XV/7002/95 EN

DOCUMENT OF THE ACCOUNTING ADVISORY FORUM

PRUDENCE AND MATCHING

DIRECTORATE-GENERAL XV
Internal Market and Financial Services
This document has been prepared for use within the Commission. It does not necessarily
represent the Commission’s 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 Accounting
Advisory Forum (Forum) as an advisory document to the Commission. The views
expressed 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 the
European Union. The Forum is not a standards-setting body. Its main function is to advise
the Commission on accounting matters and possible ways to facilitate further
harmonisation. 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 been
nominated, 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 and
Matching. The document examines the various possibilities for furthering the presentation
of comparable and equivalent information within the context of the Accounting Directives.

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4
 CONTENTS

Paragraphs

INTRODUCTION 1-3

REASONS FOR DIFFERENT INTERPRETATIONS AND 4-7

APPLICATIONS OF THE PRUDENCE AND MATCHING
PRINCIPLES

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 15

particular risk

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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6
INTRODUCTION
1. One of the objectives of the European accounting harmonisation is to make accounts
in the European Union equivalent and comparable and, for this purpose, "the
different methods for the valuation of assets and liabilities must be coordinated to the
extent necessary"1. This means that the existence of differences can be tolerated as
long as it does not prevent accounting information from being comparable and
equivalent. Sometimes, however, different interpretations and applications of
valuation rules and accounting principles can constitute an obstacle to the European
accounting 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 in

Member States have highlighted divergencies in the interpretation and application of
valuation rules and accounting principles. These problems seem to affect in particular
the principles of prudence and matching. A survey conducted by FEE2, covering a
selection of EU Member States, has recently confirmed the existence of :

a. Differences in the interpretation of both prudence and matching, which mainly

relate to the different ways of perceiving whether profits are realised or not.

b. Differences in the interpretation of the relationship between these two

principles, which often result in the prudence principle taking precedence
over 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 valuation
of long-term contracts, the recognition of translation differences on foreign currency
balances, the treatment of government grants for capital expenditures, the treatment
of 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 the
interpretation and application of the prudence and matching principles, in order to
understand to what extent such problems may render more difficult to obtain
equivalent and comparable accounts. In order to reach its objectives, the paper, after
an analysis of the reasons for different interpretations and applications of prudence
and matching, will examine the characteristics of the two principles as well as the
relationship 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 the
prudence and matching principles, one should at first note that, generally, the
application of any accounting principle is in no way a mathematical exercise. Unlike
technical rules in fact, it always requires the use of a certain degree of judgement
which, by definition, can change depending on people and situations.

In the Accounting Directives no derogation from the normal application of an

accounting principle is allowed on the basis of the size (large, medium, small), the
business 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 principle
stated in the Directives how such principle should be applied in practice, nor to say
that 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 accountancy
evolve, 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, the
lack of specific guidance on how to deal with them can lead to different
interpretations and applications of the same general principles.

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

6. It is often said that the main reason why the prudence and matching principles are
interpreted so differently is the different understanding of the objectives of financial
statements. 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 assuring
shareholders and other interested parties (e.g. creditors) of the capability of the
enterprise to produce distributable profits, to satisfy its obligations and to continue to
exist 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. The
presentation of more conservative information, while in the former case is not
perceived as constituting a major problem, is usually considered as misleading for the
achievement 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, ulterior
effect. A different use of financial information may however result in a different
emphasis given to the accounting principles used in the preparation of the financial
statements, and lead to different interpretations and applications of the same
accounting principles and rules.

7. Another reason which is often advanced in order to explain the existence of a

different understanding of prudence and matching is taxation. Fiscal considerations
play an important role in the application of valuation rules, at least in certain Member
States. As fiscal rules vary from country to country, this has important consequences
on the application of accounting rules. The Accounting Directives do not directly
deal with fiscal problems. However, in those Member States where a strong linkage
exists between the commercial accounts and the accounts which serve as a basis for
the assessment of income tax, there is no doubt that the Accounting Directives may
have 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 additional
information to be included in the notes to the accounts, in order to restore the
comparability of the accounts. As valuation rules in some countries are directly
linked 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 income
be proposed.

