LOS C requires us to:
distinguish between conservative and aggressive accounting
a. The policy of conservatism, also known as prudence policy, involves anticipating all the expected losses but not future gains and making provisions for the same in the current period. On the other hand, aggressive accounting involves, deferring the expenses to the future period, and reporting the future revenues in the current period.
b. Conservative accounting results in increased earnings in the future periods, whereas, aggressive accounting results in greater current earnings. The use of conservative and aggressive accounting may help in the smoothening of earnings.
c. The conceptual framework for reporting standards supports neutrality in financial reporting. However, the financial reporting standards, both IFRS and GAAP are slightly biased towards conservatism. The main benefits of conservative accounting are:
i. It reduces the possibility of litigations,
ii. It results in bonds of the company ‘pricing in’ a higher risk,
iii. It may also result in tax cash outflow benefits (due to lower profits resulting from higher expenses).
d. Despite its benefits, conservative accounting can still be considered as a deviation from the framework of neutrality and faithful representation and reduces the usefulness of financial reports for its users.
e. The application of any standards requires judgment, even if it is inherently neutral. The management may disguise their bias as conservatism by using techniques such as ‘big-bath behavior’ or ‘cookie-jar reserves’.