Bac304 Advanced Accounting Theory | Assessment Answers

Scenario:

When Australia moved to IFRS in 2005, the IASB’s 1989 Framework for the Preparation and Presentation of Financial Statements replaced the Australian systems of SACs 3 and 4. The IASB framework included a specific reference to “prudence” in 37-38 as part of the Qualitative Characteristics of Financial Statements.  Some viewed this to be in direct conflict with the goals of “neutrality” 36 and “faithful representation” 33-34.  Subsequently the 2010 update to the Conceptual Framework (CF) entitled “Framework for the Preparation and Presentation of Financial Statements” removed any reference to either prudence or conservatism. This new framework was adopted by the AASB on 1 July 2014.

This overturned 100 years of accounting assumptions since Paton’s (1916) seminal work in Principles of Accounting. Many in the profession expressed concern that this may open the door to overly optimistic reporting and thus potentially increase auditor’s liability.

The CF project is a work in progress, and the IASB is currently seeking public comment on their new Exposure Draft for the new CF. 

Requirements:

You are in the graduate rotation program at Big Phore Partners, currently your 6 month placement is with the Financial Analysis Team (Corporate Advisory Group). A heated debate has broken out between the partners on the matter of prudence. Mr Price (Executive Director of Audit), believes prudence is a cornerstone of financial reporting, but Dr Waterhouse (Executive Director of Corporate Advisory) believes it is critical that investors get “the right information” to make “the right decision”. Executive Chair Dr Coopers believes that the firm should have an internal debate to settle the matter, and subsequently the firm should make a formal submission to the IASB on the outcome.

You have been asked to draft the initial discussion paper for Board of Executive Directors:

Part 1 Internal Audience Directors’ Brief:

Outline the context of the change, and explain the arguments for and against the re-inclusion of prudence in the new CF

Part 2 IASB Audience ED:

A draft submission letter to the IASB answering to what extent does your firm support re-inclusion of prudence? 

Part 1: Internal Audience Directors’ Brief

To,

The Directors,

Big Phore Limited

Date: 05/10/2018

Subject: Arguments for and against the re-inclusion of prudence in the new conceptual framework

This is to highlight the attention that contradictory opinions are prevalent among the senior management regarding whether the principle of prudence needs to be included in the new conceptual framework. Some members perceive that prudence is the cornerstone of accounting and financial reporting, while the other members think that prudence might not provide crucial information to the investors for undertaking appropriate decisions.

This paper would emphasise on the concept of prudence and the benefits of this principal to the auditing process and the ways through which prudence would assist the organisation in making more money. In the words of Baker and Burlaud (2015), prudence could be seen as something, which needs to be embedded in the standards. However, the preparers need to exercise it when those standards are applied. Moreover, this principle compels the accountants to think on conservative lines, in which all the likely expenses and liabilities would be recognised; however, the recognition of assets and income is made only when they are realised or assured.

Certain arguments are put forward against the prudence principle and the main issues include comparability and neutrality of the resulting financial reports. For instance, professional investors like Chartered Financial Analysts (CFA) would like the management to disclose the actual results transparently, which should free from bias and they would be neutral to good news as well as bad news (Barker and Teixeira 2018). In the presence of uncertainties, the investors would want the best estimate of the management supported by adequate disclosures based on which the estimate has been prepared.

It has been identified that prudence might hold profits back in a year and this restraint might result the release in a subsequent year due to which exaggerated results might be published. For instance, Daimler Benz’s restatement of profit record from prudent German accounting to US GAAP for the New York listing signify the smoothing prudence effect (Barker 2015). Moreover, the Spanish banks as well as dynamic provisioning in the crisis are depicted as a further case, in which the prudent reserves have undermined the underlying weaknesses temporarily due to change in condition and delayed remedial measure.

