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Accounting Conservatism Definition
Accounting conservatism exhibits the potential worst scenarios in financial statements. This accounting method seeks to answer the volatility by selecting the situation with the most conservative income. Accountants practice this method to avoid overestimation of fiscal capacity. This practice includes waiting to recognize income until it is officially made because then reasonableness can be recognized.
A Little More on What it Accounting Conservatism?
In order to decrease negative prospects in accounting information, many professionals use a method called accounting conservatism. The method, characteristically conservative, prepares for small fiscal returns in addition to gross losses. Businesses employ this method to avoid the misperception of fiscal integrity or health. Accountant may employ accounting conservatism to many accounting practices internally.
The standards for recognizing fiscal gains are much stricter than recognizing a loss in accounting conservatism. The principle of prudence is followed by greater prudence. Accounting conservatism also anticipates equal losses and gain. In order to recognize either, accountants must have meaningful verification. The verification is dependent on the company policies. Many recognize losses when there is an indication, but only substantiate fiscal gains until said gains materialize. In layman terms, conservative accounting prepares for losses but defers identification of profits.
Conservative accounting is the opposite of aggressive accounting. As with any accounting practice, there are both advantages and disadvantage.
In regards to advantage, the following are the common assets:
- Conservative accounting reduces volatility in regards to the company image.
- By giving an accessible representation of a business’ fiscal situation, the company smooths access to financing.
- The accounting method allows financial analysts to create objective and accurate forecasts.
As with all assets, there are disadvantages, as well:
- The forecasts may present a negative fiscal trend which is not representative of the actuality.
- Information is asymmetric.
Accounting Conservatism Methods
For companies that utilize accounting conservatism, following a stringent fiscal reporting is paramount. This policy adheres to the standard accounting principle of congruence. This requires all losses to be recorded in the expense statements. This expendable income stipulates an occurrence of cash or claims being exchanged known as an account receivable.
In accounting conservatism, only when fiscal gains are actualized does it appear on the financial records. This methodology allows business’ to avoid over-reporting income. Likewise, accounting conservatism overestimates the possibility of negative transactions. For businesses that deal in goods or services often find in their ledger a high amount of assets that have not been actualized as customers still owe on accounts. Companies in similar situations choose to use accounting conservatism to give a more accurate account of the future fiscal climate.
Other businesses may choose conservative accounting when assets and liability. This creates a conservative approach to the company’s ledger. However, recent years have seen a change in business equity to reflect the equity structure than on the ledger. However, the calculation of economic value is based on the assets minus the liabilities. Conservative accounting ensures fiscal reporting is representative of the true economic health.
This method of accounting can misused to over-report earnings at a later date. The can be for dubious reasons or simply because the method allots for a high estimate for unreliable income though it has been collected. This may lead to a distorted view of the companies fiscal state.
References for Accounting Conservatism
Academic Research for Accounting Conservatism
- Accounting conservatism and board of director characteristics: An empirical analysis, Ahmed, A. S., & Duellman, S. (2007). Journal of accounting and economics, 43(2-3), 411-437. The authors evaluate conservative accounting to determine that the number of insider directors is related negatively to the method. However, they found most other characteristics provide stable in relation to conservatism.
- Accounting conservatism, the quality of earnings, and stock returns, Penman, S. H., & Zhang, X. J. (2002). The accounting review, 77(2), 237-264. The study evaluates the fluctuations in quality of earnings in companies how utilize a conservative accounting method. The researchers explored methods to forecast the effects of joint investment and conservative accounting. The measures indicate future return and net operating assets. The study found the measures can be applied to stock returns.
- Accounting conservatism and corporate governance, Lara, J. M. G., Osma, B. G., & Penalva, F. (2009). Review of accounting studies, 14(1), 161-201. The article examines the possible correlation between strong corporate governance and conservative accounting. The researchers proved their hypothesis by testing historical data against market-based and nonmarket-based conservatism. Furthermore, the article discusses the possible implication of the findings.
- Estimation and empirical properties of a firm-year measure of accounting conservatism, Khan, M., & Watts, R. L. (2009). Journal of accounting and Economics, 48(2-3), 132-150. Khan and Watts examine the concept of firm-years in relation to conservative accounting. The duo then converted their findings into a metric in order to test their hypothesis. Through constructing event studies, the scholars found that accounting conservatism was a reaction to volatility.
- Accounting conservatism and the efficiency of debt contracts, Gigler, F., Kanodia, C., Sapra, H., & Venugopalan, R. (2009). Journal of accounting research, 47(3), 767-797. The research team examined the effects of conservative accounting, particularly in regards to debt contracts. The teams found the optimal covenants differ in regards to the degree of purity that conservatism follows. From this finding, an efficiency metric was formulated. The study found the efficiency of debt contracts decrease with regards to conservative accounting.
- Corporate suppliers and customers and accounting conservatism, Hui, K. W., Klasa, S., & Yeung, P. E. (2012). Journal of Accounting and Economics, 53(1-2), 115-135. The scholars hypothesized both suppliers and consumers prefer conservative accounting. The hypothesis is formed around the idea that suppliers and customers have a higher level of influence in trade when conservative accounting is in place. The study proves the claim while laying out potential implications for the findings.
- Conservatism in accounting part II: Evidence and research opportunities, Watts, R. L. (2003). Accounting horizons, 17(4), 287-301. The study furthers previous research in regards to conservative accounting. The implications of the previous findings are further discussed. The empirical data notes the effects of conservative accounting in managerial behavior. The data had to take into account the ability of managers to commit fiscal crimes. The scholars found asymmetric verifiability was the key to avoiding the crimes.
- The conservatism principle and the asymmetric timeliness of earnings1, Basu, S. (1997). Journal of accounting and economics, 24(1), 3-37. Basu examines the difference in conservative accounting from a psychological perspective. The study examines the sensitivity to negative and positive returns, revealing a six-point difference. Earnings response coefficients were used to prove the claim that negative earning changes are lower than for positive earning changes.
- The demand for accounting conservatism for management control, Kwon, Y. K., Newman, D. P., & Suh, Y. S. (2001). Review of Accounting Studies, 6(1), 29-52. The authors examine conservative accounting as a natural response. A model to represent reports are used for contracting and whose parameters are controlled by the principal. This allows information to be viewed from an unbiased perspective. Using the model, claims regarding penalties and the usage of conservative accounting are evaluated.
- What affects accounting conservatism: A corporate governance perspective, Chi, W., Liu, C., & Wang, T. (2009). Journal of contemporary accounting & economics, 5(1), 47-59. The study looks at corporate governance in relation to conservative accounting. The article uses historical data, the authors conclude that conservative accounting thrives in companies with weaker corporate governance.
- Accounting conservatism and the cost of capital: An international analysis, Li, X. (2015). Journal of Business Finance & Accounting, 42(5-6), 555-582. Li examines the role of conservative accounting internationally and the effect on mitigating the cost of equity and debt capital. The paper found a negative correlation between conservative accounting and the cost of equity. The findings implicated that legalities play a role in conservative accounting when a free market is present.
- Accounting conservatism and debt contracts: Efficient liquidation and covenant renegotiation, Li, J. (2013). Contemporary Accounting Research, 30(3), 1082-1098. Li evaluates the relationship between debt contracts and conservative accounting. Li uses a model to find and efficacy ratio and determine the use of in terms for renegotiations.