PRESENTED BY:

AF5102 Accounting Theory Patrick Kong

Pansy Wong
Angus Chan
- Accounting Conservatism Phyllis Chu 1
Enoch Wong
 Agenda

• What is accounting conservatism?

• How do accountants / managers produce

conservative accounting reports?

• Has the extent of accounting conservatism in

financial reporting changed over time?

• What are the biases of accounting conservatism?

What make it more or less?

• Benefit vs Cost

• How would you relate accounting conservatism to

materials that have been covered in class?
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 Content

What is accounting conservatism?

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What is accounting conservatism?

Branch of Accounting
Financial approach

Asymmetric verification
requirements Limit amount of risk of
for recognizing revenues stakeholders in using their
VS expenses financial statement

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 What is accounting conservatism?

How ? •Strict revenue recognition criteria

•Higher verification threshold for revenue which will defer
revenue until it is verified.
•recognize all probable losses as they are discovered and
most expenditures as they are incurred.
•Understating assets But Overstating liabilities and expenses

Timing ? Expenses are recognized earlier but revenues later

Result ? •Reported earnings will be lower

•Those stakeholders who rely on financial statements will be
less hurt
•The statements will not mislead internal or external business
stakeholders regarding the company’s financial situation

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 What is accounting conservatism?

IFRS paragraph 37

Accounting conservatism is the inclusion of a degree of caution in the exercise

of the judgments needed in making the estimates required under conditions
of uncertainty, such that assets or income are not overstated and liabilities or
expenses are not understated.

However, the exercise of prudence does not allow,

for eample, the creation of hidden reserves or
excessive provisions, the deliberate understatement
of assets or income, or the deliberate overstatement
of liabilities or expenses, because the financial
statements would not be neutral and not have the
quality of reliability.
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 Content

How do accountants / managers produce

conservative accounting reports?

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How do accountants / managers produce conservative accounting
reports?

Compensation
Compensation package
package
align
align managers’
managers’ and
and
shareholders’
shareholders’ interest
interest

Intention to overstate
earnings and net assets

Accounting conservatism
can mitigate this risk
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How do accountants / managers produce conservative accounting
reports?

Regulations • Regulator tend to establish conservative regulations

• Sarbanes-Oxley Act mentioned that managers (CEO
and CFO) imposes criminal penalties for
noncompliance

Timeliness of • Not timely reflect good news

reporting • Timely reflect bad news
good news • Managers and accountants tend to
and bad news
adopt accounting conservatism in
preparing financial reports
Reduction of • Conservatism guide the managers and accountants to
litigation cost reflect the potential cost or contingent liability in the
financial statements
• Future event is likely to be occurred and potential
losses can be quantified
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How do accountants / managers produce conservative accounting
reports?

Fair value • Financial assets and liabilities should be recognized in

fair value
• Firm should report the impaired losses in the income
statement  net assets value would be reduced
• Impaired assets cannot be restored once the impaired
amount has been recognized

Contingent • conservatism principal requires a stronger verifiability

asset in recognizing gains than losses
• Firms cannot recognize its contingent assets in the
financial statements
• Contingent assets can only be mentioned in the
footnote

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 Content

Has the extent of accounting conservatism

in financial reporting
changed over time?

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Has the extent of accounting conservatism in financial reporting
changed over time?

US:
US: After
After Sarbanes-Oxley
Sarbanes-Oxley
Act
Act (2002)
(2002)

Asia:
Asia: Financial
Financial Crisis
Crisis (1997)
(1997)
and
and Financial
Financial Tsunami
Tsunami (2008)
(2008)

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 Has the extent of accounting conservatism in financial reporting
changed over time?
Time
Scandals:
Scandals: Enron
Enron &
& Worldcom
Worldcom 2001-02

Sarbanes-Oxley
Sarbanes-Oxley Act
Act 30/6/2002

•Rules on public companies

•Additional corporate board responsibilities
•Public Company Accounting Oversight Board (PCAOB)
oversee, regulate and discipline accounting firms
•Criminal penalties
Study Findings
Accounting Conservatism, the In post-SOX period:
Sarbanes Oxley Act, and Crash Risk •accrual-based earning management
•reveal bad news timelier
Auditor conservatism following audit After accounting failure:
failures 2% in discretionary accounting
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accruals as a percentage of total assets
 Has the extent of accounting conservatism in financial reporting
changed over time?