The audit process would be complex; in case, material misstatements are inherent in the financial reports and hence, qualified auditors are needed for the audit process. The work of the auditors would increase and if prudence is not carried out effectively, the auditors would be held accountable for the failure of the organisation because of audit failure (Bauer, O'Brien, and Saeed 2014). For Mr. Price, the expectation gap could not be filled completely and the auditors would be blamed, if they undertake incorrect decision. This would impose direct threat to the reputation of the organisation. The integrity of the managers would be questioned and the investors might lose trust in the organisation leading to market failure (Cooper 2015). Difficulties would be encountered by the corporate advisory group in terms of providing client advice, as the biasness of the financial statements would increase. Finally, there would be additional regulations for controlling the accounting process from the end of the professional groups and thus, micromanage situation might take place.

However, there are certain points that are put forward in favour of including prudence in the new conceptual framework. Majority of the auditors and accountants would argue for including the prudence principle and it is adjudged as the cornerstone of modern accounting and financial reporting (Linsmeier 2016). This principle protects the interests of the small investors as well as those of the overall investor community. In case, this principle is not present, there might be realisation of uncertain income in the books of accounts and the value of uncertain assets might be reflected in the statement of financial position.

In addition, the organisations might switch over to the window dressing techniques under such situations and these might aggressively depict additional revenue, reflect additional assets and hide few expenses and liabilities from the financial statements (Macve 2015). Therefore, this might lead to loss of trust on the financial statements. For instance, if a bank provides loan to an organisation having absence of prudence in its financial statements and following aggressive mechanism of revenue recognition, it might pose problem for the bank. This is because the organisation might not be able to service the debt. Hence, for maintaining the interests of the debt service providers, minimising the chances of window dressing from the end of the company board and investors, prudence principle is crucial (Mora and Walker 2015). 

Therefore, based on the above evaluation, it could be stated that even though prudence has certain limitations, its benefits outweigh the drawbacks. Therefore, re-inclusion of prudence in the new conceptual framework would enhance the financial reporting quality of the business organisations.  

Part 2: IASB Audience ED

Big Phore Partners Level 99 101 Collins Melbourne VIC 3000 05/10/2018 Hans Hoogervorst, Chairman International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom Re: Exposure Draft ED/2015/3 Conceptual Framework for Financial Reporting Dear Chair Hoogervorst: On behalf of our clients and team at Big Phore Partners, we thank you for the opportunity to provide our comments on the International Accounting Standards Board's (IASB) Exposure Draft (ED) regarding Conceptual Framework for Financial Reporting (CF). Big Phore Partners appreciates the opportunity of commenting on the proposals of IASB in revising the conceptual framework in its existing exposure draft. The organisation supports the claims of IASB to update the framework so that completeness and clarity could be applied at the time of developing accounting policies. It is believed that the prudence is a positive leap for future standard setting and the comments of the organisation are associated exclusively to the below-stated question: 2 - Qualitative Characteristics of Useful Information  1-Proposed changes to Chapters: Do you support the proposal to reintroduce an explicit reference to the notion of prudence (described as caution when making judgments under conditions of uncertainty) and to state that prudence is important in achieving neutrality; Why or why not? Even though Big Phore Partners emphasise on broader data sources in its evaluation, the financial statements are considered to be valuable for financial analysis. From the perspective of the organisation, it is necessary that the other comprehensive income statement represents a fair view of financial position, which is free from bias.    According to the management, if a general prudence reference is to be re-initiated into the framework, there needs to be effective implementation examples and guidance in relation to its practical application. In the absence of practical guidance, it is believed that asymmetrical bias risk could be introduced by the management at the time of applying the prudence principle. This could provide opportunities in managing financial reporting earnings (Penman 2016). It is recognised that the prudence principle has limited and particular use in relation to financial reporting. For instance, prudence has particular and suitable application in IAS 37 in order to gauge and measure contingent assets and contingent liabilities and the case is similar in IAS 38 for protecting internal goodwill recognition and setting stringent criteria for realising development costs (Sutton, Cordery and Van Zijl 2015). However, more particularly, the prudence and neutrality principles are not compatible with each other all the time. There could be relation between conservative accounting and prudence leading to conservative reporting bias and this might compromise neutrality while preparing the financial statements of the organisation (Tracey 2015). From the perspective of the organisation, the neutrality principle needs to be overreaching, since accounting should depict the underlying events and transactions with fair and true overview not containing any bias. Due to this reason, it is necessary for IASB to incorporate implementation guidance with instances about the practical prudence application, in which a particular interpretation or standard could not be applied. Thus, the conceptual framework would be dependent on formulation of accounting policy (Van Mourik 2014). According to the view of Big Phore Partners, this would be beneficial in assuring that the initiation of a general principle of prudence in the framework is not violated or leads to asymmetrical bias. Any conservative moves for assuring solvency, which the voluntary management intention or prudential regulation mandates, needs to be addressed ideally from the perspective in equity. This is conducted either through developing non-distributable reserves or application of policies related to capital management (Watts and Zuo 2016). Moreover, Big Phore Partners is of the notion that that prudence in conceptual framework has direct association with corporate governance. As per the opinion of the management, conservatism and prudence are critical to the overall functions of corporate governance. Therefore, it is essential for IFRS to rake into account these aspects in future standards of accounting. Moreover, majority of the auditors and accountants would argue for including the prudence principle and it is adjudged as the cornerstone of modern accounting and financial reporting (Zhang and Andrew 2014). This principle protects the interests of the small investors as well as those of the overall investor community. In case, this principle is not present, there might be realisation of uncertain income in the books of accounts and the value of uncertain assets might be reflected in the statement of financial position. Hence, the organisation supports the re-inclusion of prudence in the new conceptual framework. Thank you for the opportunity to provide our comments. If you have any questions, please do not hesitate to contact me on +61(3) 9555 9999 or [email protected] June Coopers, FCA, PhD, AO Executive Chair

