prudence and matching

8/8/2019 Prudence and Matching

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XV/7002/95 EN

DOCUMENT OF THE ACCOUNTING ADVISORY FORUM

PRUDENCE AND MATCHING

DIRECTORATE-GENERAL XV

Internal Market and Financial Services


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This document has been prepared for use within the Commission. It does not necessarilyrepresent the Commissions official position.

Reproduction is authorized, except for commercial purposes, provided the source is

acknowledged.


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PREFACE

This document deals with Prudence and Matching. It has been prepared by the AccountingAdvisory Forum (Forum) as an advisory document to the Commission. The viewsexpressed in this document do not necessarily represent a Commission's official position.

The Forum is an advisory body of experts from main parties interested in accounting in theEuropean Union. The Forum is not a standards-setting body. Its main function is to advisethe Commission on accounting matters and possible ways to facilitate furtherharmonisation. The members of the Forum are invited on a personal basis. Their opinions,as expressed in this document, do not commit the organisations by whom they have beennominated, nor do they reflect the unanimous view of all the members.

The purpose of this publication is to stimulate discussions among standards-setters,preparers, users and auditors of accounts in Member States on the subject of Prudence andMatching. The document examines the various possibilities for furthering the presentationof comparable and equivalent information within the context of the Accounting Directives.


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CONTENTS

Paragraphs

INTRODUCTION1 - 3

REASONS FOR DIFFERENT INTERPRETATIONS AND

APPLICATIONS OF THE PRUDENCE AND MATCHING

PRINCIPLES

4 - 7

PRINCIPLE OF PRUDENCE

A) Prudence and Risk 8 - 10

B) The use of prudence in the Fourth Directive 11 - 12

1) Prudence in recognising and valuing assets and liabilities 13 - 14

2) Prudence in obtaining an adequate assessment of situations of particular risk

15

3) Prudence in dealing with profits (Realisation principle) 16 - 21

C) Possible consequences of different interpretations of prudence 22 - 25

PRINCIPLE OF MATCHING 26 - 29

RELATIONSHIP BETWEEN PRUDENCE AND MATCHING 30 - 33

CONCLUSIONS 34 - 38


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INTRODUCTION

1. One of the objectives of the European accounting harmonisation is to make accountsin the European Union equivalent and comparable and, for this purpose, "thedifferent methods for the valuation of assets and liabilities must be coordinated to theextent necessary" 1. This means that the existence of differences can be tolerated aslong as it does not prevent accounting information from being comparable andequivalent. Sometimes, however, different interpretations and applications of valuation rules and accounting principles can constitute an obstacle to the Europeanaccounting harmonisation process and therefore their elimination constitutes one of the major challenges that European accounting faces in the near future.

2. Several years' experience in the implementation of the EC Accounting Directives inMember States have highlighted divergencies in the interpretation and application of valuation rules and accounting principles. These problems seem to affect in particularthe principles of prudence and matching. A survey conducted by FEE 2, covering aselection of EU Member States, has recently confirmed the existence of :

a. Differences in the interpretation of both prudence and matching, which mainlyrelate to the different ways of perceiving whether profits are realised or not.

b. Differences in the interpretation of the relationship between these twoprinciples, which often result in the prudence principle taking precedenceover the matching principle.

Such differences are evident when considering issues such as the capitalisation of research and development costs, the valuation of marketable securities, the valuationof long-term contracts, the recognition of translation differences on foreign currency

balances, the treatment of government grants for capital expenditures, the treatmentof payments on account and tangible assets in course of construction, the choice of cost formulae used for finished goods and goods held for resale.

3. The objective of this paper is therefore to analyse problems relating to theinterpretation and application of the prudence and matching principles, in order tounderstand to what extent such problems may render more difficult to obtainequivalent and comparable accounts. In order to reach its objectives, the paper, afteran analysis of the reasons for different interpretations and applications of prudenceand matching, will examine the characteristics of the two principles as well as therelationship between them. In its conclusions the paper does not present any ultimate

solution to the problems analysed but tries to identify what could be possible ways of moving ahead on this subject.

REASONS FOR DIFFERENT INTERPRETATIONS AND APPLICATIONS OF

THE PRUDENCE AND MATCHING PRINCIPLES

1 Fourth Council Directive of 25 July 1978 (78/660/EEC) on the annual accounts of certain types of companies - O.J. L222 of 14.8.1978 - Preamble

2 Discussion paper on the application of prudence and matching in selected European countries-Brussels- 1994


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4. When looking at the reasons for different interpretations and applications of theprudence and matching principles, one should at first note that, generally, theapplication of any accounting principle is in no way a mathematical exercise. Unliketechnical rules in fact, it always requires the use of a certain degree of judgementwhich, by definition, can change depending on people and situations.

In the Accounting Directives no derogation from the normal application of anaccounting principle is allowed on the basis of the size (large, medium, small), thebusiness activity or other characteristics (whether listed or not) of a company.However, it is not always possible to decide on the basis of an accounting principlestated in the Directives how such principle should be applied in practice, nor to saythat it must be applied in the same way in different situations.

5. The existence of certain divergencies is, in a certain sense, unavoidable. Some of them are due to the fact that times change and that economies and accountancyevolve, so that the interpretation of principles may change and the application of rules established in the past may not be sufficient to fit the present economic and

accounting framework. When new types of business transactions are created, thelack of specific guidance on how to deal with them can lead to differentinterpretations and applications of the same general principles.

Other differences are due to the implementation and application process. The samephrases can be interpreted differently depending on the country, because of differences in culture, history, tradition and language. Moreover, as the AccountingDirectives state general rules but do not specify all their practical applications, thereis no certainty that the specific technical rules developed in Member States alwaysinterpret the same general principle in the same way. Therefore, while an agreementcan be reached on a general concept, divergencies may appear afterwards, in thepractical applications of the concept itself.

