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BACCC11 Advanced Accounting Theory
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BACCC11 Advanced Accounting Theory
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Course Code: BACCC11
University: Royal Melbourne Institute Of Technology
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Country: Australia
Question:
Conceptual Framework for Financial Reporting
IASB Consultation re Conceptual Framework for Financial Reporting.
Conservatism as a Defining Principle for Accounting
Contemporary Issues in Accounting John Wiley & Sons Australia Limited.
The Association of Chartered Certified Accountants Prudence and IFRS.
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Answer:
Introduction
The present discussion paper is developed to be presented to the Board of Executive Directors at Big Phore Partners in relation to the matter of prudence. The paper is aimed to develop an understanding of the concept of prudence and to analyze its implications on the financial reporting. This has been done for presenting a conclusive set of findings to the IASB (International Accounting Standards Board) regarding the re-inclusion of prudence in the Conceptual Framework (CF) of financial reporting. This has been conducted by presenting detailed arguments for and against the re-inclusion of prudence concept in the conceptual framework of accounting. Also, a letter has been prepared to be presented to the IASB relating to eth discussion in reference to extent of support given by our auditing team to the inclusion of prudence in the CF.
Arguments for and Against the ‘Prudence’
The IASB is presently seeking comments in relation to the re-introduction of the principle of ‘prudence’ as an essential qualitative characteristic of financial reporting in its conceptual framework for the year 2015. The exposure draft released by the IASB has defined prudence as a degree of caution to be used by the accountants at the time of making judgments during conditions of uncertainty. This re-inclusion of the concept by the IASB has resulted from the demand from the log-term investors for the presence of a degree of protection for them by ensuring that financial information is disclose in a faithful manner. The concept of prudence was introduced by the IASB in its framework for development and presentation of financial statements of the year 1989. As such, the standard-setting body of Australia, AASB, when adopted IFRS in 2005 has included the concept to be referred by the business entities during financial reporting. It was removed from the CF by the IASB in the year 2010 that was adopted by the AASB in the year 2014. IASB is currently emphasizing on re-introduction of prudence in the conceptual framework and that will have a direct impact on the financial reporting of Australian business entities. IASB is currently seeking opinions from various financial experts about the decision of including prudence principle again as a major characteristic of financial information (George, 2016). As such, the discussion paper has presented arguments for and against the concept for assisting IASB in taking an adequate decision as follows:
Arguments against the ‘Prudence’ Inclusion
The conceptual framework of the financial reporting has stated the general objective of developing the financial statements and presented a discussion in relation to the necessary characteristics to be presented in them for protection of investor’s interest. Prudence is regarded as one of the major characteristics that have gained significant attention from the investors. However, the concept was removed from the CF in the year 2010 as it is reported to be in conflict with ‘neutrality’ and ‘faithful presentation’ principle of financial reporting. This is because the rationale behind the use of prudence principal is that a company should not recognize the asset at a value higher than the expected amount to be recovered from its sales. On the other hand, it also stated that liabilities should not be presented in a lower amount that is expected to be paid in future for meeting them. As such, the principle means that developers of financial statements need to take caution in exercise of judgments and estimates taken for recording the value of asset and liabilities that have uncertainties such as collection of receivables or probable useful life of plant and equipment. This means that produce does not allow for overstating an asset or understating the value of a liabilities. This may contradict the faithful representation of financial information as the application of the concept can result in restricting the depiction of real worth of an entity and therefore can lead to inaccurate decision-making of investors (Cooper, 2015).
It has been pointed by various accounting experts that restraining profits in a year can result in release of it in the coming period of time that can lead to depiction of the exaggerated results of an entity. Therefore, as such it can be stated that the principle of prudence can lead to reduced reliability of information. Also, it contradicts with the neutrality principle of financial reporting which emphasizes on avoiding biasness during development of financial statements. The financial information should be neutral to both good and bad news however prudence inclusion can restrict the disclosure of financial information that has greater measurement uncertainty. However, this may cause materialistic change in the worth of an entity during the occurrence of good or bad situations and thus prudence fails to depict faithful information to the investors. Thus, it can be said that re-inclusion of prudence can negatively impact the interest of the investors as the degree of reliability of financial information will be dependent on the accuracy of accounting estimates taken by the management during uncertainties. As such, its inclusion can negatively impact the competitiveness of Australian companies in the countries such as US, that have not yet adopted IFRS. This is because prudence will result in differing the nature of accounting judgment exercised for reporting value of uncertain assets or liabilities and thus may reduce the comparability of financial information. This can lead to reduced attractiveness of entities in the eyes of global investors that are adopting IFRS (The Association of Chartered Certified Accountants, 2014).
