Prudence Leads to “Cookie Jar Accounting”

By Katharina Schlueter

IASB chairman Hans Hoogervorst is critical of the concept of prudence, believing that companies could be smoothing their figures under its guise. He believes conservative accounting comes at the cost of transparency and trust in financial figures.

IASB chairman Hans Hoogervorst is critical of the concept of prudence, believing companies could be smoothing their figures.

When the international accounting standard-setting body IASB changed its IFRS Framework by replacing the

concept of prudence with the concept of neutrality in September 2010, the accounting community was up in arms. Especially in countries like Germany, where the concept of prudence is so deeply entrenched in its DNA, the IFRS was criticised as being “imprudent”. The IASB accused companies of reporting overstated profits and understated liabilities.

In a speech 2 years later, IASB chairman Hans Hoogervorst defended this step: conservative accounting practices will always come at the cost of transparency. “Cookie jar accounting,” says Hoogervorst, “reduces trust in accounting in general.” Hoogervorst points out the case of DaimlerChrysler: When the carmaker went public in the United States in 1993 and had to prepare its balance sheet according to the US GAAP for the first time, gigantic hidden reserves came to light. “This led many to wonder what other companies that drew up their accounts according to the German Commercial Code had been hiding on their balance sheets, since hidden reserves can quickly become hidden losses,” says Hoogervorst.

CFOs practice earnings management

CEOs and CFOs would have enormous interest in earnings management: payment and reputation depended on steadily increasing profit figures. Even analysts, who are, in fact, interested in the most realistic account balancing possible, would have been completely sympathetic to earnings management: “Forecasting profits is an analyst’s bread and butter. Too much volatility makes it very difficult,” says Hoogervorst.

Vincent Papa, director of the CFA Institute, disagrees: “Stable profits on the basis of a volatile business model make investors suspicious.” Papa also thoroughly criticises his own guild: “In the past, some investors have been too focused on smooth earnings. In the long run, it doesn't do any good if CFOs only try to meet investors’ expectations and fail to report real economic volatility. The short-term fixation should come to an end.”

Arguing semantics?

In every discussion, questions are raised as to whether changing the wording from “prudence” to “neutrality” is just hair-splitting in the end. Since those who both prepare the balance sheets as well as those who audit them orient themselves first and foremost to the standard itself. “It will mostly be just borderline cases where the strict formulations used in the IFRS framework will have to be applied in practice. That’s why it’s often important to look at the US GAAP before looking at the IFRS framework,” says IFRS expert Dr Stefan Bischof of Ernst &Young. Even when it creates new standards, the impression still exists that the IASB itself does not hold to its own framework, Bischof argues. “If nothing else, the current discussions surrounding accounting for leases show that the standards represent, in part, more of a compromise between various stakeholders than being uniform and consistent. It remains to be seen what sort of meaning the framework will acquire in its practical application if the entire framework is revised.”

Since 2007 the CFA Institute has been arguing for the concept of neutrality: “Reporting should simply tell the reality. Neutrality is better than prudence.” For Papa, the change in wording is more than simply hair-splitting: “The change in wording has led to more neutrality in the standards. A good example is greater adoption of fair value accounting that reflects the economic reality.” At the same time, Papa asks companies to explain their numbers, especially the derivation of profit and loss figures, in more detail in the notes: “Accounts are composed of point estimates. Investors can work much better with disclosure of the range of potential outcomes.” On the other hand, whether this is in the interest of CFOs is questionable. IFRS accountants are already groaning under the weight of countless notes.