6. It is often said that the main reason why the prudence and matching principles areinterpreted so differently is the different understanding of the objectives of financialstatements. It is a fact that in Europe the relative importance of the objectives of financial reporting and the role of financial statements vary from country to country.In some Member States financial information is mainly used as a means of assuringshareholders and other interested parties (e.g. creditors) of the capability of theenterprise to produce distributable profits, to satisfy its obligations and to continue toexist as a going concern, while in other Member States it is mainly used as the basis

for taking economic decisions by investors, particularly in the capital markets. Thepresentation of more conservative information, while in the former case is notperceived as constituting a major problem, is usually considered as misleading for theachievement of the latter objective..


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Accounts should be neutral and therefore be designed to represent the results of events that have actually happened rather than to achieve a predetermined, ulterioreffect. A different use of financial information may however result in a differentemphasis given to the accounting principles used in the preparation of the financialstatements, and lead to different interpretations and applications of the sameaccounting principles and rules.

7. Another reason which is often advanced in order to explain the existence of adifferent understanding of prudence and matching is taxation. Fiscal considerationsplay an important role in the application of valuation rules, at least in certain MemberStates. As fiscal rules vary from country to country, this has important consequenceson the application of accounting rules. The Accounting Directives do not directlydeal with fiscal problems. However, in those Member States where a strong linkageexists between the commercial accounts and the accounts which serve as a basis forthe assessment of income tax, there is no doubt that the Accounting Directives mayhave been interpreted in a way which is influenced by the fiscal situation of companies. Where the accounts have been influenced by value adjustments which

have been carried out for tax purposes only, the 4th Directive requires additionalinformation to be included in the notes to the accounts, in order to restore thecomparability of the accounts. As valuation rules in some countries are directlylinked to the determination of taxable income, this should clearly be borne in mind,should any change to valuation rules with the effect of modifying the taxable incomebe proposed.

In several cases the legal and economic environment may influence the application of accounting rules. Such influences may render the comparability of financialinformation very difficult and it is for this reason that the Accounting Directives,when permitting options, often require additional disclosures in the notes, in order torestore comparability.

Differences in the socio-economic and legal environment may also lead tointerpretations of a number of provisions contained in the Accounting Directivesgiven by national law or standards adopted by national standard setting bodies whichare different from one Member State to another. In addition, it has been pointed outthat sometimes a distorted use of accounting principles is made by economicoperators, which results in an arbitrary way of applying accounting techniques withthe only purpose of serving specific financial strategies.

PRINCIPLE OF PRUDENCE

A) PRUDENCE AND RISK

8. In the case of prudence, the above-mentioned general statement that the applicationof an accounting principle is in no way a mathematical exercise is particularly true.This is because the application of prudence is particularly linked to situations of uncertainty and risk which make greater demands on judgement. The IASCFramework addresses this point when it defines prudence as "the inclusion of adegree of caution in the exercise of the judgements needed in making the estimatesrequired under conditions of uncertainty, such that assets or income are not

overstated and liabilities or expenses are not understated."


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9. Although the linkage between prudence and risk is unanimously recognised, viewsdiffer as far as the consequences of such a linkage are concerned.

One school of thought (IASC Framework, FASB Concept No.2, UK Statement of Principles) lists prudence among the several qualitative characteristics (attributes)which make the information provided in financial statements useful to users. IAS1defines prudence as one of the considerations that should govern the selection andapplication by management of the appropriate accounting policies. In developing theIASC text, the UK ASB also specifies that prudence is to be seen as an attitude of mind, denoting the careful assessment of all uncertainties and a vigilance to possiblerisks rather than a systematic measurement bias. In none of these documents isprudence seen as an overriding accounting principle.

Another school of thought understands prudence as a principle having precedenceover all other principles, a fundamental valuation rule to be applied in the preparationof the accounts. In some EU Member States this understanding lies at the basis of theinterpretation of the 4th Directive.

10. As prudence is associated with risk and its perception, it has been suggested that oneway towards a better understanding of prudence is to define and analyse risk. This isnot an easy task, because different people almost always have different perceptionsof the same risks, and sometimes they take certain financial risks in order to manageother business risks. One should note also that the perception of risk is highlyinfluenced by the entity's activities and its characteristics, so that it has been said thatto each business activity is linked a particular, "innate" kind of risk (for example, in aloan, fixed rates are usually perceived as more risky than variable rates for the lenderbut less for the borrower, who may rely on the certainty of financial commitmentsthat they provide in order to build his medium to long-term business strategy).

B) THE PRINCIPLE OF PRUDENCE IN THE 4TH DIRECTIVE

11. The principle of prudence as contained in the Directive is set out in Article 31(1)(c)in the following terms:

"valuation must be made on a prudent basis, and in particular:

aa) only profits made at the balance sheet date may be included,

bb) account must be taken of all foreseeable liabilities and potential losses arising in the courseof the financial year concerned or of a previous one, even if such liabilities or lossesbecome apparent only between the date of the balance sheet and the date on which it isdrawn up,

cc) account must be taken of all depreciation, whether the result of the financial year is a lossor a profit ".


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While the contents of this article will be examined in the following Sections, it isimportant here to note that the Accounting Directives do not provide a full definitionof prudence. Article 31(1)(c) states some important specifications, but it is clear fromthe word "in particular", that only a part of the practical implications of prudence isindicated there. Therefore, in order to have a more precise idea of how prudence inaccounting should be understood, it is useful to go further and see how the concept is

developed in the 4th Directive as a whole.12. The different ways in which the prudence principle plays a role in the 4th Directive,

could be grouped under three basic headings:

a) Prudence reflected in the recognition and valuation of assets and liabilities.Prudence plays a fundamental role in the recognition of assets and liabilities,by delimiting the circumstances under which certain expenditures can berecognised as assets and by requiring adequate consideration of foreseeableliabilities and potential losses. Prudence also plays an important role in thevaluation of assets: although the basic rule is that assets must be valued athistorical cost, the application of the prudence principle requires that they areshown at a lower value attributable to them at the balance sheet date.

b) Prudence in obtaining an adequate assessment of situations of particular risk.As economic activities involve risks and uncertainty, prudence should be usedin reflecting them in the accounts, in order to give a true and fair view.

c) Prudence in dealing with profits. Prudence plays a role in determiningwhether profits can be recognised in the profit and loss account and indeciding their destination.

