Aggressive financial reporting choices lead to an overstatement of current financial performance at the expense of future performance and sustainability. On the other hand, conservative choices, decrease current performance and increase future performance. Even though conservative choices do not hurt sustainability, they hurt the predictive power of financial information. While some investors may prefer companies to make conservative choices, because it is easier to digest a positive surprise than a negative one, unbiased financial reporting (neither aggressive nor conservative) is most useful.
While users may believe that financial statements generally overstate performance, it might not always be the case. It is because in many cases, the accounting standards, and in some cases management may adopt conservatism which requires greater verification in recognition of gains than losses.
IASB framework and neutrality
IASB Conceptual Framework espouses neutrality of information: neither upward nor downward bias. However, not all standards are free from conservative bias and each of them has differing degrees of conservatism.
Common example of conservatism in accounting standards include expensing out research costs under IFRS and US GAAP (because future benefits are not yet clear), immediate recognition of ‘probable’ litigation losses under both IFRS and US GAAP (even if there is no current legal liability), and late recognition of any insurance recoverable.
Advantages of conservatism
Conservatism has four advantages:
- Given the asymmetrical nature of information (i.e. management has more information about a company than investors have), conservatism balances for the greater risk faced by the investors.
- It reduces litigation, or potential litigation costs, because there is a lower chance of a company overstating its financial performance and position.
- It reduces the liability of regulators, politicians and those charged with governance.
- In some cases, tax laws are linked with financial reporting laws. Hence, recognizing expenses early may have tax advantages.
Conservatism and aggressiveness in policy choices
Regardless of whether a standard is conservative or otherwise, it may be applied aggressively or conservatively. Companies may engage in conservatism with the intent of manipulating performance. For example, they might charge very high (big bath) restructuring charges and asset impairments in the current year in order to show high profitability in future periods. Similarly, it may increase current expected losses on loans to create a cookie-jar reserve for use in future periods. To counter this, the SEC has clarified the use of restructuring reserves and required an explanation of critical accounting estimates in MDA.