of Change
Understanding the aforementioned case overview, the background of the proposed
change is further outlined in a brief manner. The difference in the opinions among the members
of the board raised a serious issue with respect to the re-inclusion of ‘prudence’ in the new CF.
In this context, a serious as well as a heated debate has occurred in the organization, which must
be solved immediately. One of the members stated that it is imperative to provide precise
information to the investors so that they can be able to take decisions accordingly. Another
member argued that prudence is more important, especially when it comes to preparing financial
reports. After the conversation of both the board members, Executive Chair Dr. Coopers decided
to solve the underlying issue with the support an internal debate and the result of which will be
submitted to the IASB. This can help in ensuring that future considerations will be taken into the
account while developing the standards of the new CF. In brief, this was the context of change
i.e. the re-inclusion of prudence that may or may not is considered in the new CF. Hence, this
changing context has been evident in the comprehensive Exposure Draft (ED) published by
IASB.
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According to Deloitte (2015), IASB proposed to reintroduce a certain reference of
prudence in the new CF. It was further stated that prudence supported “neutrality”, thereby
defining it as the exercise of caution, which needs to be considered by the companies. This is
mostly at the time of making crucial judgments during uncertain conditions. This changed was
proposed to be included in the second chapter, which provided standards relating to qualitative
characteristics of the financial information (Deloitte, 2015). This proposed change was
considered in the year 2018 Conceptual Framework by the IASB. However, the effective date
has not been finalized and so the companies have not yet considered prudence and associated
concepts at the time of financial reporting (Deloitte, 2018). Therefore, only after the actual
implementation of the new CF, its effectiveness can be analyzed so that the IASB, in addition to
the companies can further enjoy benefits. Thus, in order to understand the impact of re-inclusion
of “prudence”, arguments are set by analyzing both the aspects outlined in the internal debate of
Big Phore Partners.
Arguments For
Some of the members including Mr. Price, the Executive Director of Audit, stressed the
importance of prudence in the financial reports. He further stated that it is the “cornerstone” of
the financial reports. Similar opinions were also presented by IFRS (2015) that although there
were certain flaws in the previous inclusion of prudence, which were eliminated in the year
2010. However, it has been proposed to be reintroduced with respect to the preparation of
financial reports. The IASB further made sure that the inclusion of prudence yielded better
outcomes for the companies. Hence, it did so, by making prudence as one of the important
aspects for preparing financial statements. It has been proposed to be one of the characteristics,
which helps in making financial reports of the companies use for mainly for the investors.
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Moreover, it has been identified as one of the virtues in the daily life hence, proving its
importance. It has further been defined that in the financial accounting context, prudence is
“cautiousness”. This implies that prudence encourages good judgment, which is highly crucial
vital for financial reporting. This is due to the fact that various estimations have to be made while
preparing these statements (IFRS, 2015). Similarly, Oreshkova (2017) stated that it is highly
necessary for prudence to be re-introduced in the CF. The main aspect highlighted for including
it was that there is certain information, which cannot be disclosed by the companies for
safeguarding certain sources of income. This phenomenon is termed as capital preservation, for
which the principle of prudence comes into consideration (Oreshkova, 2017).
The term ‘conservatism’ is also used in place of prudence. Hence, in order to understand
its importance, a distinctive definition must be used in the CF. This would facilitate to make sure
that its precise essence can be highly depicted. It is only then that the companies can make
optimal use of the principles relating to prudence, especially in favor of the investors. This is
mostly due to the fact that the concept of prudence is essential to adhere to the standards such as
“IAS 36 Impairment of Assets” and “Contingent Liabilities and Contingent Assets”. Therefore, if
it is reintroduced, balanced (reasonable) judgment can be done in uncertain situations, thereby
enabling the companies to estimate fairly at the time of valuation (Oreshkova, 2017). On the
other hand, ACCA (2014) stated that “prudence” is a concept, which must be embedded in the
accounting standards and at the same time, it must be effectively exercised by the companies
preparing financial reports. However, many companies might misuse or misinterpret the meaning
of prudence. Hence, in the new CF, it is highly essential to understand the requirements as well
as the extent to which firms can utilize it set for implementing the guidance (ACCA, 2014).
Similar observations are made by Kronbauer, Marquezan, Barbosa, & Diehl (2017) that even
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though prudence may lead the companies to have tax burden if used wisely, low-profit levels at
the time of uncertainty can reduce it.
According to Narayanan & Burkart (2005), prudence in accounting is an essential aspect
for making the system of corporate governance to be effective and efficient. In this context,
‘good corporate governance’ is positively related to the high-level implementation of
conservatism i.e. prudence. However, in the case of the IASB, it has been highly observed that
prudence must not be overused, as it may mislead the investors (Narayanan & Burkart, 2005).