B.1) P RUDENCE IN RECOGNISING AND VALUING ASSETS AND LIABILITIES13. The 4th Directive does not define assets, but contains some specific rules concerning

their recognition and valuation, in which prudence plays an important role.

Certain expenditures (formation expenses, costs of research and development,internally generated patents, licences and trade marks) may be recognised as an assetin so far as this is permitted by national legislation (Articles 9 and 10(Assets)(B)/(C)(I)(1)(2b)). The recognition as assets of goodwill and otherintangibles like concessions, patents, licences and trade marks, is in any casepermitted, when they have been acquired for valuable consideration (Articles 9 and10 (Assets)(C)(I)(2a)(3)). Internally generated goodwill can never be recognised asan asset.

The valuation of assets is based on the principle of historical cost (Article 32).However, the application of the prudence principle requires that economic reality iscorrectly reflected in the accounts and that any decrease in value is duly recorded, bytaking account of all depreciation, whether the result of the financial year is a loss ora profit (Article 31(1)(c)(cc)). Therefore, assets might be valued at a figureattributable to them at the balance sheet date, which is lower than the historical cost.


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a) As far as fixed assets are concerned, this provision may be applied to financialassets (Article 35(1)(c)(aa)), and must be applied to all fixed assets for whicha reduction in value is expected to be permanent (Article 35(1)(c)(bb)).

b) As far as current assets are concerned, this provision is always applicable(Article 39(1)(b)).

In addition, Member States have the option to permit exceptional value adjustmentsto be made in respect of current assets, where such adjustments are necessary if thevaluation of the items concerned is not to be modified in the near future because of fluctuations in value (Article 39(1)(c)). This option gives the possibility to anticipatethe losses for those commercial sectors (for example : commodities with fluctuatingprices) where it is expected that a future drop in the value of the goods will occur.

14. The 4th Directive does not specifically deal with the valuation of liabilities, norprovide for their definition. The influence of prudence is however evident in somerules concerning their recognition. The general requirement of Article 31(1)(c)(bb)

that account must be taken of all foreseeable liabilities and potential losses arising inthe course of the financial year concerned or of a previous one, even if such liabilitiesor losses become apparent only between the date of the balance sheet and the date onwhich it is drawn up, is further detailed in Article 20(1) .

This paragraph covers probable losses and probable debts where there is anobligation to third parties. It requires the setting up of provisions to cover losses ordebts the nature of which is clearly defined and which at the date of the balance sheet,are either likely to be incurred or certain to be incurred, but uncertain as to amount oras to the date on which they will arise.

B.2) P RUDENCE IN OBTAINING AN ADEQUATE ASSESSMENT OF SITUATIONS OF PARTICULARRISK

15. Another basic way in which prudence plays a role in the 4th Directive relates to theassessment of situations of particular risk, which do not, as such, appear in thebalance sheet. In order to take account of these off-balance sheet situations, theDirective requires certain disclosures in the notes.

All foreseeable liabilities and potential losses should be reflected in the accounts,according to the above mentioned Article 31(1)(c)(bb). In addition, Article 43(1)(7)explicitly requires that the total amount of any financial commitments not included inthe balance sheet be shown in the notes, insofar as this information is of assistance inassessing the financial position of the company.

These two requirements demonstrate the clear intention of the 4th Directive to ensurethat all material situations of risk be adequately examined and sufficiently reported bydisclosing both quantitative and qualitative information.


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The role that prudence plays in obtaining an adequate assessment of items involvingsituations of particular risk not covered in the balance sheet is extremely important,given the enormous effect that such situations can have on the company's overallposition. This is clearly evident also from recent debates on environmental accountingand financial instruments issues.

B.3) P RUDENCE IN DEALING WITH PROFITS (REALISATION PRINCIPLE )

B.3.1) The origin of profits

16. As far as profits are concerned, the 4th Directive contains the basic requirement thatonly profits made at the balance sheet date may be included in the accounts. Theproblem is that this rule, laid down in Article 31(1)(c)(aa), can be interpreteddifferently, depending on what is considered as a profit "made" (or, as it is said inother languages, "realised"). One possible way of looking at the problem of realisation could be that of examining how profits are generated. In this respect,three different categories can be identified:

a) profits arising from transactions,

b) surpluses arising from increase in value,

c) income arising from other events.

B.3.1.a) Profits arising from transactions.

17. As far as the treatment of profits arising from transactions is concerned, a transaction

is usually considered realised and the corresponding profit is recognised in the profitand loss account when the following criteria are met (realisation test) 3:

- Existence of a contractual agreement,

- Compliance with the relevant terms of the contractual agreement,

- Transfer of risk has taken place.

The universality of such a realisation test, however, is increasingly challenged. In thecase of long-term contracts, for example, although the above-mentioned criteria are

not completely met, it is possible to recognise the profit in proportion to the stage of completion of the contract. As stated by the Contact Committee on the AccountingDirectives, this is however subordinated to the condition that the prudence principleis observed, and particularly that: -) the total contract income is known, -) theproportion of work completed can be calculated accurately and -) the work on thecontract must be sufficiently advanced 4.

