Definition
Accounting conservatism implies that all revenue cash flow should have asymmetrical verification requirements for profit gains and losses. The greater the degree of separation in verification, the stronger the conservatism (known as differential verification). This approach results in a repetitive understatement of net asset values. This influences the financial period reports, but conservatism tends to take a broader approach to cumulative firm income.
Conservative accounting is beneficial when a firm chooses to use contracting. The limited information and liability of external firms are offset by conservatism and helps to contain managers in reporting account measures. Moral and hazard problems continue to exist in financial reporting, and the constraints applied by conservatism offset bias and opportunistic managerial practice. It helps to raise the firm value limiting payouts to executives and shareholders, deferring tax payments, and reducing political costs of regulators.
In addition, understating net assets protects from litigation and negative public opinion. Overall, the benefits to conservatism are united by the principle of limiting payouts and meticulous verifiability of profits, which aid in providing accurate information to all involved parties.
Contracting Explanations
Contracting implies debt and management compensation contracts, the company’s organization arrangement, managerial control systems, and even tax payments. Unlike other explanations, contracting has been used for corporate and management purposes for centuries, which influenced modern accounting. Timeliness is necessary to efficiently reflect the actions of managers and shareholders on the firm’s value as well as avoid dysfunctional outcomes. Verification is critical for contract enforcement and legal liability through control of cash flows. It reduces the possibility of payouts that violate contractual obligations. Overall, the firm value increases as conservatism eliminate manager bias and the possibility of negative net present value projects.
Conservative accounting acts as a method of providing information to investors as it acts to verify the estimates of future cash flows. This increases the quality of the information in all accounting reports. The firm value is maximized through downward-biased estimates as any gains are deferred until there is verification that they exist. Asymmetric verifiability reduces positive earnings bias. However, the information perspective, based on regulation objectives, supports further downward-bias on net assets.
Other Explanations
Conservatism protects from litigation under the Securities Acts, which is more likely if net assets are overstated. Tax law encourages conservatism as the deferment of income helps to reduce the value of taxes based on accounting reports. Conservatism is supported by the regulation perspective since losses from overvalued assets are more prominent in a political process. A shift away from conservatism causes goodwill impairment, which requires an evaluation of unverifiable and non-contractible future cash flows. Unlike the FASB, the SEC enforces a high level of conservatism due to the political repercussions caused by overvaluation.
Implications for Regulators and Standard Setters
The FASB should be more inclined towards conservatism as a standard since it is an efficient measure of performance and net assets even without contracting. Their current neutral approach does not ensure the verifiability of market estimates or manager bias. The FASB standards encourage managers to create valuations of future cash flows. They are incompetent in determining firm valuations as the market has many informed participants. The FASB should focus on the core of accounting, which is to provide verifiable information that can be used by the market to gather information and produce a firm valuation. Neither the FASB of the SEC are consistent in their policy, which may lead to fraud and overvaluations that conservatism seeks to address.