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Before as well as producing examples of

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Before discussing the role of Prudence, it is important
that the role of Prudence is understood. Many people tend to confuse Prudence
with Conservatism; believing that they are synonyms (Barker, R 2015). When in fact, prudence
falls under the accounting characteristic of conservatism. They are two concepts that are used by
accountants when creating financial statements. Conservatism refers to any
method of accounting that leads to book value being less than economic value (Barker, R 2015). Economic value is an
estimate of future cash flows and worth after discounting. Some argue that conservatism
is an intrinsic system property as accountants following the framework should
already be focused on valuing assets at appropriate values. Prudence concept is
the accounting term used to define the characteristic that allows one to act
with or show care and thought for the future. Prudence arises from a
cautious response to Uncertainty (Barker, R 2015). Prudence is fundamental
in financial accounts as it makes financial accounts relevant and useful (Barker, R 2015). Financial accounts
should always aim to produce conservative and cautions figures in order to
produce the best financial interpretations of any business (Barker, R 2015).  In this essay, I will be discussing the effect
prudence has on the preparation of financial statements. Whether Prudence
should be considered as a qualitative characteristic in the accounting
framework. How prudence plays a role in decision making as well as producing
examples of how prudence can successfully be applied when calculating financial
statements.
                          

A good example of how Prudence can successfully be
applied when calculating financial statements is in the case of inventories. Based on
prudence, the accounting standard states that inventories should be valued for
the purposes of the financial statements at cost or net realisable value,
whichever is lower. By so doing, the entity is recognising the possibility of
the loss likely to arise due to drop in the selling price of the commodity.
Therefore portraying a realistic financial picture of the value of the
inventories.

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There are many advantages of the effect prudence has on
the preparation of financial statements.

Firstly, Prudence has developed a clear expectation among many users that
accountants should put a restraint on the anticipated over-exaggerations of
management in reporting a company’s results. (Prudence and IFRS – ACCA Global).
This means that the results of financial statements are more likely to have a
more truthful representation. In doing so, Prudence really helps to achieve a
better balanced image of the businesses successes and shortcomings in
accordance with any externalities the business may face which management may
not want to display but need to accept.

Secondly, Prudence
certainly fixes where profits and assets have been overstated – and not where
they have been understated.  This is
where accounts, accountants and accounting standards have received the most
criticism. (Prudence and IFRS – ACCA Global) The main use of financial statements
is to take a transparent image of the business and prudence ensures that a business
does not appear to have over valued assets. This is why provisions have to be
made when formulating financial statements.

A great example
would be “The financial crisis in 2008/9”. This is the most recent example of
how a more prudent approach to accounting by banks might have restrained
excessive bonuses and dividends; making banks more resilient. It also provided
greater financial stability to the whole economic system that was going through
the effects of this financial crisis (Prudence and IFRS – ACCA Global). Prudence
forces accountants to think about the way figures are represented.

Prudence is
ultimately a fairly easy concept to follow as the benefits of the exercise of
prudence in the application of the standards are perhaps more widely agreed
upon. For example the chairman of the IASB has described the definition of
prudence in the IASB’s former framework as ‘sheer common sense’ (Prudence and
IFRS – ACCA Global). Prudence can be easily understood as not overestimating assets
and in the same respect underestimating expenses.

However, the
exercise of prudence does not allow, the creation of hidden reserves or
excessive provisions, the deliberate understatement of assets or income, or the
deliberate overstatement of liabilities or expenses (Prudence and IFRS – ACCA
Global). One could say Prudence dramatically contributes to a production of
ethical financial statements. This Is done in order to not distastefully deceive
those who gather information from financial statements.

However there are
some well-developed arguments against prudence in the accounting industry. Many
experts see Prudence in a transparent manner that is not biased but neutral to
both good and bad news (Prudence and IFRS – ACCA Global). Essentially this
contradicts the use of Prudence as through “transparency”
there is possibility for a lack of truthfulness in the financial statements
created.

Another disadvantage is the desirability of
restraint in profit recognition. As it is often pointed out that while prudence
may hold back profits in one year, such restraint may simply lead to their
release in a subsequent period which as a result will show exaggerated results (Prudence
and IFRS – ACCA Global). Exaggerated results at a later date also contradicts
the use of accounting concepts as they go against a truthful representation of
the business’ financial position.

Furthermore, this can gravely effect the way
decisions are made by accountants. Accountants can use Prudence as a way to
hide discrepancies within the business when producing financial statements. For
example, the Spanish banks and the dynamic provisioning during the crisis are
cited as a further case in point – prudent reserves temporarily masked their
underlying weakness as conditions changed, and delayed remedial action (Prudence
and IFRS – ACCA Global).

The other main issue with the role of Prudence is
that it is a concept that cannot be measured. The problem with prudence is
determining how much downward bias has been used in measuring the assets by
Company A compared with its competitor B (Prudence and IFRS – ACCA Global). For
example, Apple and Samsung. Both successful companies would strive to use the
role of prudence to their advantage. As they are both Plc.’s both of these companies
would want to keep their competitive advantage and not disclose a transparent,
truthful picture of their companies’ financial positions through financial
reporting.

However, some may argue that the problem does not
lie with prudence but rather prudential regulators (Prudence and IFRS – ACCA
Global). Financial reporting is used to capture a truthful, transparent financial
picture and therefore prudence is a necessary concept. Perhaps if there was
more efforts placed with prudential regulators then these financial pictures
could be managed in a conducive format.

In the conclusion, the aim of the use of Prudence
is to make sure that any financial statements produced show a truthful representation
of the business’ financial position. I have discussed in depth what effects
Prudence can have on the appearance of a business such as deception and bias.
Furthermore, I have also discussed how Prudence can support a truthful
representation of a business and influences accountants to think of their
ethical responsibilities when completing financial statements. Prudence should be considered as a
qualitative characteristic in the accounting framework. Especially as it cannot
be directly measured or quantifiable. Although the main subject of this essay is
Prudence, I believe that as long as the concept of conservatism is practiced in
the accounting industry then there is some leeway to remove Prudence from the
conceptual framework. As at the very least a business is taking into account
economic values. I can also appreciate the ethical standpoint Prudence holds.

 

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