What Is Accounting Conservatism?

Accounting conservatism is a set of bookkeeping guidelines that call for a high degree of verification before a company can make a legal claim to any profit. The general concept is to factor in the worst-case scenario of a firm’s financial future. Uncertain liabilities are to be recognized as soon as they are discovered. In contrast, revenues can only be recorded when they are assured of being received.

How Accounting Conservatism Works

Generally Accepted Accounting Principles (GAAP) insist on a number of accounting conventions being followed to ensure that companies report their financials as accurately as possible. One of these principles, conservatism, requires accountants to show caution, opting for solutions that reflect least favorably on a company’s bottom line in situations of uncertainty.

Accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.

Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.

A cautious approach presents the company in a worst-case scenario. Assets and revenue are intentionally reported at figures potentially understated. Liabilities and expenses, on the other hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to record it and amplify its potential impact. In contrast, if there is a possibility of a gain coming the company’s way, they are advised to ignore it until it actually occurs.

Recording Revenue

Accounting conservatism is most stringent in relation to revenue reporting. It requires that revenues are reported in the same period as related expenses were incurred. All information in a transaction must be realizable to be recorded. If a transaction does not result in the exchange of cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to be reported.

Advantages of Accounting Conservatism

Understating gains and overstating losses means that accounting conservatism will always report lower net income and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.

Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.

Disadvantages of Accounting Conservatism

On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. That means that some companies will always find ways to manipulate them to their advantage.

Another issue with accounting conservatism is the potential for revenue shifting. If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods to be overstated, making it difficult for an organization to track business operations internally. 

Using Accounting Conservatism

Accounting conservatism may be applied to inventory valuation. When determining the reporting value for inventory, conservatism dictates the lower of historical cost or replacement cost is the monetary value.

Estimations such as uncollectable account receivables (AR) and casualty losses also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles.

However, if a litigation claim is expected to be lost, an estimated economic impact is required in the notes to the financial statements. Contingent liabilities such as royalty payments or unearned revenue are to be disclosed, too.

What is an Actuarial Gain Or Loss?

Actuarial gain or loss refers to an increase or a decrease in the projections used to value a corporation’s defined benefit pension plan obligations. The actuarial assumptions of a pension plan are directly affected by the discount rate used to calculate the present value of benefit payments and the expected rate of return on plan assets. The Financial Accounting Standards Board (FASB) SFAS No. 158 requires the funding status of pension funds to be reported on the plan sponsor’s balance sheet. This means there are periodic updates to the pension obligations, the fund performance and the financial health of the plan. Depending on plan participation rates, market performance and other factors, the pension plan may experience an actuarial gain or loss in their projected benefit obligation.

While those accounting rules require pension assets and liabilities to be marked to market on an entity’s balance sheet, they allow actuarial gains and losses, or changes to actuarial assumptions, to be amortized through comprehensive income in shareholders’ equity rather than flowing directly through the income statement.

Understanding Actuarial Gain Or Loss

Actuarial gains and losses are best understood in the context of overall pension accounting. Except where specifically noted, this definition addresses pension accounting under U.S. generally accepted accounting principles (GAAP). While U.S. GAAP and International Financial Reporting Standards (IFRS) prescribe similar principles measuring pension benefit obligations, there are key differences in how the two standards report pension cost in the income statement, particularly the treatment of actuarial gains and losses.

Funded status represents the net asset or liability related to a company’s defined benefit plans and equals the difference between the value of plan assets and the projected benefit obligation (PBO) for the plan. Valuing plan assets, which are the investments set aside for funding the plan benefits, requires judgment but does not involve the use of actuarial estimates. However, measuring the PBO requires the use of actuarial estimates, and it is these actuarial estimates that give rise to actuarial gains and losses.

There are two primary types of assumptions: economic assumptions that model how market forces affect the plan and demographic assumptions that model how participant behavior is expected to affect the benefits paid. Key economic assumptions include the interest rate used to discount future cash outflows, expected rate of return on plan assets and expected salary increases. Key demographic assumptions include life expectancy, anticipated service periods and expected retirement ages.

Actuarial Gains and Losses Create Volatility in Results

From period to period, a change in an actuarial assumption, particularly the discount rate, can cause a significant increase or decrease in the PBO. If recorded through the income statement, these adjustments potentially distort the comparability of financial results. Therefore, under U.S. GAAP, these adjustments are recorded through other comprehensive income in shareholders’ equity and are amortized into the income statement over time. Under IFRS, these adjustments are recorded through other comprehensive income but are not amortized into the income statement.

Footnote Disclosures Contain Useful Information About Actuarial Assumptions

Accounting rules require detailed disclosures related to pension assets and liabilities, including period-to-period activity in the accounts and the key assumptions used to measure funded status. These disclosures allow financial statement users to understand how a company’s pension plans affect financial position and results of operations relative to prior periods and other companies.

