That was the year that significant changes were made in the Securities Act and the rules for bringing class action lawsuits were adjusted and modified. Because of those changes, it became more important from a litigation standpoint to ensure that conservatism was used in accounting valuation. Because there are empirical differences between the contracting and litigation perspectives, there have been many discussions regarding them in the past and that will likely continue well into the future. Each accounting firm must do what it feels is in the best interest of both itself and its clients, but the avoidance of lawsuits is a highly significant issue to consider when a company is planning to focus on a particular accountancy option.
C. Income Tax Perspective
Because income taxes are so closely tied to earnings, it only stands to reason that there would be an accounting valuation issue as it relates to conservatism where income tax is concerned (Ball & Watts, 1972). Income taxes often influence how earnings are calculated. Depreciation, for example, must be recorded as an expense now, due to changes requested by the U.S. Treasury. If it is recorded that way in any and all reported financial statements, that makes it possible for it to also qualify as tax deductible. Now that the depreciation laws are so well established they no longer influence taxable income - but the accounting laws still have a strong effect on how the taxable income of any company or individual is reported (Ball & Watts, 1972).
There have been many court decisions over the years that have also served as precedents for the ways in which income reporting and other accounting issues have been handled. As long as a firm is showing a profit and has taxable income and positive interest rates, there is an incentive to defer income so that the present value of taxes can be reduced. This leads to the understatement of assets in many cases, so that taxes will be lower and the company will not have to pay out as much to the IRS. This may sound illegal, but it is not. The income will be properly reported when it is received and is not hidden. It is simply not reported on anything as a speculation and is kept off of the books until it is actually acquired. In this sense, the income tax perspective shares much with the contracting perspective, as both are interested in minimizing current assets for various reasons.
D. Regulatory Perspective
Regulators and those who set standards have reason to be conservative, because they know that overvalued assets and overstated income (and the losses that those things frequently produce) are more easily seen by others than foregone gains due to the fact that everything was understated and undervalued (Beaver, 1993). That does not mean that understating things will never be noticed, but only that it is less observable - and viewed as far less of a problem. It is one thing for a company to make more than the market was expecting, but it is quite another thing entirely for that company to make less than the market had planned.
Making more indicates that the company was actually doing better than anyone would expect. Making less indicates that the company was not performing well, but that it was trying to convey a good performance until it was no longer able to do so (Beaver, 1993). There have been several cases of companies doing this illegally in the past, but there are more legal ways for something like that to occur, also. Avoiding that is by far the best choice for companies, all of which should be focused on handling their earnings in a conservative manner.
Accounting overvaluation was even blamed for what took place in the Stock Market in 1929 (Beaver, 1993). Since history has shown how badly that turned out, there are more and more regulatory bodies that are leaning toward the idea of remaining conservative with virtually any and all accounting practices.
2.2 Empirical Approach
In order to address the empirical approach to this issue, it is very important to understand that there are two different types of conservatism: unconditional (balance sheet) conservatism, and conditional (earnings) conservatism. These are very different in how they are used, and those who work in accounting must be clear on the differences so that both approaches can be used properly. Without using a specific kind of accounting approach correctly, a company can easily have a problem where its assets are concerned.
In unconditional conservatism, there is a greater focus on the expense of the costs of most intangibles (Benston, 1969; Carhart, et al., 2002). For example, this could include the costs for research and development, intellectual property, and other things that are generally not seen and are not part (in a sense) of the finished product or service. Intangibles are not things that the company can touch, but they are certainly very real and they have to be clearly and properly addressed in order to be used by the company as a savings device where accountancy is concerned.
When looking at the balance sheet, is the company really including all of the costs? Are intangible costs being included, and are they being priced fairly and equitably? If they are not, they certainly need to be. Research and development, as well as other intangibles, are expenses that are seen by the vast majority of companies - and those companies will want and need to show those as real expenses when and as they occur (Basu, 1995; Basu, 1997). If they have paid money out for something, or if they have acquired a debt in relation to something intangible, showing that right away is vital to proper conservatism in accounting.
With conditional conservatism, there is less of a focus on the balance sheet and the costs, and more of a focus on the earnings side of the issue (Basu, 1997). Conditional conservatism can help to balance out the asymmetry that is often seen in recognition of earnings and that is also often present with unrealized gains and losses. Impairment of assets would be one example of this. If assets are not functioning correctly and cannot be used (i.e. broken, malfunctioning, or obsolete equipment), they can quickly change from providing gains to providing losses for the company who must repair or replace them.
By having timeliness in both gains and losses, a company is better able to show how its financial bottom line really looks to Wall Street and to potential investors and creditors (Ball, Kothari, & Robin, 2000). The goal is to be honest about finances, but also to paint the company in the best possible, legal light. There are ways to do that, and conservatism is one of those ways. By keeping accounting both timely and conservative, any company can have a bottom line that speaks to what it really has to offer to others and that will not decrease significantly because of unexpected losses or gains that are not realized.
It is never a good practice to show income or assets that have not actually been acquired, or to show ownership of something on which the company still has a debt load. To do so fails to provide an accurate portrayal of the company's financial strength.
2.3 Theoretical Approaches
There are several theoretical approaches that are seen with conservatism in accounting valuation. One of those is the signaling model. In that model, investors in the market use the signals that are picked up based on the decisions that the manager makes (Ball, Kothari, & Robin, 2000). From those decisions, the investors are able to infer more private information about the firm. That can lead them to predict the future value of the firm more easily. There are still no real easy ways to make predictions about how a firm will perform, however, because there may be other influences that are not seen or noticed by investors.
Still, the signaling model is relatively reliable and is one of the best ways to gain information and make decisions when one does not work in the inner circles of a company or have any kind of inside information as to what the company might do in the future. The signals that are given off by the managers in the decisions they make can be very telling for someone who is good at deducing those kinds of things, but it takes practice and analysis in order to discover what the managers are really doing based on the decisions that they are making.
Sometimes, they appear to make decisions that do not seem to be in the best interests of the company. When that is the case, investors may need to sit back and wait to see what the manager will do next. It is possible that the decision was part of a greater (and often very effective) plan that the investors cannot see from their viewpoint, so…