Prudence statements should exercise when making judgements about

Prudence
is a concept that preparers of financial statements should exercise when making
judgements about uncertain items such as doubtful debts, assets lives, etc. It
is deemed as one of the qualitative characteristic of accounting information
and refers to the inclusion of a degree of caution in accounting judgements
under conditions of uncertainty.  According to the framework, ‘information
included in financial statements should be prudent’. The aim of using prudence
is to avoid the overstatement of assets and under-statement of liabilities as both
would lead to an over-statement of profit. In my essay, I will discuss the role
of prudence and whether it should be characterised as a qualitative
characteristic.

One positive of
prudence comes from The IASB who state that ‘there is a false pretence that prudence
is inconsistent with neutrality.’ Instead, it can be argued that it could be
a mechanism for ensuring neutrality exists. Neutrality is a term included in
the IASB’s conceptual framework and is deemed important when assessing
financial information. The role of neutrality is to remove bias by ensuring
financial information is not weighted, emphasised, de-emphasised or manipulated
to increase the probability that such information will be received favourably or
unfavourably by the users. It is a necessary component for providing faithful
representation. An example of prudence being consistent with neutrality is when
measuring the depreciation of an asset. It is ethically important that any potential
investors are not only aware of the estimates calculated but also that these
estimates are realistic and without bias. In this instance, prudence is consistent
with such estimates and the need for neutrality. On the other hand, despite The
Framework stating ‘the exercise of prudence does not allow, for example, the
creation of hidden reserves or excessive provisions, the deliberate
understatement of assets or income, or the deliberate overstatement of
liabilities or expenses, because the financial statements would not be neutral
and, therefore, not have the quality of reliability’, prudence was still used
inappropriately by Nortel in November 2002 (USSEC
Press Release November 2010). The report shows that ‘In November 2002, three
senior managers of Nortel learned that Nortel was carrying over $300 million in
excess reserves and did not release these excess reserves into income as
required under US GAAP. Instead, they concealed their existence and maintained
them for later use to avoid posting a profit. These reserve manipulations helped
to erase Nortel’s pro forma profit for the fourth quarter of 2002 and caused it
to report a loss instead. This allowed the company to delay paying bonuses to
its stakeholders such as shareholders and employees. This clearly demonstrates
a lack of consistency between neutrality and the use of prudence and it is also
an example of how prudence can work against a number of stakeholders. For
example, for investors who use financial statements to make decisions on future
investments. Any over- or under-statement within the statement could lead to substandard
decisions and a misallocation of capital. ‘It therefore seems to me that
prudent and well-considered estimates should be neither overstated nor
understated’. (Steve Cooper, member of the IASB 2015)

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