What Is the Accounting Cycle?

The accounting cycle is a collective process of identifying, analyzing, and recording the accounting events of a company. It is a standard 8-step process that begins when a transaction occurs and ends with its inclusion in the financial statements.

The key steps in the eight-step accounting cycle include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.

How the Accounting Cycle Works 

The accounting cycle is a methodical set of rules to ensure the accuracy and conformity of financial statements. Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors. Today, most software fully automates the accounting cycle, which results in less human effort and errors associated with manual processing.

Steps of the Accounting Cycle

There are eight steps to the accounting cycle.

1. Identify Transactions: An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.
2. Record Transactions in a Journal: Next come recording of transactions using journal entries. The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.
3. Posting: Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account.
4. Unadjusted Trial Balance: After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal the total credits in the financial records.
5. Worksheet: Analyzing a worksheet and identifying adjusting entries make up the fifth step in the cycle. A worksheet is created and used to ensure that debits and credits are equal. If there are discrepancies then adjustments will need to be made.
6. Adjusting Journal Entries: At the end of the period, adjusting entries are made. These are the result of corrections made on the worksheet and the results from the passage of time. For example, an adjusting entry may accrue interest revenue that has been earned based on the passage of time.
7. Financial Statements: Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual formalized financial statements.
8. Closing the Books: An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using closing entries. These closing entries include transferring net income into retained earnings. Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.

Timing of the Accounting Cycle

The accounting cycle is started and completed within an accounting period, the time in which financial statements are prepared. Accounting periods vary and depend on different factors; however, the most common type of accounting period is the annual period. During the accounting cycle, many transactions occur and are recorded.

At the end of the year, financial statements are generally prepared, which are often required by regulation. Public entities are required to submit financial statements by certain dates. All public companies that do business in the U.S. are required to file registration statements, periodic reports, and other forms to the U.S. Securities and Exchange Commission. Therefore, their accounting cycle revolves around reporting requirement dates.

The Accounting Cycle Vs. Budget Cycle

The accounting cycle is different than the budget cycle. The accounting cycle focuses on historical events and ensures incurred financial transactions are reported correctly. Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle assists in producing information for external users, while the budget cycle is mainly used for internal management purposes.

What Is Accountability?

Accountability is an acceptance of responsibility for honest and ethical conduct towards others. In the corporate world, a company’s accountability extends to its shareholders, employees, and the wider community in which it operates. In a wider sense, accountability implies a willingness to be judged on performance.

Understanding Accountability

Accountability has become an essential concept in corporate finance. It is particularly relevant to the accounting practices that a company adopts when it prepares the financial reports that are submitted to shareholders and the government. Without checks, balances, and consequences for wrongdoing, a company cannot retain the confidence of its customers, regulators, or the markets.

However, in recent years corporate accountability has come to encompass the company’s activities as they affect the community. A company’s environmental impact, its investment decisions, and its treatment of its own employees all have come under public scrutiny.

Types of Accountability

The concept of accountability runs throughout all industries, sectors, companies, and professions. Here is an overview of where accountability is most prevalent in the business sector.

Corporate Accountability

At its most prosaic, accountability is about the numbers. Every public company is required to publish a financial report quarterly and annually detailing its income and expenses. An independent auditor reviewing a company’s financial statements is responsible for obtaining reasonable assurance that the financial statements are free from any material misstatements caused by error or fraud. This auditor is holding the company accountable for its reporting.

Accountability requires corporate accountants to be careful and knowledgeable, as they can be held legally liable for negligence. An accountant is responsible for the integrity and accuracy of the company’s financial statements, even if an error or misstatement was made by others in the organization. This is why independent outside accountants audit the financial statements. Public companies are required to have an audit committee within the board of directors. Their job is to oversee the audit.

Political Accountability

Political accountability can relate to political contributions and how candidates use resources. For example, the non-partisan Center for Political Accountability and the Wharton School at the University of Pennsylvania jointly publish an annual index rating the disclosure and oversight policies of major public corporations regarding their donations to political causes and candidates.

These scandals resulted in tougher regulations, and there are armies of regulators and private watchdogs working to make sure that companies report their earnings correctly, that the exchanges execute trades in a timely fashion, and that information provided to investors is timely and accurate.

The Center shines a spotlight on corporate spending to influence politicians. Recently, the Center reported in-depth on a campaign by the pharmaceutical industry to head off a proposal to allow Medicare to negotiate drug prices with vendors. The report named the names of members of Congress who accepted political donations from drugmakers.

Government Accountability

The role of corporate cash is only one of the global issues regarding government accountability.

