Concept of Conservatism Paper Example

Introduction

The concept of conservatism is a principle that best anticipates future loss rather than the gains. It maintains a balance between expenses and liabilities in a situation that has an unwarranted outcome. Therefore, assets and revenues are only recognized in such a situation only if they are assured. It dictates that in a situation that the organization is uncertain about forthcoming loss, then they record it as a loss but conversely if the uncertainty is about a profit, then it is not recorded. The method further applies in the recognition of estimates but letting the records tend towards the bad debts rather than the receivables. It is a major principle in the lowering of cost marketing rule. It is used severally by companies and countries in the bit to play safe. The paper will investigate the conceptual and practical reasons for it, the strengths and limitations and the views that companies and investors have regarding the issue.

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Literature review

Accounting theory

There are two very important accounting theories; the normative and the positive accounting theories. Positive theories are used in the prediction and explanation of phenomenon. Normative on the other hand is based on perspectives and not ideas; basing the judgements on the assumptions made by the accountant. Conservatism is based on both aspects of the theories and thus takes both the normative and the positive theories into account (Ademola and Olayinka 89). Positive theories explaining conservatism are the most prevalent and they explain the functioning of relations between the individuals that deliver resources and the firm. Part of the Positive Accounting theory is the Agency theory. The theory bases its judgement on the assumption that any functioning organ has its self-interest at heart. For example, when the director of the firm has more information about the firm than the shareholder and both have interest on the firms, they could be termed as having conflict of interest. The costs that arise because of the conflict of interest are called agency costs.

The basis of the conservatism theory in accounting is the definitions given by Bliss "anticipate no profit but anticipate all losses". Before any profit is legally acclaimed that they will be generated, then they are not considered to be profits. It however isn't to mean that there are no profits generated within the venture. Only that the recognition is based on verifiability. It later resulted to the definition Baus that claimed conservatism is the tendency of the accountant to require concrete verification in order to recognize good or bad news (Kim and Liandong 421). The resultant action from the definitions is the understating of the company assets which may result to an overstatement of future earnings caused by understatement of future earnings.

Types of conservatism

Unconditional Conservatism

It is the type of conservatism that does not depend on the news reaching the accountant to recognize the book value of the assets. Some specific accounting methods are used in the determination and not specifically on the confirmations. At the beginning of a new book cycle, accounting methods are used to give a lower book value to the assets than the value it is supposed to gain within the lifetime. The underlying criteria is the stringent recognition method and is used in the reporting of assets and less on reporting of liabilities. Examples of the unconditional conservatism are the accelerated depreciation and the historical methods of cost accounting for positive net. The reason for unconditional accounting is that the prediction of the assets is difficult for the accountant.

Conditional Conservatism

Conditional conservatism gives the value to the assets depending on new meaning that the accounting estimates have figured out after the book cycle or on when an activity has occurred. It therefore has an impact on the income statement. An example of a situation that has a conditional conservatism procedure is when depreciations are taken as soon as they happen and taken as much as possible to lower the results (Lara et al. 221). Under unfavorable circumstances within the organization, the value of the assets that would be recorded would be the book value. In the contrary case, the book value is not used. The asymmetrical method of recording the data is effective in creation of conservatism. The reason behind this form of conservatism is to give the accountants a greater verification in the case of reporting good news than when it is bad news. An example of a real life situation depicting this type of conservatism is the impairment test where the manager restrains from reporting a higher gain in the case of unfavorable circumstances.

Research Questions

• Is conservatism a part of the conceptual framework? Why or why not?
• What are conceptual and practical reasons for applying conservatism in accounting?
• What are problems or negatives associated with its use?
• How do companies have different views on this matter than investors and creditors?

Methodology

The main source of data from the research would be secondary sources of data. The reasons behind the choice are the ease of availability from online libraries and the feasibility of the international comparative studies and the longitudinal studies. The sources of the data were peer reviewed journal and articles related to the topic. The search for the journals was made in the accounting databases such as Amedus, EconLit and RePEc. The main search tool was Google Scholar and the search keywords were; Accounting Conservatism, conservatism as a conceptual framework, problems or negatives of conservatism, and the reasons for conservatism. Once the related information was gathered, the necessary data was analyzed based on the research questions, and the results therein were compiled.

