Concept of Conservatism
The concept of conservatism is a principle that best anticipates future loss rather than the gains. It maintains a balance between expenses and liabilities in a situation that has an unwarranted outcome. Therefore, assets and revenues are only recognized in such a situation only if they are assured. It dictates that in a situation that the organization is uncertain about forthcoming loss, then, they record it as a loss and conversely if the uncertainty is about a profit, then it is not recorded. The method further applies in the recognition of estimates but letting the records tend towards the bad debts rather than the receivables. It is a major principle in the lowering of cost marketing rule. It is used severally by companies and countries in the bit to play safe. The paper will investigate the conceptual and practical reasons for it, the strengths and limitations and the views that companies and investors have regarding the issue.
There are two very important accounting theories; the normative and the positive accounting theories. Positive theories are used in the prediction and explanation of phenomenon. Normative on the other hand is based on perspectives and not ideas; basing the judgements on the assumptions made by the accountant. Conservatism is based on both aspects of the theories and thus takes both the normative and the positive theories into account (Ademola and Olayinka 89). Positive theories explaining conservatism are the most prevalent and they explain the functioning of relations between the individuals that deliver resources and the firm. Part of the Positive Accounting theory is the Agency theory. The theory bases its judgement on the assumption that any functioning organ has its self-interest at heart. For example, when the director of the firm has more information about the firm than the shareholder and both have interest on the firms, they could be termed as having conflict of interest. The costs that arise because of the conflict of interest are called agency costs.
The basis of the conservatism theory in accounting is the definitions given by Bliss “anticipate no profit but anticipate all losses”. Before any profit is legally acclaimed that they will be generated, then they are not considered to be profits. It however isn’t to mean that there are no profits generated within the venture. Only that the recognition is based on verifiability. It later resulted to the definition Baus that claimed conservatism is the tendency of the accountant to require concrete verification in order to recognize good or bad news (Kim and Liandong 421). The resultant action from the definitions is the understating of the company assets which may result to an overstatement of future earnings caused by understatement of future earnings.
Types of conservatism
It is the type of conservatism that does not depend on the news reaching the accountant to recognize the book value of the assets. Some specific accounting methods are used in the determination and not specifically on the confirmations. At the beginning of a new book cycle, accounting methods are used to give a lower book value to the assets than the value it is supposed to gain within the lifetime. The underlying criteria is the stringent recognition method and is used in the reporting of assets and less on reporting of liabilities. Examples of the unconditional conservatism are the accelerated depreciation and the historical methods of cost accounting for positive net. The reason for unconditional accounting is that the prediction of the assets is difficult for the accountant.
Conditional conservatism gives the value to the assets depending on new meaning that the accounting estimates have figured out after the book cycle or on when an activity has occurred. It therefore has an impact on the income statement. An example of a situation that has a conditional conservatism procedure is when depreciations are taken as soon as they happen and taken as much as possible to lower the results (Lara et al. 221). Under unfavorable circumstances within the organization, the value of the assets that would be recorded would be the book value. In the contrary case, the book value is not used. The asymmetrical method of recording the data is effective in creation of conservatism. The reason behind this form of conservatism is to give the accountants a greater verification in the case of reporting good news than when it is bad news. An example of a real life situation depicting this type of conservatism is the impairment test where the manager restrains from reporting a higher gain in the case of unfavorable circumstances.
Is conservatism a part of the conceptual framework? Why or why not?
What are conceptual and practical reasons for applying conservatism in accounting?
What are problems or negatives associated with its use?
How do companies have different views on this matter than investors and creditors?
The main source of data from the research would be secondary sources of data. The reasons behind the choice are the ease of availability from online libraries and the feasibility of the international comparative studies and the longitudinal studies. The sources of the data were peer reviewed journal and articles related to the topic. The search for the journals was made in the accounting databases such as Amedus, EconLit and RePEc. The main search tool was Google Scholar and the search keywords were; Accounting Conservatism, conservatism as a conceptual framework, problems or negatives of conservatism, and the reasons for conservatism. Once the related information was gathered, the necessary data was analyzed based on the research questions, and the results therein were compiled.