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

Differences in the socio-economic and legal environment may also lead to

interpretations of a number of provisions contained in the Accounting Directives
given by national law or standards adopted by national standard setting bodies which
are different from one Member State to another. In addition, it has been pointed out
that sometimes a distorted use of accounting principles is made by economic
operators, which results in an arbitrary way of applying accounting techniques with
the 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 application
of 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 IASC
Framework addresses this point when it defines prudence as "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."

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9. Although the linkage between prudence and risk is unanimously recognised, views
differ 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. IAS1
defines prudence as one of the considerations that should govern the selection and
application by management of the appropriate accounting policies. In developing the
IASC 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 possible
risks rather than a systematic measurement bias. In none of these documents is
prudence seen as an overriding accounting principle.

Another school of thought understands prudence as a principle having precedence

over all other principles, a fundamental valuation rule to be applied in the preparation
of the accounts. In some EU Member States this understanding lies at the basis of the
interpretation of the 4th Directive.

10. As prudence is associated with risk and its perception, it has been suggested that one
way towards a better understanding of prudence is to define and analyse risk. This is
not an easy task, because different people almost always have different perceptions
of the same risks, and sometimes they take certain financial risks in order to manage
other business risks. One should note also that the perception of risk is highly
influenced by the entity's activities and its characteristics, so that it has been said that
to each business activity is linked a particular, "innate" kind of risk (for example, in a
loan, fixed rates are usually perceived as more risky than variable rates for the lender
but less for the borrower, who may rely on the certainty of financial commitments
that 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 course
of the financial year concerned or of a previous one, even if such liabilities or losses
become apparent only between the date of the balance sheet and the date on which it is
drawn up,

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

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 While the contents of this article will be examined in the following Sections, it is
important here to note that the Accounting Directives do not provide a full definition
of prudence. Article 31(1)(c) states some important specifications, but it is clear from
the word "in particular", that only a part of the practical implications of prudence is
indicated there. Therefore, in order to have a more precise idea of how prudence in
accounting 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 be
recognised as assets and by requiring adequate consideration of foreseeable
liabilities and potential losses. Prudence also plays an important role in the
valuation of assets: although the basic rule is that assets must be valued at
historical cost, the application of the prudence principle requires that they are
shown 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 used
in 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 determining

whether profits can be recognised in the profit and loss account and in
deciding their destination.

B.1) PRUDENCE IN RECOGNISING AND VALUING ASSETS AND LIABILITIES

13. 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 asset
in 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 other
intangibles like concessions, patents, licences and trade marks, is in any case
permitted, when they have been acquired for valuable consideration (Articles 9 and
10 (Assets)(C)(I)(2a)(3)). Internally generated goodwill can never be recognised as
an 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 is
correctly reflected in the accounts and that any decrease in value is duly recorded, by
taking account of all depreciation, whether the result of the financial year is a loss or
a profit (Article 31(1)(c)(cc)). Therefore, assets might be valued at a figure
attributable 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 financial
assets (Article 35(1)(c)(aa)), and must be applied to all fixed assets for which
a 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 adjustments
to be made in respect of current assets, where such adjustments are necessary if the
valuation 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 anticipate
the losses for those commercial sectors (for example : commodities with fluctuating
prices) 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, nor
provide for their definition. The influence of prudence is however evident in some
rules 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 in
the course of the financial year concerned or of a previous one, even if such liabilities
or losses become apparent only between the date of the balance sheet and the date on
which it is drawn up, is further detailed in Article 20(1) .

This paragraph covers probable losses and probable debts where there is an
obligation to third parties. It requires the setting up of provisions to cover losses or
debts 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 or
as to the date on which they will arise.

B.2) PRUDENCE IN OBTAINING AN ADEQUATE ASSESSMENT OF SITUATIONS OF PARTICULAR

RISK

15. Another basic way in which prudence plays a role in the 4th Directive relates to the
assessment of situations of particular risk, which do not, as such, appear in the
balance sheet. In order to take account of these off-balance sheet situations, the
Directive 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 in
the balance sheet be shown in the notes, insofar as this information is of assistance in
assessing the financial position of the company.

