Abstract
The narrative report is prepared to provide a clear understanding of the prudence concept and historical information attributed to this concept. The prudence concept was applied in 1989 that was not included in the external references of 2010. The IASB observed that the concept was missing or ignored, so they provided an amended definition of the prudence in accounting. The significance of the inclusion of this concept is necessary to provide a clear and complete view of the financial position of users. The prudence concept is related to neutrality and conservatism, so it is badly affected by the adverse changes in all these concepts. A conceptual framework is necessary to provide a clear definition of different terms included in the report. It can be observed that prudence has much importance in financial reporting, and conceptual framework should be included in the annual reports that also support the prudence concept.
Introduction
Financial reporting is done to facilitate the users of financial statements including investors, creditors, lenders, shareholders, customers, etc. The decisions are based on the annual reports prepared by companies every year. It should reveal complete and concise information that can facilitate users during decision-making. The true and fair view is an important concept that should be followed in the preparation of annual reports. The concept of prudence is also important to present all the information to the investors and other potential users. Prudence refers to the concept that refrain companies to overestimate their income and assets or underestimate costs and expenses for the year. The International Accounting Standards Board (IASB) presents framework periodically that should be followed by all companies.
The reference to prudence concept was explicitly included in the framework in 1989. However, its definition was not presented in the conceptual framework of 2010. The absence of prudent definition resulted in the confusion that whether the concept is applicable or not. The IASB identified that prudence is widely considered important by the investors so there should be a simple and clear definition of the concept that must be included as an explicit reference in the exposure draft of 2015. The importance of prudence definition cannot be denied as the removal and approval of this concept resulted in a variety of questions that are required to be answered by accounting related institutions and authorities. However, these questions are considered as strong arguments in favor and against the arrival prudence concept.
Why is Prudent Accounting Important?
Companies to present a true and fair view to investors do financial accounting and reporting. There are different estimations regarding revenues, assets, liabilities, and expenses that are done to provide a true and fair view. However, cautious is essential in presenting such information in the annual reports. It can only be done if companies practice adopting prudent concept while preparing annual reports.
Effective research and judgment are required to do for the estimations that can reduce the chances of ambiguity in the financial statement. The prudent concept is important to provide a better understanding of financial statements to the users. Investors consider the thing important to recognize if the company has the potential to grow in future or there are many risks associated with it.
Companies consistently followed it before 2010 when every company was entitled to follow the framework set by the IASB. However, confusion arose due to the absence of explicit reference of prudence in 2010. The IASB cleared by providing a clear definition of the concept in the exposure draft that companies are restricted to an underestimate of overestimating their income, assets, liabilities, and expenses at all. The estimations based on market research are considered reliable as market surveys provided true and fair information regarding the estimations (Atrill, McLaney, & Harvey, 2014).
Are Faithful Representation and Conservatism Issues Affecting Prudence Concept?
Companies are entitled to prepare financial statements to provide faithful representation to the investors. Faithfulness refers to provide a complete set of information that can provide help in making decisions for investment. The prudence concept was badly affected by this approach before 2010 where companies use this type of techniques while presenting their performance report at the year-end. The inevitable practice has no effect on the decision of capital allocation due to the inclusion of irrelevant information in the financial accounting and reporting. Prudence and conservatism are a synonym to each other; therefore, the issues of conservatism also put a direct impact on the practice of prudence in accounting. Moreover, investors are much concerned for the dividends that may reduce by the application of conservatism in recording and reporting. It results in raising the issue for the accountants that how much the conservatism approach should be applied while preparing financial statements for a company. Investors argue for a faithful representation of all the relevant information in the financial statement (Collier, 2015).
Are Neutrality Fits to the Prudent Accounting?
Prudent accounting was introduced for cautious taken by the management to be careful in preparing financial statements. Companies were entitled to make estimations for the components of financial statement and provide a clear and concise view to the users. However, the question arose how it can be judged that the decisions are not biased? The argument was addressed by the IASB that provided a clear definition of prudence inconsistent with neutrality. The neutrality is essential in accounting to provide best estimations based on external market research. The management should provide an authentic report to the auditor of the estimations that are collected by analyzing all the things in a neutral manner. Prudence has significance in financial accounting, but neutrality is the main factor that should be considered extensively while applying this concept. The information provided in the financial statement should be unbiased and free from any deterioration made by the management (Alexander & Britton, 2004).
