Prudence and the New Conceptual Framework in Accounting

This paper discusses the debate on prudence in financial accounting and the update of the IASB's Framework for the Preparation and Presentation of Financial Statements. Arguments for and against the inclusion of prudence in the new Conceptual Framework are presented.

Running head: PRUDENCE AND NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 1
Prudence and the New Conceptual Framework in Accounting
Your Name
Institutional Affiliation

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 2
Prudence and the New Conceptual Framework in Accounting
There has been a heated debate on the matter of prudence in financial accounting over
the recent years. Some people have argued that financial accounting is a conservative practice
that requires accountants to be cautious. Others believe that accountants should be neutral when
applying the principles of the International Accounting Standards Board (IASB) so that there is a
faithful presentation during financial reporting. There are inherently many risks attached to the
application of prudence in financial accounting. One of the main items that often fall into the trap
of prudence is the valuation of assets (Barker, 2015). It is usually common to find that the book
value of assets being less than the economic value of the same assets. Because of these
differences, there are both practical and conceptual reasons for the outcome when neutrality or
prudence concepts are applied. If an accountant uses the prudence principle to value an entity’s
assets, there would be information asymmetry bias which might lead to a conservative outcome
of the financial statements being presented (Holt, 2018). This saw the need for the update of the
IASB’s 1989 Framework for the Preparation and Presentation of Financial Statements to remove
the concept of conservatism and prudence in financial reporting. This paper seeks to make an
outline of the initial discussion paper draft for the Board of Directors of Big Phore Partners
detailing the context of the change and the arguments for and against the inclusion of the matter
of prudence in the new Conceptual Framework by IASB. This paper is also intended to prepare a
letter of the draft to be submitted to the IASB in regard to the firm's position on the issue of re-
including prudence in the Conceptual Framework.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 3
Part 1 Internal Audience Directors’ Brief
The Context of the Change
We can all attest to the fact that financial accounting is not a subject for the neutral
measurement and recording of the economic value of items of the financial statements. We also
all know that the book value and the economic value of items are conceptually different because
of the issue of conservatism (Dichev, 2015). This issue of inherent conservatism seems to have
been overlooked by the IASB and other critics. The decision of IASB to remove prudence from
the Framework for the Preparation and Presentation of Financial Statements has sparked a lot of
criticism from practitioners and academia (Barker, 2015; Tracey, 2015). Although it can be
argued that the challenge of the new framework is being implied by adopting an agency –based,
contracting demand for prudent accounting, critics of this principle believe that the actual
problem, for the most part, does not exist.
What appears to be the truth of matters is that, most investors today, desire that the
management through the accountants of an organization will avail ‘‘the right information’’ for
them to make the right decisions. As a comment to this new Conceptual Framework, we can
suggest as a company (Big Phore Partners) to ask IASB not to re-include the principle of
prudence and conservatism as it is against the desires of most investors. But because Mr Price
(the company's executive director) believes that prudence is the cornerstone of financial
reporting, we have to look at the arguments for and against the re-inclusion of the principle of
prudence in the Framework for the Preparation and Presentation of Financial Statements during
financial reporting.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 4
Arguments for Inclusion of the Matter of Prudence in the New Conceptual Framework
Prudence in financial accounting and reporting has had a long-established track record.
Since the prudence matter was done away in 2010, there has been a heated debate on whether to
re-include it or not. As the body mandated to review and update accounting standards and
frameworks, the International Financial Reporting Standards (IFRS) should consider these
arguments for and against the matter of prudence before making a decision on the same.
The Need to Be Cautious
There has been a general, clear and acceptable expectation that has been placed among
accountants by users of financial statements over a long time. These users have always believed
that accountants should restrain themselves from a situation of anticipated over-exuberance of
the management when it comes to the preparation and presentation of a company’s financial
statements. Some users also usually believe that the reported and audited financial statements are
usually hard and that most certainly some estimates might have been made cautiously by the
accountants during the preparation of such numbers ("Conceptual Framework", 2018). This
scenario was being referred to by the previous framework as prudence where accounting
standards supported it. The view of caution during the preparation and presentation of financial
statements is not only held by the general public but also by professional investors, accounting
researchers and organisations stakeholders. Investors are particularly interested in this area
because of the profits figure they desire for payment of dividends and bonuses.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 5
The Need to Reduce Asymmetrical Risk
It is most certainly possible that where assets and profits have been overstated rather than
being understated, the accountants, books of account and the underlying accounting standards
would receive more criticism than the later. There are many asymmetrical risks that are
associated with being non-prudent (Hogarth, 2015). The latest example that can be attributed to
non-prudent behaviour is the 2008/2009 financial crisis that hit most banks in the US and
Australia. During the financial crisis, the more prudent banks and firms who might have
restrained excessive dividends and bonuses are the ones which became resilient and thereby
provided financial stability to the whole economic system. The application of prudence in entity
ensures that cases of changing accounting policies, changing reals' variables of the accounts,
timing of new accounting standards, managing discretionary accruals and timing of transactions
to suit the interest of the company does not occur.
Prudence is Perceived as a Sheer Application of Common Sense
Many proponents of the re-inclusion of the principle of prudence believe that its
application is more widely agreed upon than its rejection (https://www.accaglobal.com, 2018).
According to the chairman of IASB, the inclusion of the concept of prudence in the International
Accounting Standards Board's is a way of promoting a sheer common sense across the
accounting profession where professional accountants would have to choose a ‘‘wise'' option of
conservatism rather than being overly optimistic. An example of a sheer common sense scenario
is where the accountant has to ensure that revenues are not overstated while expenses should not
be understated. Prudence should, therefore, be re-included to guide accountants to judge
situations more wisely.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 6
Importance of the Prudence and Conservatism Principle
 The concept of prudence has been a worldwide principle which has been used by many
companies around the world in the preparation of their financial statements over the past
years.
 The principle of Prudence has enabled the comparison of the financial statements since
many firms have been using the principle of prudence in the preparation of financial
statements (Hernandez Robles & SSnchez Vidal, 2018).
 Prudence has been proved to adhere to the true and fair representation when it comes to
the preparation and presentation of the financial statement figures (Singleton-Green,
2012).
 Prudence helps to conserve the effect of overestimating or underestimating of the
financial figures of items of an entity.
 Prudence has helped to minimize losses in the past (Hernandez Robles & SSnchez Vidal,
2018).
 Prudence helps the management in trying not to overstate an entity’s financial results.
 In cases of uncertainty, prudence has been used in many instances by accountants to try
and remain true which has been proved to create a higher probability of success
(Hernandez Robles & SSnchez Vidal, 2018).
Reasons Why Exclusion of Prudence in the Conceptual Framework May Lead to
Overly Optimistic Reporting
Proponents for the re-inclusion of the concept of prudence in the conceptual framework
have argued that the current conceptual framework does not include an explicit reference to
substance over and conservatism as it used to be before. They argue that adding the practices of