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

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 The role that prudence plays in obtaining an adequate assessment of items involving
situations 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 overall
position. This is clearly evident also from recent debates on environmental accounting
and financial instruments issues.

B.3) PRUDENCE 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 that
only profits made at the balance sheet date may be included in the accounts. The
problem is that this rule, laid down in Article 31(1)(c)(aa), can be interpreted
differently, depending on what is considered as a profit "made" (or, as it is said in
other 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 profit
and 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 the

case 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 Accounting
Directives, this is however subordinated to the condition that the prudence principle
is observed, and particularly that: -) the total contract income is known, -) the
proportion of work completed can be calculated accurately and -) the work on the
contract must be sufficiently advanced4.

3 FEE: op.cit., page 6

4 The accounting harmonisation in the European Communities: problems of applying the Fourth
Directive 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 some
people that, in the case of highly liquid organised markets, the existence of a
specific contractual agreement might no longer be necessary for a profit to be
considered as "made". A market is usually defined as "highly liquid" in
relation to a potential transaction when it is of sufficient depth to absorb the
transaction without significantly affecting the price. In such organised
markets (like for example securities markets), the existence of "market
makers" operators committed to buy certain assets (for example securities) at
a published price would ensure the existence of a certain profit at a certain
date, which would be recognised in the profit and loss account, regardless of
whether the corresponding asset has in fact been sold. Even when "market
makers" in the above sense are not present, the volume of trading in a market
may be sufficient to determine at any time an objective price at which an asset
could be sold.

In these circumstances it is contended that no substantial difference exists

between a " not yet realised but highly realisable" profit and a profit which
has been "completely realised" through the sale of an asset and immediately
reinvested in an identical asset. Others however respond that if the existence
of the sale of an asset were no longer necessary to consider the related profits
realised, any manufacturer could claim the realisation of profits on a sale
even if no real sale has yet occurred.

In this context it is interesting to note that the Bank Accounts Directive

permits the recognition of "realisable" profits for transferable securities not
held as financial fixed asset and that the Insurance Accounts Directive
permits, and in certain cases requires, that investments are shown in the
accounts at their current value. Neither the Bank Accounts Directive nor the
Insurance Accounts Directive contain a specific justification for this departure
from the 4th Directive.

b. As far as the transfer of risk is concerned, the problem here mainly consists in
the 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 the
transfer of risk has occurred when all risks have been transferred, except of
course those which are a direct consequence of the realisation of the
transaction itself. The credit risk for example should not be considered when
deciding whether a transaction is realised or not, because the existence of the
credit 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 true
for the "risk for after sale guarantees" and the "risk for exceptional events",
which would exist only on the assumption that the transaction to which they
refer 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 regards
the moment at which such risks are considered as being transferred (for
example, when signing the contract or when delivering the goods). These
differences are particularly significant when the transfer of risks is not strictly
linked to the transfer of the legal title of ownership. Lease contracts
constitute a typical example of how much accounting treatments may differ
simply depending on how the transfer of risk (and its relationship with the
transfer of title) is defined5.

18. A more fundamental question relating to realisation consists in considering whether it

is appropriate to apply the same realisation criteria to all profits, regardless of the
specific characteristics of the assets from which the profits are generated. In this
respect, 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 currency
items and marketable securities.

In the case of finished goods, it is normally understood that no market can be

considered sufficiently liquid to allow the recognition of "realisable" profits. For
instance, in the case of the sale of a stock of cars, a liquid organised market does not
exist 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 that
particular market seem to permit the recognition of "unrealised" profits without this
being necessarily in conflict with a correct interpretation of the prudence principle. It
is understood in fact that foreign currency markets are normally capable to absorb a
substantial 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 any
moment by a simple phone call. No general risks exist, besides the one that
authorities may stop trading activities. However, this does not appear sufficient to
consider the liquidity of security markets in general so high to allow the recognition
of "realisable" profits. In fact, the liquidity of a single, particular security may be
significantly different from the average liquidity of the total market. Obviously certain
shares are more tradeable than others and state bonds usually have a liquidity which
is 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 with
reference 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 into
account. For these reasons it seems necessary to operate a distinction inside each
security market. While there are cases (e.g. state bonds) where such markets have a
liquidity 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 material
transaction 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 markets
the 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 to

