title: The prudence concept in accounting
Creators: name: Weetman, Pauline
Publisher: name: University of Glasgow
Year: 1989

description: The Fourth Directive of the European Community was the direct cause of accounting principles being incorporated in UK company law. The concept of prudence and the concept of a realised profit now have a significance in statute although neither is comprehensively defined therein. This project shows first that perceptions of conservatism, or prudence, have changed over time. It then traces the development of the realisation concept as a particular practical aspect of that conservatism. Within the UK the role of prudence as an influence on UK standard setting is explored. The research brings out a picture of a lack of consistency in the application of the prudence concept but shows that it is certainly perceived by the standard-setters as being something more than is suggested by the narrow wording contained in SSAP 2 and now embodied in the Companies Act 1985. There is a strong theme of prudence as a reaction to uncertainty, where the nature of the uncertainty depends very much on the problem being considered. Turning to analyse the international viewpoint, the project takes as its starting point the statement of international standard IAS 1 that prudence is to be seen as a reaction to uncertainty. The US, Australian and Canadian standard setters show evidence of this approach in their conceptual framework programmes. European viewpoints show stronger adherence to the conservative reaction, even when the Fourth Directive has been implemented. This international analysis provides a wider context against which to compare UK prudence. It should be possible to quantify the potential prudence or lack of it in UK accounting standards by analysing published financial statements but each attempt at analysis was defeated by lack of data, even where SSAPs such as SSAP 1 or SSAP 15 prescribed disclosure which would have been adequate for the exercise. An alternative source of data presented itself in Form 20-F, produced by UK companies reporting to the US Securities and Exchange Commission. This allowed quantification of the effect on profit of some of the more controversial UK accounting standards, particularly those on deferred taxation and amortisation of goodwill. The idea of an “index of conservatism", developed in earlier research by Gray (1980), was applied. It showed that on average over the period 1985-1987 inclusive, UK reported profits were some 6% or 8% higher than they would have been under US accounting practices. The main cause of the difference was the amortisation of goodwill, which affects the US profit but generally has no impact on UK profit. Items' such as deferred taxation or foreign currency translation, which might be expected to have an impact, had very little effect overall, although they could be important in isolated cases. The concept of realisation is closely linked to the recognition of income and hence to the recognition of assets and liabilities. Research into the extent to which there might be a pattern running through existing recognition practices showed a link by way of the concept of prudence, viewed as a reaction to uncertainty. The project concludes by exploring some of the schemes which have been suggested for reporting the effects of uncertainty and considers the nature of uncertainty in financial reporting. The final remarks consider the implications for the realisation concept, the role of prudence in reporting as compared with decision making, the need to revise SSAP 2, the need to model uncertainty and the need to formulate a conceptual framework in a UK context.