Asia
1997 Financial Crisis Study: The Impact of the Asian Financial Crisis on
Conservatism and Timeliness of Earnings: Evidence
from Hong Kong, Malaysia, Singapore, and
Thailand
Findings:
During crisis - more aggressive in reporting
positive information and delaying bad news
After crisis - more conservative accounting
earnings and timelier report
Why? - Improvement in corporate governance
2008 Financial HKIPCA: press release ““Breathing room” for
Tsunami banks in financial crisis” on 15/10/2008
Adopted amendments to IAS 39 & IFRS 7
reclassification of certain non-derivative securities
out of the trading category
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NO IMPAIRMENT
 Has the extent of accounting conservatism in financial reporting
changed over time?

Conclusion
Conclusion

Time

Accounting conservatism always enhances after accounting

failure/financial crisis as new/amended regulations/market
practices will be subsequently implemented. However, at the
time when the event happens, the use of this principle is usually
in lower level.

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 Content

What are the biases of accounting conservatism?

What make it more or less?
Benefit Vs. Cost

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 What are the biases of accounting conservatism?

1. High degree of verification before making legal claim to any revenue

• All
All probable
probable losses
losses recognizes
• Strict
Strict revenue-recognition
revenue-recognition
• Systematic
Systematic undervaluation
undervaluation of
of net
net assets
assets

2. Timeliness Problem

•Reflect Bad News more quickly than Good News

•Negative return will be stronger than Positive

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 What are the biases of accounting conservatism?

Companies report income at a later time over current accounting period

Reasons
• Does not recognize revenue until it is verified or creates a high allowance
for bad debts
• Then the income will be reported in next accounting period and mislead
stakeholders

Finally, False Reporting the better performance

that it really does

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 What are the biases of accounting conservatism?

Historical Cost Method

• Lower of cost or Market Value

• Does not reflect latest information
• Difficult to forecast earning
• Investors under react
• Overstate Contingent Liabilities
e.g. US GAAP probable and reasonable
contingent liabilities should be estimated,
whereas gains are no longer contingent

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 What make it more or less?

Strong Corporate
Governance lead Managerial
a higher Discretion
--affect the degree of
sensitivity of conservatism, e.g.
earning towards CEO ,BOD want to
Bad News!! boost the earning
and assets
Aggressively!!
Provide a early warning
signal ensure sound
management that assets
are used efficiently and Anti-
avoid inappropriate takeover
distribution!! Policy!!

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 What make it more or less?

• Managerial compensation, Leverage, Size, Risk

• Interest Coverage & Dividend Constraints
• Dividend-to-assets ratio
• Liabilities-to-assets ratio
• Investors Preference???
• Big 4 Auditors Clients

Big 4 High Reputation = High Conservatism?

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 What make it more or less?

Changing Accounting standard

Historical Cost Fair Value

• Concern latest market value

• Important aspect for market participants

All Affect Conservatism Policy!!

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 Benefits VS Cost ?

Acco
Cons unting
erva
tism

Benefits

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 Benefits and Cost ?

Benefits
Benefits

Benefit
Benefit the
the use
use of
of Increase
Increase firm
firm
financial
financial reports
reports value
value

Minimize
Minimize
taxable
taxable income
income
Accounting figures
Accounting figures
become
become more
become more
more reliable
reliable
reliable Reduce
Reduce agency
agency
and
and litigation
litigation
costs
costs
link
link executive
executive Disciplining
Disciplining
compensation
compensation more
more mechanism
mechanism which
which
closely
closely to
to accounting
accounting forces managers
forces managers to
to
performance
performance invest
invest more
more
efficiently
efficiently
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 Benefits and Cost ?

