Article2008

Accounting Conservatism under IFRS

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Accounting Theory and Financial Reporting Auditing, Earnings Management, Governance Accounting and Organizational Management

Abstract

In a recent discussion paper on an improved conceptual framework (IASB, 2006a), the IASB and the FASB argue that prudence and conservatism are not desirable qualities of financial reporting information (IASB, 2006a, BC2.22). One interpretation of this proposal is that the consistent undervaluation of net assets (consistent conservatism), which used to be common under Continental European GAAPs and to some extent under US GAAP, is not considered to be an adequate way of dealing with uncertainty. Instead, the changes in the business conditions of a firm should be, to a greater extent, reflected in the financial reporting via changes in future-oriented estimates and probabilities. In turn, this should increase the decision relevance to users. However, although the boards suggest that the improved framework will not include prudence or conservatism as desirable qualities, this paper suggests that a more valid description is that consistently conservative accounting treatments will be replaced by accounting methods that leave more opportunities for temporary conservatism (changes in accounting estimates that temporarily understate net assets via the creation of hidden reserves which later may be reversed). From a user perspective, temporary conservatism is demanding because of the increased income-shifting between periods. This is illustrated in the paper by examining three cases concerning loss carryforwards, development costs and construction contracts, related to three different standards (IAS 12, IAS 38 and IAS 11, respectively). Furthermore, the paper illustrates how the mixing of consistent and temporary conservatism may lead to counter-intuitive interpretations of the underlying business activities that, in turn, make the information less relevant to users.

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References

1999A Review of the Earnings Management Literature and Its Implications for Standard Setting 1997The conservatism principle and the asymmetric timeliness of earnings1 1995Valuation and Clean Surplus Accounting for Operating and Financial Activities*2000The changing time-series properties of earnings, cash flows and accruals: Has financial reporting become more conservative?2002Accounting Conservatism, the Quality of Earnings, and Stock Returns 1998Are Accruals during Initial Public Offerings Opportunistic?1979The Demand for and Supply of Accounting Theories: The Market for Excuses.2000Biases and Lags in Book Value and Their Effects on the Ability of the Book-to-Market Ratio to Predict Book Return on Equity

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2018A review of the current debate on the determinants and consequences of mandatory IFRS adoption 2014Do IFRS and board of directors’ independence affect accounting conservatism?2010Value relevance of accounting information in the pre- and post-IFRS accounting periods 2021Capitalisation of R&D and the informativeness of stock prices: Pre- and post-IFRS evidence

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