Distinguish Between Conservative and Aggressive 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 used is more aggressive or conservative as this will affect their ability to determine a company’s true value.

Company management may prefer aggressive to conservative accounting methods. This is because, generally, aggressive accounting methods increase the reported performance and financial position of a company in the current period. Investors, on the other hand, may prefer conservative to aggressive accounting choices because positive surprises are more acceptable than negative surprises.

Aggressive vs. Conservative Accounting

Aggressive accounting tends to employ more creative accounting techniques that result in overstated financial performance. The use of 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 the fact that conservative accounting techniques decrease a company’s reported performance and financial position in the current period. It is imperative to note, however, that if a company uses conservative accounting techniques, the reported performance and financial position may increase in later periods.

Some accounting standards specifically require a conservative treatment of a transaction or event. Generally speaking, this means that revenues may be recognized once a verifiable and legally enforceable receivable has been generated. buy provigil ireland https://analystprep.com 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:

• given asymmetrical information, conservatism may protect the contracting parties with less information and greater risk;
• conservatism reduces the possibility and costs of litigation;
• conservative rules may protect the interests of regulators and politicians by reducing the possibility that they will be blamed for overstating earnings or assets; and
• the present value of tax payments can be reduced by electing conservative accounting policies for certain events.

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 the fact that conservative accounting choices decrease 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

With regard to 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 their compensation is mostly 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 real position of the company.