The role of conservatism in financial reporting essay

This report investigates the application of conservatism in accounting and its role in financial reporting. We also examine and compare the advantages and disadvantages associated with conservatism and provide our opinion about conservatism.

Conservatism may be a controversial accounting measurement principle but it has a long history and its use is far-reaching. Conservatism by definition is that all probable losses or expenditures will be recognized as they are discovered and revenue will be deferred until it is verified. As an important accounting principle, it has been widely used for preventing the overstatement of assets and income, understatement of debt and cost, and plays the role of early warning signal to help reduce risks. Conservatism principle’s origins can be traced back to the Middle Ages. For the purpose of alleviating responsibilities of entrusted property, the custodians did not appreciate any expected value for its custody property; then as the 19th century the popularity of accounting accountability, the idea was gradually recognized and accepted by the accounting profession in order to reduce the rising litigation risks accountants were facing. However, the principle implicates that accountants can use all sorts of means to undervalue assets and income, overestimate liabilities and cost, in order to reduce accountability; also this view is lack of accounting and economics theory basis; consequently, leading to many criticisms. During the 1980s, along with accounting target by accountability view shift to decision-making usefulness, the criticism towards conservatism has increasingly intensified.

The principle of prudence and its connotation was reviewed by accounting professional groups and by standard setting bodies. FASB Concepts Statement 2 discusses conservatism—meaning prudence—, defining it as “ a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered,” but pointedly leaves it out of its table of qualitative characteristics. Meanwhile FASB also explicitly pointed out that, the concept of conservatism may conflict with some important characteristic quality, such as fair representation, neutrality and comparability; and in the financial statements conservatism should no longer deliberately and consistently be used to underestimate net assets and profits.

Despite many criticisms, including from standard setters, conservatism has become the most influential contemporary accounting concept, and is widely used in modern financial reporting. It appears not only to have survived in accounting for many centuries, but also to have increased in the last 30 years. Actually, as long as the uncertainty and inherent risk exist in business operations, conservatism must be an essential accounting principle or convention to protect the benefit of investors, creditors and potential financial statement users. The important implication we discussed in this report is to understand the concept of conservatism clearly and how to use it properly. Applications of Conservatism in Accounting Conservatism appears to have withstood the test of time and despite increasing criticism from many groups including regulators, it continues to prevail in accounting (Watts, 2002). Conservatism is applied in many areas of accounting including but not limited to the following areas; contracting, tax optimization, shareholder litigation and corporate governance.

Contracting – One of the most common applications of conservatism relates to contracting. According to Watts, the reason why conservatism is used in contracting relates to asymmetric information, asymmetric payoffs and limited liability issues (Watts, 2002). Contracting refers not only to debt contracts but also to management compensation contracts and others. It is easy to recognize that information asymmetry exists in contracting due to the principal-agent nature of the relationship between a lender and a borrower, as well as between shareholders and managers of the firm. In both cases the agent has more information about the firm than does the principal.

In accordance with the bonus plan hypothesis of positive accounting theory, managers will have a tendency to overstate the net value of assets and debt-holders are aware this. Watts also mentions that the agents have limited liability in contracts because the cost of their actions can be well over their individual wealth; therefore the principal may never recover the losses incurred (Watts, 2002). Conservatism allows the principals to use “ lower bounds measures” to monitor the agents by applying restrictions such as debt covenants and impede behaviour that could lower the value of net assets or the loan, thus increasing the firm’s risk (Watts, 2002). In contracting, conservatism is used to offset some of the information asymmetry in an attempt to reduce agency costs and overall risk of debt-holders. Contracts also tend to exclude non-verifiable assets such as intangibles, making the net value of assets conservative. Shareholder’s litigation – Many academics identify shareholder litigation as another cause for the continued use of conservatism in accounting. The reason is that litigation produces asymmetric payoffs because “ overstating net assets is more likely to generate litigation than understating net assets” (Watts, 2002). This motivates managers to use conservatism to understate net assets and potentially reduce litigation costs.

The litigation costs also affect auditors, discussed in the next section. Auditor’s Legal Liability – An increase in auditor’s legal liability in recent years can also be a contributing factor to the continued application of conservatism. Empirical evidence of this was found by Basu, who found that auditors were being exposed to greater legal liability after 1983 (Basu, 1997).

