Despite criticism, accountancy regulator’s chairman says the downgrading of prudence from a fundamental concept is justified
The IASB has come in for increasing criticism in light of its supposedly relaxed approach to governing how companies report their yearly finances, but reforms have been underway over the last few years. Spearheaded by Chairman Hans Hoogervorst, who took the reins of the organisation in July 2011, the IASB is reviewing its conceptual framework so that it can efficiently develop and rewrite the International Financial Reporting Standards (IFRS).
One contentious issue is the emphasis placed on prudence in reporting standards. Previously a fundamental accounting concept, prudence ensured that companies only reported anticipated gains in their accounts if these were almost certain to happen.
The IASB has now relegated prudence from a fundamental concept to merely ‘desirable’, as a means to stop companies from creating hidden reserves that might be used to cover up losses. Hoogervorst told reporters: “Prudence was often being used for excessive conservatism, for the creation of hidden reserves which can be released in bad times, creating a problem with earnings management. It sounds conservative to create these reserves, but if they are used to cover up losses in bad times, they are far from prudent.”
While prudence ensures that companies can only report proven gains, the downgrading of the concept means that research costs might be able to be capitalised in accounts.
Companies could, in theory, beef up their accounts with research costs that may result in an unsuccessful project.
Hoogervorst says that the downgrading of prudence prevents conservative bias in reporting standards, and that neutrality was an essential part of how companies reported their accounts: “The meaning of prudence was that we don’t want a conservative bias in the standards and they have to be neutral, but if you are quite certain about an uncertain outcome of a measurement, you better err on the cautious side.”
In the UK, there has been concern about the relegation of prudence, with the House of Lords releasing a report in 2011 calling for its reinstatement as a fundamental principle. The report also blamed the IASB for worsening the banking crisis that begun in 2008, saying that standards introduced in 2005 had “encouraged box-ticking and reduced scope for auditors to exercise judgement to reach a true and fair view.”
However, Hoogervorst maintains that the IASB still encourages companies to be prudent in their accounting practices, with many of the previous requirements maintained: “If you look at our standards, we still practice that. When a contract is loss-giving, we require it to be taken immediately. In our new revenue standards, we only allow recognition of revenue when a company is certain. We are now making an impairment standard that is much more forward-looking and requires banks to recognise losses even when they are not yet in default. We are quite prudent.”