The IASB’s conceptual framework – prudently stirred, but not shaken

Let’s take a look at another aspect of the IASB’s recently issued revised conceptual framework for financial reporting.

The revised document contains the following much-debated paragraphs:

  • 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 or income or the overstatement of liabilities or expenses. Such misstatements can lead to the overstatement or understatement of income or expenses in future periods.
  • The exercise of prudence does not imply a need for asymmetry, for example, a systematic need for more persuasive evidence to support the recognition of assets or income than the recognition of liabilities or expenses. Such asymmetry is not a qualitative characteristic of useful financial information. Nevertheless, particular Standards may contain asymmetric requirements if this is a consequence of decisions intended to select the most relevant information that faithfully represents what it purports to represent.

I wrote a few years ago about some of the issues underlying these paragraphs. I observed then that the proposal (as it was at that stage) was:

  • 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.

The basis for conclusions suggests that the material isn’t primarily there for its own sake, but rather to paper over the cracks of a possible history:

  • “The Board found that the removal of the term ‘prudence’ in the 2010 revisions had led to confusion and had perhaps exacerbated the diversity in use of this term. People continued to use the term, but did not always say clearly what they meant by it. In addition, some stakeholders said that, because the term had been removed, financial information prepared using IFRS Standards was not neutral but was, in fact, imprudent.

I don’t know if this will be the end of the political storms I’ve written about before (here for instance) – I don’t suppose anyone can anticipate a certain end to any kind of European storm for as long as Brexit is blowing wreckage into the tent.

The basis for conclusions sets out several interesting arguments raised by commenters for why the IASB should place greater weight on the concept of “assymetric prudence” – in particular that “by limiting distributions to shareholders, asymmetric prudence minimizes the risk that today’s shareholders would benefit at the expense of future shareholders” and that “by limiting management remuneration, asymmetric prudence would reduce management’s opportunism and encourage long-term growth.” Of course, the Board doesn’t base its determinations on such considerations:

  • in the Board’s view, accounting information (such as reported profit) is not, and should not be, the sole determinant of distributions of dividends and bonuses. Distribution policy is affected by many other factors, for example, the entity’s financing needs, current and projected liquidity, the risks faced by the entity, legal constraints and (in the case of bonus decisions) remuneration policy and incentive arrangements. These factors differ by entity, by country and over time. It would be neither desirable nor feasible for the Board to consider them in standard-setting decisions.

Put very bluntly, there’s nothing “wrong” from a standard-setting perspective if a company drives itself into the ground by distributing or paying out too much, or for that matter, just through general recklessness. Just as written, the notion that limiting distributions “minimizes the risk that today’s shareholders would benefit at the expense of future shareholders” seems rather willfully selective, given that virtually every strategic decision taken by a company (for example to emphasize some products over others, to squeeze operating costs, to cut back on research and development) might have that impact. And as I’ve also written before, maybe we’re often just better off accepting that reality:

  • The arguments for or against short-termism are to some extent moral and ideological rather than economic. To illustrate this, consider whether a $1 million bequest to a food bank would be best spent to feed hungry people in the short term, or rather invested at a conservative rate of return, with the resulting income going to feed such people into near-perpetuity. The latter might appear more rational from some perspectives, but can one appropriately say to people starving right now that available resources are being actively denied them, their current suffering counting for less than that of theoretical future individuals?  Likewise, if companies focus primarily on exploiting their current strengths and on generating and delivering some short-term wealth, you might conclude that’s better than setting out to compete against others for the same overpriced pool of long-term opportunities (recall that the great majority of corporate mergers and takeovers fall short of expectations) or to (say) pursuing development projects that may just not pan out. The average life of S&P 500 corporations has been reported as 18 years – should we just roll with that reality then?

But of course, I was knowingly making that point from inside a capitalist box which often seems to be splitting at the seams, and for which IFRS doesn’t seem likely to be the super-glue…

The opinions expressed are solely those of the author

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