allow for the inclusion in income of positive differences on marketable securities, a
distinction would have to be made between those situations where the market is
"highly" liquid and those situations where it is not. Another question which would
then also have to be answered is whether these positive differences should be
available 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 the
conditions set out in Article 33. As marketable securities, unlike foreign currency
translation differences, are assets, any consideration about their liquidity is
subordinated to the possibility that higher market values be recognised in the
accounts according to the 4th Directive. This would of course require an amendment
to 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 than
historical cost, for instance in order to reflect the effects of changing prices. The
treatment of such surpluses does not seem to constitute a problem in relation to the
prudence principle. The 4th Directive, in fact, already provides specific rules to deal
with these surpluses, which may be recognised in the profit and loss account only
under the particular conditions and following the specific procedure laid down in
Article 33. So far, the Member States which have applied Article 33 have not
experienced 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 a
part of equity, unless they are realised through use or sale.

In the case where the arguments concerning the "not yet realised but highly realisable
gains" referred to in the above paragraphs 17a and 18 are considered as valid, the
present category should also include such gains. However, while the increases in
value dealt with by Article 33 are to be considered as "holding gains", the readily
realisable gains arising from assets simply held as a store of value would be
considered as a part of the operating performance of the enterprise, and therefore be
recognised 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 a
transaction or with an increase in value. It therefore includes income arising from
several different sources, like for example reimbursement from tax authorities and
insurance 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 be
examined by looking at profits not from the point of view of their origin, but rather
from 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 a
profit, but also when deciding how this profit should be used. This is the case in
several company law provisions where, through the concept of legal capital
maintenance, prudence sets limits to the distribution of profits6. A similar approach
may also be noted in the 4th Directive (Articles 33,34 and 37), where a specific
allocation of certain profits is required because of prudence. According to Article 33,
surpluses deriving from revaluations are included in a specific reserve and are not
distributable until they represent gains actually realised. Articles 34 and 37 do not
allow profits to be distributed, when the level of the reserves available for
distribution does not exceed the amount necessary to cover the residual amortisation
of certain capitalised expenditures (formation expenses and research and
development expenses).

C) LIMITS TO THE INTERPRETATIONS OF PRUDENCE

22. So far, the document has shown quite clearly how difficult it is to avoid different
interpretations of prudence. This is because the way of perceiving risk, uncertainty
and consequently prudence is different in Member States, for historical, cultural and
economic 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 consequence
that the application of prudence is seen as a tendency to create deliberate
understatements. This perception also plays an important role in the international
accounting debate.

This danger has been recognised in IAS1, which says:

"Uncertainties inevitably surround many transactions. This should be recognised by exercising

prudence in preparing financial statements. Prudence does not however justify the creation of secret
or 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 limited
liability 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 to
require 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 that
no 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 order
to ensure an even-handed use of prudence relate both to the assets and to the
liabilities side.

a) On the assets side, for example, it has been provided, for both fixed and
current assets, that the lower amount attributed to them cannot be maintained
if the reasons for which it has been made have ceased to apply (Articles
35(1)(c)(dd), 39(1)(d)).

b) On the liabilities side, it has been required that the setting up of provisions is
limited 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 adjust
the value of assets (Article 20, paragraph 3) and cannot exceed in amount the
sums which are necessary (Article 42, paragraph 1).

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

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 to
Member States the possibility of authorising the creation of provisions
intended to cover charges which have their origin in the financial year under
review or in a previous financial year, 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 or as to the date on which
they will arise. It has been noted that sometimes this possibility has been used
for 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 an
option, different results of such a calculation are possible. This can generate
major differences, particularly as regards the valuation of stocks. The use of
direct costing for example, if compared with the use of full production cost
methods, will generate a lower inventory value and, where stock levels are
increased, will cause an increase in charges in the profit and loss account and
a reduction of income. Therefore, some people believe that direct costing
may be deliberately selected with the specific intention of obtaining more
conservative results.