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 7
conservatism and substance explicitly would add more clarity to reporting. The IASB Exposure
Draft that was released for public opinion in 2015 proposed changes among them being the issue
of application of the concept of substance over form and faithful recognition and representation
when it comes to recording, summarizing and presenting the results of economic phenomenon of
an entity (Măciucă, Hlaciuc & Ursache, 2015). The 2015 IASB's Exposure Draft therefore
proposed in favour of conservatism way of accounting rather than merely providing economic
information about the legal existence of items of an entity. The most important reason behind
this outcome is that even if accounting is done in accordance with the legal form of items and or
relevant disclosures, the faithful representation cannot occur when the economic substance of an
organization is reported with a lot of optimism (Positive Accounting).
Positive accounting and or optimistic accounting is a recent practice that has been accused of
trying to seek to predict and explain the accounting practices rather than deriving and prescribing
a normative or optimal accounting standard. Optimistic accounting, as opposed to convertism
accounting, usually tries to make things look good by making ‘‘positive'' theories aimed at
explaining the real economic substances of an entity and translating them into accounting
transactions (Sutton, Cordery & van Zijl, 2015). The application of the prudence concept,
therefore, is a way of trying to adhere to normative accounting theories and hence reducing
overly optimistic reporting.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 8
Arguments Against Inclusion of the Matter of Prudence in the New Conceptual
Framework
The Need to be Neutral
Proponents of the anti-inclusion of the prudence matter in the “Framework for the
Preparation and Presentation of Financial Statements argue that the principle of prudence is
against prudence and faithful presentation (Bouvier, 2018). When IASB made an update to the
Framework for the Preparation and Presentation of Financial Statements, it removed the
reference made to prudence and conservatism on grounds that prudence lack consistency when it
comes to the issue of neutrality. Neutrality and faithful presentation are the core practices and
principles that should underlie the preparation and presentation of financial statements (Cuguerr-
Escofet & Rosanas, 2016). IASB, therefore, would have no option to re-include the concept of
neutrality when developing and revising its principles.
Prudence Has Been Accused to Lead to Smoothing Effect
While prudence has been desired because of its restraint when it comes to profit
recognition overstatement, it is often found that prudence may hold back profits in one year
(restraint) and release them in the subsequent fiscal periods. This situation will result in
exaggerated results over time. Dimler Benz’s is a company that was once affected because of
prudence ("Daimler-Benz Reports Loss", 2018). The profits were restated using the German
accounting standards to the US Generally Accepted Accounting Standards (USGAAP) for it to
be listed in New York. This restatement was duped as ‘smoothing' effect of the prudence
principle. In other cases, prudence has also been accused of causing a crisis to the Spanish Banks
where the prudence concept was used to provide strategic provisioning during the period.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 9
Because of these factors, prudence has been accused of providing a temporary reservation to an
entity's weakness as the conditions change causing a delayed remedial action.
Part 2 IASB Audience ED Submission
Big Phore Partners
Level 99

