Dear Prudence or Fair Value?

Dr Steve Priddy argues that the standard setters’ abandonment of dear Prudence in favour of the alluring fair Value is a retrogressive step that we will have to work around.

“My business habits had one other bright feature, which I called “leaving a Margin.” For example; supposing Herbert’s debts to be one hundred and sixty-four pounds four-and-twopence, I would say, “Leave a margin, and put them down at two hundred.” Or, supposing my own to be four times as much, I would leave a margin, and put them down at seven hundred. I had the highest opinion of the wisdom of this same Margin, but I am bound to acknowledge that on looking back, I deem it to have been an expensive device. For, we always ran into new debt immediately, to the full extent of the margin, and sometimes, in the sense of freedom and solvency it imparted, got pretty far on into another margin.”

- Charles Dickens (Great Expectations)

The great novelist points to two of the fundamental traits of being human – our ability to hoodwink ourselves, and our ability to be over optimistic.  As chartered accountants, whether management or statutory, I can safely say you will encounter these traits throughout your careers.

Financial statements have never been a purely historical record of accounting transactions.  They are rather shot through with estimations, judgements, and views about the future.  Here are some examples:

• Accounts are prepared on a going concern basis.  Assets and liabilities are valued on the basis that the organisation will be alive and kicking for the foreseeable future – usually taken to be at least 12 months since the date of sign off of the balance sheet;
• Long term contracts and work in progress are underpinned by an assessment of the recoverability of future sums, as well as the accuracy of future project costs;
• Tangible assets are predicated on an assessment of useful economic life and depreciated accordingly;
• Intangible assets are subject to an impairment test.  Part of that impairment test is to discount future cash flows at the current cost of a company’s capital which in turn is based on a very distinctive view of the future;
• Point values are included for all items in the financial statements where a value range based on a stated confidence level would often be more appropriate.

And if the above, and many other examples, apply to statutory accounts, they apply even more to an organisation’s management accounts.  They have to because the overwhelming majority of working people are not accountants, and because the majority of them, as with young Pip in the above quote, are eternally optimistic.  Markets know this, and are unforgiving when things go wrong.  For example, Royal Dutch Shell’s calculation of proven reserves forms no part of its statutory accounts but when it was shown in 2004 that these had been deliberately overstated, the share price plunged and several directors at C-level were forced to resign.  This was because a key element of Shell’s future was suddenly undermined.

When I started out in accountancy there were four fundamental accounting concepts.  One of these was dear Prudence.  For once the standard setters had reflected on human nature and enshrined in regulation that it was a good thing to temper natural optimism with a dose of reality.  Put simply, a bird in the hand was to them worth two in the bush.  If you see trouble ahead, provide for it now; only recognise revenue when it is virtually certain to materialise.  Hopefully this will sound to you like common sense – it is at the centre of Prospect Theory as developed by the Nobel Prize winner Daniel Kahneman.

Unfortunately, this statement of common sense was not good enough for our standard setting masters.  What they drew attention to was ‘bathwater provisioning’, i.e. the never-to-be-trusted CFO managing earnings by the introduction of a whole series of margins, thereby depressing the true and fair statement of financial performance.  Dear Prudence was unceremoniously dumped in favour of the youthful Fair Value.  In my opinion this was a serious retrogressive step.  Firstly, it demonstrates a mistrust of those practitioners in finance and their exercise of professional judgement.  Secondly, it assumes rather naively that a fair value is possible in all circumstances and for all economic transactions.  But lastly, and most importantly, it shows a complete non-recognition of how we as human beings are wired, and how we behave at the margin.

As far as I am concerned, dear prudence never left the counting house.  I hope the same applies for you in your future careers.

Dr Steve Priddy is Head of R