MPA Group 1

8/8/2019 MPA Group 1

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PRESENTED BY:PRESENTED BY:

Patrick KongPatrick Kong

Pansy WongPansy Wong

Angus ChanAngus Chan

Phyllis ChuPhyllis Chu

Enoch WongEnoch Wong

AF5102 Accounting TheoryAF5102 Accounting Theory

--Accounting ConservatismAccounting Conservatism


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WhatWhat isis accountingaccounting conservatism?conservatism?

How do accountants / managers produceHow do accountants / managers produceconservative accounting reports?conservative accounting reports?

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

What are the biases of accounting conservatism?What are the biases of accounting conservatism?What make it more or less?What make it more or less?

Benefit vs CostBenefit vs Cost

HowHow wouldwould youyou relaterelate accountingaccounting conservatismconservatism totomaterialsmaterials thatthat havehave beenbeen coveredcovered inin class?class?

Agenda


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Content

What is accounting conservatism?What is accounting conservatism?


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Limit amount of risk ofLimit amount of risk of

stakeholders in using theirstakeholders in using their

financial statementfinancial statement

What is accounting conservatism?

Branch of AccountingBranch of Accounting

Financial approachFinancial approach

Asymmetric verificationAsymmetric verification

requirementsrequirements

for recognizing revenuesfor recognizing revenues

VS expensesVS expenses


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How ? Strict revenue recognition criteria

Higher verification threshold for revenue which will deferrevenue 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 companys financial situation



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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 understatementof 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.


IFRS paragraph 37IFRS paragraph 37


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Content

How do accountants / managers produceHow do accountants / managers produceconservative accounting reports?conservative accounting reports?


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How do accountants / managers produce conservative accounting reports?

Compensation packageCompensation packagealign managers andalign managers and

shareholders interestshareholders interest

Intention to overstateIntention to overstate

earnings and net assetsearnings and net assets

Accounting conservatismAccounting conservatism

can mitigate this riskcan mitigate this risk


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Regulations Regulator tend to establish conservative regulations Sarbanes-Oxley Act mentioned that managers (CEO

and CFO) imposes criminal penalties for

noncompliance

Timeliness ofreporting

good news

and bad news

Not timely reflect good news

Timely reflect bad news

Managers and accountants tend to

adopt accounting conservatism in

preparing financial reports

Reduction of

litigation cost

Conservatism guide the managers and accountants to

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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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

asset

conservatism principal requires a stronger verifiability

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 conservatismHas the extent of accounting conservatismin financial reportingin financial reportingchanged over time?changed over time?


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Has the extent of accounting conservatism in financial reporting changed over

time?

US: After SarbanesUS: After Sarbanes--OxleyOxley

Act (2002)Act (2002)

Asia: Financial Crisis (1997)Asia: Financial Crisis (1997)

and Financial Tsunami (2008)and Financial Tsunami (2008)


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Rules on public companies

Additional corporate board responsibilitiesPublicCompany Accounting Oversight Board (PCAOB)

oversee, regulate and discipline accounting firms

Criminal penalties

Scandals: Enron & WorldcomScandals: Enron & Worldcom

SarbanesSarbanes--Oxley ActOxley Act

20012001--0202

30/6/200230/6/2002

Study Findings

AccountingConservatism, theSarbanes Oxley Act, and Crash Risk

In post-SOX period:accrual-based earning management

reveal bad news timelier

Auditor conservatism following audit

failures

After accounting failure:

2% in discretionary accounting

accruals as a percentage of total assets

TimeTime

Has the extent of accounting conservatism in financial reporting changed over

time?


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1997 FinancialCrisis Study: The Impact of the Asian Financial Crisis onConservatism and Timeliness of Earnings: Evidence

from Hong Kong, Malaysia, Singapore, and Thailand

Findings:

During crisis - more aggressive in reporting positive

information and delaying bad newsAfter crisis - more conservative accounting

earnings and timelier report

Why? - Improvement in corporate governance

2008 Financial Tsunami HKIPCA: press release Breathing room for

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

NO IMPAIRMENT

AsiaAsia

Has the extent of accounting conservatism in financial reporting changed overHas the extent of accounting conservatism in financial reporting changed over

time?time?


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Conclusion

Conclusion

TimeTime

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.

