The International Accounting Standards Board

21 November 2015

Mr Hans Hoogervorst

Chairman

The International Accounting Standards Board

IFRS Foundation

30 Cannon Street

London EC4M 6XH

Dear Hans

IASB Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting

I am pleased to submit the comments below, relating specifically to the treatment of prudence in the conceptual framework.

Kind regards,

Richard Barker

Professor of Accounting

Prudence in the Conceptual Framework

1.  What is Prudence?

The term ‘prudence’ gets used in different ways, with different meanings. It is important, therefore, to be clear about definition. In particular, there appear to be two distinct concepts of prudence that are prominent in the debate around the conceptual framework.

The first definition is the version described by the IASB itself – let’s call this ‘IASB Prudence’ - according to which prudence is not inconsistent with neutrality but can instead be seen as a mechanism for ensuring neutrality, for exercising careful judgement in ensuring that accounting is neutral. Note that ‘neutral’ can be interpreted here to mean selecting and applying measurement attributes in a way that is free from bias. So, for example, the IASB has selected a recoverable cost basis for inventory under IAS 2, and in that context an entity’s accounting is neutral when this basis is applied, even though the market value of the inventory is unrecognised if it exceeds cost, yet recognised when it falls below. It follows that neutral accounting need not be symmetric, in the sense that gains and losses are equally likely to be recognised (Barker, 2015).

The second definition is that which describes the more traditional interpretation of prudence in accounting practice – let’s call this ‘Conventional Prudence’ - according to which prudence is the application of a higher threshold of verifiability for the recognition of gains than for losses. According to this definition, prudent accounting results from asymmetry in recognition criteria (with recognition more likely for liabilities than assets), or else from asymmetry in the application of any given measurement attribute (with loss recognition more likely than gain recognition).[1]

The application of conventional prudence results in a lower carrying amount of net assets than the application of IASB prudence. It is important, however, to understand the nature of this difference. In particular, it is important to address the question of whether conventional prudence implies a downward bias in net asset value and whether it is therefore inconsistent with neutrality.

A first observation is that conventional prudence does not mean that there should be a systematic bias towards undervaluing all assets and overvaluing all liabilities: it is not a carte blanche for a misleading understatement of net assets. As set out in Table 1 below, the concept of conventional prudence applies only where there exists significant uncertainty in measurement, and even then only when the uncertainty concerns gains as opposed to losses. ‘Uncertainty’ here means that any carrying amount under consideration is an estimate that would be difficult to verify, in that there is significant subjective judgement in determining the carrying amount at the balance sheet date.[2] Conventional prudence does not in principle allow either a deliberate understatement of gains in the absence of uncertainty or, under any circumstance, the deliberate overstatement of losses; in each of these contexts, there is no difference in accounting between conventional prudence and IASB prudence. Rather, the purpose of conventional prudence is to defer the recognition of gains that are subjectively estimated (i.e. ‘uncertain’) at the balance sheet date and that therefore can neither be verified nor relied upon, and it is in this context only that accounting under conventional prudence is different from accounting under IASB prudence.

Table 1: the scope of Conventional Prudence
Uncertainty: is it difficult to verify the carrying amount?
No / Yes
Assets/Gains / Timely recognition / Deferred recognition
Liabilities/Losses / Timely recognition / Timely recognition

The test case, therefore, is when economic gains are uncertain. In this context, net asset values under conventional prudence cannot be higher than they would be under IASB prudence, and are likely instead to be lower. Whether or not this difference amounts to bias depends upon how the concept of neutrality is understood, because it is against the benchmark of neutrality that the presence of bias is determined. Noteworthy, therefore, is that neutrality could in principle be interpreted in at least three different ways. The first is that neutral means that the carrying amount of an asset is an unbiased estimate of its economic value. This is the notion of neutrality that might most commonly be applied in domains other than accounting, but it is not the sense in which neutrality in accounting is usually interpreted. (Neutrality does not imply a ‘full fair value’ balance sheet.) A second meaning is that recognition and measurement criteria are applied equally to assets as to liabilities, to gains as to losses. Yet we have seen already that recoverable amount fails this test, and so again this not a helpful interpretation for accounting. Third, neutral could just mean that IFRS is specified and applied without prejudice, without distortion that influences users of accounts. On this view, neither IASB prudence nor conventional prudence is biased. This is because, while each form of prudence differs in the recognition and measurement criteria determined by the IASB, they do not differ with respect to whether the design and implementation of accounting standards has a distorted influence on users. Hence, while the carrying amounts could differ, either approach may be described as being consistent with neutrality.

The key difference to explore between the two concepts of prudence does not, therefore, concern neutrality per se, but instead whether there is a role for the delayed recognition of gains under conditions of uncertainty. In addressing this question, the structure of this note is as follows: first, the note reviews how the concept of prudence in the Framework has evolved, from inception in 1989, through revision in 2010, and how ambiguity in definition existed throughout this period; second, it is argued that the 2015 ED ended the ambiguity, but did so by unhelpfully identifying prudence with neutrality; third, the theoretical and practical case for conventional prudence is reviewed; fourth, arguments against conventional prudence are evaluated; finally, recommendations are made for the treatment of prudence in the Framework.

2.  Ambiguity in the pre-2015 Framework

In the original (1989) version of the IASB’s Framework, prudence was described (in para. 37) as an aspect of reliability. Immediately prior to that description, in para. 36, was a description of neutrality, which is important in setting the context for the subsequent discussion of prudence. The full text of both paragraphs is as follows.

