Prudence
is defined in the dictionary as caution with regard to practical matters; discretion.1 This is the whole concept behind financial prudence being
a desirable quality when it comes to financial reporting. It is the idea that,
when making financial reports, the accountant in question should base his
actions on the ‘prudent man.’ This basically means that accountants should err
on the side of caution for when making budgets and so forth. This was outlined
as a framework or guidelines for financial statements followed by organizations
such as the IASB(International Accounting Standards Board ).2 For example, when a company is in progress of their
balance sheet, they should take extra precautions not to overestimate assets
that are coming in and not to underestimate liabilities coming out. This is put
there as a sort of safety guideline for businesses to be ‘sensible’ and not
take unnecessary risks. This is especially a factor for PLC’s as they actually
have large amounts of other people’s capital in escrow.  Since then prudence has been
discussed in many literature articles as to whether it should be a quality that
is enforced. In this passage the role of prudence in when preparing financial
statements will be elaborated and whether there is need for it to be a set
framework in financial reporting.

To start, we will explore how financial
prudence has been implemented in the modern world of accounting. An example of a law passed
specifically for the idea to have display more prudence in the corporate world
was the 1974 Employment Retirement Income Security Act (ERISA) to
preserve and protect the pension plans of millions of American workers.(LAWUPEN
cite)3.
This was because there was a wave of business failures as they had
overestimated their incomings- the revenue generated from being in business and,
underestimated their outgoings- the pensions that they had promised their
workers. The ERISA set out minimum standard for private businesses when setting
out pension and health plans for employees. This law meant that there were set
numbers when preparing a financial statement which helps both businesses and
buyers. This is because when budgeting it is harder to underestimate losses as
there is now a benchmark loss so businesses would have to budget according to
these new figures. This now kept businesses safer as well as their many
stakeholders. Even though there may evidence that suggests that the law had a
direct impact on businesses, from the article “””4 it
suggests that prudence is inherent in business accounting. This is because
business accounting, unlike economic accounting, doesn’t take into account the
human side of the business but instead is strictly the monetary value of
assets. This then brings to question that, in a field that is dealing with the
incomings and outgoing of a business, prudence has always been an unsaid
quality that is necessary for this nature of work. Linking back to ERISA, it
may not have been that the businesses had failed because they were not being
conservative and basing their budgets and actions on a prudent man, it may just
have been that the businesses had a problem elsewhere that led to them becoming
bankrupt.

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With prudence being a qualitative conceptual
framework in business accounting, there have been issue that have arisen. One
of these issues is the opportunity for individuals or businesses to embellish
funds and keep unnecessary reserves. This is because the companies now have a
format to change numbers. For example, in 2002 Nortel was found to be holding
$300 million in reserves through following the guidelines.5 Some
of their employees didn’t release this excess into the income of the company
statements and rather used them as overstated liabilities which actually ended
up being fabricated to show that Nortel was operating at a loss instead. It
then can be argued that from prudence being a qualitative measure, businesses
now have easier ways to doctor financial reports what could then bring doubt
upon the reliability of a businesses financial statement. Leading on from the
idea of a business having questionable reliability, the use of prudence as a
framework could lead to more tampering in order to protect individuals,
departments, or businesses themselves. An example of this is when companies use
the prudent guidelines to exaggerate profits and make losses lesser. This gets
rid of the transparency in business statements as the statements should be
neutral and not biased to get favourable results6.
This is because if a business is in a time of uncertainty they should judge
their budget on what they think is the most possible outcome at the time not
what they will think will please shareholders. This closely links to the idea
of “”conditional conservatism””7
again from basu where the author distinguishes the difference between
unconditional and conditional conservatism. As deduced from the article,
prudence is under the term of unconditional conservatism which is conservative
in every way. If a business was to use conditional conservatism it would mean
that they would have to take into account everything at the time the statement
is being prepared and also they would have to be prudent as according to their
best judgement. The IASB is completely independent from businesses which makes
it hard to lay a blanket rule set down for all businesses to follow as there
are so many. With conditional conservatism it makes businesses be as prudent as
they need to be in order to grow. Linking back to the example of businesses
holding unnecessary reserves, with prudence just being a quality of a business Nortel
would have had to use their judegment as to what they decide was prudent which
would lead them to having to use all their funds to make a proper financial
statement as they wouldn’t have set numbers to work around and manufacture
profits or losses for the benefit of a few. This may add a bigger degree of
transparency when it comes to preparing financial reports. Saying that, Basu
did also lay out that an negative earnings changes have more chance of
reversing in the next year in comparison to positive earnings changes. This
could mean that the work of financial prudence framework is effective in ways
of it seems that businesses are using the figures to reverse their performance.8

In summary some of the main key factors to
whether there is a need for a financial prudence as a conceptual framework are
apparent. The ERISA act could be a clear indication as to financial prudence,
when enforced, is a key to healthy business growth and in turn a healthier
economy. All that being said there are strong arguments to why financial
prudence should be more of a desired quality than a framework such as “””
argument that prudence or conservatism is actually inherent to running a
business and that there is no need to tell a business exactly how to be
cautious as there isn’t a definitive set of rules. Also Basu shows that a
different approach of prudence may been in need which is conditional. Most
importantly the use of prudence as a framework seems to shroud the what is
meant to be the transparency of business statements so it may actually be doing
more harm than good. So, in conclusion, The discussion in literature mostly
seem to indicate that these frameworks may be outdated and from the points mentioned
above it may be time to- not completely get rid of the conceptual framework-
but to adjust them enough to allow a manageable amount of uncertainty so
businesses can adjust their statements accordingly and more transparently.

1 http://www.dictionary.com/browse/prudence

2 https://www.accountingweb.co.uk/business/financial-reporting/the-iasb-conceptual-framework-an-introduction

3 https://www.dol.gov/general/topic/retirement/erisa

4
Barker, R., (2015). Conservatism, prudence and the IASB’s conceptual framework.
Accounting and Business Research, 45, pp. 514-538.

5
highered.mheducation.com/sites/dl/free/0077132688/936874/ch06.pdf

 

6
https://www.accaglobal.com/content/dam/acca/global/PDF…/tech-tp-prudence.pdf

7 http://www.scirp.org/(S(351jmbntvnsjt1aadkposzje))/journal/PaperInformation.aspx?PaperID=70733

 

8 http://www.scirp.org/(S(351jmbntvnsjt1aadkposzje))/journal/PaperInformation.aspx?PaperID=70733

Watts, R.L. (2003b). Conservatism in Accounting Part
II: Evidence and Research Opportunities. Accounting Horizons, 17(3), pp. 287-30