3 FEE: op.cit., page 6

4 The accounting harmonisation in the European Communities: problems of applying the FourthDirective on the annual accounts of limited companies, Luxembourg,1990 - page23.


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Criticism of the above-described realisation test concentrates in particular on the first(existence of a contractual agreement) and third (transfer of risk) criteria.

a. As far as the first criterion is concerned, it has been pointed out by somepeople that, in the case of highly liquid organised markets, the existence of aspecific contractual agreement might no longer be necessary for a profit to beconsidered as "made". A market is usually defined as "highly liquid" inrelation to a potential transaction when it is of sufficient depth to absorb thetransaction without significantly affecting the price. In such organisedmarkets (like for example securities markets), the existence of "marketmakers" operators committed to buy certain assets (for example securities) ata published price would ensure the existence of a certain profit at a certaindate, which would be recognised in the profit and loss account, regardless of whether the corresponding asset has in fact been sold. Even when "marketmakers" in the above sense are not present, the volume of trading in a marketmay be sufficient to determine at any time an objective price at which an assetcould be sold.

In these circumstances it is contended that no substantial difference existsbetween a " not yet realised but highly realisable" profit and a profit whichhas been "completely realised" through the sale of an asset and immediatelyreinvested in an identical asset. Others however respond that if the existenceof the sale of an asset were no longer necessary to consider the related profitsrealised, any manufacturer could claim the realisation of profits on a saleeven if no real sale has yet occurred.

In this context it is interesting to note that the Bank Accounts Directivepermits the recognition of "realisable" profits for transferable securities not

held as financial fixed asset and that the Insurance Accounts Directivepermits, and in certain cases requires, that investments are shown in theaccounts at their current value. Neither the Bank Accounts Directive nor theInsurance Accounts Directive contain a specific justification for this departurefrom the 4th Directive.

b. As far as the transfer of risk is concerned, the problem here mainly consists inthe fact that in some countries this is interpreted as the transfer of all risks,while in other countries it is understood as the transfer of all material risks.The most appropriate approach seems to be that of recognising that thetransfer of risk has occurred when all risks have been transferred, except of course those which are a direct consequence of the realisation of thetransaction itself. The credit risk for example should not be considered whendeciding whether a transaction is realised or not, because the existence of thecredit risk itself is a consequence of the fact that the transaction is realised(otherwise no credit will exist and therefore no credit risk). The same is truefor the "risk for after sale guarantees" and the "risk for exceptional events",which would exist only on the assumption that the transaction to which theyrefer is considered as realised.


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In addition to the question of how many risks one has to take into account(all or all material), differences in interpretation can also be noted as regardsthe moment at which such risks are considered as being transferred (forexample, when signing the contract or when delivering the goods). Thesedifferences are particularly significant when the transfer of risks is not strictlylinked to the transfer of the legal title of ownership. Lease contracts

constitute a typical example of how much accounting treatments may differsimply depending on how the transfer of risk (and its relationship with thetransfer of title) is defined 5.

18. A more fundamental question relating to realisation consists in considering whether itis appropriate to apply the same realisation criteria to all profits, regardless of thespecific characteristics of the assets from which the profits are generated. In thisrespect, it seems appropriate to consider the remarks expressed in paragraph 17 a)and b) above in relation to the specific cases of finished goods, foreign currencyitems and marketable securities.

In the case of finished goods, it is normally understood that no market can beconsidered sufficiently liquid to allow the recognition of "realisable" profits. Forinstance, in the case of the sale of a stock of cars, a liquid organised market does notexist and all risks are not really transferred until the cars have actually been delivered.

On the contrary, in the case of foreign currency items, the characteristics of thatparticular market seem to permit the recognition of "unrealised" profits without thisbeing necessarily in conflict with a correct interpretation of the prudence principle. Itis understood in fact that foreign currency markets are normally capable to absorb asubstantial number of important transactions without this significantly affecting

prices.The case of marketable securities is a particular one and raises a number of considerations. Here organised markets exist where securities can be sold at anymoment by a simple phone call. No general risks exist, besides the one thatauthorities may stop trading activities. However, this does not appear sufficient toconsider the liquidity of security markets in general so high to allow the recognitionof "realisable" profits. In fact, the liquidity of a single, particular security may besignificantly different from the average liquidity of the total market. Obviously certainshares are more tradeable than others and state bonds usually have a liquidity whichis much higher than that of shares. Moreover, in the case of shares, although the

market is very liquid in general, the risk that it becomes suddenly unliquid withreference to some specific shares may still be high. Indeed, the riskiness of a market,in addition to its liquidity, is an important element that should also be taken intoaccount. For these reasons it seems necessary to operate a distinction inside eachsecurity market. While there are cases (e.g. state bonds) where such markets have aliquidity comparable to that of foreign currency markets, other cases exist (e.g.corporate shares) where it seems difficult to admit that in the absence of a materialtransaction profits on marketable securities may be considered as realised. The

5 Accounting for lease contracts - Paper of the Accounting Advisory Forum, Luxembourg,1995 -paragraphs 5-15


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question of course remains how to determine exactly within given security marketsthe boundary between the highly liquid and non-highly liquid part of them.

In conclusion, if Article 31(1)(c) of the 4th Directive were to be amended so as toallow for the inclusion in income of positive differences on marketable securities, adistinction would have to be made between those situations where the market is"highly" liquid and those situations where it is not. Another question which wouldthen also have to be answered is whether these positive differences should beavailable for distribution.

In any case, the 4th Directive as presently drafted is based on the principle of historical cost and assets can be shown at their higher market value only under theconditions set out in Article 33. As marketable securities, unlike foreign currencytranslation differences, are assets, any consideration about their liquidity issubordinated to the possibility that higher market values be recognised in theaccounts according to the 4th Directive. This would of course require an amendmentto Article 32 of the 4th Directive.