Has the extent of accounting conservatism in financial reporting changed overHas the extent of accounting conservatism in financial reporting changed over

time?time?


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Content

What are the biases of accounting conservatism?What are the biases of accounting conservatism?What make it more or less?What make it more or less?

BenefitBenefit VVss.. CostCost


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ReflectBad News more quickly than Good News

Negative return will be stronger than Positive

ReflectBad News more quickly than Good News

Negative return will be stronger than Positive

All probable losses recognizes

Strict revenue-recognition

Systematic undervaluation of net assets

All probable losses recognizes

Strict revenue-recognition

Systematic undervaluation of net assets

What are the biases of accounting conservatism?What are the biases of accounting conservatism?

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

2.2. Timeliness ProblemTimeliness Problem


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Companies report income at a later time over current accounting period

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 misleadstakeholders

Finally, False Reporting the better performancethat it really does

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 misleadstakeholders

Finally, False Reporting the better performancethat it really does


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Historical

Cost Method

Historical

Cost Method

Lower of cost or Market Value

Does not reflect latest information Difficult to forecast earning

Investors under react

OverstateContingentLiabilities

e.g. US GAAP probable and reasonable

contingent liabilities should be estimated,

whereas gains are no longer contingent

Lower of cost or Market Value

Does not reflect latest information Difficult to forecast earning

Investors under react

OverstateContingentLiabilities

e.g. US GAAP probable and reasonable

contingent liabilities should be estimated,

whereas gains are no longer contingent


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Strong Corporate

Governance lead

a higher

sensitivity of

earning towardsBad News!!

Managerial

Discretion--affect the degree of

conservatism, e.g.

CEO ,BOD want toboost the earning

and assets

Aggressively!!

Provide a early warning

signal ensure sound

management that assetsare used efficiently and

avoid inappropriate

distribution!!

What make it more or less?What make it more or less?


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Managerial compensation, Leverage, Size, Risk

InterestCoverage & Dividend Constraints

Dividend-to-assets ratio

Liabilities-to-assets ratio

Investors Preference???

Big 4 Auditors Clients

Managerial compensation, Leverage, Size, Risk

InterestCoverage & 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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Historical Cost


Changing Accounting standard

Fair Value

Concern latest market value

Important aspect for market participants

All Affect Conservatism Policy!!

Concern latest market value

Important aspect for market participants

All Affect Conservatism Policy!!


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Benefits VS Cost ?Benefits VS Cost ?


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Cost

Cost

Benefits and Cost ?

Negative effect

for efficiency

Seriously affect

investors decision

& suffer from loss

Possibility -

overstatement of

earnings in future

periods

Increase owners

marginal cost to

motivate the agent &

manager

Share price is sensitive

to value of assets and

liabilities

Possibility

Understatement of

future expenses


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Content

How would you relate accounting conservatismHow would you relate accounting conservatismto materials that have been covered in class?to materials that have been covered in class?


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

in class?

Station 1:

Information

Asymmetry

Station 2:

Valuation of

inventories

Welcome to Accounting Conservatism journey!

Station 4:

Regulators

Station 6:

Managing

risks

Station 3:

Information

system

Station 5:

Managing

earnings

Station 1:

Information

Asymmetry

Station 2:

Valuation of

inventories

Station 3:

Information

system

Station 1:

Information

Asymmetry

Station 2:

Valuation of

inventories

Station 3:

Information

system


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in class?

Station 1:

Information

AsymmetryWelcome to Accounting Conservatism journey!

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


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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: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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in class?

Welcome to Accounting Conservatism journey!Station 3:Information

system

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 theprobability.

=> Information system for decision theory : illustrate linkage between

financial statement and future performance


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in class?


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

Decrease likelihood of investor suing the auditors

=> Demonstrate the need for accounting conservatism

Station 4:

Regulators


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in class?


Managers 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.

2. Reduce the need for upward earnings management : Increase contract

efficiency

3. Bring positive impact to the company by netoff effect

Station 5:

Managingearnings


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in class?


Station 6:

Managing

risks

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


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in class?


Station 4:

Regulators

Station 6:

Managing

risks

Station 5:

Managing

earnings

Station 1:

Information

Asymmetry

Station 2:

Valuation of

inventories

Station 3:

Information

system

End of journey !


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THANK YOU !

MPA Group 1

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