Conservatism as a Conceptual Framework
Conservatism is conceptual framework that stemmed from original philosophical ideas of political philosophy that expressed defined the national defined cultural, social and political attitudes in relation to change. The philosophical idea meant to reject revolutionary change unless it was organic. The basis of the argument is that any attempts to change the complex web of human relations purely for the sake of theory risk running foul the law of unintended consequences. The word conservatism comes from the Latin word ‘Conservarve’ that means protect or preserve. The application of the original theory was intended for the financial statement of a company. The financial statements of a firms are published to inform the company stakeholders on the position of the firm. There are very significant impacts that arise from the release of the information to the general public. For example, in the stock market, when there is any new information pertaining a company, the stock prices become volatile very fast and change regarding the news received (Caskey and Volker 524). When the company then decided to preserve of regulate the information they release in their financial statements, then it becomes a situation of conservatism. That is the basis of the concept,
Reasons for Conservatism
It is the reason that most cases of conservatism are based upon. The main basis of contracts between organizations and other parties is the accounting books. The reason behind this is to reduce the agency costs that the organization will have to pay. The relationship between managers and the debt holders is the main source of concern and therefore much attention is given to the area (Balakrishnan et al. 514). The prospects of a firm are to make a very high risk venture that upon completion would result to even higher profits. However, when the prospects fail, the losses incurred would be lower than that of the debt holder. When the project is a success, the debtor bears all the profits and doesn’t share them with the firm. Therefore the upside to the debt holder is that they don’t get to share any of their profit but the downside is that they get to suffer significant losses by themselves. Therefore, when taking a debt, the debtors prefer a time conservative accounting. Lenders therefore lower the interest rates they charge to the conservative borrowers. The result of conservatism therefore is the reduced interest rates for loans.
When a firm understates its assets then the chances to make the litigation costs are lower than when they overstate the net assets. The litigation costs are like the lawsuits from shareholders when they think that they made a fraud in the book keeping. When the net assets are kept at the lower minimum, then the litigation costs will be at the same level. Litigation within the security acts of many countries including the United States of America encourage conservatism (Li 555). The other form of litigation costs are the political costs. The government and interest groups find the act of generating too much profit as unacceptable. There is attention drawn therefore in such a case. The government therefore would seek to find out the sources of the excess profits; if they are because of high pricing or maybe it is because of the cheaper production costs that result to degradation of the environment (Lara et al. 221). When firms make high profits, the trade unions and workers unions begin to claim for increased wages. some firms therefore opt to reduce the attention they draw to themselves by conservatism to reduce the litigation costs that come with it.
Income Tax Explanation
The taxes that a company has to pay depend on the income that it generates. Therefore, something has to be done to regulate the income recorded for the company. They therefore adopt depreciation methods; an assets depreciation rate is taken to be as fast as possible. Taxes incentivize the mangers of the corporations to be more conservative when it comes to the reporting of their income. Moreover, there is need to increase the period that they eventually pay the taxes. The timeline of money stipulates that it is important to pay taxes later than sooner. It is however applying to the cases where the taxable profit and the profit are measure using the same parameters. Some countries define the parameters differently.
County, business and Regulators also promote the use of conservative accounting methods. Overvaluing net assets cause bigger problems than the assets that are undervalued. When a company is not conservative, it may end up to be overvalued within the stock market. To set the standard a company needs to be conservative in the standard accounting practices (Ruch and Gary 22). The effects of the International Finance reporting standards (IFRS) in the recent years have cause the opposite to happen. The trend of companies has been more to the less conservative side and more standard based valuation. The IFRS regards the concept of conservatism as an undesirable and a bias method of reporting information. European countries adopted IFRS in 2005 and thus businesses within these regions have reduced their involvement in the use conservative methods.