How Conceptual Framework is Helpful in Developing Financial Reporting Standards?
A conceptual framework is a system of objectives and ideas that are helpful in providing more clear and updated set of concepts. Financial reporting standards are set by the IASB in the name of International Financial Reporting Standards (IFRS) that may not understand by the investor who has invested in a public limited company (Kieso, Weygandt, & Warfield, 2010). It provides a clear view to the viewers of financial statement regarding the basic elements of financial statements. The basic elements such as assets, liabilities, income, expenses, and equity are required to be measured for recording in the financial statement. The conceptual framework is prepared by IASB for the development of their provided standards. The issue and basic problems regarding the treatment of different elements of financial statements ate solved in developing this framework.
Conceptual framework is prepared by identifying and analyzing the important areas in the financial reporting that is not easily understandable by potential investors. The framework consists of different definitions and clarification of accounting terms that are used in the report. Also, policies and rules are also mentioned in the conceptual framework that allows stakeholders to understand the financial reporting. General purpose of accounting cannot provide clear view of the components of financial statements. Framework is helpful for preparing financial reporting standards as significant knowledge of the concepts and terms used is given in the conceptual framework. However, it is difficult to prepare conceptual framework but it is the main requirement for preparing annual financial statements and reports.
The purpose of accounting cannot be fulfilled by the exclusion of conceptual framework. A flexible system is always required to ensure prudent and matching concept in the financial reporting. Accountants are much concerned about eliminating conceptual framework from the annual report, but the main reason for not doing so is its relevancy with the topic. Conceptual framework entitles companies that the treatment of accounting transactions for different components should be dealt with the specific purpose. A conceptual framework is necessary for providing principle-based accounting system (Macve, 2015).
How it Helps Stakeholders to acknowledge Accounting Practices and Earning Management?
The stakeholders of the business are interested in the financial statements and annual reports of the company. The report can provide actual and estimated performance of a company in the coming period (Macve, 2015). The stakeholders also include investors who are willing to get information regarding the financials of a company and makes decisions by such information. The conceptual framework is extensively needed to provide clear information to the investors regarding different terms and sentences used in the report.
If a company does not provide a conceptual framework, investors may not attract to the stocks of the company. A company is entitled to provide a true, clear, fair, and concise view to the user to remain sustainable and stable in the competitive market. Also, prudent accounting is also covered in this topic as neutrality and conservatism need to follow while preparing financial reports (Kieso, Weygandt, & Warfield, 2010).
Conclusion
Prudence was originally important at that time because financial statements should provide actual income and expenses account. It was eliminated erroneously in 2010 and investors, and capital market giants thought that it has gone away. However, it was included in the reports, but the reference was not provided that created confusion among people. After that, IASB realized that there is a need to reintroduce the concept as it has much importance in the financial reporting. The concept arrived with the new definition that clarified all the matters related to the prudence concept and its implementation while preparing financial reports. The conceptual framework is also essential in the preparation of financial statement as this section include definition and clarification of the terms used in the report. The section highlights some important facts to the users that cannot be understood easily. Investors require clarification of the rules and principles used in the annual reports. The conceptual framework is necessary to maintain so to provide specific and reliable information to the users.
References
Alexander, D., & Britton, A. (2004). Financial Reporting. Mason: Cengage Learning.
Atrill, P., McLaney, E., & Harvey, D. (2014). Accounting: An Introduction, 6/E. London: Pearson Education.
Collier, P. M. (2015). Accounting For Managers: Interpreting Accounting Information for Decision Making. Hoboken: John Wiley & Sons.
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2010). Intermediate Accounting: IFRS Edition, Volume 1. Hoboken: John Wiley & Sons.
Macve, R. (2015). A Conceptual Framework for Financial Accounting and Reporting: Vision, Tool, Or Threat? London: Routledge.
Meall, L. (2015). Perspective on Prudence. Economia, 1 (40), 80-81.
