In believe we should adapt to suit

In this report, I will be critically
discussing the role of prudence in the preparation of financial statements,
whether and in what form prudence should be considered as a qualitative
characteristic providing reasons to justify my opinion. I will be supporting my
answer with relevant examples and references.

Prudence

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The prudence concept is an accounting principle
that requires an accountant to record liabilities and expenses as soon as they
occur and to record revenues only when they are assured. (1.0) This concept has
been around for many years and many experts believe we should adapt to suit the
needs for this century because they believe this concept is outdated and it
leads to understatement, though some experts believe prudence is fundamental
when it comes to recording your financial statements. (2.0) However, there is 2
different definitions of prudence which I am going to analyse. The first
definition is the
deliberate understatement of assets and profits, or the deliberate
overstatement of liabilities and expenses. (3.0) The second definition is the
inclusion of a degree of caution in making the estimates required under
conditions of uncertainty, such that assets and income are not overstated, and
liabilities and expenses are not understated. All long-term assets (LTAs) – except land – have a finite life, when the
economic benefits from the LTAs would cease. Prudence demands that this matter
should be recognised by writing off in each accounting period a proportion of
the LTA’s cost to represent the economic benefit consumed during the period
which ensures asset values are not over-stated.

Some experts would believe prudence is irrelevant because it
creates a sense of uncertainty within the business when it comes to making the
financial statements. Such doubts are recognised by the disclosure of their
nature and extent and by the exercise of prudence in the preparation of the
financial statements. (4.0) 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. This is because prudence is the
inclusion of liabilities and expenses recorded in the financial statements
which is then viewed by the directors/shareholders which they can then make
estimates required for the next financial year. So, because of this, the income
or assets cannot be overstated, and the expenses or liabilities cannot be understated.
However, the exercise of prudence does not allow 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. Prudence is consistent with
neutrality. Uncertainty may allow management the opportunity to be
over-optimistic in their measurement of net assets, then a requirement to be
prudent may simply be a caution to be neutral in the sense of framework
neutrality. This means that gains and losses should be treated unevenly, such
that a given level of uncertainty might lead to recognition of the latter but
not the previous. (5.0) This is not neutrality but instead bias, because it is
indeed intended to influence the making of a decision or judgement to achieve a
predetermined result or outcome.

(6.0) The qualitative characteristics of financial
information, as set out in the conceptual framework is the International
Accounting Standard Board (IASB) which is fundamental for standard setting and
are intended to be used by firms when they make certain accounting decisions, policy
choices and policy changes. For accounting information to be useful, it must be; Relevant,
capable of making a difference in the decision to be made, it
must have predictive or confirmatory value or both, a
faithful representation of what it is to present, and it must
be complete, free-of-error and neutral. The usefulness of financial information is
further enhanced if; It can be compared with other entities or
overtime, it can be verified through observations, estimation etc, if it increases
representational faithfulness, if it is at the right time given the
decision that is to be made, if it increases relevance, if it is understandable
and sometimes, more complex information needs to be included for
completeness even if it isn’t completely understandable. The qualitive characteristics for
prudence are as follows, appropriateness to use, disclosure of significant
relationships, inclusion of environmental information, uniformity of practice
within and among entities, and consistency of practices through time. Many of
them are to be seen in the later frameworks of the IASB and the Financial
Accounting Standards Board.

(7.0) A good example of how this concept affects
accounting practice is the basic rule that stock should be valued at the lower
of cost and NRV. Where NRV is above cost, the profit is likely to arise which
is ignored and stock remains in the accounts at the lower figure until the sale
occurs, i.e. revenue is not anticipated. On the other hand, where NRV is below
cost, stock must be immediately restated at the lower figure so that full
provision is made for the foreseeable future loss. (2.0) Approval of a prudent
approach to profit measurement is based on the potential dangers of an
over-optimistic calculation that may be used as the basis for an excessive
distribution of funds, to ownership, that deprives the business of much needed
resources. Another possible pitfall is that an attractive presentation of the
current position, not justified by the underlying facts, may cause management
to expand the level of operations wrongly and incur heavy losses.

Prudence enhances
the usefulness of company’s financial statements by clearly stating where the
company has lost money and where it has earned money. It does this by showing
you clearly in a clear format where you’re spending the most/least money on.
With this information, you can use this to benefit the company. (4.0) For
example, when you make your financial statements through prudence, you can see
you might be paying too much on one expense, so you would alter the amount you
use this expense so that this amount decreases, which would mean your company
would save some money which you can use to improve the company and to also
carry on growing through the different markets. Prudence has a positive effect
on several types of employees within an organisation. (5.0) The different types
are; accountants, directors, managers and shareholders. These types of
stakeholders can use the information gathered from their financial statements
for their benefit so that they can improve the company in the department that
they are in. For example, accountants would benefit from prudence because of
bad debts. (7.0) Bad debts are
possible in many businesses, so prudence creates a new expense in the financial
statements called ‘bad debts’ which brings the accounts receivable balance to
the amount which is expected to be realized which then prevents overstatement
of assets. An expense called bad debts expense is also booked to stop net
income from being overstated. (1.0) This is one-way prudence affects several
types of stakeholders positively. However, prudence can also affect the
business negatively. (3.0) For example, if you are not careful with prudence,
you can overstate your
liabilities and understate your assets which may lead to a false impression of
the organisation being in a worse financial position than it is. This might put
off potential investors meaning the company would stop growing and progressing
through the market. (6.0) This also means the financial statements will no
longer be neutral which can disrupt the companies’ future business if the
financial statements are incorrect. This is because the shareholders might
think they have more money than what they have so because of this, they would
think they can improve the company, however this wouldn’t be the case and they
could possibly go bankrupt.

Conclusion

In
conclusion, I believe prudence is very effective in today’s world of business.
This is because prudence allows the company to be cautious on potential bad
debts meaning the company can consider money they might not get. With this,
they can use this money they will be saving for their own benefit to improve
the company by either opening a new product line or expanding one of their
departments. Without prudence, I believe company’s financial position and financial
statements would be unprofessional and it wouldn’t be clear and precise. This
is because with prudence, you can clearly see where you are spending money and
where you are not spending money which you can use for your benefit. Prudence avoids
overstatement of assets and understatement of liabilities which is good because
both would lead to an overstatement of profit.