References:

Baker, C.R. and Burlaud, A., 2015. The historical evolution from accounting theory to conceptual framework in financial standards setting. The CPA Journal, 85(8), p.54.

Barker, R. and Teixeira, A., 2018. Gaps in the IFRS conceptual framework. Accounting in Europe, 15(2), pp.153-166.

Barker, R., 2015. Conservatism, prudence and the IASB's conceptual framework. Accounting and Business Research, 45(4), pp.514-538.

Bauer, A.M., O'Brien, P.C. and Saeed, U., 2014. Reliability makes accounting relevant: a comment on the IASB Conceptual Framework project. Accounting in Europe, 11(2), pp.211-217.

Cooper, S., 2015. A tale of ‘prudence’. Investor Perspectives, IFRS.

Linsmeier, T.J., 2016. Revised model for presentation in statement (s) of financial performance: Potential implications for measurement in the conceptual framework. Accounting Horizons, 30(4), pp.485-498.

Macve, R., 2015. A Conceptual Framework for Financial Accounting and Reporting: Vision, Tool, Or Threat?. Routledge.

Mora, A. and Walker, M., 2015. The implications of research on accounting conservatism for accounting standard setting. Accounting and Business Research, 45(5), pp.620-650.

Penman, S., 2016. Conservatism as a defining principle for accounting. The Japanese Accounting Review, 6(2016), pp.1-16.

Sutton, D.B., Cordery, C.J. and Van Zijl, T., 2015. The purpose of financial reporting: The case for coherence in the conceptual framework and standards. Abacus, 51(1), pp.116-141.

Tracey, E., 2015. Discussion of ‘Conservatism, prudence and the IASB's conceptual framework’by Richard Barker (2015). Accounting and Business Research, 45(4), pp.539-542.

Van Mourik, C., 2014. The equity theories and the IASB conceptual framework. Accounting in Europe, 11(2), pp.219-233.

Watts, R.L. and Zuo, L., 2016. Understanding practice and institutions: A historical perspective. Accounting Horizons, 30(3), pp.409-423.

Zhang, Y. and Andrew, J., 2014. Financialisation and the conceptual framework. Critical perspectives on accounting, 25(1), pp.17-26.