Prudent Accounting Principles are essential for business survival in this pandemic

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CEM Insight, Lagos
The coronavirus pandemic have rocked havoc on economies, due to restrictions that followed which brought business activities to abrupt halt. Every business that involve human movement is definitely impacted leaving a lot in financial mess.

In a matter of just two weeks in mid-March 2020, entire industries and sectors were brought to an abrupt halt. In the UK, for instance, car manufacturing fell from more than 70,000 cars in April 2019 to just 197 cars in April 2020; for further contrast, the UK made more than 120,000 units during February 2020.

To survive this crisis, business must be both efficient and resilient says Karthik Ramanna in his article in Harvard Business Review

Now, to be efficient and resilient, prudent accounting principles must be practice. This is the common-sense accounting concept that there should be a higher threshold to recognizing anticipated gains relative to recognizing anticipated losses.

This principle had for generations helped businesses balance these two pulls. In turn, businesses were better prepared for an unpredictable blow. Then, at about the turn of the 21st century, accounting rulemakers did away with prudence. We are living the consequence today: The economy is teeming with crappy balance-sheets that necessitate gargantuan bailouts when crises hit.

We cannot say that a financial crisis like our current one was unimaginable. It has only been slightly more than a decade since the world last experienced a sudden shock to global industrial solvency, and the idea that such a shock could come from disease was made very real by the near-miss Ebola and Zika outbreaks of 2014 and 2016.

So the real question is how do we avoid finding ourselves here again when we face the next major economic shock? One answer is to bring “prudence” back to corporate accounting.

Prudent accounting balances the forces that drive a business to be efficient and resilient by helping a company stay asset light and forcing it to write off dud projects as their losses become apparent, even in otherwise good times. Such a company is thus less likely to throw good money after bad, lowering waste in the company and in the economy. And, when bad times hit, the company is less prone to be carrying unwanted costs, a huge relief for everyone, including the taxpayer.

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Likewise, when a prudent company raises debt, it does so despite the downward bias in its accounts — so that debt is safer, in that it sits on a more conservative cushion. This makes the company and its creditor less likely to fail when a crisis hits.

And finally, by being prudent in good times, the company has recognized losses earlier, and attenuated the scale of its dividend and bonus payouts. This means there’s more of buffer in retained capital to weather it through a crisis.

How do we get back to prudence?

Prudence is both a regulatory principle and a managerial state of mind. To bring back prudence into accounting; two layers of action is requires.

First, Securities & Exchange Commission (and its equivalents worldwide) should mandate that any new accounting standards — and indeed any accounting standards issued since about 2000 — meet the prudence test. Put differently those standards should require objective evidence before companies can book gains (or avoid losses) on the basis of expected future profits.

Second, boards and auditors should exercise greater skepticism when approving CEO and CFO judgments on highly discretionary items such as capitalizing intangibles and avoiding goodwill charge-offs. In anticipating such pushback, senior management will then impose their own higher standards in making these decisions, resulting in higher quality balance-sheets.

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