B.3.1. b) Surpluses arising from increase in value

19. Surpluses arise from revaluation when items are reported at a value higher thanhistorical cost, for instance in order to reflect the effects of changing prices. Thetreatment of such surpluses does not seem to constitute a problem in relation to theprudence principle. The 4th Directive, in fact, already provides specific rules to dealwith these surpluses, which may be recognised in the profit and loss account onlyunder the particular conditions and following the specific procedure laid down inArticle 33. So far, the Member States which have applied Article 33 have notexperienced any particular problems with the prudence principle. This is due to the

fact that increases in value cannot be distributed and are retained in the company as apart of equity, unless they are realised through use or sale.

In the case where the arguments concerning the "not yet realised but highly realisablegains" referred to in the above paragraphs 17a and 18 are considered as valid, thepresent category should also include such gains. However, while the increases invalue dealt with by Article 33 are to be considered as "holding gains", the readilyrealisable gains arising from assets simply held as a store of value would beconsidered as a part of the operating performance of the enterprise, and therefore berecognised in income rather than being allocated to the revaluation reserve.

B.3.1.c) Income arising from other events

20. Income arising from "other events" is that which cannot be associated either with atransaction or with an increase in value. It therefore includes income arising fromseveral different sources, like for example reimbursement from tax authorities andinsurance undertakings and income deriving from reversal of provisions.

B.3.2) The destination of profits

21. Another possible way in which prudence plays a role as regards profits can beexamined by looking at profits not from the point of view of their origin, but ratherfrom the perspective of their destination. One could in fact argue that prudence


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comes into consideration not only at the moment of recognising something as aprofit, but also when deciding how this profit should be used. This is the case inseveral company law provisions where, through the concept of legal capitalmaintenance, prudence sets limits to the distribution of profits 6. A similar approachmay also be noted in the 4th Directive (Articles 33,34 and 37), where a specificallocation of certain profits is required because of prudence. According to Article 33,

surpluses deriving from revaluations are included in a specific reserve and are notdistributable until they represent gains actually realised. Articles 34 and 37 do notallow profits to be distributed, when the level of the reserves available fordistribution does not exceed the amount necessary to cover the residual amortisationof certain capitalised expenditures (formation expenses and research anddevelopment expenses).

C) LIMITS TO THE INTERPRETATIONS OF PRUDENCE

22. So far, the document has shown quite clearly how difficult it is to avoid differentinterpretations of prudence. This is because the way of perceiving risk, uncertainty

and consequently prudence is different in Member States, for historical, cultural andeconomic reasons.

The fact that there are no clearly defined criteria and rules to determine the level of prudence to be used in different situations could lead to the unfortunate consequencethat the application of prudence is seen as a tendency to create deliberateunderstatements. This perception also plays an important role in the internationalaccounting debate.

This danger has been recognised in IAS1, which says:

"Uncertainties inevitably surround many transactions. This should be recognised by exercisingprudence in preparing financial statements. Prudence does not however justify the creation of secretor hidden reserves."

The same idea is expressed in FASB Concept No. 2, which says:

"unjustified excesses in either direction (overstatement or understatement) may mislead one group of investors to the possible benefit or detriment of others".

6 Second Council Directive of 13 December 1976 (77/91/EEC) on the formation of public limitedliability companies and the maintenance and alteration of their capital - OJ L26 of 31.1.1977-Articles 15 and 16


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23. The 4th Directive recognises this risk and, besides many provisions intended torequire the use of an adequate level of prudence, it also contains a certain number of provisions intended to limit the possible consequences of a distorted interpretation of prudence. This is due to the fact that being over-prudent will result in accounts thatno longer show a true and fair view. For instance, when a provision is overstated,this will affect not only the periods in which it is overstated, but also those periods in

which the provision is released. The measures provided in the 4th Directive in orderto ensure an even-handed use of prudence relate both to the assets and to theliabilities side.

a) On the assets side, for example, it has been provided, for both fixed andcurrent assets, that the lower amount attributed to them cannot be maintainedif the reasons for which it has been made have ceased to apply (Articles35(1)(c)(dd), 39(1)(d)).

b) On the liabilities side, it has been required that the setting up of provisions islimited to those cases in which losses, debts or charges are clearly defined in

their nature and are either likely to be incurred or certain to be incurred(Article 20, paragraphs 1 and 2) . Such provisions may not be used to adjustthe value of assets (Article 20, paragraph 3) and cannot exceed in amount thesums which are necessary (Article 42, paragraph 1).

24. It is a fact however, that, despite the existence of specific measures which aim atavoiding an incorrect use of prudence, certain provisions of the 4th Directive havebeen used sometimes as a means of significantly influencing the results of anenterprise.

a) An example is constituted by Article 20(2), which refers to provisions for

charges where there is no obligation to third parties . This paragraph gives toMember States the possibility of authorising the creation of provisionsintended to cover charges which have their origin in the financial year underreview or in a previous financial year, the nature of which is clearly definedand which at the date of the balance sheet, are either likely to be incurred orcertain to be incurred, but uncertain as to amount or as to the date on whichthey will arise. It has been noted that sometimes this possibility has been usedfor other purposes, so as to create hidden reserves.

b) Another case where prudence is required in valuing assets, but the use of different degrees of it can lead to different results, is the calculation of production costs (Article 35(3)). As the inclusion of certain costs is anoption, different results of such a calculation are possible. This can generatemajor differences, particularly as regards the valuation of stocks. The use of direct costing for example, if compared with the use of full production costmethods, will generate a lower inventory value and, where stock levels areincreased, will cause an increase in charges in the profit and loss account anda reduction of income. Therefore, some people believe that direct costingmay be deliberately selected with the specific intention of obtaining moreconservative results.