Negatives Associated with Conservatism
A high level of conditional conservatism in a company reduces the level of investments that the companies are involved in. With reduced projections of the total incomes and profits there is low energy directed towards investment opportunities. Conditional conservatism creates a rigid mentality in managers in the company and causes a situation where there is least need to spend the assets of the company. The managers are also reluctant to invest due to the fear of recording the incomes or losses from the new ventures (Biddle et al. 98). Further, a high level of conditional conservatism further leads to managers in the firms to invest in low risk ventures. The attitude of managers in the conservative companies is attributed to psychological barriers towards investment opportunities. Even in the case where there is need for investment to take place within the company, the managers would opt for low risk investment opportunities.
Other Issues Associated with Conservatism
International harmonization of accounting standards
Harmonization is the process of compatibility between different bodies to increase the level of consensus between them. there has been harmonization of financial statements, accounting methods extent of details to expose and accounting regulations. The European context poses several materials the introduce these types of harmonization applied to accounting methods. Analysis of accounting methods in the region proves that there is less use of conservatism within the region. With the EU taking action and the introduction of IFRS, the levels have gone down. The implications of conservatism regarding the regulatory bodies such as FASB show that conservatism will exist even without the use of contractual financial statements. Moreover, using unverifiable estimates to the future of the company are not in tandem with rules FSAB.
How companies may have different views on this matter than investors and creditors
The view that companies, investors or creditors have towards the idea of conservatism is dependent on its benefits towards them. Companies benefit from conservatism by reducing their losses during times of crisis. Moreover, it helps companies to increase the level of investment efficiency, reduce the cost of debt financing, enhances cash holdings value and prevents risks to the firms such as bankruptcy risk or cash flow risks (Biddle et al. 98). Conservatism makes the firm credit constrained at the times of crisis and prevents unshriven investments thus avoiding loss. On the sides of investors and creditors, the conservatism is detrimental to their work. Companies not indicating their full potential because investors panic and withdraw from firms because of the poor quality of accounting information. Investors and creditors make their decisions depending on the information they get from the company accounts, when however, the information is false or adjusted, then it would mean that their valuation of companies is impeded. Conservatism prevents investment which is the primary role of creditors and investors. The companies that adopt the method thus limit the working of the creditors and investors and take them out of the business.
The concept of conservatism in a firm introduces a characteristic of accountants to be less revealing of the income and assets level within a firm. The accountants are meant to look out for the company and therefore their involvement in conservative actions ensure that protect the company from losses during times of crisis, litigation costs and also tax and regulation related costs. Conservatism allows the firm to provide poor quality information to creditors and investors. Due to the reason of conservatism and the poor quality information provided by the company, there is least involvement in any financial straining activities such as investments of getting loans. While the activities may be seen as an advantage to the company, it creates a rigid managerial strategy that makes the company less effective on the investment scene. There is reduced effort towards any investment as the accountants want to protect any information regarding the company’s income or losses. Eventually the company only participates in low risk ventures which also means low income generated from the ventures. The decision to participate in conditional conservatism has a detrimental effect to the investors and creditors. They are provided with low quality information and if they base their decisions on the information, then they are unable to maximize on their financial potentials towards these companies.
The research has been influential in introducing the conceptual framework of accounting conservatism. It reveals that there are benefits that the activity has towards a company such as reduced risk awareness towards investments and increased costs related to litigation and taxations. The limitations of conservatism are that it reduces market for creditors and investors and reduces the profit making ventures of a company. The implications of conservatism regarding the regulatory bodies such as FASB show that conservatism will exist even without the use of contractual financial statements. The limitations of the study derive from the fact that the conclusions were based on analysis of secondary data that have measurement errors associated with empirical calculations of conservative data from companies. The window of analysis of the data changes with time and therefore validity of the information is timed.
The areas that should be tackled in future research are the effects of conservatism on the managers reporting behaviors in relation to incentives, corporate events. Moreover, the reaction of investors and creditors during a crisis to companies with conservatism and those without accounting conservatism should be investigated further.
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