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IPE special report May 2018

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Accounting Standards: Prudence redux

The International Accounting Standards Board says it has listened to long-term investors and is considering the reintroduction of the concept of prudence into its conceptual framework. Stephen Bouvier reports

The Conceptual Framework for International Financial Reporting Standards (IFRS) starts with the premise that the objective of what the International Accounting Standards Board (IASB) calls general purpose financial reports is to provide information that can help when making decisions. That is, information that is “useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity”. 

Those decisions capture such activities as buying, selling or holding equity and debt instruments, as well as providing or settling loans and other forms of credit. The IASB now wants to add a reference to “[investors’] assessment of management’s stewardship of the entity’s resources” and also reintroduce prudence as a characteristics of useful financial statements.

The Conceptual Framework, as well as defining the objective of general purpose financial reporting, also details two fundamental qualitative characteristics of useful financial information – relevance and faithful representation.

Under these two characteristics are four so-called enhancing qualitative characteristics – comparability, verifiability, timeliness and understandability. Putting all those pieces together, financial information will be useful, if it is relevant – that is, has a predictive and confirmatory value based on the nature or magnitude, or both, of the item it relates to – and faithfully represents what it purports to represent.

In other words, it must be complete, neutral and free from error. Moreover, the usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. This has been the position under the IFRS Conceptual Framework since 2010. 

The Framework was first approved by the IASB’s predecessor, the IASC Board, in April 1989. The IASB adopted it in April 2001. Then in September 2010, the IASB revised the objective of general purpose financial reporting and the qualitative characteristics of useful information. The move was driven largely by the rush to converge the Conceptual Framework with the position in the US.

One of the casualties of that stalled convergence effort was prudence. The IASB’s roadmap for killing off prudence is set out in gory detail in a May 2005 IASB meeting paper. In paragraph 13 of that paper, the IASB staff team wrote: “Reliability is said, in FASB Concepts Statement 2, to comprise representational faithfulness, verifiability, and neutrality, with an overlay of completeness, freedom from bias, precision, and uncertainty. It is said in the IASB Framework to comprise faithful representation, substance over form, neutrality, prudence, and completeness.”

The problem facing the staff – and indeed the board – was that although they took the view that “the inclusion of neutrality [was] a non-issue”, it clashed with the accounting traditions of prudence and conservatism. And, if anything had to give back in 2005, it was never going to be neutrality. Staff explained: 

“You might detect some lack of neutrality in the staff‘s choice of words in that last sentence, which of course is intended to influence your decision on the next cross-cutting issue in order to achieve a recommended, though not predetermined, result! That heavy-handed humor is actually intended to remind you of the need for and value of neutrality in financial reporting standards.”

The American-English spelling of humour is perhaps no accident. First, against the backdrop of the rush to converge, it was a foregone conclusion that the IASB would land on an aligned position with the FASB’s definition of neutrality – the absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behaviour.

And the decision to dump prudence was really the kind of arcane development in accounting that it was, no doubt, easy to overlook. Back in 2005, the global economy was booming: banks were too big to fail, so it was thought, and politicians had abolished boom and bust. 

But for some investors at least, prudence does matter. In a letter to the Financial Times dated 16 February 2015, one group of investment luninaries, among them Iain Richards of Threadneedle Investments, as well as Roger Collinge of the UK Shareholders Organisation, repeated their long-standing demand for the IASB to bring back prudence – as an overriding accounting principle. 

The investors wrote: “Most importantly, prudence should be restored as the overriding accounting principle so that capital and performance are not overstated. The breakdown of realised and unrealised income should be visible to all.

“They [IASB] are developing standards that suit the profession but they are not setting standards with any consideration as to how they might be audited. Put another way, they have ignored long-term investors, which means they have also ignored most of the pension funds and written, instead, accounting standards for day traders” Stella Fearnley

“These changes are not just vital for effective stewardship by executives, directors and shareholders; they are necessary to bring the accounting framework back into line with existing legal requirements for capital protection as originally set out in the EU’s second directive.”

But not every investor shares this vision. Former UBS sell-side analyst-turned-IASB member Stephen Cooper recently wrote in an IASB publication: “It is also important to remember that applying a conservative bias would be likely to provide investors with information that is less relevant for their capital allocation decisions, unless somehow they knew the degree of bias being applied and could therefore make their own corrections.”

The solution, he concluded, is to “apply IFRSs in a prudent but neutral and unbiased manner”. And so in its latest proposals to amend the Conceptual Framework, the IASB has proposed to reintroduce prudence in the following terms: “Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated.

Long-standing IFRS critic Stella Fearnley, a professor of accounting at Bournemouth University, says the IASB has lost sight of the true purpose of financial reporting: “You have to ask yourself what matters about audited financial statements? You want to be able to believe the numbers in them, you want to be able to believe the audit report, and you want to believe that the accounts show the economic substance of the business. In other words, you want to be sure that the profits really are profits and the assets really are assets. And if that is your destination, I don’t think you get there by talking about accounts being neutral or faithfully representated.”

“If you step back from the May 2005 meeting paper, you have the feeling that the IASB is not overly concerned with the consequences of its standards. It is as if they are in a hot air balloon talking about debits on pinheads. They are developing standards that suit the profession but they are not setting standards with any consideration as to how they might be audited. Put another way, they have ignored long-term investors, which means they have also ignored most of the pension funds and written, instead, accounting standards for day traders.

Professor Fearnley says that the IASB, back in 2005, was hunting around for a justification for the conceptual model it was determined to bring in: “They have elevated the status of decision-usefulness but totally ignored stewardship. However, that is all about whether directors are running a business properly and discharging their own duty or not.

“And so we end up with ‘relevance’ and ‘faithful representation’ as if they were some sort of alternative to reliability. Similarly, we have verifiable information, although that isn’t much use if you verify it to something that is unreliable – like the banks’ valuation models.” 

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