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25. The fact that prudence may sometimes be taken as an excuse to justify deliberateunderstatements of the results is however not only linked to the particular use of certain specific provisions. It is understood that Article 31(1)(c) of the 4th Directiverequires an "uneven" treatment of unrealised profits and losses (i.e. recognition of unrealised losses and deferral of unrealised profits). Although there is no doubt that,because of prudence, a cautious approach in the treatment of unrealised results is

required, it should be equally clear that this cannot be used as a means of modifyingthe financial position of an enterprise. In particular, when unrealised profits andlosses are so closely linked that the realisation of the latter is not conceivable withoutadmitting at the same time the realisation of the former, even the application of theso-called "imparity principle" would not lead to the recognition of the unrealisedlosses without taking account, at the same time, of the unrealised profits.

Therefore, prudence should not be taken as an excuse to apply accounting rules in aninconsistent way. Once a particular treatment has been selected and judged asappropriate, it should not be possible to apply it only when it gives the most"prudent" results. For example, when from the translation of items expressed in thesame foreign currency (receivables and payables of the same amount, expressed inUS$ and having the same expiry date) both gains and losses arise, prudence shouldnot be used as the justification for including in income only the losses and for notrecognising the gains.

Nor should prudence be used to support a too literal interpretation of certainprovisions of the Accounting Directives. For example, although Article 31(1)(e)states that the components of assets and liabilities must be valued separately, such aseparate valuation may not correspond to economic reality. When one already knowsthat at the expiry date no profits or losses will arise, prudence should not be taken as

an excuse to recognise the losses and to defer the gains at the balance sheet date.PRINCIPLE OF MATCHING

26. The 4th Directive does not contain any definition of the matching principle, which iscommonly considered as embodied in the accrual principle. The accrual principle iscommonly understood as set out in Article 31(1)(d) of the 4th Directive, whichstates:

" account must be taken of income and charges relating to the financial year, irrespective of the dateof receipt or payment of such income or charges".

While there are no divergencies in interpreting the accrual concept, no uniqueinterpretation of matching exists. The principle of matching is often understood as thepractice of allocating expenditure to the related income. Any resulting balance sheetnumbers are explained as essentially residuals from the matching process. This isusually referred to as the "profit and loss account approach".

Allocating expenditure to the related income could be interpreted to mean deferringsome costs and anticipating others on the basis of a somewhat subjective view of what matches current income. There is concern that matching of this kind opensconsiderable flexibility for management to smooth results. Consequently, many prefer

to specify that the application of matching can in no case allow for the recognition of items in the balance sheet which do not represent rights or other access to futureeconomic benefits (assets) or obligations to transfer benefits in the future (liabilities),


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or the ownership interest (equity) which is equal to the net of assets and liabilities.This is usually referred to as the "balance sheet approach".

Although the matching principle is not explicitly defined in the 4th Directive, itshould be pointed out that several valuation rules exist, applying in practice theprinciple of matching, like, for example, the possibility to capitalise expenses and therequirement to depreciate assets.

27. The distinction between accrual and matching is not always immediately perceivedand, in this respect, the following example could be useful. A rental contract isentered into in year 1 for hire of a machine in year 2 for the production of goods tobe sold in year 3. The accrual principle requires that the invoice for hire of themachine, paid in year 1, is recorded as a prepayment, because it refers to year 2; thematching principle requires that, if indirect production costs are capitalised, themachine hire invoice is taken into account in the calculation of the value of thefinished products sold in year 3. In year 3, when products are sold and income isrecognised, the costs are charged to the profit and loss account.

28. Among the provisions which contain the principle of matching, it has been noted thatone could list also the option of including indirect costs in the production cost(Article 35(3)), already mentioned in paragraph 24(b) above.

An additional provision which embodies the principle of matching is Article 20(2),which allows Member States to authorise the creation of provisions for charges (seealso paragraph 24). This option, which has been provided for in order to cover majorand recurring maintenance costs and expenditures on major repairs, permits a moreprecise periodic calculation of profits. For example, in the case of an aircraft, certainmaintenance expenditures are incurred once every ten years, and are anticipated by

creating a provision in order to spread the costs equally over the periods. Anotherway of dealing with this may consist in depreciating parts of the assets faster, inorder to have a depreciation allowance sufficient to cover the cost of themaintenance expenditures, when it is needed.

29. The technique of matching should of course never become the occasion of anticipating income which cannot be reasonably considered as already "realised". Ina certain sense, therefore, the application of matching should be done "prudently" (asfor example in the case of the application of the "stage of completion" method for thevaluation of long term contracts, see paragraph 17 above), by carefully taking intoaccount all the circumstances that may affect the prospective income. On the other

hand, matching should not be taken as an opportunity to defer income which canreasonably be considered as already "realised". In conclusion, trends of both over-matching and under-matching should be strongly condemned (as it is for prudence).The 4th Directive is quite explicit in this sense, at least when it states that:

"Provisions for liabilities and charges may not be used to adjust the values of assets(Article 20(3))".

"Accounts must be taken of all depreciation, whether the result of the financial yearis a profit or loss (Article 31(1)(c)(cc)).

Value adjustments may not be continued if the reasons for which they were madehave ceased to apply (see Articles 35(1)(dd) and 39(1)(d)/(e)).


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"Provisions for liabilities and charges may not exceed in amount the sums which arenecessary (Article 42)"

RELATIONSHIP BETWEEN PRUDENCE AND MATCHING

30. It is generally agreed that conflicts do not arise between accrual and prudence.However, views differ regarding the relationship between matching and prudence. Inthis respect, different approaches can be identified.

