Accounting conservatism and bankruptcy risk

Introduction
1.Accounting conservatism
A set of bookkeeping guidelines that call for a high degree of verification before a company can
make a legal claim to any profit. The general concept is to factor in the worst-case scenario of a
firm’s financial future. Uncertain liabilities are to be recognized as soon as they are discovered.
In contrast, revenues can only be recorded when they are assured of being received.

Accounting conservatism is a principle that requires company accounts to be prepared with

caution and high degrees of verification.
All probable losses are recorded when they are discovered, while gains can only be registered
when they are fully realized.
If an accountant has two solutions to choose from when facing an accounting challenge, the one
that yields inferior numbers should be selected.

Generally Accepted Accounting Principles (GAAP) insist on a number of accounting

conventions being followed to ensure that companies report their financials as accurately as
possible. One of these principles, conservatism, requires accountants to show caution, opting for
solutions that reflect least favorably on a company’s bottom line in situations of uncertainty.
It is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a
method of accounting that provides guidance when uncertainty and the need for estimation arise:
cases where the accountant has the potential for bias.

Accounting conservatism establishes the rules when deciding between two financial reporting
alternatives. If an accountant has two solutions to choose from when facing an accounting
challenge, the one that yields inferior numbers should be selected.
A cautious approach presents the company in a worst-case scenario. Assets and revenue are
intentionally reported at figures potentially understated. Liabilities and expenses, on the other
hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to
record it and amplify its potential impact. In contrast, if there is a possibility of a gain coming the
company's way, they are advised to ignore it until it actually occurs.

Accounting conservatism is most stringent in relation to revenue reporting. It requires that

revenues are reported in the same period as related expenses were incurred. All information in a
transaction must be realizable to be recorded. If a transaction does not result in the exchange of

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cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to
be reported.

Advantages of accounting conservatism

Overestimating gains and exaggerating losses means that accounting conservatism will always
report lower net income and lower future financial benefits. Painting a bleak picture of a
company's finances actually brings many benefits.

It clearly encourages management to exercise more caution in its decisions. It also means that
there is more scope for positive surprises, rather than disappointing turmoil, which are a major
factor in stock prices. Like all standardized methodologies, these rules should also make it easier
for investors to compare financial results across different industries and time periods.

Disadvantages of accounting conservatism

On the flip side, GAAP rules like conservatism in accounting can be open to interpretation. This
means that some companies will always find ways to manipulate them in their favor.
Another problem with conservatism in accounting is the possibility of transferring revenue. If the
transaction does not meet the reporting requirements, it must be reported in the next period. This
will lead to an underestimation of the current period and an overestimation of future periods,
making it difficult for the organization to track business operations internally.

Accounting conservatism may be applied to inventory valuation. When determining the reporting
value for inventory, conservatism dictates the lower of historical cost or replacement cost is the
monetary value.
Estimations such as uncollectable account receivables (AR) and casualty losses also use this
principle. If a company expects to win a litigation claim, it cannot report the gain until it meets
all revenue recognition principles.
However, if a litigation claim is expected to be lost, an estimated economic impact is required in
the notes to the financial statements. Contingent liabilities such as royalty payments or unearned
revenue are to be disclosed, too.

2.Bankruptcy risk
Bankruptcy risk refers to the possibility that a company will be unable to pay its debts, making it
insolvent; It is often caused by insufficient cash flows or excessive costs.

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Investors and analysts can measure solvency with liquidity ratios, such as the current ratio, which
compares current assets to current liabilities.
When a public company files for bankruptcy, it can reorganize its operations, close its
operations, or sell its assets and use the proceeds to pay down its debts.

A company can fail financially due to cash flow problems resulting from inadequate sales and
high operating expenses. To address cash flow problems, the company may increase its short-
term loans. If the situation does not improve, the company is at risk of bankruptcy or bankruptcy.
Basically, insolvency occurs when a company cannot meet its contractual financial obligations as
they fall due. Liabilities may include interest and principal payments on debt, payments on
accounts payable, and income taxes.
More specifically, a company is technically insolvent if it cannot meet its current obligations
when they fall due, even though the value of its assets exceeds the value of its liabilities. A
company becomes legally insolvent if the value of its assets is less than the value of its liabilities.
A company is considered finally bankrupt if it is unable to pay its debts and files for bankruptcy.