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 10
101 Collins
Melbourne VIC 3000
23-09-2018
Hans Hoogervorst, Chairman
International Accounting Standards Board
30 Cannon Street
London EC4M 6XH
United Kingdom
Re: Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting
Dear Chair Hoogervorst:
On behalf of our clients and the entire team of the Big Phore Partners, we sincerely thank you for the
opportunity you have given us to provide our comments on the International Accounting Standards Board's
(IASB) Exposure Draft (ED) regarding Conceptual Framework for Financial Reporting (CF).
At Big Phore Partners we have always believed that the principle of prudence has been and remains a
cornerstone of accounting when it comes to the preparation and presentation of financial statements.
Following your decision to remove the word ‘prudence’ from the conceptual framework in 2010, it seems the
removal of this word might have just been a technical word for academia and accountants. Although the
removal of ‘prudence’ and conservatism might have created a lot of mixed reactions and excitement in the
accountancy profession, many companies including ours have not actually been doing things differently since

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 11
its removal because things have not been done differently. As an organization, we can, therefore, say that the
decision to remove the principle of prudence and conservatism in the conceptual framework really
represented the abandonment of one of the most important tenets of financial accounting principles that ever
existed.
Before the removal of the prudence concept from the Framework for the Preparation and Presentation of
Financial Statements, many firms (mostly banks) in the United States went into a financial crisis between the
year 2008 to 2010. People can, therefore, argue that the re-introduction of the same principle, may lead to the
same situation in future ("The Never Ending Story of Prudence and IFRS | IFAC", 2018). It is, however,
important to note that this argument may not be true since, at the time, the economy of US was tumbling long
before IASB had made the decision to remove the concept. Nevertheless, the re-introduction of prudence may
be a way of discouraging accountants from using creative accounting or positive accounting techniques by
trying to present an unfair view of an entity's financial performance. Moreover, the lack of prudence and or
conservatism during the preparation and presentation of financial statements may open doors for accountants
to be over-optimistic thus potentially increasing the auditor's liability.
Chapter 2 - Qualitative Characteristics of Useful Information
Question 1-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

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 12
uncertainty) and to state that prudence is important in achieving neutrality;
Why or why not?
Among the core qualitative characteristics of financial statements is the principle of prudence. Others include
relevance and faithful presentation. The faithful presentation has three characteristics, that is completeness,
neutrality and free from error (Birt, Muthusamy & Bir, 2017). Neutrality is also another important component
of the principle of prudence. Neutrality is a condition or an act that involves depiction without bias when it
comes to selection, preparation and presentation of financial information in a way that it is not manipulated,
influenced or ‘cooked' so as to serve the interests of the decision makers. The principle of prudence can,
therefore, be changed to include the idea of fairness (true and fair value) so that financial statement
information is free from bias.
The previous version of IASB conceptual framework described prudence as the inclusion of a certain degree
of caution when excising the judgments that are needed when it comes to making estimates during conditions
of uncertainty or doubt. For financial statement information to be of good quality, they must be free from bias
or error. Prudence is, therefore, one of the inseparable qualitative elements of quality financial information
(Głębocka, 2016). With prudence under consideration, financial statement information such as assets or
revenue is not overstated while liabilities and expenses are not understated so as to present a ‘positive view'
of the financial results of a corporation. Because situations of uncertainty are many, professional accountants
will always lie on the side of caution whenever there is doubt. This will ensure that financial statements of
reporting entities are not cooked or overdone thereby increasing auditor’s liability.
Based on the above proposals, we, therefore, suggest at Big Phore Partners that there should be an explicit
reference to the principle of prudence so that it can guide professional accountants in cases of uncertainty in
such a way that in case someone is in doubt, she or he can choose to make a conservative judgement.

PRUDENCE AND THE NEW CONCEPTUAL FRAMEWORK IN ACCOUNTING 13
Prudence can also help to achieve neutrality. We, therefore, support the proposal to its reintroduction.
Thank you for the opportunity to provide our comments. If you have any questions, please do not hesitate to
contact me on [phone] or [e-mail]
June Coopers, FCA, PhD, AO
Executive Chair
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