Impairment, Revaluation and Derecognit ...
The impairment, revaluation, and derecognition of a company’s property, plant, and equipment, as... Read More
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.
Company management may prefer aggressive to conservative accounting methods. This is because, generally, aggressive accounting methods increase a company’s reported performance and financial position in the current period. On the other hand, investors may prefer conservative to aggressive accounting choices because positive surprises are more acceptable than negative ones.
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 cause a decrease in the company’s reported performance and financial position in later periods. This creates a sustainability issue.
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.
Some accounting standards specifically require conservative treatment of a transaction or event. This means that revenues may be recognized once a verifiable and legally enforceable receivable has been generated. Further, losses need not be recognized until it becomes “probable” that an actual loss will be incurred.
Conservatism contradicts the characteristic of neutrality or unbiasedness because it tends to lead to biases in measuring assets, liabilities, and earnings. This can impair the relevance of financial statements to external decision-makers.
In comparison to aggressive accounting, four potential benefits of conservatism are:
Question 1
Which of the following statements is the most accurate?
- Conservative accounting choices may lead to upward biases in current-period financial reports.
- Aggressive accounting choices may lead to downward biases in current-period financial reports.
- 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?
- Managers prefer aggressiveness, investors prefer conservatism, and regulators prefer neutrality.
- Managers prefer aggressiveness, investors prefer conservatism, and regulators prefer conservatism.
- 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.