18
25. The fact that prudence may sometimes be taken as an excuse to justify deliberate
understatements 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 Directive
requires 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 modifying
the financial position of an enterprise. In particular, when unrealised profits and
losses are so closely linked that the realisation of the latter is not conceivable without
admitting at the same time the realisation of the former, even the application of the
so-called "imparity principle" would not lead to the recognition of the unrealised
losses 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 an

inconsistent way. Once a particular treatment has been selected and judged as
appropriate, 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 the
same foreign currency (receivables and payables of the same amount, expressed in
US$ and having the same expiry date) both gains and losses arise, prudence should
not be used as the justification for including in income only the losses and for not
recognising the gains.

Nor should prudence be used to support a too literal interpretation of certain

provisions of the Accounting Directives. For example, although Article 31(1)(e)
states that the components of assets and liabilities must be valued separately, such a
separate valuation may not correspond to economic reality. When one already knows
that 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 is
commonly considered as embodied in the accrual principle. The accrual principle is
commonly understood as set out in Article 31(1)(d) of the 4th Directive, which
states:

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

While there are no divergencies in interpreting the accrual concept, no unique

interpretation of matching exists. The principle of matching is often understood as the
practice of allocating expenditure to the related income. Any resulting balance sheet
numbers are explained as essentially residuals from the matching process. This is
usually referred to as the "profit and loss account approach".

Allocating expenditure to the related income could be interpreted to mean deferring

some 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 opens
considerable 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 future
economic benefits (assets) or obligations to transfer benefits in the future (liabilities),
19
 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, it
should be pointed out that several valuation rules exist, applying in practice the
principle of matching, like, for example, the possibility to capitalise expenses and the
requirement to depreciate assets.
27. The distinction between accrual and matching is not always immediately perceived
and, in this respect, the following example could be useful. A rental contract is
entered into in year 1 for hire of a machine in year 2 for the production of goods to
be sold in year 3. The accrual principle requires that the invoice for hire of the
machine, paid in year 1, is recorded as a prepayment, because it refers to year 2; the
matching principle requires that, if indirect production costs are capitalised, the
machine hire invoice is taken into account in the calculation of the value of the
finished products sold in year 3. In year 3, when products are sold and income is
recognised, the costs are charged to the profit and loss account.

28. Among the provisions which contain the principle of matching, it has been noted that
one 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 (see
also paragraph 24). This option, which has been provided for in order to cover major
and recurring maintenance costs and expenditures on major repairs, permits a more
precise periodic calculation of profits. For example, in the case of an aircraft, certain
maintenance expenditures are incurred once every ten years, and are anticipated by
creating a provision in order to spread the costs equally over the periods. Another
way of dealing with this may consist in depreciating parts of the assets faster, in
order to have a depreciation allowance sufficient to cover the cost of the
maintenance 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". In
a certain sense, therefore, the application of matching should be done "prudently" (as
for example in the case of the application of the "stage of completion" method for the
valuation of long term contracts, see paragraph 17 above), by carefully taking into
account 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 can
reasonably 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 year
is a profit or loss (Article 31(1)(c)(cc)).

Value adjustments may not be continued if the reasons for which they were made
have 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 are
necessary (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. In
this respect, different approaches can be identified.

31. According to some people, prudence as it is stated in the 4th Directive is not in
conflict with matching, if properly conceived. This is the logical consequence for
those who think that prudence is an attitude of mind, say a general attitude which
governs the application of accounting policies and leads to a true and fair
representation of financial statements. According to these people, while matching is
an accounting convention, prudence is a general attitude which, when properly
conceived, is instrumental in leading to the true and fair view. While matching is
routine, prudence is a judgement made at a later stage, after applying all accounting
conventions, to assess if all risks have been fairly represented. Following this
interpretation, the possibility of conflicts between prudence and matching lies in the
consequence of conceiving prudence in a mechanistic way, which approach should be
rejected.

