IASB Conceptual Framework 2010 Version on Exclusion of Prudence - Essay Example

IASB Conceptual Framework Version on Exclusion of Prudence By al Affiliation IASB Conceptual Framework 2010 Version on Exclusion of Prudence Introduction IASB (International Accounting Standard Board) made a revision on the first chapters of Conceptual Framework in September 2010. A Conceptual Framework is a model that governs the preparation and presentation of financial statements. The financial statements include the statements of financial position, cash flows and comprehensive income. The model is usually developed by the IASB. In the revision, IASB replaced the concept of Prudence by Neutrality (Kampanje, 2013). According to IASB Discussion Paper (2013), Neutrality is reflected as a faithful representation component which acknowledges the need to exercise caution in cases dealing with uncertainties. Therefore, prudence is not identified as being of a separate qualitative characteristic. This is because the influence and intent of prudence in the identification of information (included in the general purpose financial reports) have already been embedded in the faithful representation notion (Paul, 2013). A Review of the Conceptual Framework for Financial Reporting and Comments (2014) with the FTSE 100 company holdings like the Standard Life Investment Limited use the IASB conceptual framework. They fulfill their clients’ responsibilities by fully relying on the IFRSs (International Financial Reporting Standards). The company, therefore, believes that there is need to develop an understandable and relevant conceptual framework to provide governance to the IFRSs and its development. The chairman of IASB, Mr. Hans Hoogervorst, explained the removal of prudence concept was mainly due to the convergence with the GAAP of United States (Hoogervorst, 2012) Since the U.S GAAP did not have a definition of prudence concept, Mr. Hans Hoogervorst explained that many people had a feeling that the prudence concept was used frequently as a pretext for cookie jar accounting system. However, the reason provided by IASB for the exclusion of prudence concept as a result of convergence with US GAAP has been highly criticized and questioned as explained by DePree (2011). Many feel that this is not a justifiable reason enough for the removal. IASB conclusively excluded the concept of prudence since it the need for the concept’s principles to be completely unambiguous. It can, therefore, be concluded that the old concept of prudence is not dead but rather still alive and kicking indeed (Barry Elliott and Jamie Elliott, 2013). In a debate relating to the exclusion of prudence concept, some stated that the prudence should not be reintroduced back to the conceptual framework. They provided a number of reasons as discussed below. There is lack of a common understanding on what prudence as a term means. The term is being interpreted differently by different parties. Therefore, the inclusion of the word in the Conceptual framework could likely lead to its inconsistent application (Mackintosh, 2014). According to Bouvier (2013), the exercise of prudence has a high possibility of leading to biases in the financial statements, and the term is of an inconsistency with neutrality. The exercise of prudence was also provided to be of a one period exercise, and this could lead to performance overstatement in the subsequent periods. Moreover, the concept of prudence was regarded by the users of financial statements to provide the management with the potential of being biased towards optimism and the concept’s adjustment. The users were, therefore, aware that prudence leads to greater financial subjectivity which makes assess of financial entity performance difficult. In addition, it was argued that prudence should not be applied by IASB when setting standards. It should rather be applied by regulators and investors when conducting an analysis on entities. One of the user groups, however, made a proposal that the support for many ways was a means of rejecting and reducing the measurement of fair value. It, therefore, supported that having an open debate on fair value would be more useful than having to debate about it indirectly through prudence (Fukui, 2007). On the hand, there were many user groups of financial statements who commented and debated on the issue of prudence exclusion stating that the concept should be reinstated. They also provided a number of reasons for the reinstatement as follows. They argued that prudence was a concept being used both in the proposed and existing standards. It is of importance therefore to be included in Conceptual Framework explanation so that it is and can be consistently applied. Another support was that prudence is needed during the counteraction of natural biases by management towards optimism. Also, investors have been proved to be more concerned about the risk the principle of upside potential as stated by Bouvier (2012). Prudence is the most viable concept that can be used to address this concern as explained by Bouvier (2012). There is a suggestion by the Academic Research that conditional conservatism has a role to play in the process of financial reporting. Conditional conservatism is a principle concept that is concerned with more timely losses recognition than gains. Prudence was in addition supported for reintroduction as being an exercise that helps in the aligning of shareholders and managers interests which help reduce moral hazard. Consequently, prudence has also been demonstrated for its need by the financial crisis users in processes of making estimates. After the removal of prudence from the Conceptual Framework, a number of different interpretations for the word prudence were debated. The interpretations included the following. Prudence is a caution under uncertain conditions. This was an interpretation made by those proposing for the reinstatement of prudence. They suggested that the pre-2010 prudence definition should not be used. Prudence is a different threshold of recognition for liabilities and assets. Prudence was regarded as having the greater-need-evidence relating to the existence of income and assets than for expenses and liabilities. Prudence was referred to as having more timely expenses and liabilities recognition than of income and assets. It was explained as a conservative bias in measurement and recognition (Lugo 2010). Prudence