Results

Conservatism as a Conceptual Framework

Conservatism is conceptual framework that stemmed from original philosophical ideas of political philosophy that expressed defined the national defined cultural, social and political attitudes in relation to change. The philosophical idea meant to reject revolutionary change unless it was organic. The basis of the argument is that any attempts to change the complex web of human relations purely for the sake of theory risk running foul the law of unintended consequences. The word conservatism comes from the Latin word 'Conservarve' that means protect or preserve. The application of the original theory was intended for the financial statement of a company. The financial statements of a firms are published to inform the company stakeholders on the position of the firm. There are very significant impacts that arise from the release of the information to the general public. For example, in the stock market, when there is any new information pertaining a company, the stock prices become volatile very fast and change regarding the news received (Caskey and Volker 524). When the company then decided to preserve of regulate the information they release in their financial statements, then it becomes a situation of conservatism. That is the basis of the concept,

Reasons for Conservatism

Contracting Explanation

It is the reason that most cases of conservatism are based upon. The main basis of contracts between organizations and other parties is the accounting books. The reason behind this is to reduce the agency costs that the organization will have to pay. The relationship between managers and the debt holders is the main source of concern and therefore much attention is given to the area (Balakrishnan et al. 514). The prospects of a firm are to make a very high risk venture that upon completion would result to even higher profits. However, when the prospects fail, the losses incurred would be lower than that of the debt holder. When the project is a success, the debtor bears all the profits and doesn't share them with the firm. Therefore the upside to the debt holder is that they don't get to share any of their profit but the downside is that they get to suffer significant losses by themselves. Therefore, when taking a debt, the debtors prefer a time conservative accounting. Lenders therefore lower the interest rates they charge to the conservative borrowers. The result of conservatism therefore is the reduced interest rates for loans.

Litigation explanation

When a firm understates its assets then the chances to make the litigation costs are lower than when they overstate the net assets. The litigation costs are like the lawsuits from shareholders when they think that they made a fraud in the book keeping. When the net assets are kept at the lower minimum, then the litigation costs will be at the same level. Litigation within the security acts of many countries including the United States of America encourage conservatism (Li 555). The other form of litigation costs are the political costs. The government and interest groups find the act of generating too much profit as unacceptable. There is attention drawn therefore in such a case. They government therefore would seek to find out the sources of the excess profits; if they are because of high pricing or maybe it is because of the cheaper production costs that result to degradation of the environment (Lara et al. 221). When firms make high profits, the trade unions and workers unions begin to claim for increased wages. some firms therefore opt to reduce the attention they draw to themselves by conservatism to reduce the litigation costs that come with it.

Income Tax Explanation

The taxes that a company has to pay depend on the income that it generates. Therefore, something has to be done to regulate the income recorded for the company. They therefore adopt depreciation methods; an assets depreciation rate is taken to be as fast as possible. Taxes incentivize the mangers of the corporations to be more conservative when it comes to the reporting of their income. Moreover, there is need to increase the period that they eventually pay the taxes. The timeline of money stipulates that it is important to pay taxes later than sooner. It is however applying to the cases where the taxable profit and the profit are measure using the same parameters. Some countries define the parameters differently.

Regulatory explanation

County, business and Regulators also promote the use of conservative accounting methods. Overvaluing net assets cause bigger problems than the assets that are undervalued. When a company is not conservative, it may end up to be overvalued within the stock market. To set the standard a company needs to be conservative in the standard accounting practices (Ruch and Gary 22). The effects of the IFRS in the recent years have cause the opposite to happen. The trend of companies has been more to the less conservative side and more standard based valuation.

Negatives Associated with Conservatism

A high level of conditional conservatism in a company reduces the level of investments that the companies are involved in. With reduced projections of the total incomes and profits there is low energy directed towards investment opportunities. Conditional conservatism creates a rigid mentality in managers in the company and causes a situation where there is least need to spend the assets of the company. The managers are also reluctant to invest due to the fear of recording the incomes or losses from the new ventures (Biddle et al. 98). Further, a high level of conditional conservatism further leads to managers in the firms to invest in low risk ventures. The attitude of managers in the conservative companies is attributed to psychological barriers towards investment opportunities. Even in the case where there is need for investment to take place within the company, the managers would opt for low risk investment oppo...