Some investors may prefer or be perceived to prefer conservative rather than aggressive accounting choices, because a positive surprise is acceptable. In contrast, management may make, or be perceived to make, aggressive accounting choices because they increase the company’s reported performance and financial position.
Aggressive accounting choices in the period under review may decrease the company’s reported performance and financial position in later periods, which creates a sustainability issue.
Conservative choices do not typically create a sustainability issue because they decrease the company’s reported performance and financial position, and may increase them in later periods.
Conservatism in Accounting Standards
The Conceptual Framework supports neutrality of information: “A neutral depiction is without bias in the selection or presentation of financial information.”
Neutrality—lack of upward or downward bias—is considered a desirable characteristic of financial reporting. Conservatism directly conflicts with the characteristic of neutrality because the asymmetric nature of conservatism leads to bias in measuring assets and liabilities—and, ultimately, earnings.
Both IFRS and US GAAP specify an impairment analysis protocol that begins with an assessment of whether recent events indicate that the economic benefit from an individual or group of long-lived assets may be less than its carrying amount(s). From that point on, however, the two regimes diverge:
- Under IFRS, if the “recoverable amount” (the higher of fair value less costs to sell and value in use) is less than the carrying amount, then an impairment charge will be recorded.
- Under US GAAP, an impairment charge will be recorded only when the sum of the undiscounted future cash flows expected to be derived from the asset(s) is less than the carrying amount(s). If the undiscounted future cash flows are less than the carrying amount, the asset is written down to fair value.
Bias in the Application of Accounting Standards
Careful analysis of disclosures, facts, and circumstances contributes to making an accurate inference of intent. Management seeking to manipulate earnings may take a longer view by sacrificing short-term profitability in order to ensure higher profits in later periods.
A similar manifestation of big bath accounting is often referred to as “cookie jar reserve accounting.” Both US GAAP and IFRS require accruals of estimates of future non-payments of loans.