USAID, the federal agency that administers civilian foreign aid, defines measures government accountability by these key factors: a free and fair political justice system; protection of human rights; a vibrant civil society; public confidence in the police and courts, and security sector reform.

To aid in protecting citizens, the Government Accountability program protects federal, state, and local whistleblowers who spot problems and report them to appropriate agencies. In this model, governments are held accountable through unofficial, internal audit. Anyone can report anyone else for improper behavior, forcing accountability to be systematic and prevalent throughout organizations.

Media Accountability

The media in the U.S. is uniquely protected by the First Amendment from interference by Congress. This does not mean that it is free from accountability.

The media have long been under the constant scrutiny of a number of watchdogs, internal and external. In the internet era, these have been augmented by independent fact-checking organizations such as FactCheck.org, Snopes, and PolitiFact. These and other organizations monitor the media for bias and errors and publish their findings for all to see.

Now, through the introduction of social media, individuals can now easily contribute to media. There is arguement whether the platforms (i.e. Facebook) it is a publisher or if the users of the platform are the publishers. In either case, social media continues to be under fire for spreading dangerous misinformation, providing a platform for hate speech, and having a generally lacking sense of accountability.

Accountability in the Workplace

For companies to be successful, employees must conduct themselves with accountability. This is done is several ways.

First, there are soft skill aspects of accountability. Accountability includes showing up to work when expected and showing up to work prepared for the tasks for the day. Accountability extends to every department and every employee, as it starts with being present, honest, and engaged in every day tasks outside of one’s job.

There is also a deep rooted sense of accountability in specific positions. Professionals who handle physical or digital money have a standard of accountability to be honest and responsible with funds that do not belong to them personally. Managers have a duty of accountability to properly oversee employees, treat them well, and guide them through growth opportunities.

There’s a few ways a company builds, manages, and sustains accountable practices, such as:

• Making employees verbally commit to completing certain tasks and ensuring them follow through with these tasks.
• Having upper management set expectations on the duties to be completed and the associated deadlines.
• Creating a safe environment where taking risks is rewarded and learning occurs in a natural, non-threatening way.
• Defining ownership of tasks, projects, or other aspects of work. Should there be a problem, the owner of that task or project must be held accountable.

Benefits of Accountability

Accountability will be different at every company. However, there are overarching benefits that accountability can provide should a business be able to appropriately execute accountability practices:

• Accountability promotes operational excellence. When employees understand that their work is being looked at and will be evaluated, they are more likely to put forth stronger effort as it is understood that what they do matters. This is especially true when employees are rewarded for strong accountability with raises, promotions, and public recognition.
• Accountability safeguards company resources. Accountability is not limited to just doing your job; it is the practice of being honest and responsible for your actions in all situations. When employees are accountable, they are held to a standard that company resources are to be respected, and employees are less like to mistreat company assets as they understand there will be consequences for their actions.
• Accountability yields more accurate results. Companies with a standard of accountability will have boundaries of acceptable deviation. For example, a company may allow for a certain dollar threshold of financial misstatement due to immateriality. If a company holds itself accountable to a low threshold of materiality, it will not accept larger errors, unexplainable variances, or delays in reporting.
• Accountability builds external investor trust. An investor’s confidence in a company is only driven so far based off of the prospect of financial success. Investors must believe that a company is well-run, honest, competent, and efficient with its resources. If a company can demonstrate their accountability, they will be seen more favorable, especially compared against an untrustworthy adversary.

Accountability in the Real World

Corporate accountability can be hard to quantify but that doesn’t stop anyone from trying.

The publication Visual Capitalist ranked the best performing U.S. corporations on environmental, social, and corporate governance issues. The top performer on environmental issues was HP, which has decreased its greenhouse gas emissions by 44% since 2015. General Motors got the highest marks for social responsibility as the only U.S. company with a woman as both CEO and CFO. Qualcomm topped the list in corporate governance due to its introduction of STEM programs for women and minorities.

Some high-profile accounting scandals in the past demonstrated that a public company cannot continue to exist if it loses the trust of the financial markets and regulators.

The erstwhile energy giant Enron collapsed in 2001, taking the venerable accounting firm Arthur Andersen with it after its false accounting methods were exposed. The global financial crisis in 2008–2009 revealed gross financial speculation by some of the nation’s biggest banking institutions. The LIBOR scandal revealed currency rate manipulation by several London banks.

But many leaders have called for the creation of a new culture of accountability in finance—one that comes from within.

The Bottom Line

Accountability can be a management buzzword, or it can be a real framework for evaluating the success or failure of an individual or an entity. The concept of corporate accountability has always meant honest and transparent financial reporting. In recent years that concept has expanded to encompass a corporation’s performance and responsiveness to environmental, social, and community issues.