Accounting Prudence: from the traditional idea to the modern and

back again.

Sion Owen updated 22ND August 2019

Introduction to Traditional Prudence

Prudence is one of the original accounting concepts, first codified in the

1970’s in UK. The application of traditional accounting Prudence is
encapsulated in frequently heard statements such as:

Assets must not be over valued

Liabilities must not be under-valued.

Income must not be exaggerated, over-stated or anticipated.

Costs must not be understated.

The impact of prudence is that profit tends to be under-stated in a

particular year, often due to accrual of expenses and provisions. If profits
are underestimated in 2019 because of provisions made against, say,
legal costs, the impact may be to increase the profits in 2020. Fixed
Assets (tangible and intangible), Stock and Debtors (Receivables) tend to
be valued conservatively, compared to more aggressive accounting
policies such as fair value, based on market value and DCF (value in use).

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Tesco plc has the “capitalised interest” accounting policy (see workbook),
which increases the value of fixed assets. How does this policy look from
the point of view of Prudence? It is not a Prudent policy as it increases
profits, by reducing interest costs, and increases fixed asset values. Fixed
asset values are not, therefore, conservative if capitalised interest is
added.

Prudence applies to both accounting policies (e.g. HCA) and accounting

estimates (e.g. useful economic life and residual value).

The Modern Economists’ Reaction to Prudence

Economists have argued that there is an asymmetry in tradition thinking

about prudence, or a lack of what has been called, in modern times,
“neutrality”. The treatment of costs differently from sales seems illogical
to economists, it is difficult to justify in theory, but, easier to understand in
accounting practice. It could be argued, as well, Prudence lead to a lack
of “reliability”, in a specific year as profits are under reported. If Prudence
is strictly applied, accruals and provisions may be exaggerated. The
traditional idea of Prudence makes it easier to hide profits, to make them
look smaller than they are, it was argued.

It is certainly true that Prudence can be taken too far, and it can be used
as a way of hiding profits. Accountants need to judge the right level of
prudence, and stop managers from using it to hide or smooth profits.

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On the other hand, it is difficult to overstate profits if accounting policies
and estimates are Prudent. Prudence does mean underestimating profits,
but this can be considered to be a wise approach to accounting in the light
of all the risks faced by businesses. Economists tend to think that over
estimating profits is just as bad as underestimating them, but traditional
accountants tend to disagree. In their view, underestimating profits is good
idea,

Some more Examples of Prudence

Well known examples of prudence include:

Stock valued at the lower of cost or net realisable value

Debtors with bad debt provisions attached.

Slow moving stock provisions

Historical cost convention.

Impairment of Fixed Assets

Typically, Accruals of Costs should be large, but, accruals of revenue

should be few.

Within prudent accounting, the anticipation of revenue was rare, not

encouraged.

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Prudence in Revenue Recognition

The conflict between Prudence and the anticipation of future revenue is

important. Prudence dictates that revenue should not be anticipated, and
this sits uneasily with the idea of “present value” (Discounted Cash Flow,
Internal Rate of Return, Net Present Value) which actively encourages
anticipation of future revenue. This is an example of the contradiction and
conflict between the traditional accounting perspective and the modern.
Not just two different theories, but, the opposite of each other, two
extremely different views, incompatible with each other. This is why I talk
about traditional accounting as something total different from modern
accounting.

Within the CF 2010 the traditional and modern were combined, but, this
is never going to work if prudence and neutrality are so different.
Revenue recognition emphasises the incompatibility of the traditional
and modern perspective.

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Even More Prudent Accounting Policies
Some more examples of Prudent accounting policies and estimates:
Depreciation over short useful life rather than long periods, e.g., 20
years useful economic life, not 25 or 30.
Zero residual values, rather than estimating residual values far in the
future
Frequent review of fixed assets to identify impairments (write off of fixed
assets)
Rapid amortisation of goodwill, rather than periodic review of impairment
Rapid amortisation of other intangibles
Strict implementation of rules regarding research and development
Rapid amortisation of development expenditure, rather than impairment
review.
Interest costs of property development not capitalised
Review of old stock and immediate write off.
Rapid recognition of bad debts and immediate write off
100% provision doubtful debts.
Rapid recognition of customer returns and credit notes
Full recognition of costs of discounts and bonuses

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Links between Prudence and other traditional accounting concepts
There are links between prudence and going concern, and links between
prudence and matching.

Going Concern means assuming that the business will continue in

operational existence. When a company has low profit margins, low
liquidity and high gearing the possibility of bankruptcy increases. As profit
margins fall, the going concern assumption needs to be questioned. The
evaluation of going concern needs to be prudent, recognising the
possibility of “worst case scenario” and bankruptcy.

There is some tension between Prudence and matching (accruals).

Stock is a cost carried forward to next year, to match with sales. Carrying
forward stock to next year means reducing costs this year, and increasing
profits. The higher the stock, the more cost that was shipped out of this
year into next year.