Similarly, Pătraşcu (2014) stated that the principle of prudence has been widely researched in the
past history. This is mostly due to conflicting interests. However, prudence can be effectively
considered as a part of ‘credibility’, is necessary for the financial reporting, thereby allowing the
investors for providing a rational judgment at the time of uncertainty (Pătraşcu, 2014). Hence,
although the application of prudence while preparing financial reports can lead to a certain level
of biases. However, various estimations are to be considered so it must be reintroduced in the CF
due to its significance.
Arguments Against
Arguments Against
On the contrary to the abovementioned opinions, Dr. Waterhouse, the Executive Director
of Corporate Advisory stated that providing “right information” should be considered. This is to
make sure that the investors take correct decisions rather than being cautious. Authority of the
Accounting Standards (ANC) (2015) further asserted that the value of prudence in accounting
can vary according to the firms and countries. Hence referring to the Australian political
environment, it was reported by AASB (2015) that it is essential to clarify the role of prudence at
the time of financial reporting in the CF. The main reason for this is that if a company uses a
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high level of prudence in its financial accounting, it makes the information less pertinent. Hence,
more prominent definitions are to be provided in the CF so that the usage of prudence can be
done in a positive manner by the Australian companies. It further highlighted the issue of
reintroducing the concept of prudence in an explicit manner. In this context, the IASB proposed
that prudence must be described as the act of being cautious while making judgments in
uncertain situations. It was also found that it stated the importance of prudence towards the
achievement of neutrality. However, this exercise indicated that the income as well as assets
must not be overstated whereas the expenses and liabilities must not be understated. This also
reflected that the understatement of income and assets are not allowed and an overstatement of
liabilities as well as expenses is also not allowed. These limitations must be considered in the
new CF and then the only misstatement of information can be avoided. If these limitations are
not considered by the IASB and the complying companies, then the incomes can be overstated
and expenses can be understated in future circumstances (AASB, 2015 a; AASB, 2015 b). This is
the key drawback of reintroducing the notion of prudence in the CF.
Similarly, according to Mora & Walker (2015), it was asserted that one of the reasons for
removing prudence from CF was that it was used mainly as the pretext for the purpose of
managing extra earnings. Moreover, at times this concept was used as a conditional conservatism
in which the firms applied lower cost/market value while conducting inventory valuation. As a
result, inventory value decreased sooner than the amount to be increased. This enabled a
considerable amount of biases in the financial information. Moreover, contracting costs are
incurred, which acts as an essential determinant of conditional conservatism’s demand. This
displays that other drivers of conservatism must also be identified in a view to properly report
accounting earnings in the financial statements, in turn, eliminating the biased information (Mora
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& Walker, 2015). Furthermore, ACCA (2017) observed that the proposed CF involved proper
identification of values/costs of liabilities and assets, which must be measured in an attainable
manner. The proposed changes were also regarding the probability criterion regarding the
information that was beneficial for the companies as it exceeded the cost of its provision (ACCA,
2017).
Hence, these considerations have the potential to improve the standards as well as benefit
all the involved parties without creating any misinterpretation for the investors. In accordance to
Wagenhofer (2015), cautious prudence has been examined, which further highlighted that neutral
accounting neglected the requirement of measuring all liabilities and assets at their fair value.
Moreover, it did not prohibit assets’ impairment that was measured at cost (Wagenhofer, 2015).
Hence, it can be stated that the reintroduction of this concept needs to be highly considered to the
flaws that it had earlier so that every party can benefit from its implementation in the financial
reporting. Even though prudence had negatively affected the financial standards, especially in the
Australian context but ethically considering this concept can be highly beneficial.
Part 2: IASB Audience Exposure Draft Submission
Big Phore Partners
Melbourne
Australia
Date: 27.09.2018
Chairman
International Accounting Standards Board (IASB)
United Kingdom
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Re: Exposure Draft (ED)/2015/3 Conceptual Framework for Financial Reporting (CF)
Dear Chairman,
On behalf of all the stakeholders of ‘Big Phore Partners’, we express our gratitude for
providing us the opportunity to present our opinion related to the re-inclusion of the concept of
‘prudence’. This is mainly related to the ED considering the inclusion/exclusion of prudence in
the CF. We had conducted an internal debate in the organization for understanding both the
aspects. The results indicated that re-inclusion is highly imperative, especially in uncertain
situations, as it helped our company to attain neutrality.
