Looking for more insight into the ongoing debate in Europe about the role of prudence in the IASB’s conceptual framework, I came across Getting a Better Framework: Prudence, a bulletin issued a year or so ago by the European Financial Reporting Advisory Group. The document provides a useful overview of the diverse notions of prudence and of its place (if any) in financial reporting. This is how it sums up the big picture:

• “The main objection some raise is that prudence introduces bias into reporting, which conflicts with the neutral (or unbiased) view that financial statements should provide. In particular, they argue that prudence may be used to artificially smooth income, reducing profits in good years to provide a cushion that may camouflage the results of poor years, making it difficult to understand the entity’s performance. Because it is often difficult for users to detect the exercise of prudence, and to quantify its effect, prudence may impair, in their view, the transparency of financial information.
• In contrast, others believe that the application of prudence results in an earlier reflection of existing risks in the financial statements, preventing the recognition of profits which are not yet realized. They see prudence as the opposite of imprudence, which concept may result in recognizing illusory profits and an overstatement of income, and can lead to ill-based economic decisions. In their view, prudence is clearly linked to profit distribution…in particular in jurisdictions where legislation has established a direct link between net income and dividend distributions.”

Of course, as the bulletin points out, there’s plenty of room in these two broad camps for further shadings of opinion:

• “There now seems to be widespread acceptance of the distinction between ‘bad’ prudence (prudence as deliberate misstatement, which is generally rejected) and ‘good’ prudence (prudence as caution, which is generally supported). Hans Hoogervorst, the Chairman of the IASB, has recently described it as ‘plain common sense’…However, even though there is wide agreement that prudence should not go beyond bringing an appropriate level of “caution”, there remain quite divergent views as to what the appropriate level of “caution” is, since it is not a defined term in the Framework.”

After going through various examples, the bulletin expresses the “tentative view” that whether or not the concept of prudence is explicitly included in the conceptual framework, the variety of views about what constitutes appropriate “caution” in standard-setting “plays a role in the decisions to be made, in the context of the revisions of the Conceptual Framework, about recognition, measurement, presentation and disclosures. Therefore, it is in our view useful that, in making these decisions, the role of prudence is explicitly considered.” Which seems to me to say so little that there’s hardly any need to be tentative about it. After all, there’s not much downside in the IASB “considering” prudence in its discussions of various matters, as it can always quickly conclude it’s considering the concept only for the purpose of rejecting it.

Verbal slipperiness?

If that sounds like excessive verbal slipperiness on my part, the bulletin’s main value seems to be in confirming that it’s impossible to grapple with the concept otherwise. Of course, it would be relatively easy to devise a hardline approach to financial reporting, where (say) revenues are never recognized until realized in cash, and all potential liabilities have to be recognized and measured at their maximum possible amount, and so forth. But as soon as you accept that wouldn’t be the best way of providing relevant information for ongoing decision-making, it seems that individual views of where to draw the line of prudence are as diverse and unreliable as, well, human perspectives on anything else (and simply asserting that one’s view of where to draw the line is based on prudence, in opposition to someone else’s “neutral” view, is neither here nor there). The bulletin sets out a few areas of existing IFRS where prudence might be identified as a factor – for example, the fact of a higher threshold for recognizing contingent assets than for recognizing contingent liabilities – but these matters could likely be explained just as effectively without referring to the concept at all. As much as anything, the notion of prudence, as the bulletin perceives it, seems in some general way to attach to areas of standard-setting nervousness, where a lack of consensus exists for doing what would “normally” be done. For instance:

• “Under IAS 16, there is an option to revalue property, plant and equipment to its fair value. This appears to be less prudent than recognition at cost. However, the resulting gain is reported in other comprehensive income rather than in profit or loss. This may be seen as a case where prudence is reflected in presentation.”

So prudence is a matter of structure as well as of measurement? Does it follow that it’s more prudent to disclose information about potential gains way down in note 40 rather than in note 2? One wonders, not with much optimism, whether any possibility exists of a standard-setting notion of prudence that would be relatively objective, such that confidence might exist that all participants were using the term in a comparable way. Alex Milburn might have tried to light a path in that general direction with his recent research paper Toward a Measurement Framework for Financial Reporting by Profit-Oriented Entities, ­but I think to this point it’s been a rather lonely enterprise.

A key point here, surely, is how discussions about financial reporting are often intertwined with issues of language (even more so, presumably, when the issues are often being debated via translation). Terms like “prudence” or “conservatism” (or, indeed, “neutral”), in whatever context they’re used, are always shifting or mutating (for instance, to be a “conservative” in current American politics denotes a quite different policy agenda to that of a few decades ago), so that even if we achieved a workable consensus on their meanings, we couldn’t count on it lasting. I can’t help thinking of the scene in Annie Hall where he describes two or three times a week as “hardly ever” and she describes it as “constantly”.…

The opinions expressed are solely those of the author