One of the main reasons for this view appears to be the fact that the 4th Directive
does not contain a definition of assets and liabilities, which would be of extreme
usefulness for the definition of a more clear relationship between prudence and
matching. To this it is sometimes replied that, even where a definition of assets and
liabilities existed, there would still be difficulties to clearly identify the exact balance
between the two principles (e.g. in the case of advertising costs).
32. Other people are of the opinion that conflicts between prudence and matching, as
they are intended in the 4th Directive, are possible. For instance, some people argue
that certain expenditures cannot be capitalised as particular types of assets such as
internally generated intangible assets because such capitalisation would be in conflict
with the prudence principle, although the application of the matching principle might
imply that these expenditures be effectively capitalised as intangible assets. In this
case, the question arises which of the two principles should have priority. From the
FEE survey7 it appears that, in the surveyed countries, where the application of the
matching principle appears inconsistent with the prudence principle, the latter is
commonly regarded as taking precedence. This appears particularly in those
countries where the main objective of financial statements is legal capital
maintenance and creditors' protection. In this sense, the prudence principle plays a
predominant role in preparing accounts. This does not necessarily mean that the
prudence principle is intended as an overriding principle, but rather that all other
principles are applied by taking prudence duly into account.

33. Under a different perspective, some people believe that the 4th Directive does not
establish a hierarchy among valuation principles. They base their thesis on the general
provisions of Article 2, where it is stated that:

7 op.cit., page 5

21
 " 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 a
true 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 incompatible

with the obligation laid down in paragraph 3, that provision must be departed from in order to
give 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 in
those exceptional cases where this application leads to a picture which is not true and
fair. They underline also the different level of application of the prudence and
matching principles compared with that of the true and fair view concept. The
prudence and matching principles are applied only in examining and estimating the
individual items composing annual accounts and do not constitute real underlying
assumptions. 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 a
whole.

According to this line of thinking, the establishment of a hierarchy between the

prudence and matching principles is not necessary, since there is only one possible
balance of the two that generates a true and fair view. This balance is normally
provided by the application of the provisions in the Accounting Directives, in which
no supremacy is given to either of these two concepts. Instead of being seen as
alternatives, 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 always
depending on the state of mind of the preparers, taking account of what users expect
to receive, which is not necessarily corresponding to an objective balance of prudence
and matching (other preparers and users could have a different judgement of such a
balance).

CONCLUSIONS
34. The discussion in the above paragraphs clearly shows that, at present, in Europe
there 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 State
a 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 at
the level of national legislation and/or accounting standards, are amplified by the
sometimes distorted use which is made in practice of the two principles. Problems
arise in particular when preparers of accounts give their own interpretations to
general principles contained in the Accounting Directives or to the interpretations
already given at national level to those principles. This may result in an arbitrary way
of applying accounting techniques with the exclusive objective of serving a particular
financial strategy. In this way, it may happen that companies be prudence-oriented
when they have good performances and desire not to show their results completely,
while they become suddenly matching-oriented when their performances are poorer
and do not meet the budgeted results.

22
 For these reasons, more and more people today recognise that the differences
analysed in the preceding pages may constitute an obstacle not only to further
developments in the European accounting harmonisation process, but even to the
preservation 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 existing
Accounting Directives, in order to make the wording more precise (and therefore to
limit the possibility of applying different interpretations) and to reflect the experience
acquired since their implementation. Other people prefer to leave the Directives as
they are, to give an official interpretation of their text and to deal separately with
new issues originally not covered by the Directive, so that material divergencies in
their application are no longer possible. In this respect, it is important to note that the
4th Directive itself already provided for a solution in this sense: a Contact Committee
composed by the representatives of the Members States has been in fact established
with these specific tasks8.