As indicated by Scott, auditors are often under pressure by managers to bend accounting rules but doing so can result in substantial legal liability. The only way to protect themselves from these liabilities is to adopt ethical behaviour which can be strengthened by the application of conservative accounting (Scott, 2010). Basu demonstrated that there was a correlation between auditor legal liability exposure and changes in accounting conservatism (Basu, 1997). Good corporate governance – Garcia, Garcia and Penalva take Watts’ contracting and litigation explanations for the existence of conservatism and carry on to associate them with good corporate governance. In their view, good corporate governance involves protecting the firm’s assets by ensuring that they are used efficiently and not distributed to other parties at the expense of shareholders (Garcia et al. , 2005).

They argue that conservative choices result in many valuable advantages such as providing managers with early warning signals by accelerating the recognition of bad news (Garcia et al. , 2005). Tax optimization – The application of conservatism has also been linked to tax optimization. Taxes have always been related to the reported earnings in the financial statements.

As long as firms have positive taxable income the managers have an incentive to manipulate reported earnings downwards in order to reduce the amount of taxes payable (Watts, 2002). However, it can be argued that this can be an example of earnings management and not conservative accounting. Reducing regulator’s costs – There is also asymmetry in regulator’s costs because the regulators and standard-setters are more likely to be blamed if a firm overstates the value of its net assets.

So incongruously, standard-setters are vouching for a reduction in the use of conservatism in accounting, while conservatism actually helps to reduce political costs imposed on them (Watts, 2002). Application of Conservatism across firms and countries– It was found that the amount of conservatism can also differ greatly between young and mature firms. Based on research by Khan and Watts (2007), it was found that younger firms with long investment cycles tend to be more conservative. They explain these findings by pointing out that younger firms are less stable and therefore more subject to information asymmetry problems (Khan and Watts, 2007). This explanation ties back to Watt’s hypothesis stating that conservatism reduces information asymmetry (Watts, 2002).

The extent of application of conservatism varies across countries as well. Studies by Ball, Kothari and Robin have established that common-law countries such as the US, Canada and Britain have financial reporting that is more conservative when compared to code law countries such as France, Japan and Germany (Ball et al. , 2000). The rationale is that there is less information asymmetry in code law countries because important constituencies are included within the corporate governance, allowing them to quickly find out about major losses (Scott, p515). Advantages Associated with Conservatism The FASB’s and the IASB have already tended to exclude conservatism from the current accounting method, due to its lack of qualitative characteristics of accounting information; the recent empirical evidence shows that accounting conservatism not only exists, but also has increased in recent years in varying degrees. Conventional expert explains that the benefit from using conservatism is non substitutable. Basu (1997, p.

8) argues that conservatism has influenced accounting practice for at least five hundred years. Sterling (1970, p. 256) rates conservatism as the most influential principle of valuation in accounting. Recent empirical evidence shows that accounting conservatism becomes more popular in the last 30 years. These results are surprising given the opposition of standard-setters. The long survival of conservatism and its apparent resilience to criticism strongly suggests conservatism has significant benefits that are missed by its critics. (source? ) Reducing Information AsymmetryThe problem of information asymmetry exists between the inside managers and outside investors, and it is impossible to be eliminated.

Information asymmetry leads to conservatism. LaFond and Watts (2008) provide evidence that the level of information asymmetry between inside managers and outside investors is positively related to the degree of conservatism. Greater information asymmetry between insiders and uninformed investors results in (1) lower gains and greater losses, and (2) larger asymmetric recognition of gains and losses as reflected in current financial statements. LaFond and Watts point out that information asymmetry between them not only generates agency costs reducing future cash flows of the firms, but also increases the required rate of return on the stock, since information asymmetry between the security traders will reduce the firm value, put a demand for creditable information into practice, such as conservatism, is potentially cost effective. Therefore, the conclusion of LaFond and Watts (2008, p.

48) that “ conservatism is an equilibrium response to mitigate value reductions resulting from information asymmetries between managers and outside equity investors”. Moreover, “ empirical evidence suggests that conservatism mitigates information asymmetries. The information asymmetry in the current period will further drive an increase of conservatism in the next period. ” Reducing information uncertainty Two important feature of conservatism are asymmetric timeliness in recognition of revenues versus losses and systematic understatement on company’s asset (Givoly, Hayn, and Natarajan, 2007; Roychowdhury and Watts, 2007). These two features result from outside investors’ requirement for a high level of verification and certainty for the profitability and liability of the company.

