Improving the conceptual framework – with appropriate prudence?

As we discussed here, the IASB has published for public consultation proposals to improve the Conceptual Framework for Financial Reporting, with comments to be received by October 26, 2015.

As at present, the proposal sets out faithful representation as a fundamental qualitative characteristic of financial information – that is:

  • “Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. A faithful representation provides information about the substance of an economic phenomenon instead of merely providing information about its legal form. Providing information only about a legal form that differs from the economic substance of the underlying economic phenomenon would not result in a faithful representation.
  • To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The IASB’s objective is to maximize those qualities to the extent possible.”

The description of a neutral depiction, one that is “without bias in the selection or presentation of financial information,” includes the following proposed paragraph:

  • “Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets and income or the overstatement of liabilities and expenses, because such mis-statements can lead to the overstatement of income or the understatement of expenses in future periods.”

This reflects a long-running debate about the absence of prudence from the current conceptual framework (I discussed some of those issues here). Here’s part of what the IASB says about it in the basis for conclusions to the new exposure draft:

  • “The IASB considers that prudence (defined as the exercise of caution when making judgements under conditions of uncertainty) can help achieve neutrality in applying accounting policies… Thus, cautious prudence is a factor in giving a faithful representation of assets, liabilities, equity, income and expenses. Setting out that message clearly in the Conceptual Framework can be expected to:
  • (a) help preparers, auditors and regulators counter a natural bias that management may have towards optimism; for example, it would point to the need to exercise care in selecting the inputs used in estimating a measure that cannot be observed directly; and
  • (b) help the IASB to develop rigorous Standards that could counteract any bias by management in applying the reporting entity’s accounting policies.
  • Therefore the IASB, in paragraph 2.18 of the Exposure Draft, proposes to reintroduce the term prudence, defined as cautious prudence, in the Conceptual Framework. It notes that the removal of the term prudence in the 2010 revisions led to confusion and perhaps has exacerbated the diversity in usage of this term. People continue to use the term, but do not always say clearly what they mean. In addition, some have claimed that, because the term was removed, financial information prepared using IFRS is not neutral but is in fact imprudent. The IASB thinks that reintroducing the term with a clear explanation that caution works both ways (so that assets and liabilities are neither overstated nor understated) will reduce the confusion.”

That may be so, but the proposal reads to me like an emblematic diplomatic compromise, perfectly calibrated to allow opposing parties to brandish harmlessly conflicting interpretations of what it actually means. Those who put a premium on conservatism might look at the proposed passage and see a possible basis for at least limiting what they see as the illusory effects of fair value accounting. Others (including myself) will conclude that the proposed paragraph says just about nothing. Prudence is the exercise of caution – well, is there any aspect of IFRS in which the IASB counsels lack of caution? And the rest of the paragraph merely says that nothing should be overstated, and nothing should be understated, so there’s not much new insight there.

On the other hand, one IASB member at least must think it means something, because he dissented from the passage, on this basis: “if prudence is included in the Conceptual Framework or any Standard, it would introduce bias and would create confusion in the minds of many preparers about whether or how it should be applied… the use of that term within the Conceptual Framework could result in: (a) Standards designed to produce weighted outcomes; (b) preparers being cautious by understating assets and overstating liabilities or being cautious in communicating bad news and hence overstating assets and understating liabilities. Such actions have the potential to confuse investors and lower their confidence in financial reporting.” Which seems to me a lot to potential damage to detect within an airy 80-word passage…

The opinions expressed are solely those of the author

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