Cost
Cost

Share price is sensitive Seriously affect

to value of assets and investors’ decision
liabilities & suffer from loss

Increase owner’s
marginal cost to
Negative effect
motivate the agent &
for efficiency
manager

Possibility Possibility –
-overstatement of Understatement of
earnings in future future expenses
periods
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 Content

How would you relate accounting conservatism

to materials that have been covered in class?

26
How would you relate accounting conservatism to materials that has
been covered in class?

Station 2: Station 4:
Valuation of Regulators
inventories
Station 5:
Managing
earnings

Station 3: Station 6:
Information Managing
system risks

Welcome to ‘Accounting Conservatism’ journey!

Station 1:
Information
Asymmetry
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How would you relate accounting conservatism to materials that has
been covered in class?
Information advantage over the others !
Manager may behave by biasing or managing information released to investors.
(eg. Increase stock option they hold or selectively release information earlier to
selected parties..)

Impact:
Adverse to interest of ordinary investors and reduce their ability to make right
investment decision

=> Corresponding reaction by accounting conservatism

Station 1:
Information
Welcome to ‘Accounting Conservatism’ journey!
Asymmetry

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How would you relate accounting conservatism to materials that has
been covered in class?

Station 2:
Valuation of
inventories

Concept of historical cost-based !

•Lobo and Zhou (2006) document decrease in aggressive accounting practices
subsequent to the passage of the Sarbanes-Oxley Act.
•Capital assets and inventories are commonly valued on the basis of historical
cost

Benefit: Welcome to ‘Accounting Conservatism’ journey!

•Accounting information become reliable but less relevant
•Helps investors to make own estimates of future economic prospects

=> Inherent with the concept of accounting conservatism

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How would you relate accounting conservatism to materials that has
been covered in class?
Conditional conservatism
•write down are conditional on a loss in value actually taking place
=>Recognition of unrealized losses raises the information system probability
Unconditional conservatism
•profitable capital investments are recorded at historical cost instead of
current value
•inventories are carried at cost until objective evidence of realization is
achieved.
=>Recognition lag for good news in financial statements lowers the
probability.
=> Information system for decision theory : illustrate linkage between
financial statement and future performance

Station 3:
Information Welcome to ‘Accounting Conservatism’ journey!
system

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How would you relate accounting conservatism to materials that has
been covered in class?

Station 4:
Regulators

• Expect to have fewer investors’ losses and lawsuits

• Encourage conservatism with punitive laws for those who fail to release bad
news in timely manner
•New accounting standards such as ceiling tests

Benefits:
Avoid utility loss Welcome to ‘Accounting Conservatism’ journey!
Decrease likelihood of investor suing the auditors

=> Demonstrate the need for accounting conservatism

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How would you relate accounting conservatism to materials that has
been covered in class?

Station 5:
Managing
earnings

Manager’s behaviour (obtain high compensation =>manage earnings upwards)

•=> decreasing contract efficiency

•=> lowering firm value
•=> decrease informativeness of net income about manager effort

Accounting conservatism helps in neutralizing the effects:

1. reducing compensation contract efficiency : decrease contract efficiency and
result in low net income and compensation.Welcome to ‘Accounting Conservatism’ journey!
2. Reduce the need for upward earnings management : Increase contract
efficiency
3. Bring positive impact to the company by netoff effect
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How would you relate accounting conservatism to materials that has
been covered in class?

• Delay recognition of unrealized gains

• Discouraging premature revenue recognition
• Brings up with sided effect on executive compensation plan
• Constrain manager from gaining compensation
• Gives less incentive to invest in risky projects
• No compensation will receive until project starts to generate realized profits

=> Demonstrate the effectiveness of accounting conservatism

Station 6:
Managing
risks
Welcome to ‘Accounting Conservatism’ journey!

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How would you relate accounting conservatism to materials that has
been covered in class?

Station 2: Station 4:
Valuation of Regulators
inventories
Station 5:
Managing
End of journey ! earnings

Station 3: Station 6:
Information Managing
system risks

Welcome to ‘Accounting Conservatism’ journey!

Station 1:
Information
Asymmetry
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THANK YOU !

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