3.The relation between accounting conservatism and bankruptcy risk

This study investigates the relationships between accounting conservatism and bankruptcy risk,
and provides evidence that conservatism helps mitigate subsequent bankruptcy risk through cash
enhancement and restricted earnings management.
Bankruptcy risk, in turn, is negatively related to the province, which reflects the control of
auditors and regulators and the motives of administrative professionalism.
These results are robust for surrogate measures of bankruptcy risk, surrogate measures of
conservatism, its internal integration, and other controls.
Taken together, these findings indicate that conservatism influences and is affected by
bankruptcy risk, thus contributing to the ethics around conservatism and bankruptcy.
This study supports the traditional rationale for conservatism and helps inform ongoing debates
about the role of conservatism as a pervasive property and enduring central principle of financial
accounting.

The motives of this study are numerous, by examining the relationships between accounting
conservatism and bankruptcy risk, this study provides clues regarding the traditional logic of
conservatism. Historical evidence indicates that accounting conservatism arose at least a
thousand years ago in response to the demands of capital.

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Providers inform lending and liquidation decisions and influence the risk of failure (Basu (1997,
2009), Watts (2003), De Ste. Croix (1956)).
Whereas many previous studies have examined how conservatism reduces the cost of debt in
both initial and ongoing lending contracts.

The evidence from this study can help inform current discussions by setters of accounting
standards regarding the continuing role of conservatism as an enduring principle of financial
accounting. In the Statement of Financial Accounting Concepts (SFAC), the Financial
Accounting Standards Board defines accounting conservatism as a prudent response to
uncertainty to ensure that uncertainty and risks inherent in business situations are adequately
taken into account” (Financial Accounting Standards Board (1980), p. 10).
This definition corresponds to the fact that reticence is closely related to the assessment of
bankruptcy risk. but, in the presentation draft of its Conceptual Framework for Financial
Reporting (FASB (2008)).
The FASB recently argued that conservatism may produce information asymmetry that reduces
investors' insights into future cash flows from growth options.

Based on this reasoning, the Financial Accounting Standards Board and the International
Accounting Standards Board (IASB) have proposed removing conservatism from their emerging
conceptual framework, arguing that “describing prudence or conservatism as a qualitative
characteristic or desirable response to uncertainty would conflict with the quality of impartiality”
(FASB (2008)), para. BC2.21). Kothari et al. (2009) argue in contrast that the broader economic
consequences of accounting standards are of primary importance, while their role in the
valuation of equity is of secondary importance.

If accounting conservatism serves to reduce the risk of bankruptcy, it is also fundamental to the
interests of corporate stakeholders, including shareholders (dividends and capital gains),
creditors (payment), directors and employees (jobs and compensation to customers (products and
services), suppliers (sales), and governments (Tax revenues)
The recent financial crises have led to increased interest in the mechanisms of that promote cash
adequacy and solvency.
Given the transmissible effects of bankruptcy risk within industries, along supply chains, and
between the non-financial and financial sectors (Lange et al. (1992), Herzl et al. (2008), Gurion
et al. (2009)), evidence of relationships between conservatism and bankruptcy risk is a precursor
to assessing their role in mitigating panic and economic crises. , with great repercussions for
various economic policies.

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This study examines both contemporary associations and possible causal relationships between
conservatism and risk of bankruptcy. This reticence may influence subsequent bankruptcy risks
by enhancing the criticism, media characteristics, and historical evidence mentioned above.
Bankruptcy risk may, in turn, affect accounting conservatism which stems from the reasoning
that higher bankruptcy risk may prompt creditors, auditors and regulators to require more
conservative treatments to help preserve cash and enhance access to external capital, thus
reducing the risk of bankruptcy in the future.
Managers may in turn resist such requests to justify spending and portray more favorable
performance, at least until creditors, auditors, and regulators assert their control under conditions
of extreme distress (Rosner (2003), Demirkan and Platt (2008)), and their ability to do so.

Examination of whether province is associated with bankruptcy risk is motivated by prior

evidence indicating that province can play different roles in contracting, regulation, taxation,
valuation and in reducing information asymmetries (Ball and Shivakumar (2005), Qiang (2007,
2008)), as well as There is evidence that they are negatively associated in the short term and
positively associated in the long term (Roychowdhury and Watts (2007), Ball et al. (2009)).
Since managers may exercise greater control over conservativeness, at least in the short term,
and prefer anti-conservative therapies for career advancement (Watts (2003), Qiang (2007),
Kothari, Ramanna and Skinner (2009)), it becomes an empirical question to whether the
province is similarly associated with bankruptcy risk.