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

35. The discussion on the prudence principle (and particularly Section B.3) illustrates the
present division of opinion over the interpretation of the concept of realisation. Some
people conclude from this discussion that it is not possible, under the present
circumstances, to interpret the concept of realisation in a way that justifies the
recognition in income of gains which do not meet the realisation test as set out in
paragraph 19. In their view, allowing exceptions to this interpretation of the concept
of realisation in specific cases (for instance, for readily realisable but not yet realised
gains), stretches out the realisation principle in such a way that eventually it will
make the principle meaningless. Others, however, take a different point of view.
They believe that it is possible to give a broader interpretation to the realisation
principle by taking into account other criteria for realisation, such as for example, the
reliability of measurement of an asset. The question remains whether this broader
interpretation can be justified on the basis of the present text of the 4th Directive, or
whether 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 different
interpretations of accounting principles (notably prudence and matching) is due to
the fact that the profit shown in the annual accounts is significantly influenced by the
distribution of dividends and in some countries also by the calculation of income
taxes. To solve this problem it has been proposed that accounting principles be
applied differently in annual and in consolidated accounts, the latter not being linked
to 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 consolidated
accounts can be different from those applied in annual accounts, provided that they
are 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

23
 understand how there are different profit figures in both sets of accounts, just
because one is the annual and the other is the consolidated accounts.

37. Internationally speaking, there is an increasing tendency to give to the prudence

principle an interpretation much less conservative than the one presently given in
certain Member States. This tendency is becoming stronger particularly as regards
certain 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, the
attention is focused on consolidated accounts. The negative consequences that a too
strict interpretation of prudence could have on the international acceptance of
European accounts is an element to be carefully considered, should the debate on
what 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 for
different interpretations. The document has stressed what are the outer limits of such
different interpretations. It is unlikely that these divergencies can be eliminated in the
short-run because they are due to specific historical, cultural and economic reasons
and are part of specific legal and economic environments. The reduction of these
differences will therefore mainly depend on the evolution of these environments.
More integration in Europe is a key factor in this process and will certainly
contribute to narrow the different interpretations of the prudence and matching
principles.

It is important to establish what are the outer limits of the Accounting Directives and
which interpretations can be admitted within these limits. Accordingly, while in
certain cases the high liquidity of very organised markets may justify the inclusion in
the profit and loss accounts of unrealised gains arising from foreign currency
translation differences without prejudice to the prudence principle, this does not
seem possible, at present, in the case of unrealised gains relating to marketable
securities. The main reason for this lies in the fact that the 4th Directive requires
assets to be shown at historical cost, revaluations being permitted only under the
conditions set out in Article 33. The fact that marketable securities are assets while
exchange differences are not, explains why, even when highly liquid markets exist in
both cases, the accounting treatment of positive gains might be different.

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

However, in order to be successful, any proposal for an amendment should be

preceded by a definition of the exact limits to which a possible valuation "mark-to-
24
 market" would be applicable. In the same way it should be examined whether this
should be an option or become a compulsory treatment. Recent developments in
accounting for financial instruments have clearly demonstrated that, given the wide
variety of different instruments existing nowadays, this is not an easy task, but the
need for further transparency might indeed require in the near future some action in
this field.

Consolidated accounts are by nature less linked with national environments, although
national considerations always play an important role. For this reason, further
harmonisation in the consolidated accounts would seem easier than for annual
accounts. In addition, consolidated accounts often serve purposes which are
significantly different from those served by annual accounts. Therefore, progress in
finding a common understanding of prudence and matching for consolidated
accounts might proceed separately and probably more quickly than for annual
accounts. At the international level also harmonisation focuses on consolidated
accounts, and therefore all efforts should be made to arrive at a more harmonised
European 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 annual
and consolidated accounts can be pursued on the basis of the present text of the 7th
Directive. This approach is currently being examined in another document9.

All around the world there are companies ("global players") which have attained such
a transnational exposure that they can no longer be referred to as belonging to a
specific country. Their operations and the philosophies with which they are run go
well beyond national boundaries. These companies are free from the traditional,
historical and cultural linkages mentioned above and their consolidated accounts are
prepared and used internationally. They will therefore increasingly undergo the
influence of international capital markets and the financial reporting requirements
imposed in this context. It is exactly to address the needs of these companies, that
the European Commission has adopted in November 1995 a New Accounting
Strategy10. This new approach aims at ensuring that financial reporting requirements
for global players remain in line with European Accounting legislation and to provide
an effective European input into the process of creating accounting standards to be
used internationally.

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

10 Accounting Harmonisation: a new strategy vis-à-vis International Harmonisation.- Communication of

the Commission - COM (95)508 of 14 November 1995.

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