IASB Chairman Hans Hoogervorst: The Concept of Prudence - Dead or alive?

18 September 2012

Hans Hoogervorst, Chairman of the IASB, delivered a speech entitled The Concept of Prudence: dead or alive? at the FEE Conference on Corporate Reporting of the Future in Brussels. He explained that prudence also plays an important role in the development of new Standards.

Mr Hoogervorst mentioned in his speech that there are various initiatives trying to address a question "What is the future of corporate reporting?“. One of the most important is the work to take a more holistic view of corporate reporting, known as integrated reporting. The goal of integrated reporting is to bring together many reporting requirements including sustainability, the environment, social issues as well as of course financial reporting. These topics are becoming more inter-dependent, and many investors want to understand the interplay between them. He also thinks for investors to understand financial statements properly, they are in need of non-financial key performance indicators. For example, a company might decide to cut back sharply on training and education of its employees. This decision might make its next quarterly statement look good, but it could be disastrous for long-term profitability.

He continued his speech with the revision of Conceptual Framework, referring specifically to the Concept of Prudence.

The previous version of Conceptual Framework listed Prudence as a characteristic of Reliability (which is now called Faithful Representation). The Framework said that Prudence was the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.

He thinks that the old definition of Prudence, stressing caution while warning against cookie jar accounting, was spot on. Why then did the IASB remove it?

One reason was convergence with US GAAP, which did not have a definition of Prudence. More generally, many felt that in practice the concept of Prudence was often used as a pretext for cookie jar accounting. In this respect, it is important to realise that the incentives for earnings management are huge. Remuneration and reputations are very much dependent on steadily rising earnings figures. Accordingly, the ability to smooth earnings is highly prized by executives.

Even analysts are often (wittingly or unwittingly) sympathetic to accounting techniques that allow for some earnings management. Predicting earnings is the bread and butter of analysts and too much volatility makes that very hard to do! Given all these temptations, both the IASB and FASB felt it was important to stress the neutrality of financial reporting, by leaving out the concept of Prudence. In this context, he finds this a defensible decision.

In conclusion, Mr Hoogervorst said: "I think I made it clear in this speech that I think it is absolutely vital that our standards result in information that is as neutral as possible. A systemic bias towards conservatism undermines the value of earnings as a performance indicator. I have also shown my understanding for the fact that IASB felt a need to be completely unambiguous about this issue by removing the Concept of Prudence from our Conceptual Framework.

Yet, I have also demonstrated that the basic tenets of the Concept of Prudence are still vital for our work. Indeed, the exercise of caution is visible in many of our standards and is also an important issue in the development of new standards. Indeed, one might very well conclude that the old Concept is not dead, but alive and kicking indeed.“

Press release

Full speech


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