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Prudent reporting builds confidence
May, 28th 2008

Much has been written and debated about the recent announcement by Institute of Chartered Accountants of India (ICAI) that encourages early adoption of accounting standard on recognition and measurement of financial instruments (AS30). The announcement further mandates that those companies which do not adopt AS30 should measure and recognise unrealised losses on financial instruments using the principles of prudence, as explained in accounting standard on disclosure of accounting policies (AS1).

AS1 states that in view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised, though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.

Therefore, as per principle of prudence, corporates with outstanding financial instruments, and which have not adopted AS30, will need to measure unrealised gains/losses on financial instruments and record unrealised losses while ignoring unrealised gains.

Companies recognise uncertainties that inevitably surround many events and circumstances by disclosing their nature and extent and by exercising prudence in preparation of financial statements. Prudence is the extent of caution used in making estimates, required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.

However, the exercise of prudence does not allow creation of hidden reserves or excessive provisions or deliberate understatement of assets or income or deliberate overstatement of liabilities or expenses.

Frequently, assets and liabilities are measured in a context of significant uncertainties. Determining a loss or liability using prudence does not imply absolute certainty or precision. Sometimes, a range of an estimate could convey information more reliably than can a single estimate. Taken as a whole, financial statement users prefer that possible errors in measurement be in the direction of understatement rather than overstatement of net income and net assets.

All accounting frameworks recognise that a difference between an estimate and an accurate measurement may be material in one context and not material in another. Consequently, what constitutes a significant loss or gain may vary and thereby, may be impacted by the precision of estimate of losses and liabilities.

With evolving times, the convention of prudence, which was once commonly expressed in the admonition to anticipate no profits, but anticipate all losses too has evolved. For financiers, who are the principal external users of financial statements, understatement for its own sake is widely considered to be desirable, since greater the understatement of assets, greater the margin of safety the assets provided as collateral.

However, with periodical reporting it is evident that understated assets frequently lead to overstated income in later periods.ICAIs announcement requires companies, using the principles of prudence, to record unrealised losses on derivatives, whilst ignoring unrealised gains. However, accounting standard on foreign exchange translations (AS11) allows recognition of unrealised gains on certain foreign currency items.

Similarly, AS30 also allows recognition of unrealised gains on assets available for sale or held for trading. Therefore, conceptually this would insinuate that the principles of prudence and recognition of unrealised gains are not meant to be mutually exclusive.

To conclude, in uncertain times the best way to avoid the injury to investors that imprudent reporting creates is to try and ensure that what is reported represents what it purports to represent. The reliability of financial statements is enhanced by accounting and/or disclosing the nature and extent of the uncertainty surrounding events and transactions reported.

In assessing the prospect that as yet incomplete transactions, such as outstanding derivatives, will be concluded successfully, a degree of scepticism is warranted. The aim must be to put the users of financial statements in the best possible position to form their own opinion of the probable outcome of the events reported. Prudent reporting based on a healthy scepticism builds confidence in the results and, in the long run, best serves all of the divergent interests of different constituents.

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