The definition of the term prudence in an accounting perspective is ‘The principle of not showing assets or profits to be greater than they might be, or losses to be smaller than they might be, in a company’s accounts.’1 This is when a company does not exaggerate their assets, sales and therefore profits whilst never underestimating their losses within the company’s accounts and financial statements within a year. Within the financial statements they should include; the financial position in which a company is in at the end of a period, profit and loss statement, a balance sheet, cash flow, notes and comparative information. The real question is, should prudence be included within financial statements and if so, how it should be included within it. Within this essay I will be discussing; why prudence is regarded as a qualitative characteristic of financial information, how it enhances the usefulness of information given to users to aid them in decision making and the negatives and drawbacks of prudence especially if it is done incorrectly.
Prudence aids in enhancing the usefulness of information provided to various users to help them in their decision-making. An example of prudence in accounting which does this is Depreciation. Depreciation is defined as ‘A reduction in the value of an asset over time, due in particular to wear and tear.’2 Depreciation is key to knowing the exact value that any given tangible asset has within your business at any given time. If a business buys a van for £10000 and they are intending to use and keep that vehicle for 10 years, if it is said that after 10 years the van would be worth £0 after 10 years then the business should depreciate the vehicle year upon year therefore the van would lose £1000 in market value year upon year. This would mean that after 3 years the vehicle would have a netbook value of £7000 and not the initial £10000 that it was bought for, accumulating a depreciation of £3000. Many businesses use the straight-line method in such cases as it would show how much an asset is worth. Depreciation would aid many stakeholders in a business when making decisions. It would help the managers know if an asset is living up too it’s full potential in regards of how much income it is generating and if that is much higher than its depreciation year upon year. If that asset is not generating enough profit, then the managers could decide to sell it on before it is too late. Prudence in the form of depreciation would help shareholders in a company decide if they want to keep their shares or sell them whilst also aiding possible future shareholders when deciding on whether or not to invest in the business. Prudence, in this case, by not overestimating your assets, will enhance future investors knowledge of the business and will aid in their decision making to see how much their investments would be at risk if they invest in a company. If the company keeps its assets netbook value at how much they were bought, then it will not be a faithful representation of how much the assets are worth within the company which would then be mirrored into how much the company is worth as a whole. This gives the sense of comparability within a single company year upon year as the true value of assets can be compared because of using the same method which is depreciation. The sense of comparability can be further widened when comparing more than one company as their current assets worth can be analysed side by side with competitors and firstly for a business to see how they are competing amongst their fellow rivals and secondly for investors to see what business is most profitable and worth their risk in capital and time.
Prudence is regarded a qualitative characteristic of financial information because of the relevance it gives regarding predictive values that are formulated when predicting how much assets will be worth within the business at any given point and confirmatory values to provide enough feedback when checking back on preceding goals and targets. In addition to prudence making information relevant, it also shows a faithful representation within the information sent out to the wider public. This includes; completeness, neutrality and freedom from error. With all three of these qualitative factors it allows anybody to see step by step what that business has purchased, and nothing should be hidden from any audience. This will disregard bias in any shape or form because of the neutrality of the financial statement. Prudence regarding the qualitative factor of comparability allows that companies accounting information can be compared to the same accounting information of another companies and even the same information of previous years within a company. This is evident within companies within the same sector competing for the same target market trying to increase their market share and then become a monopoly within that market.
The qualitative factor which is timeliness is key for any business within any market. This is because it should give users of goods and services belonging to the business enough time for processing that information in order to make further decisions on whether or not to invest in that business. It will also inform employees whether or not their company is doing well within the market and if not it will guide them in the direction they need to go to be successful. For companies listed on London Stock Exchange they must comply with the rule that “An issuer must make public its annual financial report at the latest four months after the end of each financial year.”3 This gives an investor enough time to see whether the performance of that company was good enough for them to risk some of their capital in that business. Whilst having to publicise their annual financial report within four months of the end of the financial year the company also must make sure that those same financial reports are available for at least ten more years.4 This is a great idea as it links in with the other qualitative factor of comparability. It will allow companies, investors and even the general public to compare the financial growth, if any, of any given company.
Without prudence within accounting information it will allow businesses to create a false representation of their financial status. Companies would be able to ‘sell investors dreams’ by portraying that they are doing so much better financially than they actually are. This would mean more investors would run to that company and buy stocks within the company because it looks extremely profitable when it is not. This would come to light when the investors do not receive as much dividends as they hoped to or even none at all if the false representation of finance was tampered with that much. Furthermore, to the false representation that prudence would cause, it also makes it easier for manipulation of all financial documents from anybody with any power within the organisation. A manager could make it looks as if the store is making a plethora of profits, only to get a bonus, even though they are not. This would have a massive impact once that manager leaves because the next manager would struggle to recoup all the false profits that were said to have been made by the previous manager.
In conclusion, I believe that prudence should be considered as a desirable quality of financial reporting because it helps predict future accurate values regarding to assets and the business as a whole. It allows a business’s financial information to become relevant, aids in it being comparable and gives it faithful representation.
1 (Dictionary, 2017)
2 (Oxford Dictionaries | English, 2017)