What is Accounting Conservatism?
Accounting conservatism refers to financial reporting guidelines that require accountants to exercise a high degree of verification and utilize solutions that show the least aggressive numbers when faced with uncertainty. It is a longstanding principle in financial reporting intended to protect users of financial information from inflated revenues and to make sure that all potential liabilities are recorded as soon as they are realized.
How Accounting Conservatism Works
Companies are required to follow several accounting conventions to guarantee the utmost accuracy when reporting their financial statements, as provided by the Generally Accepted Accounting Principles (GAAP). Conservatism is one of such accounting standards that require accountants to choose methods and estimates that keep the book values of net gains relatively low in situations of uncertainty.
The accounting rule provides guidelines for estimation in times of uncertainty and in circumstances where there is a likelihood of measurement bias from an accountant. It also arises naturally from two contracting parties and is considered an efficient concept for contracting.
Such a perspective is based on the idea that contracting parties face asymmetric payoffs from certain contracts – such as executive compensation and debt. As a result, the payoffs lead to timelier financial reporting that can potentially impact the contracting parties.
Accounting conservatism affects the quality of figures reported in the balance sheet, income statement, and other financial statements. In the event of increased investment, this principle leads to relatively lower reported earnings than other liberal accounting options. However, the unrecorded reserves created by the lower earnings give the flexibility to report more earnings in the future. A company can inject more funds in reserve to increase investment, thereby reducing earnings.
Conversely, a company can also distribute funds in reserve to increase earnings and subsequently minimize investment. However, uncertainties can still arise, whether intended or not. With accounting conservatism, current earnings are increased, making them a poor indicator of the future marginal return.
Accounting conservatism sets the guideline when an accountant is facing a financial reporting dilemma between two alternatives. In such a situation, the accountant selects the inferior option. A company is forced to adopt a cautious approach in a worst-case scenario.
For example, the book values of assets and revenues are intentionally understated when reporting, while losses and liabilities are overstated. Accountants are required to record and expand the potential impact of uncertainty about incurring losses. In the same vein, accountants are advised to ignore any possibility of market reward until it occurs.
Advantages of Accounting Conservatism
Understating gains and overstating losses means that accounting conservatism will always report lower net income and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.
Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.
Disadvantages of Accounting Conservatism
On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. That means that some companies will always find ways to manipulate them to their advantage.
Another issue with accounting conservatism is the potential for revenue shifting. If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods to be overstated, making it difficult for an organization to track business operations internally.
Limitations of Accounting Conservatism
Several disadvantages affect accounting conservatism. First, the asymmetric response of earnings to economic gains and losses is open for interpretation. In such regard, the management of a company may manipulate accounting values to their advantage.
Secondly, accounting conservatism promotes revenue shifting. A transaction can be deferred into the next period if it does not meet the reporting requirements of the current period.