The Never Ending Story of Prudence and IFRS
Alfred Wagenhofer | October 13, 2015 |
Prudence is engrained in many, if not the majority of, the International Financial Reporting Standards (IFRS) but it is contentious as ever. The 1989 Framework by the predecessor committee to the International Accounting Standards Board (IASB) included prudence alongside neutrality as a desirable quality of financial reporting. In joint work with the US Financial Accounting Standards Board (FASB), the IASB removed prudence in 2010 because of its conflict with neutrality. This decision was made after long and controversial debates. The IASB continued the Framework project without the FASB and produced a discussion paper in 2013, in which it stood firm with its previous decision to exclude prudence, and tried to prevent further discussion by indicating an unwillingness to reopen the debate.
Unsurprisingly, the debate did not end there. In a bulletin on prudence from 2013, the European Financial Reporting Advisory Group noted diverse views on the desirability of prudence. Later that year, some constituents again tried to push the IASB toward including prudence in the Framework. The IASB indeed reintroduced prudence into its May 2015 Exposure Draft (ED) Conceptual Framework for Financial Reporting, the comment period of which is open until November 25, 2015.
Introducing Cautious Prudence
It is worthwhile taking a closer look at the new proposal. The IASB distinguishes “cautious prudence” from “asymmetric prudence.” Cautious prudence is “the exercise of caution when making judgements under conditions of uncertainty” (paragraph 2.18), and is now included within neutrality. Asymmetric prudence, which many see as the essence of prudence, is explicitly dismissed. By defining away a conflict between neutrality and prudence, the IASB attempts to stay aligned with its earlier position.
The discussion in the Basis for Conclusions that accompanies the ED is revealing. The IASB argues that cautious prudence should help counteract a natural optimistic bias of management. This suggests that asymmetric standards may be useful to lead to neutral information. The IASB also notes that neutral accounting:
- does not require recognition of all assets and liabilities or of the value of the entire entity (including originated goodwill);
- does not require measurement of all assets and liabilities at fair value; and
- does not prohibit impairment of assets measured at cost.
Such outcomes could follow from trading off relevance and faithful representation, according to the IASB.
Can Asymmetry be Neutral?
These outcomes are difficult to reconcile with neutrality. For example, recognition of an impairment loss but not a possible gain due to an increase in the economic resource above cost is not neutral, neither as a standard nor as an outcome. In some cases, only downside risks are recognized or disclosed (consider contingent liabilities, onerous contracts, and the like).
In a recent article, “An Analysis of Concepts and Evidence on the Question of Whether IFRS Should be Conservative” published in Abacus, Richard Barker and Anne McGeachin compile a comprehensive list of instances of asymmetric prudence in existing IFRS, even in standards developed after 2010 when the IASB had dismissed prudence. In another article, “Conservatism, Prudence and the IASB’s Conceptual Framework” in Accounting and Business Research, Barker even argues that financial accounting is inherently conservative. Under a broader perspective, economic consequences of decisions are rarely symmetric. So why would neutral financial reporting provide the most useful information to make such decisions?
If the Framework does not acknowledge asymmetric prudence, many of these existing asymmetries lose their conceptual basis, but would only qualify as ad hoc exceptions from the principles laid out in the Framework. One way to overcome this is to reintroduce prudence, for example, in the way it was stated in the 1989 Framework. There it stood alongside neutrality and required a trade-off between the two characteristics. Importantly, it clearly dismissed a deliberate bias, but not asymmetric prudence per se. With acknowledging neutrality and prudence, the Conceptual Framework would include all conceptual underpinnings for standard development and provide the flexibility to incorporate insights from ongoing research that studies the costs and benefits of prudence. The recent survey, “The Implications of Research on Accounting Conservatism for Accounting Standards Setting” by Araceli Mora and Martin Walker in Accounting for Business Research nicely discusses this research.