Prudence convention explained

Prudence or Conservatism convention explained

Prudence or the conservatism convention explains the need for accountants to avoid overstating the profit earned by an entity. The prudent convention can be found in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Although it is a convention, it cannot be found in the IFRS foundation’s conceptual framework for financial reporting.

1. What's prudence convention

The prudence convention is a principle that states that when preparing the financial statements of an entity, it is necessary that the preparer ensures that revenue and assets are not overstated and expenses and liabilities are not understated. This is to ensure that all possible losses are accounted for while ensuring that only income that has a high degree of collections are recognized in the books of account.

By conservatism convention, accountants understand that a “degree of caution” is necessary when using estimates in preparing financial statements (FS) during periods of uncertainties. The principle helps finance professionals to ensure that all areas of expenses are covered in the FS, thereby reducing the profit earned by the entity. As a result, it is possible to include expenses that were not incurred by the entity in those statements.

For example, an entity may include training and development expenses in the financial statements although it didn't train its staff. Also, it can charge a rental fee on the building, although, it is clearly stated in the books of accounts that the business owns the building.

2. Removal of prudence convention

The use of prudence as a principle in accounting has been removed by the International Financial Reporting Standard (IFRS) Foundation in its latest conceptual framework for financial reporting. This means that entities using the IFRS accounting standards in the preparation of financial statements are not expected to comply with the conservatism convention.

Despite the foregoing, the IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors states that an entity can apply prudence and other stated principles when there are no IFRS standards that apply to a transaction or event. The best way to support the removal of conservatism from the framework is the use of matching concepts. Instead of ensuring that profit is understated by overstating expenses and undercasting revenue, these two elements of FS should be matched accurately in those statements.

3. Disadvantages of the conservatism convention

The primary disadvantage of the principle is that management may purposely overstate expenses so as to reduce profit and pay lower taxes. This is why the tax authority in Nigeria does not allow the use of the term general and administrative expenses in the financial statement. Companies can purposely use it to understate profit claiming compliance with the principle of prudence.

Companies can also use the conservatism convention to provide for expenses. Imagine an entity providing for utility bills on a monthly basis or providing for discounts allowed. These are ways entities may reduce profit by adding items in the financial statement that are not relevant to the report provided to the users. Doing so will distort the comparability of the statements with other entities. Thereby affecting users ability to make decisions negatively.