For the right kind of ‘prudence’

By Neeraj Goel, a chartered accountant.

Prudence is no stranger to accountants. Any accountant will tell you that prudence is ensuring that assets or income are not overstated, and liabilities or expenses are not understated. This ensures that gains are reported only if they are highly probable or reasonably certain but that losses, even if expected, are recognised as soon as they are identified. And thus, many believe prudence contributes to the credibility of financial statements.

Critics of this concept propose the concept of ‘neutrality’ instead. They argue that financial information should convey a neutral or unbiased depiction of the economic phenomenon. Prudence is often used to artificially smoothen income, reducing profits in good years to provide a cushion to camouflage results in the poor years, making it difficult to understand the entity’s performance.

A neutral depiction is not slanted, weighted, emphasised, or otherwise manipulated to increase the probability that the financial information will be received favourably or unfavourably by users. Neutral depiction would not mean information with no purpose or no influence on behaviour; relevant financial information is, by definition, capable of making a difference in users’ decisions.

Those supporting the concept of prudence believe that there should be a distinction between ‘bad’ prudence (deliberate misstatement, which is unacceptable) and ‘good’ prudence (caution in making the judgments necessitated by uncertainty, which is desirable). Prudence only purports the latter. They argue that exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or overstatement of liabilities or expenses.

In what could be a major development in the history of accounting literature in the times to come, the International Accounting Standards Board (IASB) recently undertook to revise and improve its ‘Conceptual Framework for Financial Reporting’.

While the proposal raises many interesting points for discussion, one that is particularly interesting is the doing away of the concept of prudence — the proposal does not mention the concept of prudence. The IASB also acknowledged that ‘prudence’, which was an aspect of ‘reliability’, is not considered an aspect of ‘faithful representation’ (stated in the proposal as a qualitative characteristic of general purpose financial information). The IASB’s conceptual framework has always been a reference for many national standard-setters for their respective frameworks.

The dictionary meaning of prudence too is ‘the quality of being prudent; cautiousness’ — that is, acting with or showing care and thought for the future. Thus, prudence is the inclusion of a degree of caution in the exercise of the judgment needed to make estimates under conditions of uncertainty, and it should not go beyond an appropriate level of ‘caution’. Every individual or organisation suffers from one or more natural bias. A listed enterprise is influenced to report better profitability to meet market expectations, a sales manager would always be interested in reflecting higher sales, and a closed held business may be influenced to show low profitability to minimise tax. Prudence as a concept pushes us to identify our natural bias and counter those when dealing with matters requiring the exercise of judgments or estimates. In that sense, prudence is much bigger than just an accounting concept — rather, it is the value that each of us should imbibe in our actions, and exercise whenever faced with a challenge to make a key judgment.

It will be interesting to see if the ICAI and other standard makers in India follow the IASB’s footsteps to revise their own conceptual framework. More interestingly, will it change the application of accounting standards? I only hope that we continue to use this concept in its true sense.

Chartered accountant Kovid Chugh contributed to the article.

The article was published in The Hindu Business Line on 06 January 2013.