Aggressive vs. Conservative Accounting

Aggressive vs. Conservative Accounting

Companies have a certain level of discretion concerning the methods they use to evaluate and report their financial performance. Investors are often concerned with whether the accounting method is more aggressive or conservative, as this will affect their ability to determine a company’s actual value.

Recall that aggressive accounting tends to employ more creative accounting techniques, resulting in overstated financial performance. Using these aggressive accounting choices in a company’s current reporting period can decrease the company’s reported performance and financial position in later periods, creating a sustainability issue.

On the other hand, conservative accounting uses methods that are more likely to understate financial performance and, as a result, do not usually create a sustainability issue. This arises from conservative accounting techniques decreasing a company’s reported performance and financial position in the current period. However, it is imperative to note that if a company uses conservative accounting techniques, the reported performance and financial position may increase later.

It is commonly assumed that financial reports are often biased upward, but this is not always true. While accounting standards ideally aim for unbiased financial reporting, some standards specifically require conservative treatment of transactions or events. Additionally, managers may opt for a conservative approach when applying these standards. Analysts should consider the potential for conservative choices and their implications.

Bias in the Application of Accounting Standards

Applying accounting standards often involves significant judgment, regardless of whether the standard itself is neutral. Characterizing the application as conservative or aggressive is largely a matter of intent; as such, it is important to analyze disclosures, facts, and circumstances that can help accurately infer this intent.

Management may manipulate earnings by sacrificing short-term profitability for higher future profits. One example of this is the “big bath” restructuring charge. Both US GAAP and IFRS allow for the accrual of future costs associated with restructurings, often presented along with asset impairments. However, companies sometimes use these provisions to estimate large losses in the current period to make future performance appear better.

In summary, some of the biases in applying accounting standards are big bath and cookie jar reserve accounting:

• Big Bath Accounting. Companies might inflate restructuring charges and asset impairments to create a significant loss in one period, allowing for improved results in subsequent periods. This practice gained attention in the late 1990s, leading the SEC to issue rules limiting when costs can be categorized as part of a “non-recurring” restructuring event and enhancing transparency around these charges.
• Cookie Jar Reserve Accounting. This involves overstating allowances for future non-payments of loans to smooth income over time. In 2003, the SEC issued interpretive guidance requiring a separate section in the management discussion and analysis (MD&A) titled “Critical Accounting Estimates.” This section should disclose the nature and uncertainty of material subjective estimates and judgments, in addition to required disclosures in the financial statement notes.

Question 1

Which of the following statements is the most accurate?

1. Conservative accounting choices may lead to upward biases in current-period financial reports.
2. Aggressive accounting choices may lead to downward biases in current-period financial reports.
3. Conservative accounting choices may lead to downward biases in current-period financial reports.

Solution

The correct answer is C.

Conservative accounting choices may lead to downward biases in current-period financial reports. This results from conservative accounting choices decreasing a company’s reported performance and financial position in the current period.

A is incorrect because conservative accounting choices lead to downward biases and not upward biases in current-period financial reports.

B is incorrect because aggressive accounting choices lead to upward biases and not downward biases in current-period financial reports.

Question 2

Concerning conservatism and aggressiveness, what are the preferences of managers, investors, and regulators?

1. Managers prefer aggressiveness, investors prefer conservatism, and regulators prefer neutrality.
2. Managers prefer aggressiveness, investors prefer conservatism, and regulators prefer conservatism.
3. Managers prefer conservatism, investors prefer aggressiveness, and regulators prefer aggressiveness.

Solution

The correct answer is A.

Managers prefer aggressiveness since compensation is mainly tied to the company’s financial performance. Investors prefer conservatism since they prefer good surprises over bad surprises. Regulators prefer neutrality because they want the financial results to reflect the company’s actual position.