Arguments for Inclusion of ‘Prudence’
The exposure draft developed for the revised conceptual framework has emphasized on the inclusion of prudence principle again in the financial reporting. The decision is mainly undertake for protecting the interest of long-term investors as its lack can results in negatively impacting their welfare. This is because the lack of prudence can results in disclosure of manipulated financial information by overstating our understating the value of assets or liabilities. This is mainly undertaken by the IASB through removing ambiguousness in its previous definitions that have cause uncertainties in its implications in practice. This is because the previous definition has resulted in including conservatism biasness in financial reporting, that is, biasness in understating the net assets (Penman, 2016). The definition has emphasized on achieving a consensus with the neutrality of financial information. The inclusion of prudence gain will help the accounts in maintaining neutrality of the financial information. IASB at present is emphasizing on including prudence in the financial reporting but in a neutral and unbiased manner by introduction of the term ‘cautious prudence’. As such, it can be said that re-inclusion of prudence would help in overcoming the issues that have occurred with its inclusion in the past. The use of cautious judgments would ensure that there is mis-representation of financial information because it will not allow either the understatement of assets or overstatement of liabilities (Barker, 2015).
Therefore, the financial information disclosed through the inclusion of prudence would be neutral and also will ensure faithful presentation of information. The re-inclusion of prudence is also supported by stewardship theory of accounting as per which managers have a stewardship role in managing a company on the behalf of the shareholders and also protecting the interest of all its stakeholders. As such, managers have the accountability to disseminate true and reliable information that does not have any deliberate intention of manipulating its quality in any form. The exercise of caution prudence is an important step taken by IASB in this context as it will lead in protection of interest of wide range of stakeholders. It will also help the Australian business entities in promoting comparability of financial information in context of other global companies and thus improving their competitive position in the financial market globally (Rankin, 2012).
Exposure draft submitted to the IASB
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
On behalf of our clients and team at Big Phore Partners, we thank you for the opportunity to provide our comments on the International Accounting Standards Board’s (IASB) Exposure Draft (ED) regarding Conceptual Framework for Financial Reporting (CF).
We support the International Accounting Standard Board (IASB) for taking the project to update the conceptual framework of financial reporting. It will prove to be milestone in the history of accounting. The main reasons to support the review of the conceptual framework are provided as under:
· There is requirement of well formulated and robust concepts that can support the standards
· The more robust and updated conceptual framework helps to achieve consistency and discipline in the process of standard setting by IASB
· The robust framework will help to achieve the consistency in the accounting principle ad qualitative characteristics of financial reporting (ICGN, 2015)
The updated conceptual framework is revolutionary task and it would really prove to be milestone for the future requirement of accounting principles and concepts. The approach used by the IASB in updating, improving and redeveloping the conceptual without fundamentally reconstructing all the aspects is marvelous. We take opportunity to answer the questions given in exposure draft and thinks that our view on revised conceptual framework will help to make better conceptual framework.
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 caution when making judgments under conditions of uncertainty) and to state that prudence is important in achieving neutrality;
Why or why not?
The new definition on prudence supports the objectives of conceptual framework as it supports neutrality in the financial judgments. We truly agree on the point that financial statements of an entity should provide the neutral depiction of results of financial operations. So it essential to include the prudence in the conceptual framework (Project history, 2018). The old definition of prudence does not provide with neutrality concept that make it out of the conceptual framework. We support the inclusion of prudence only the IASB provide a detailed definition of neutrality along with it. There is no proper understanding of prudence among the shareholders that make it difficult to interpret the concept of prudence. Resultants there are different understanding of prudence between the shareholders (Comment Letters, 2015). So it can be said that without the proper definition of prudence it can be interpreted differently. It may be possible that some constituents may take prudence as similar to conservatism. As per new definition of prudence it reflects the high degree of caution while exercising the judgments but it seem that it does properly reflects without the definition of neutrality. There are many examples such as recognition of liabilities without it has actually been exists is typically oppose the idea of prudence as neutrality principle has been void in this case.