Additional recent evidence suggests that conservatism reduces asymmetry and information
uncertainty (Watts (2003), Guay and Verrechia (2007), Gox and Wagen Hofer (2010)) through
less optimistic reports of net income and assets and more timely reports of bad news.
This informational role of conservatism enhances cash flows and reduces bankruptcy risk
because better-informed creditors and investors are more likely to provide financing capital at a
lower cost.
A related empirical question is whether conservatism assumes additional importance under
conditions of extreme distress by facilitating negotiations and exercises between creditors and
corporations as alternatives to formal bankruptcy filing (Giammarino (1989), Mooradian (1994)).
By this reasoning, negative associations and causal relationships between conservatism and risk
of bankruptcy were projected, and highly distressed and bankrupt firms were examined
separately.
Recent studies also point to relationships between bankruptcy risk and accounting conservatism
that balance managers' interests with those of auditors, creditors, and regulators. If conservatism
mitigates the risk of bankruptcy, then a higher risk of bankruptcy may also increase the demand
for conservatism.

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 Indeed, evidence indicates that auditors and regulators (e.g., the U.S. Securities and Exchange
Commission (SEC)) pay particular attention to accounting conservatism as reflected in audits
required for periodic reporting, financial and legal functions, and reputational penalties for non-
compliance.

The associations between conservatism and bankruptcy risk examined in this study were reported
by recent research on monetary promotion and media roles in conservatism.
For example, recent findings indicate that accounting conservatism reduces cash outflows by
mitigating capital overinvestment, reducing risk transfer, enhancing precautionary savings, and
reducing agency costs (Lara et al. (2009b), Loktionov (2009), Lewis et al. (2009), Callen et al.
(2010), Kirschenheiter and Ramakrishnan (2010)).
Other evidence suggests that conservatism increases cash flows from operations by obtaining
better terms from suppliers and reducing investment shortfalls due to capital restrictions (Hui et
al. (2009), Lara et al. (2009b)). The conservatism-enhancing properties of cash should reduce
contemporary and subsequent bankruptcy risk, which is essentially a condition of insufficient
liquidity as formulated theoretically and empirically in finance (Kim et al. (1993), Uhrig-
Homburg (2005), Campbell et al. (2008)).

Managers also weigh trade-offs between career advancement, which may benefit from anti-
conservatism remedies, and disciplinary concerns, which may differ in accounting conservatism.
Disciplinary concerns are likely to dominate for managers because of close monitoring and
disciplinary risks; Where managers exercise more discretion over reporting bad news (Qiang
(2007)), occupational concerns may dominate, leading to disincentives to conservatism with an
increased risk of bankruptcy.
These projections were tested using USA observations for the confirmed year from 1989-2007
with available data on accounting conservatism, bankruptcy risk, and control variables.
Risk measures are a priori estimates derived from Merton (1974) and Campbell et al. (2008),
respectively, that allow tests of causal relationships between accounting conservatism and
bankruptcy risk.

For a large sample of listed US companies, accounting conservatism helps reduce the risk of
bankruptcy. They further found that the mitigating effect of accounting conservatism on
bankruptcy risk functions through cash enhancement and earnings management mitigation
channels. This guide is relevant to accounting standard setting, financial regulation, and financial
risk management, and helps explain the long-standing presence of conservatism as a pervasive
feature of financial accounting.

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SOX Reporting Influence on Accounting Conservatism:
The Sabanes-Oxley (SOX) reporting requirements enacted in 2002 provide regulatory
intervention in maintaining accounting albeit with related and simultaneous effects on
bankruptcy risk. Lobo and Zhou (2006) and Iliev (2010) reported that SOX increased accounting
conservatism with Jha (2013) finding in contrast that SOX restricted managerial ability to use
accruals to ward off bond covenant violations.

Consider whether the observed relationships between accounting conservatism and bankruptcy
risk hold up under conditions of extreme stress. In distressed firms with high leverage, rights of
control may pass to debt holders who demand greater discretion to constrain managerial risk
incentives (Brockman et al. 2012) consistent with the mitigating effect of discretion on
bankruptcy risk.
However, in highly distressed companies, shareholders' implied purchase options on assets are at
or close to the money, and stock values increase as assets fluctuate.
If shareholder risk transfer incentives dominate, companies may have less incentive to use
discretion to mitigate the risk of bankruptcy. In addition, the going concern assumption in
accrual accounting is unlikely to apply in highly distressed companies, making accrual
accounting less relevant.