31. According to some people, prudence as it is stated in the 4th Directive is not inconflict with matching, if properly conceived. This is the logical consequence forthose who think that prudence is an attitude of mind, say a general attitude whichgoverns the application of accounting policies and leads to a true and fairrepresentation of financial statements. According to these people, while matching isan accounting convention, prudence is a general attitude which, when properlyconceived, is instrumental in leading to the true and fair view. While matching isroutine, prudence is a judgement made at a later stage, after applying all accounting

conventions, to assess if all risks have been fairly represented. Following thisinterpretation, the possibility of conflicts between prudence and matching lies in theconsequence of conceiving prudence in a mechanistic way, which approach should berejected.

One of the main reasons for this view appears to be the fact that the 4th Directivedoes not contain a definition of assets and liabilities, which would be of extremeusefulness for the definition of a more clear relationship between prudence andmatching. To this it is sometimes replied that, even where a definition of assets andliabilities existed, there would still be difficulties to clearly identify the exact balancebetween the two principles (e.g. in the case of advertising costs).

32. Other people are of the opinion that conflicts between prudence and matching, asthey are intended in the 4th Directive, are possible. For instance, some people arguethat certain expenditures cannot be capitalised as particular types of assets such asinternally generated intangible assets because such capitalisation would be in conflictwith the prudence principle, although the application of the matching principle mightimply that these expenditures be effectively capitalised as intangible assets. In thiscase, the question arises which of the two principles should have priority. From theFEE survey 7 it appears that, in the surveyed countries, where the application of thematching principle appears inconsistent with the prudence principle, the latter iscommonly regarded as taking precedence. This appears particularly in thosecountries where the main objective of financial statements is legal capitalmaintenance and creditors' protection. In this sense, the prudence principle plays apredominant role in preparing accounts. This does not necessarily mean that theprudence principle is intended as an overriding principle, but rather that all otherprinciples are applied by taking prudence duly into account.

33. Under a different perspective, some people believe that the 4th Directive does notestablish a hierarchy among valuation principles. They base their thesis on the generalprovisions of Article 2, where it is stated that:

7 op.cit., page 5


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" 3. The annual accounts shall give a true and fair view of the company's assets, liabilities,financial position and profit and loss.

4. Where the application of the provisions of this Directive would not be sufficient to give atrue and fair view within the meaning of paragraph 3, additional information must be given.

5.Where in exceptional cases the application of a provision of this Directive is incompatiblewith the obligation laid down in paragraph 3, that provision must be departed from in order togive a true and fair view within the meaning of paragraph 3. "

Following this interpretation, the true and fair view principle is an overriding one.Therefore, the application of all other accounting principles can be suspended inthose exceptional cases where this application leads to a picture which is not true andfair. They underline also the different level of application of the prudence andmatching principles compared with that of the true and fair view concept. Theprudence and matching principles are applied only in examining and estimating theindividual items composing annual accounts and do not constitute real underlyingassumptions. The true and fair view concept, on the contrary, is a general provision

that applies both to the estimation of individual items and to the accounts taken as awhole.

According to this line of thinking, the establishment of a hierarchy between theprudence and matching principles is not necessary, since there is only one possiblebalance of the two that generates a true and fair view. This balance is normallyprovided by the application of the provisions in the Accounting Directives, in whichno supremacy is given to either of these two concepts. Instead of being seen asalternatives, prudence and matching should be understood as complementary.

In the opinion of other people, however, the true and fair view principle is a useful

way out in exceptional situation but cannot be seen as an absolute concept.According to this point of view in fact, the true and fair view is a situation alwaysdepending on the state of mind of the preparers, taking account of what users expectto receive, which is not necessarily corresponding to an objective balance of prudenceand matching (other preparers and users could have a different judgement of such abalance).

CONCLUSIONS

34. The discussion in the above paragraphs clearly shows that, at present, in Europethere is different understanding of what exactly prudence, matching and their mutual

relationship are. Moreover, it is a fact that in some cases where in one Member Statea certain accounting treatment is chosen, in another Member State, on the basis of the same text, a different treatment is used. These differences, which already exist atthe level of national legislation and/or accounting standards, are amplified by thesometimes distorted use which is made in practice of the two principles. Problemsarise in particular when preparers of accounts give their own interpretations togeneral principles contained in the Accounting Directives or to the interpretationsalready given at national level to those principles. This may result in an arbitrary wayof applying accounting techniques with the exclusive objective of serving a particularfinancial strategy. In this way, it may happen that companies be prudence-orientedwhen they have good performances and desire not to show their results completely,while they become suddenly matching-oriented when their performances are poorerand do not meet the budgeted results.


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For these reasons, more and more people today recognise that the differencesanalysed in the preceding pages may constitute an obstacle not only to furtherdevelopments in the European accounting harmonisation process, but even to thepreservation of the level of harmonisation which has already been achieved.

However, views about the most suitable way on how to solve these problems differ.According to some people, the best solution would consist in amending the existingAccounting Directives, in order to make the wording more precise (and therefore tolimit the possibility of applying different interpretations) and to reflect the experienceacquired since their implementation. Other people prefer to leave the Directives asthey are, to give an official interpretation of their text and to deal separately withnew issues originally not covered by the Directive, so that material divergencies intheir application are no longer possible. In this respect, it is important to note that the4th Directive itself already provided for a solution in this sense: a Contact Committeecomposed by the representatives of the Members States has been in fact establishedwith these specific tasks 8.

It is not the purpose of this paper to propose any particular action in this field. Itseems sensible, however, to summarise below the main problems, as well as possiblesolutions which seem to deserve a closer analysis in the near future.

35. The discussion on the prudence principle (and particularly Section B.3) illustrates thepresent division of opinion over the interpretation of the concept of realisation. Somepeople conclude from this discussion that it is not possible, under the presentcircumstances, to interpret the concept of realisation in a way that justifies therecognition in income of gains which do not meet the realisation test as set out inparagraph 19. In their view, allowing exceptions to this interpretation of the conceptof realisation in specific cases (for instance, for readily realisable but not yet realisedgains), stretches out the realisation principle in such a way that eventually it willmake the principle meaningless. Others, however, take a different point of view.They believe that it is possible to give a broader interpretation to the realisationprinciple by taking into account other criteria for realisation, such as for example, thereliability of measurement of an asset. The question remains whether this broaderinterpretation can be justified on the basis of the present text of the 4th Directive, orwhether an amendment of that text is necessary to make this clear.

