Conservatism, prudence and the IASB's conceptual framework

Abstract

The argument in this paper is that financial accounting is inherently conservative, in that a neutral application of the International Accounting Standards Board (IASB's) definition of (net) assets leads to book value being less than economic value. There are both conceptual and practical reasons for this outcome, neither of which is explained by an intention to be conservative, by an asymmetry or bias that is designed to lead to a conservative outcome. Financial accounting is not a system for the neutral measurement of economic value. Book value and economic value are instead conceptually different, with conservatism resulting from that difference. This inherent conservatism seems to have been overlooked both by the IASB and by its critics. The IASB has sought to remove prudence from its framework and has attracted criticism from the academic and practitioner communities for doing so. Yet the challenges to the framework implied by adopting an agency-based, contracting demand for prudent accounting are criticisms of a problem that for the most part does not exist.

Keywords:

• conceptual framework
• conservatism
• prudence

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. Note that the evidence here is indirect with respect to intent: there is an inductive explanation that fits the data, though not an empirical observation of the intent itself. The implicit assumption is that because accounting is conservative in effect, it must therefore also be conservative in intent.

2. A further, more formal, intervention was that the UK's Local Authority Pension Fund Forum and other investors commissioned a legal opinion (from G. Bompas QC, dated 8 April 2013) which cast doubt on the legality of IFRS for various reasons, including the removal of prudence.

3. While proposed rather than extant, the definition set out here is consistent with, and a useful expansion of, the extant definition in the framework.

4. The IASB has tentatively decided to drop the term ‘other source of value’. This does not change the substance of the argument made in the paper.

5. Ohlson's (1995) present value of residual income is also much the same construct.

6. Cash can be interpreted as the currency of economic benefits: it is the 1:1 exchange rate between economic benefits and economic resources.

7. This extends to the recognition of gains on the performance obligation, which are measured as ‘earned’ rather than as ‘expected’, with the performance obligation measured at a transaction price with a liability adequacy test, not at a current exit price.

8. See Sherman and Power (1994) for a discussion of different accounting and legal practices with respect to making intangible property recognised and ‘real’.

9. The IASB's distinction between ‘rights’ and ‘other sources of value’ – between legal and de facto rights – can perhaps be given greater clarity by interpreting ‘rights’ to mean legal rights and ‘rights and other sources of value’ to mean the broader concept of economic rights.

10. Arguably, an economic resource is not ‘a right … that is capable of producing economic benefits’ but instead a right with respect to economic benefits. It is the economic benefits that are logically prior, and the economic resource that is a claim with respect to them. A simple example of this point is a financial instrument, which gives its owner a claim with respect to the cash flows generated by a business. The financial instrument does not in itself produce anything; it is a piece of paper, or a digital record. It does, however, represent a legally enforceable claim to economic benefits, the existence of which is a necessary precondition for the financial instrument to have any meaning or value.

11. Note that, in this context, the input is worth more to the entity than its cost, since at the margin, all else being equal, the entity would pay for the input up to the level at which profit became zero. Hence, either an output or an input perspective can be used to understand how the valuation of the economic resource at cost leads to conservatism.

12. Current replacement cost would also be a conceptually valid alternative to historical cost on this analysis.

13. The historical cost of the asset need not be used for this purpose, and the current replacement cost would be an alternative measure of the economic resource. If historical cost is used, and if prices are rising, then this represents an additional source of conservatism.

14. Even the (rarely used) revaluation model in this case can be interpreted as a form of current cost.

15. There is a fine line here: does an entity have the ability to enjoy an expected economic inflow if it is highly probable, where that probability rests upon the distinctive characteristics of the entity?

16. Note that this is not exclusively an agency consideration.

17. The opposite may also be the case (Barker and McGeachin 2015).

18. Note also that, in the context of these constraints on the ability to measure, it is more likely to be the case that write-downs of assets can be supported while write-ups cannot, with obvious implications for conservatism. A write-down is to acknowledge loss of a claim (physical damage can be observed directly, while this may not be possible for economic gain; likewise depreciation is a smoothed representation of a process that is to a degree visible over time).

19. The obvious exception is assets acquired in a business combination, which are reported at fair value under the requirements of IFRS 3 Business Combinations, 2008. Yet this is something of a special case, being an allocation of an acquisition amount.

20. As was the case with Figure 1, the elimination of conservatism by year 10 arises only because of the finite nature of the example; an ongoing business would not typically exhibit this pattern.