Conservatism tended to protect shareholders, lenders, and other financial from virtually increased asset and inflated profits. Accounting conservatism, first, provides the best possible “ hard” information on current performance for uninformed investors; moreover, that “ hard” information provides a benchmark to generate “ soft” creditable information on unverifiable gains. This advantage is a useful safety method for outside investors, when a company prepares its financial report in an uncertainty situation.

Lenders are interested in the likelihood that the firm will have enough net assets to cover its liabilities. Investors prefer to obtain verifiable measures of the current value of net assets to monitor the firm’s ability to pay its liabilities. Reducing inflated profit As long as income and net asset measures have meaning and are used in a way that affects management’s welfare, conservatism is likely to be an optimal accounting principle. It is beneficial from the investors’ information perspective. Earning-based management compensation contract demands timely measures of performance and net asset values for compensation purposes.

This incentive contract motivates managers to obtain higher bonus by increasing net income. Conservatism produces asset and earnings downward measures that maximize the real value of the firm. Future year earnings are higher because gains are deferred until there is evidence they exist and have been earned. This makes them conservative. Some of the current corporate accounting scandals illustrate the problems of including non-verifiable future cash flows or market values in earnings measures.

For example, the event that led to WorldCom’s bankruptcy was the announcement of $3. 9 billion of WorldCom’s costs of leasing other company’s networks having been “ improperly” capitalized rather than expensed (see Krim, 2002). The Enron case also illustrates the importance of verification. Enron reportedly marked contracts and derivatives to market and incorporated the consequent value changes in earnings that were used in bonus plan compensation (see McGraw-Hill Inc. , 2002).

Reducing operational risk and financial risk In recent years, shareholder litigation is another potential source of conservatism. The reason is that litigation is much more likely to be incurred by overstatement rather than understatement of earnings and net assets. Conservatism, by deferring earnings and properly understating net assets, constrains the managerial opportunities to manipulate financial report in order to affect investors’ investment decision and managers’ welfare.

In short, conservatism is one of the most prominent financial accounting method, is actually an efficient way to address the moral hazard problem arising from the asymmetric information among interested stakeholders, if the principle is used properly. From this perspective, we suggest that the IASB/FASB should consider carefully the economic role of conservatism further before making their final decision. Put in Recommendation? Disadvantages Associated with Conservatism The negative consequences of the conservative accounting principle are also widely recognized by the Financial Accounting Standards Board (FASB) that conservatism tends to conflict with significant qualitative characteristics, such as representational faithfulness, neutrality, and comparability and consistency.

Moreover, Hendriksen and Van Breda (1992) also have the similar view: “ Conservatism is, at best, a very poor method of treating the existence of uncertainty in valuation and income. At its worst, it results in complete distortion of accounting data. ” And Watts also said (1993): one role accounting numbers fulfill is signalling when a firm is in financial distress.

Extreme conservatism in recognizing income could produce too many false signals. ” In addition, Penman and Zhang (2002) document that conservatism associated with accounting for R; D, advertising and inventory results in low quality earnings and balance sheet items, and investors appear to be unable to fully understand the implications of accounting conservatism for future earnings. In sum, the conservatism impairs the quality of accounting information, and the detailed limitations of conservative accounting policy are as below: Conservative accounting in practice delete? * Accounting conservatism does not record revenue until all information relating to financial transaction is realizable. Realizable revenue indicates a transaction where items are exchanged for cash or claims to cash, such as accounts receivable, which can lead to higher gross profits. When companies choosing LIFO as opposed to FIFO accounting for inventory in an inflationary environment, which leads to ending inventory being lower from higher cost of goods sold, and lower operating profit. * Conservative approach in accounting is overestimating the allowance for bad debts.

Companies that sell goods or services on account usually have high account receivable balances. This means several customers owe the company cash in order to completely finalize a transaction. The allowance for bad debts represents a figure the company will expect to not receive from customers. Accounting conservatism records higher allowances for doubtful accounts to ensure that the company’s accounts receivable presents an accurate future outlook for cash collections.

* Companies using accounting conservatism when measuring the value of the company’s assets and liabilities. The value of assets and liabilities presents a conservative approach to the company’s balance sheet. The effect of conservative accounting on accounting rates of return is: conservative accounting carries assets in the denominator at lower amounts; the rate of return is higher, however. Greenball’s report (1969) argues that conservative accounting (bias) interacts with growth; and it reduces earnings when there is growth in net assets so that accounting rates of return are lower than in the no-growth case.