36. As pointed out in paragraphs 6 and 7, one of the main reasons for differentinterpretations of accounting principles (notably prudence and matching) is due to

the fact that the profit shown in the annual accounts is significantly influenced by thedistribution of dividends and in some countries also by the calculation of incometaxes. To solve this problem it has been proposed that accounting principles beapplied differently in annual and in consolidated accounts, the latter not being linkedto taxation and profit distribution. This approach could be based on Article 29(2) of the 7th Directive, where it is said that valuation rules applied in consolidatedaccounts can be different from those applied in annual accounts, provided that theyare permitted under the 4th Directive. Opponents reply that, in a particular instance,there can only be one true and fair presentation and that it is hard for users to

8 Fourth Council Directive (78/660/EEC), cit., - Article 52


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understand how there are different profit figures in both sets of accounts, justbecause one is the annual and the other is the consolidated accounts.

37. Internationally speaking, there is an increasing tendency to give to the prudenceprinciple an interpretation much less conservative than the one presently given incertain Member States. This tendency is becoming stronger particularly as regardscertain current assets (e.g.: securities) and certain financial instruments (e.g.:derivatives). This may also be due to the fact that, at an international level, theattention is focused on consolidated accounts. The negative consequences that a toostrict interpretation of prudence could have on the international acceptance of European accounts is an element to be carefully considered, should the debate onwhat is an adequate level of prudence be pursued.

38. From the contents of the above paragraphs the following conclusions can be drawn:

The current text of the 4th Directive certainly gives to Member States some room fordifferent interpretations. The document has stressed what are the outer limits of such

different interpretations. It is unlikely that these divergencies can be eliminated in theshort-run because they are due to specific historical, cultural and economic reasonsand are part of specific legal and economic environments. The reduction of thesedifferences will therefore mainly depend on the evolution of these environments.More integration in Europe is a key factor in this process and will certainlycontribute to narrow the different interpretations of the prudence and matchingprinciples.

It is important to establish what are the outer limits of the Accounting Directives andwhich interpretations can be admitted within these limits. Accordingly, while incertain cases the high liquidity of very organised markets may justify the inclusion in

the profit and loss accounts of unrealised gains arising from foreign currencytranslation differences without prejudice to the prudence principle, this does notseem possible, at present, in the case of unrealised gains relating to marketablesecurities. The main reason for this lies in the fact that the 4th Directive requiresassets to be shown at historical cost, revaluations being permitted only under theconditions set out in Article 33. The fact that marketable securities are assets whileexchange differences are not, explains why, even when highly liquid markets exist inboth cases, the accounting treatment of positive gains might be different.

Annual accounts are the part of financial information which is most linked withnational environments. It does not seem realistic to think that real progress in a moreharmonised use of prudence and matching when preparing annual accounts can bemade, before further harmonisation and integration being reached in other (legal andeconomic) areas. One possibility to achieve in the short-run more comparability forthe annual accounts could be that of improving the disclosures in the notes to theaccounts. However, this does not seem to be the most practical solution, as it is oftenpointed out that the notes already contain a too large amount of information.Therefore, the most realistic way to advance harmonisation for those cases (valuationof securities) which cannot be solved within the limits of interpretation of the 4thDirective, seems to remain the adoption (when an agreement is found) of specificamendments to the Directive itself.

However, in order to be successful, any proposal for an amendment should bepreceded by a definition of the exact limits to which a possible valuation "mark-to-


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market" would be applicable. In the same way it should be examined whether thisshould be an option or become a compulsory treatment. Recent developments inaccounting for financial instruments have clearly demonstrated that, given the widevariety of different instruments existing nowadays, this is not an easy task, but theneed for further transparency might indeed require in the near future some action inthis field.

Consolidated accounts are by nature less linked with national environments, althoughnational considerations always play an important role. For this reason, furtherharmonisation in the consolidated accounts would seem easier than for annualaccounts. In addition, consolidated accounts often serve purposes which aresignificantly different from those served by annual accounts. Therefore, progress infinding a common understanding of prudence and matching for consolidatedaccounts might proceed separately and probably more quickly than for annualaccounts. At the international level also harmonisation focuses on consolidatedaccounts, and therefore all efforts should be made to arrive at a more harmonisedEuropean interpretation of the prudence and matching principle in the consolidated

accounts so as to be able to influence international developments. The question of course remains to be solved whether and to what extent a dissociation of the annualand consolidated accounts can be pursued on the basis of the present text of the 7thDirective. This approach is currently being examined in another document 9.

All around the world there are companies ("global players") which have attained sucha transnational exposure that they can no longer be referred to as belonging to aspecific country. Their operations and the philosophies with which they are run gowell beyond national boundaries. These companies are free from the traditional,historical and cultural linkages mentioned above and their consolidated accounts areprepared and used internationally. They will therefore increasingly undergo theinfluence of international capital markets and the financial reporting requirementsimposed in this context. It is exactly to address the needs of these companies, thatthe European Commission has adopted in November 1995 a New AccountingStrategy 10. This new approach aims at ensuring that financial reporting requirementsfor global players remain in line with European Accounting legislation and to providean effective European input into the process of creating accounting standards to beused internationally.

9 Further harmonisation of group accounts only? - Working document of the Accounting AdvisoryForum (XV/7003/95-Draft).

10 Accounting Harmonisation: a new strategy vis--vis International Harmonisation.- Communication of the Commission - COM (95)508 of 14 November 1995.

prudence and matching

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