a.) The word prudence means exercise of caution and good wise judgement. In the accounting sense it also means the same and the principal of prudence demands the makers of financial statements to exercise caution and wise judgement while preparing the financial statements. Hence under the concept one must not overstate the amount of revenues and neither understated the amount of expenses. In a way prudence demands makers of financial statements to be conservative. Another aspect of prudence can be that a maker of financial statement records only certain revenues and probable liabilities. Also assets are reviewed at regular intervals to see if their value has diminished and liabilities reviewed to see if their value has increased. (Hariman, 2010)
One can also say that prudence aims to prepare the financial statements in such a way that the users of financial statements don’t get any misleading information and are prepared for the worst. Although the prudence concepts aim is never to state the worst possible scenario but it is more inclined towards a pessimistic scenario in the sense that it overestimates liabilities and underestimates assets. In that sense it would be important to note that even understating revenues can have a negative effect and hence “neutrality” must be aimed for together with prudence in financial reporting. (Cooper, 2015)
Prudence would normally be exercised in setting up, for example, an allowance for doubtful accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an expense has not yet been identified, but a prudent person would record a reserve in anticipation of a reasonable amount of these expenses arising at some point in the future.
b.) Prudence is indeed very important in financial reporting as it goes hand in hand with another of accountings main principles of conservatism. Reporting assets at the lower value and liabilities at the higher value might reduce the profitability ratios and the efficiency ratios but they don’t give a distorted picture to the shareholders which may be misleading and lead to wrong decision making. Consider this suppose a company knows that 4% of its accounts receivables are bad debts but they don’t report it. Their current assets figure would be inflated to that extent and their profitability ratios would be higher but that would be actually notional.
If we were to talk about the accounting standards and prudence, GAAP (generally Accepted Accounting Principles) has incorporated prudence in most of its standards. An example is many standards required to devalue the fixed assets when their market values fall below their book values but the reverse isn’t true. On the other hand, IFRS (International Financial Reporting Standards) don’t adhere to it as strictly. (Kakabadse & Kakabadse, 2005)The International Accounting Standards Board(IASB) differentiates between cautious prudence and asymmetric prudence. While the former refers to exercising caution under uncertain conditions the latter which is considered by most to be the essence of prudence is waived off. It would be important to note that while prudence aims to eliminate biases from financial reporting, ultimately it should not be used to understate the reliability of financial reports.
c.) Telstra is a leading Australian Companies which provides telecommunication and media based services to Australian subscribers. Over the years through various mergers and takeovers its structure is now very complex where the use of proper accounting principles becomes imperative to be faithful to all the stakeholder groups. While valuing inventories Telstra has used prudence as evident from the fact that inventory has been valued using different methods. As per note 11 to financial statements in their annual report inventory valuation is divided into two groups. Firstly 234 million AUD of finished goods are recorded at cost whereas 77 million AUD worth of inventory are recorded at net realisable value. Further 40 million of raw materials and store items are recorded at cost. (Telstra, 2015) This is an evident display of prudence in accounting and reporting practises. Should they have valued the entire inventory at market price their current assets would have presented an inflated figure which is against a core principle of prudence which requires to inventory to be valued at the lower of cost or net realisable value. (Onoja, 2015) Through the usage of horses for courses policy for valuing inventories Telstra has displayed ample prudence in their accounting practices.
In the current assets section of their balance there is an entry of Noncurrent assets held for sale and discontinued operations. As per note 12 to financial statements in their annual report it is clear they have displayed prudence here. There are two example to make it abundantly clear. Telstra has classified the assets and liabilities of the Sentis Group as held for Sale. They estimated their share of 30 percent to be worth 157 million AUD as the sale price of Sentis was 454 million AUD. However, upon re measurement of assets and liabilities they impaired the goodwill of Sentis group by 150 million AUD and identified it as a loss for the year under the section discontinued operations, the impairment of goodwill is clearly an example where Telstra displayed prudence. (Telstra, 2015) Secondly in July 2014 they decided and thereafter signed papers to sell off their whole shareholding which amounted to 55 percent to Sequel media Inc. and the controlled entities namely Sequel Media Group. The consideration amount was 3 million AUD subject to all negotiations and final agreements. Now there were two areas where Telstra displayed prudence. Firstly, the assets were valued at lower of the carrying amount as opposed to their fair value. Secondly the media groups goodwill was impaired by 12 million AUD in the previous financial year. (Telstra, 2015)
IASB 2004(a) states that if the fair value of an asset is less than its market value such assets should be written down or revalued and appropriate losses should be recognised and reported. This practise is direct consequence of the prudence principle. (Stolowy & Lebas, 2006)
d.) As they have used impairment to devalue the assets of Sequel Media group Telstra don’t stand the risk of getting a lesser value then what they have recorded in their current assets and hence it will not give the stakeholders a distorted view of current assets which is very much in sync with the principle of prudence. The same case is applicable with Sentis group as well as since the goodwill has been impaired the assets which have been valued quite conservatively haven’t been distorted and consequently neither inflated the current asset figure of Telstra. Since the principal of prudence requires financial statements to be made such that assets are recorded at a value which is their probable realisable value and also to impair the assets which have lower value than their book value. Hence the impairment carried has pre-empted the stakeholders of the potential loss when the sale of these assets do take place even though it means that they have might not presented the most desirable picture from the investor’s point of view. But the investors would be rather well informed about any losses than be kept in dark.
The inventory has been valued at net realisable values and at cost depending on their status and hence in the next financial year when they are sold at profit it will reflect in the income statement and consequently tend to improve the profitability ratios of Telstra for that particular financial year. The principle of prudence in accounting requires that profts be recognised and reported only when they happen and not beforehand.
Hence it is clear how through the application of prudence Telstra has managed to present an understated position of their financial position to various stake-holder groups. Whether this presentation is good or bad is open to debate with the conservatives vouching for it and the critics vehemently opposing it.
Cooper, S., 2015. A tale of ‘prudence’, s.l.: IFRS.
Hariman, R., 2010. Prudence: Classical Virtue, Postmodern Practice. s.l.:Penn State Press.
Kakabadse, N. K. & Kakabadse, A., 2005. Prudence vs professionalism: Exploratory examination of pension trustee capability. Personnel review, 34(5), pp. 565-587.
Onoja, E., 2015. Inventory Valuation Practices and Reporting: Nigerian Textile Industry Experience. Mediterranean Journal of Social Sciences, 6(4), pp. 74-82.
Stolowy, H. & Lebas, M., 2006. Financial Accounting and Reporting: A Global Perspective. s.l.:Cengage Learning.
Telstra, 2015. Annual Report, s.l.: Telstra.