Research Paper on "Conservatism in Accounting Valuation"

Research Paper 18 pages (6022 words) Sources: 20 Style: APA

[EXCERPT] . . . .

Conservatism in Accounting Valuation

Accounting is used to determine the financial health of a business or individual. As such, it is carefully regulated and those who practice it for compensation are required to have education and certification. There are various rules, laws, and principles that govern the business of accounting and that are commonly used in order to ensure that those who work as accountants are handling others' money and financial information correctly. Because there are only a few accepted methods of accounting, it is possible to learn them all and determine which one of them would be best for a client. That way, an accountant can help his or her client save the most money on taxes and create an accounting system that can be more easily used and dealt with by accountants for the company in the future. Among the principles that are often seen in the accounting profession is the conservatism principle, which will be the focus of the information presented in the following pages.

1.1 Conservatism Principle

In short, the conservatism principle says that, when an accountant has the opportunity to choose between two specific solutions, he or she should select the choice that will be the least likely to overstate the individual or company's income and assets (Ball, Kothari, & Robin, 1999). Furthermore, the principle indicates that expected gains should not be counted as gains, but expected losses should be counted as losses. Based on this, when stock closes it is valued at the market price or the cost price, whichever is less (Ball, Kothari, & Robin, 1999). Doubtful or bad debts have their own provisions, but each debt that is expected to occur is counted in order to underestimate how much money the company may have earned or will see as its bottom line. When the recognition of gains is delayed and expected losses are acknowledged promptly, it is much easier for the company or individual to see where there are problems - and that will often allow the company to realize a final number better than what was anticipated by the accounting system they have in place and by the accountants who work for that company.

1.2 Widely used

Conservatism has been adopted in accounting because of the benefits it provides to agents that use, prepare, and/or regulate financial reporting (American, 1939). When a financial manager or accountant provides information to a client, and then the client sees later that his or her company or portfolio has actually performed better than expected, that is obviously good news. By using conservatism, it is easy to be realistic about the debts that are being incurred and the income that is coming in without overestimating income and ending up with figures that paint an inaccurate picture of the company's or individual's actual financial concerns. Accountants must be open and honest with their methods, and must follow accepted practices. Despite that, however, there are ways in which they can use those practices to underestimate or overestimate the income and assets of a client (Chadwick, 2000).

Overestimating can be troublesome and can lead to problems with the bottom line (Ahmed, et al., 2001). Underestimating is a better option, because it requires clients to operate in a more conservative financial manner and that means they will usually have more savings to enjoy instead of having more debt and less money than they anticipated. All of the approved and commonly-used ways of handling accounting are legal and acceptable, but that does not mean that they are all as valuable or that they all work as well as some of their counterparts. When accountants debate with their clients which method to use, conservatism is the most commonly suggested method because of the benefits that it is able to provide to the client (Ahmed, et al., 2001). A good accountant can discuss those benefits and show his or her client the value behind the method he or she proposes, so that everyone is on the same page financially.

The use of conservatism is long and highly significant, with evidence of the practice dating back over 500 years (Ahmed, et al., 2001). It has also been rated as the most significant and influential practice in accounting. Recent research has provided insight into the fact that accounting valuation has actually become even more conservative recently, which is surprising since there are so many who are very vocal in their opposition of the practice. Because the practice is resilient to criticism and has been widely used for such a long period of time, there are indications that critics are missing many of the benefits that others are seeing when it comes to this style of accountancy.

In order to determine why this is the case, however, what those benefits actually are must be determined. If conservatism is simply avoided, the concern is that doing so could have a detrimental effect on accounting in general, and that it would be problematic for anyone who was used to conservatism in their accounting practices.

2. Overview of Conservatism

In order to clearly understand conservatism, it is important to address the four perspectives that are included within it. That way, it is easier to see the issues that are being faced by the accountants who choose to use conservatism and one can better determine the merits of that option. As such, there will be four perspectives of conservatism discussed here, encompassing contracting, litigation, income tax, and regulatory issues. By addressing them all, a more complete picture of how conservatism works in accounting and how it is able to include all aspects of the accounting profession can be seen. If only some of the principles are addressed, that can make it more difficult to show the value of conservatism when it comes to accountancy and can also make it more difficult for accountants to justify the use of that particular style when they provide services to others.

2.1 Four Conservatism Perspectives

As has been mentioned, there are four perspectives included in conservatism. Each one of them will be addressed here and discussed thoroughly, to form a better and more complete picture of the principle.

A. Contracting perspective

The majority of contracts that are seen between parties to an accounting firm use numbers that help to reduce the agency costs that are specifically associated with that firm (Brooks & Buckmaster, 1976). That can include contracts that are seen between the firm and the holders of debt, employment contracts, contracts for management compensation, and cost plus sales contracts. Any of the parties to a contract generally expect (and often demand) the measures of performance as well as net asset values are provided in a manner that is timely. Being timely helps to avoid outcomes that can otherwise be dysfunctional.

In contracts, earnings are used in order to restrict the dividend payments to the shareholders and keep a minimum level of assets within the firm so that there is backing for the level of outstanding debt that firm has (Bliss, 1924). Whether earnings decrease or increase, reporting that information in a manner that is timely helps to ensure that shareholders are provided with the right information. It can also help the firm manage its debt correctly, because creditors will be more aware of the level of debt the firm has based on its earning power and assets - which can affect issues such as credit ratings and the percentage of interest the firm will be asked to pay on any new or refinanced debt.

When a company estimates what its earnings will be in the future, there is no way to verify that information. It may end up being correct, or it may be far off in either direction due to something unexpected that takes place in the future. Since that is the case, it is highly possible for a company that is not using conservatism in accounting valuation to end up in financial trouble. By making sure conservatism is used, no verification is necessary because there is no speculation. Everything that is claimed as income and assets has already been acquired, and anyone wanting to verify that can easily do so.

B. Litigation Perspective

The idea of litigation under the Securities Act generally encourages the idea of conservatism (Antle & Lambert, 1988). The reason behind that statement is that litigation is far more likely to be seen by the overstatement of assets and earnings instead of the understatement of that information. Since the costs of litigation are expected to be much higher with overstatement than with understatement, it is wise for firms to err on the side of caution and significantly lower their litigation risk and the costs which are associated with that risk. The lowering of that risk is a good incentive for auditors and management to understate both the net assets and the earnings that are held by the company.

Unlike the contracting perspective, which dates back hundreds of years, the litigation perspective only goes back to 1966 in the… READ MORE

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