provided that gains that are unrealised should not be recognized. Prudence was interpreted to allow for recognition of losses as early as possible. Finally, prudence was interpreted as a state of mind and not a financial information characteristic. Many respondent users of financial information stated that in a case where prudence is reintroduced into the Conceptual Framework, then IASB needs to define the term’s meaning clearly. As to those who view prudence as the caution exercise under uncertain conditions, they state that prudence should be clarified to not mean the following. Prudence should not mean the overstatement of liabilities and losses systematically (Lugo 2010). It should not also mean the understatement of income and assets. It should not also mean the smoothing of profits reported. Prudence should not be regarded as a prohibition on the fair value measurement usage. It should as well not mean Prudence as exercised by regulators who are prudential. The supporters for the prudence reintroduction expressed the view that prudence exercise is not necessarily incompatible with neutrality concept. Some of them however questioned whether financial reporting neutrality is appropriate or achievable. ASAF (Accounting Standards Advisory Forum) made a discussion on the concept of prudence in a September 2013 meeting. Most members of ASAF stated that it was considerable for IASB to at least debate about the reintroduction of prudence notion in the conceptual Framework. They however agreed that prudence as a term can have different meanings to different people. So it was paramount for IASB to clearly define the meaning of the term (Marthinus, Gerber, & Alta Van, 2014). ASAF members agreed that the prudence exercise should not be allowed to result to systematic financial statement biases. Many ASAF members instead proposed that the description of prudence should be like the exercise of caution under conditions with uncertainty. Some members of ASAF stated that if prudence is to be introduced then it should only be done so under a condition of providing better information to financial statement users (.Jeffrey, 2013) Others also stated that prudence should only be reintroduced into Conceptual Framework if steps are taken in ensuring that it would not create earnings management opportunities. On the contrary, some members questioned if the prudence reintroduction would have practical effect of any nature to the decisions of IASB. These ASAF members were rather for the argument that standard setting for same outcome is possible to be achieved by focusing on users’ needs. And not focusing on the reintroduction of prudence. Many respondents in the debate of prudence exclusion commented that preparers should exercise prudence under three situations. First is when making a selection on an accounting policy, for instance, when a choice of an accounting policy is provided by a Standard. Second, is when an accounting policy is being developed in situations where there are no specific application Standards. Thirdly, is a situation where accounting requirements of particular Standards are to be applied. The impact of IASB Conceptual Framework to financial reporting occurs mostly in the situations of hyperinflation. Hyperinflation is stated in economics as the situation when money loses its purchasing power at a rate that makes the comparison of amounts from transaction that have occurred misleading. Such transactions can be those within the same periods or even the same period. In such periods, the IASB impacts the financial reporting by making the principle of IAS 29 demands that the preparation of the financial statements in the hyperinflationary currency economy. It also requires that the financial statements date and the previous periods corresponding figures be stated in the same terms as well. IASB impacts the financial reporting in cases of estimating future developments. In this case, there is an emergence of mixed picture as a result of trying to foresee the future financial reporting changes and price level changes. The profession of accounting has been reluctant in abandoning the concept of HC since it favors the approach of valuation accounting (El Khatib & Sayed, 2014). In UK and Australia for instance, many businesses and companies have stopped their revaluation of non-current assets with a large proportion. This is because of the IASB impact created on financial statements making the companies to opt instead to revert to the historical cost basis. This is because the IASB impact has caused two main which influence the decision of management, those are, future flexibility in reporting and cost effectiveness (Dick & Walton, 2007). On the hand, the impact has caused pragmatic approach to be of prevalence. Each class of asset and liability is being considered on a basis of individual approach. For instance, liabilities are reported at an appreciated replacement cost unless if the cost is not higher than the economic value. Financial assets and liabilities are reported in market and economic value respectively. The liabilities are also reported at a higher of HC and NRV. In each of the liabilities and assets reporting cases, both the unrealized and realized changes in value always find their way into the financial performance statements reporting (Barry Elliott and Jamie Elliott, 2013). Conclusion In conclusion, the progresses that have been made by IASB especially the introduction neutrality concept and developing of suites of IFRs are worth recognizing and appreciating. This is because such progresses improve the performances of financial users. The users of financial information and reporting entities around the world are enabled to report effectively and efficiently to both the stakeholders and capital providers in equal manner. Nevertheless, there are still a number of conceptual issues that are needed to be conclusively addressed by the IASB. With this in mind, I propose that IASB should foster amendment proposals to the chapters dealing with the qualitative useful financial information characteristics and the financial reporting objective. This will ensure that IASB continue to get support from institutional investors. Also, such amendment will serve to strengthen the IFRSs frameworks significantly as well as ensuring that the resultant financial statements and reports are fit for purpose by users. 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