To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgement in order to achieve a predetermined result or outcome. (para. 36)

The preparers of financial statements do, however, have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collectability of doubtful receivables, the probable useful life of plant and equipment and the number of warranty claims that may occur. Such uncertainties are recognised by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability. (para. 37)

A first point to note is that the description of prudence in para. 37 makes a distinction between, on the one hand, ‘the deliberate understatement of assets or income, or the deliberate overstatement of liabilities and expenses’ and, on the other hand, ‘the inclusion of a degree of caution in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.’ The first of these two components is entirely in line with both IASB prudence and conventional prudence, both of which rule out the deliberate understatement of assets or income, and also the deliberate overstatement of liabilities or expenses. With respect to the second component, however – which concerns the specific question of the deferred recognition of uncertain gains - it is less clear whether the 1989 Framework is an expression of either IASB prudence or conventional prudence; it could be interpreted either one way or the other.

On the one hand, prudence might be interpreted as being consistent with timely, neutral gain recognition. If uncertainty allows management the opportunity to be over-optimistic in their measurement of net assets, then a requirement to be prudent may simply be an admonition to be neutral, in the sense of not exploiting the inherent subjectivity in applying accounting standards in order to overstate net assets. In other words, prudence means guarding against over-optimism, and ‘caution … that … assets and income are not overstated’ simply means taking care to ensure neutrality. On the other hand, the ‘however’ at the start of para. 37 can be taken to qualify the meaning of neutrality in para. 36, such that ‘caution … that … assets or income are not overstated’ but that ‘liabilities or expenses are not understated’ means that gains and losses should be treated asymmetrically, with the possibility that a given level of uncertainty leads to recognition of the latter but not the former. In other words, prudence means a higher threshold of verifiability for gains than for losses, such that there is a trade-off between prudence and timely gain recognition. In this context, it should be noted that para. 37 does not recommend ‘caution … that … liabilities or expenses are not overstated’ and that ‘assets and income are not understated.’ Instead, the language is explicitly concerned with an asymmetry, with the possibility that net assets might be overstated, and implicitly therefore unconcerned with the opposite possibility that they might be understated. This can be seen as erring on the side of cautious understatement: if the gain is uncertain, don’t recognise it, but recognise a loss even when it is difficult to estimate.

The IASB’s decision, in 2010, to remove para. 37 from the Framework, and along with it any reference to prudence, could again be interpreted in either of the two ways just described. On the one hand, it could be viewed as a simple tidying-up of what was always intended in the Framework. On this view, it was unhelpful that the reference to prudence could be interpreted as an invitation towards the biased understatement of net assets, meaning that its removal simply clarified that the aim is neutrality. In particular, as it might have appeared that the Framework was internally inconsistent in requiring both neutrality and bias, the removal of this anomaly enhanced the Framework’s ostensible conceptual clarity. On the other hand, however, the removal of prudence could be seen as fundamentally changing the Framework, because the notion of a trade-off between prudence and timely gain recognition was no longer entertained, and because neutral was thereby (re)interpreted as not being (conventionally) prudent.

It is perhaps not surprising, therefore, that there is a degree of confusion about the interpretation of prudence, both by the IASB itself and by its stakeholders, in both the 1989 and 2010 versions of the Framework.

3.  Prudence in the 2015 ED

In contrast with this ambiguity in 1989 and 2010, however, the reintroduction of prudence in the 2015 ED was clearly in the form of ‘IASB Prudence’. With no explicit acknowledgement of the presence of uncertainty, the 2015 reintroduction included the statement that ‘the exercise of prudence is consistent with neutrality and should not allow the overstatement or understatement of assets, liabilities, income or expenses.’ This insistence that ‘prudence is consistent with neutrality,’ along with the symmetric application to ‘overstatement or understatement,’ seems to rule out the asymmetry of a higher threshold of verifiability for recognising gains than losses.

This approach is, however, fundamentally flawed. The reason is that it introduces a ‘concept’ into the Framework that is not really a concept at all. At best this achieves nothing; at worst it leads to confusion. The problem is that prudence is in substance defined in a way that adds nothing to the concept of neutrality; as defined, prudence essentially means ‘make sure to be neutral’. Given that the Framework defines neutrality already, there is nothing to be gained from the introduction of an additional ‘concept’ that has no distinctive meaning. This is not to say that neutrality and prudence mean the same thing; indeed, neutrality is a broader concept than IASB prudence. Rather, the point is not that the concepts are the same, but instead that there is nothing to be gained, conceptually, by introducing the concept of prudence in addition to that of neutrality, because it does not lead to any conclusion that would not anyway be reached by the application of neutrality. Moreover, the presence of two terms and definitions that lead to the same conceptual outcome invites unavoidably fruitless attempts to understand why and how one differs from the other.

An additional concern is that, because ‘prudence’ means different things to different people, the ‘reintroduction’ of prudence is likely to be misunderstood as an accommodating response by the IASB to demands that the Framework should embed prudence as conventionally understood. Such demands were evident in numerous comment letters on the 2010 Framework revision (and see also EFRAG, 2013). In this context, the IASB’s use of a common term to convey an uncommon meaning is at best unhelpful. At worst, though, it signals problems down the road, as stakeholders become aware that the reintroduction of prudence did not actually mean the reintroduction of (conventional) prudence.