A year ago, when it replaced SSAP 2 withFRS 18, Accounting Policies, the Accounting Standards Board decided to relegate prudence from the premier division of fundamental accounting concepts. This would have pleased the late Professor David Solomons, who always maintained that even if prudence might be a desirable characteristic of financial management (currently much favoured by the chancellor of the exchequer), it was not a merit of financial reporting.
Any overuse of prudence results in a loss of transparency, which is why the ASB is right to be wary of it. When it is excessively or inconsistently applied, it can make obfuscation of results and trends possible. One celebrated example of this arose in 1993 when Daimler-Benz first went to the US capital markets and had to reconcile its German GAAP accounts to US accounting principles. The previously reported German GAAP profit of DM168m for the first half of that year was restated as a US GAAP loss of DM949m. At the time this confused many commentators, who were familiar with German accounting's reputation for conservatism, but were not sophisticated enough to understand that this could be exercised to smooth reported results up as well as down. What had happened was that the German GAAP performance reported for that period had been helped by the release of hidden reserves built up in earlier years.
Another potential abuse of prudence is the new management syndrome. When new managers are appointed to replace the sacked directors of a company that is in dire straits, they are sometimes tempted to over egg the write downs made, with the dual effect of further vilifying the departed directors and conveniently disposing of a lot of debits that would otherwise be expensed in future profit and loss accounts under their own period of stewardship. The City generally applauds such apparently hair-shirted behaviour, but doesn't fully understand its side-benefits for the new management and their incentive schemes.You can't ignore it
It is not surprising, therefore, that the ASB saw prudence as something that had to be reined in when SSAP 2 was being replaced. The difficulty it faced, however, was that SSAP 2's fundamental concepts were echoed in company law, and could not readily be dispensed with. Prudence in particular is linked to the realisation principle, expressed in the Companies Act in these terms: 'the amount of any item shall be determined on a prudent basis, and in particular only profits realised at the balance sheet date shall be recognised in the profit and loss account'. The wording in SSAP 2 was similar although not identical.
The ASB is actually pretty lukewarm about the realisation principle as well, but unless and until the law is changed it can't ignore it, so it has decided to treat prudence and realisation as separate matters.FRS 18 continues to endorse the realisation principle, as a legal requirement that must be observed, but no longer regards this as supporting the SSAP 2 notion of prudence. Instead, while prudence is still referred to in FRS 18, it is now regarded only as a subset of ' reliability', not as a fundamental concept. The standard asserts that 'financial information is reliable if . . . under conditions of uncertainty, it has been prudently prepared (ie, a degree of caution has been applied in exercising judgment and making the necessary estimates)'. Confusingly, the same paragraph also says that 'financial information is reliable if . . . it is free from deliberate or systematic bias (ie, it is neutral)'. Since it is impossible to be both prudent and neutral at the same time, these two statements are hard to reconcile.
This attempt to downgrade the significance of prudence doesn't really do justice to its enduring importance within UK accounting practice. In all sorts of situations, many of them enshrined in accounting standards, we are required to recognise losses more readily than gains. We write stock down, but not up, to its net realisable value; we similarly recognise impairment losses on fixed assets whenever their recovery has become doubtful; we provide for contingent losses as soon as they become probable, but do not recognise contingent gains until they are virtually certain; and so on.
And apart from these explicit rules that differentiate the timing of when to recognise good and bad news, all our professional instincts guide us into making conservative estimates about future events - and a good thing too, provided it is done with integrity and good judgment. We don't do any of this in order to make the balance sheet more ' reliable', as suggested inFRS 18, but deliberately to err on the side of caution, imposing a systematic bias - a conservative view - rather than stating a neutral position. This is such a deeply embedded feature of UK accounting practice that it really does deserve to be called a fundamental concept, whether or not the ASB still acknowledges it as such. Naive hope
Some consider that a greater use of fair values as the basis of accounts would remove any problem of excessive prudence, in the belief that market values will be less susceptible to manipulation. This, however, seems a rather naïve hope; there is likely to be at least as much subjectivity in determining fair values as there is in applying prudence to historical cost-based figures. It is up to auditors, not standard-setters, to ensure that prudence is kept within proper bounds and not exploited in a manipulative way. The role of standard-setters is only to state the principles that govern its use, andFRS 18 could have done this rather better.
Ron Paterson is an independent consultant on financial reporting and an honorary professor at the University of Glasgow.