Fixed Assets are not considered to be costs, but, rather, are held on the
Balance Sheet and depreciated. In other words fixed assets reduce costs.
From the point of view of prudence, it’s important that useful lives of fixed
assets are not exaggerated. Quick depreciation is better than slow.
GEGs depreciation of Generation Assets over 24 – 29 years seems a long
useful life.

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The general idea of “accountability”, “stewardship” and “control” fits well
with Prudence. Managers should not be allowed to exaggerate profits,
and fool the investors.

Accounting Estimates and Judgements and Prudence

Intangible assets are growing in significance e.g. development
expenditure, see Lidco plc. These assets are hard to value, and their
valuation involves more judgement than traditional tangible assets (PPE).
When judgement is needed, it is important this judgement is exercise
Prudently. The growth of intangible assets means that Prudence is now
more important than ever. The Prudent valuation of intangible fixed
assets such as software, development costs etc.

Judgement must be based on available facts, as far as possible, and must

always be conservative (prudent). It should not be subjective judgment
but based, as far as possible, on objective facts. There may be some
element of judgement in depreciation, stock valuation, bad debts,
accruals, work in progress, income recognition, but, it should always be
objective, as a far as possible, and conservative.

In accounting it is a good idea to take the pessimistic view, and don’t be

swept along with the crowd. The stock market gets excited about software
development and new media. Make sure you carefully assess the
commercial potential of new innovations. What is the realistic chance of
success? In the case of Lidco plc, what is the realistic chance the
company will ever be profitable? Be aware of risks, especially liquidity
and gearing levels. Be aware of competition from other firms, which

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always reduces profit margins. Risk means the risk of bankruptcy in the
worst case scenario. Understanding risk is a counter balance to over
optimism and exaggerated valuation of intangible fixed assets
characteristic of the modern stock market.

Prudence means understanding risk. The accountants’ tools for

assessing these risks include: Current ratio; debtor days; stock turnover;
gearing ratio, breakeven; payback period. These are well established
tools for measuring the financial strength (weakness) and riskiness of a
company. Contrast this with the financial perspective on risk, the CAPM
model.

As an accountant, be independent minded and carefully assess facts &

risks. Assess the extent to which judgements are pure guesswork and
subjectivity, or over optimism. Have some professional detachment, and
a cool head. This is part of accounting ethics and professionalism. Notice
here that accounting prudence is linked with the idea of an accountant as
a trusted expert, and a “professional”. It is linked to a high level of
knowledge and technical skill. It is part of the accountants’ attitude of
mind.

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Liverpool Accounting History
In Victorian times in UK, before the stock market was fully established, the
ability to raise finance depended on trust and a good reputation among a
net-work of business leaders. Liverpool merchants, for example, needed
to maintain a good reputation, to raise finance for shipping ventures. A
reputation as a prudent, honest and reliable business owner was
essential. It’s understandable that the idea of prudence was picked up by
early accountants, and they embedded it in traditional accounting.
Accounting prudence was linked with honesty and reliability.

The rapid development of the stock market in UK between 1850 and 1875
changed the financial landscape, but accountants held on to the idea of
prudence. See Josephine Maltby’s paper “The Origins of Prudence in
Accounting”, see the links in Canvas. The stock market increased the
range of people involved in investment, and, in many ways, prudence
became more important. Accountants were right to hold on to the idea.

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Financial Crisis
After the financial crisis in 2008 People started to realise that Prudence
was a good idea. FRC, and others, wanted to re-establish confidence in
financial markets. Prudence prevents the exaggeration of profits and
assets.
“Bring back prudence”
Bring back honesty and reliability.
If you take on more risk you don’t necessarily get more return, especially
if you don’t understand what risk is in the first place.

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Conclusions
The idea of prudence has changed over time responding to economic
and social conditions:
Victorian prudence
Development of the stock market
1880-1929
1970s traditional accounting, prudence
formally stated. The need for great
consistency in accounting.
Rapid expansion of financial markets
in 1980’s. Era of intangible assets &
judgements, mergers, acquisitions,
brands research & development,
medical science & the internet. The
expansion of the idea of an “asset”
driven by science and technology
1990’s Theoretical attack on prudence,
the era of “neutrality”. The
economists’ invasion of accounting.
2008 Era of financial market instability.
The future of Prudence involves understanding business risk and the
difference between investors views of risk and managers.
The trusted “man of business”, the Liverpool merchant of
around 1850. Well known, trusted and experienced in
commerce. Raising capital and credit dependent on good
reputation.
Naïve investors getting ripped off. Investing in high risk
companies and losing their money. More Prudence in
accounting to help naïve investors. Auditors brought in to
protect investors, the need for an independent (Prudent)
review.
The drive for great consistency, but this explicitly
recognised Prudence. The importance of not overstate
assets or profits
Make sure judgements are prudent. Stick to evidence
and don’t be over confident about new business ideas
and strategies.
Prudence means scepticism about new business
innovations and technology. Reduce the value of these
new and weird assets
It’s wrong to underestimate assets and profits. The new
technology assets should be valued much higher.
Prudence is needed to stabalize the markets & increase
trust. The return of prudence. Stock markets need
prudence.
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