We agree with what has been stated in chapter 2: Conceptual Framework that application of conservatism principle in period has opposite effect in subsequent or any other future year (Exposure Draft, 2015). It means neither conservation nor the principle of prudence supports decision usefulness of information. The application of prudence with regulatory definition of neutrality can have wide spread impact on the quality of financial information. It is important to say here that major cases of fraud and irregularities such as failure of Enron, Worldcom, and Lehman Brothers are due to misappropriation of prudence. It has been mentioned in objectives of financial reporting that accounting standard must be drawn in such as way that it promotes comparability and also provide enhance quality of financial reporting. In this respect we believe that the requirement of comparability can be best achieved through the application of neutrality (Exposure Draft, 2015). We suggest two major changes in definition of prudence. Firstly, there must be inclusion of neutrality definition along with the definition of prudence and word “Estimates” should be added with “Judgments” as both have separate meaning in accounting.
The new definition of prudence is provided as exercise of caution when making judgments under the conditions of uncertainty (Exposure Draft, 2015).. The clarification provided along with the prudence in relation to neutrality is helpful to prove the true application of prudence. IASB has to provide clear and concise difference between the new definition and old definition of prudence so that any misunderstanding among the constituents can be answered. It has been seen that some people still believes that prudence is related with conservatism that impacts the definition of assets and liabilities but is not true as per new definition of prudence. The new definition clearly opposes the principle of conservatism and states the relation with neutrality definition (Exposure Draft, 2015). There is only need to change few sections of the definition as provided above.
There is belief that prudence is defined for both preparer of financial report and for the standard setter. The new conceptual framework also provides with change in definition of assets and liabilities to support their change in definition of prudence and inclusion of neutrality concept (IFAC, 2015).
Summary & Recommendations
It can be stated from the overall analysis held out in the discussion paper that the topic of prudence inclusion is still a topic of debate among the accounting professionals. The revised CF introduced by IASB in the year 2015 has caused changes in the definition of prudence by introduction of the term cautious prudence. This will help largely in overcoming the potential difficulties that investors can face due to use of prudence in financial reporting process. The letter submitted to the IASB has largely extended its support to its re-inclusion as it is now believed to be consistent with neutrality principle and ensuring that it does not allow any systematic biasness of financial information. It is therefore recommended to management of business entities that application of prudence should be done to eliminate biasness by making best use of accounting judgment and estimates during uncertain condition. This in necessary to ensure so that its application does not reduce in the reliability of the financial information presented.
References
Barker, R. (2015). Conservatism, prudence and the IASB’s conceptual framework. Accounting and Business Research 45 (4), pp. 514-538.
Comment Letters. (2015). IFRS: Exposure Draft and comment letters—Conceptual Framework for Financial Reporting. Retrieved September 29, 2018, fromhttps://www.ifrs.org/projects/2018/conceptual-framework/comment-letters-projects/ed-conceptual-framework/#comment-letters
Cooper, S. (2015). A tale of ‘prudence’. Retrieved 29 September, 2018, from https://archive.ifrs.org/Investor-resources/Investor-perspectives-2/Documents/Prudence_Investor-Perspective_Conceptual-FW.PDF
Exposure Draft. (2015). Conceptual Framework for Financial Reporting. Retrieved September 29, 2018, from
George, D. (2016). A review of the IFRS adoption literature. Review of Accounting Studies 21 (3). pp. 898-1004.
https://www.ifrs.org/-/media/project/conceptual-framework/exposure-draft/published-documents/ed-conceptual-framework-basis-conclusions.pdf
ICGN. (2015). IASB Consultation re Conceptual Framework for Financial Reporting 2015. Retrieved September 29, 2018, from https://www.icgn.org/iasb-consultation-re-conceptual-framework-financial-reporting-2015
IFAC. (2015). The Never Ending Story of Prudence and IFRS. Retrieved September 29, 2018, from https://www.ifac.org/global-knowledge-gateway/business-reporting/discussion/never-ending-story-prudence-and-ifrs
Penman, S. (2016). Conservatism as a Defining Principle for Accounting. The Japanese Accounting review 6(16), pp. 1-16.
Project history. (2018). IFRS: Conceptual Framework. Retrieved September 29, 2018, from https://www.ifrs.org/projects/2018/conceptual-framework/#project-history
Rankin, M. (2012). Contemporary Issues in Accounting. John Wiley & Sons Australia, Limited.
The Association of Chartered Certified Accountants. (2014). Prudence and IFRS. . Retrieved 29 September, 2018, from https://www.accaglobal.com/content/dam/acca/global/PDF-technical/financial-reporting/tech-tp-prudence.pdf
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