Friday, January 6, 2012

Accounting Conservatism under GAAP and Future Profitability

Does a strict application of the rule of accounting conservatism influence over the future profitability of a firm?

Ahmed and Duellman (Accounting and Finance 2011, 609 et seq.) answer this question in the affirmative and state that:
  • more conservative accounting leads to higher future operating cash flows and higher future gross margins;
  • more conservative accounting leads to lower likelihood and magnitude of special item charges.

Reading about the consequences of practicing accounting conservatism, I was wondering how this principle is codified and what its status in the GAAP accounting regulation is today.

The FASB discusses the principle of accounting conservatism (= principle of prudence) in the Statement of Financial Accounting Concepts No. 2 (paragraph 91 et seq.) and in the Statement of Financial Accounting Concepts No. 8 (BC3.27 et seq.).

Conservatism is defined as “a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered”.

Even though the FASB discusses accounting conservatism within the framework of reliability, it is not part of the this concept. As a matter of fact, the hierarchy of accounting qualities, as established by the FASB, is as shown in the above table. In this schema, the blue lines represent conflicts that the FASB expressly recognizes. According to the FASB, such conflicts alter the practical application of the principle of accounting conservatism as follows:
  • Conservatism in financial reporting should no longer connote deliberate, consistent understatement of net assets and profits.
  • If two estimates of amounts to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate. However, if two amounts are not equally likely, conservatism does not necessarily dictate using the more pessimistic amount rather than the more likely one.
  • It is preferred disclosing the nature and extent of the uncertainty surrounding events and transactions rather than applying the principle of accounting conservatism right away. The user of financial information should be in the best possible position to form his own opinion.