Chapter 2 - Qualitative Characteristics of Useful Information
Question -Proposed changes to Chapters 2:
Do you support the proposal to reintroduce an explicit reference to the notion of
prudence (“described as a caution when making judgments under conditions of
uncertainty) and to state that prudence is important in achieving neutrality;
Why or why not?” (AASB, 2015, p. 10)
Hence, prudence must be re-included in the second chapter of the CF, i.e. “Qualitative
Characteristics of Useful Information” but the companies must use it efficiently. This is to make
sure that no misrepresentation is made. We further request you to set implementation limits for
the betterment of accounting standards.
Thank you for the opportunity to provide our comments. For further queries, kindly
contact us at [e-mail]
June Coopers, FCA, Ph.D., AO
Executive Chair
Conclusion
Based on the study findings can hence be concluded from the above examination that re-
inclusion must be incorporated in the new CF in the second chapter of the ED)/2015/3. Thus, on
the basis of the overall understanding of the entire report, it can be recommended that the
reintroduction of prudence is important, as it can have cost benefits to the companies that
implement these standards during financial reporting. However, there must be a limit on the
implementation and hence proper description and definition of this concept have been suggested
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for eliminating any future misinterpretation as was in the earlier CF’s case. Moreover, it must
also be noted that ethical consideration of this notion must be done by the companies so that the
information provided by the financial reports can ensure correct decision-making of the
investors.
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References
AASB. (2015 a). AASB comment letter CF EDS (final). The Australian Accounting Standards
Board. Retrieved September 27, 2018, from
https://www.aasb.gov.au/admin/file/content106/c2/AASB_Comment_Letter_CF_EDs_(fi
nal).pdf
AASB. (2015 b). Conceptual framework for financial reporting. AASB Exposure Draft.
Retrieved September 27, 2018, from
https://www.aasb.gov.au/admin/file/content105/c9/ACCED264_06-15.pdf
ACCA (2017). The IASB's conceptual framework is being renovated, says Adam Deller, and is
turning out to be a bigger task than anticipated. IASB restructures its Conceptual
Framework. Retrieved September 27, 2018, from
https://www.accaglobal.com/in/en/member/discover/cpd-articles/corporate-reporting/
deller-mar17.html
ACCA. (2014). Prudence and IFRS. Association of Chartered Certified Accountants. Retrieved
September 27, 2018, from https://www.accaglobal.com/content/dam/acca/global/PDF-
technical/financial-reporting/tech-tp-prudence.pdf
ANC. (2015). Policy paper a(nother) look at prudence/conservatism in frameworks, in standards,
in practice and in academia. Paul André & Andrei Filip – ESSEC Business School.
Retrieved September 27, 2018, from
http://www.anc.gouv.fr/files/live/sites/anc/files/contributed/ANC/3.%20Recherche/
D_Etats%20generaux/2015/PP_Prudence_P%20Andre%20VE.pdf
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Deloitte. (2015). IASB publishes exposure draft of a new conceptual framework. News.
Retrieved September 27, 2018, from https://www.iasplus.com/en/news/2015/05/cf-ed
Deloitte. (2018). IASB publishes revised conceptual framework. News. Retrieved September 27,
2018, from https://www.iasplus.com/en/news/2018/03/cf
IFRS. (2015). A tale of ‘prudence’. Investor Perspectives. News. Retrieved September 27, 2018,
from http://archive.ifrs.org/Investor-resources/Investor-perspectives-2/Documents/
Prudence_Investor-Perspective_Conceptual-FW.PDF
IFRS. (2017). Conceptual framework for financial reporting. IFRS Foundation. Retrieved
September 25, 2018, from
https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/
Kronbauer, C. A., Marquezan, L. H. F., Barbosa, M. A. G., & Diehl, C. A. (2017). Analysis of
the effects of conservatism in accounting information after the 2011 change in the basic
conceptual pronouncement. Review of Business Management, São Paulo, 19 (65), 453-
468.
Măciucă, G., Hlaciuc, E., & Ursache, A. (2015). The role of prudence in financial reporting:
IFRS versus Directive 34. Procedia Economics and Finance, 32, 738-744.
Mora, A., & Walker, M. (2015). The implications of research on accounting conservatism for
accounting standard setting. Accounting and Business Research, 45(5), 620-650.
Narayanan, S., & Burkart, M. (2005). The role of accounting conservatism in a well-functioning
corporate governance system. Munich Personal RePEc Archive, 4458, 2-15.
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Oreshkova, H. (2017). The debate on prudence in accounting. CBU International Conference on
Innovations in Science and Education, 5, 343-360.
Pătraşcu, D.R. (2014). The importance of accounting principles in the accounting profession.
Social Economic Debates, 3 (2), 47-50.
Wagenhofer, A. (2015). The never ending story of prudence and IFRS. Business Reporting.
Retrieved September 27, 2018, from
https://www.ifac.org/global-knowledge-gateway/business-reporting/discussion/never-
ending-story-prudence-and-ifrs
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