* Immediate expensing of R; D expenditures and advertising is conservative has no effect on earnings relative to capitalizing and amortizing the expenditures if the expenditures are not growing. However, increasing R; D investments and advertising, while immediately expensing the related costs, depresses earnings and increases reserves. Slowing R; D and advertising increases earnings and reduces reserves because the benefits from past expenditures are recognized without matching additional new expenditures Decreasing contract efficiency According to Gigler, Kanodia, Sapra and Venugopalan’s theory (2009), although conservative accounting may lower interest rates on debt, it carries a cost, since, by its nature, conservatism increase the likelihood of covenant violation when not warranted by the economic state of the firm. They demonstrate conditions under which this cost exceeds the benefits.

In this case, conservative accounting decreases contract efficiency. Lacking accuracy, reliability and the potential of abusiveness Although there is evidence of increasing conservatism in recent year, we still need give greater attention on the limitation of conservative accounting policy. lacking of accuracy and reliable – the most significant issue when companies using accounting conservatism are the ability for a company to under report income during a current accounting period and over report income at a later date. This is because the company does not recognize revenue or creates a high allowance for doubtful accounts even though the money is actually collectible as we discussed above. Extremely high income at later dates may lead business stakeholders and investors to believe the company is performing better than it really is under current conditions. (Abusive)This fluctuating income statement and balance sheet can create distorted information to make it difficult for companies to track their financial performance. Recommendations and conclusionsElaborating and detailing conservatism principle to enhance certainty and operability Many countries’ statement of principle do not offer a lot of detailed rules regarding the application of conservatism, which increases the difficulty of properly using the principle, and also allows enterprises more freedom to manipulate the financial data.

Therefore, to secure the interests of all parties, standard setters should formulate specific requirements, specific provisions, and provide a detailed feasible guide intended for applications of conservatism to limit the premise and applying conditions of using prudence principle. Strengthening professional and integrity education, improving accountant professional capability and judgment Prudence principle can be embodied in recognition, measurement, reporting and other aspects; this requires accountants make judgements and measurement with strong professional skill and to be true to facts. Therefore, having systematically and continuous professional and ethical education or training to increase accountant’s professional knowledge and integrity will be helpful for avoiding personal subjective bias and manipulations. Try to avoid conflict with other principles and full disclosure of applications of conservatism In the use of conservatism principle at the same time, should first, consider the principles of objective and neutrality; then reasonably determines its priorities according to the actual circumstance. Remembering conservatism in making judgements under conditions of uncertainty affects neutrality in an acceptable manner, attempting to ensure that assets, revenues and gains are not overstated and, conversely, that liabilities, expenses and losses are not understated, but rejects deliberate under- or overstatements. Furthermore, at different times and in different environment, each enterprise face the different uncertainties, prudence principle of applied time, scope and procedures are also vary. Therefore it is necessary in information disclosure of conservatism is fully illustrated the application scope, time and detail, reveal the conflict with other accounting principles; so it will improve accounting information on the comparability and reliability to help accounting statement users accurately understand enterprise financial situation.

Narrowing the differences of tax policy and accounting policy To a certain extent, government and standard setters should try to reduce the differences between tax policy and accounting policy, such as revenue and expense recognition and asset measure. Tax policy should try to gradually integrate with the enterprise economic essence, and coordinate with accounting standards and accounting practice, avoid departure or conflict, which will build a modest external environment for prudence principle in accounting practice. Supervising through external auditing Through independent external auditing to inspect abuse or misuse of conservatism and help enterprises properly applying the principle in accounting practices is an efficient and effective way. Since external auditors have been imposed stringent requirements in their evaluation of internal controls and financial reporting, investors, creditors, and other financial report users can be protected from biased financial report in certain extents.

To sum up, although conservatism principle has theoretical and practical limitations which are likely to conflict with other accounting principle and may bias the reliability of financial data, in case of uncertainty and inherent business risk widely exist in reality, for the purpose of protecting benefits of investors and creditors and to avoid management excessive optimistic, conservatism principle has important practical significance. However, accountants must fully realize the pros and cons, reasonable correctly utilize prudence principle in practices, no exaggeration, or over prudent; also standard setters should accept the reality of the existence of conservatism, and offer more applicable guide for the practising the principle. Consequently, conservatism will fully play to its role in the enterprise risk prevention, and protecting the interest of investor and creditor.