Introduction
Statement of financial accounting standards is aimed at describing the appropriate accounting standards and rules for observing accounting policies that are set by FASB. It is expected that all the companies will follow the rules of these standards, while the aspect of corporate transparency is involved in this matter.
Accounting standards are closely linked with the values of conservatism in accountancy, and the importance of these conservative measures for the effectiveness of the accounting process, and financial management of a company in general. Additionally, conservatism will be regarded as the necessary factor for defining the financial accounting effectiveness, as, by the definition of Basu Coefficient, the financial statement of the key economic processes requires a particular measure of conservatism because of the well-known asymmetry in financial information flow.
Conservatism as a Qualitative Characteristic of Financial Statements
First, it should be stated that by the key values of financial accounting, conservatism is often regarded as the necessary measurer for coping with the informational asymmetry. (Rainsbury and Bradbury, 2008) This asymmetry is common for equity-based financial structures, while investors are the key sources of this asymmetry. Conservatism helps to reduce the manager’s attempts to stimulate the appearance of asymmetry by manipulating the necessary accounting numbers, therefore, the deadweight losses may be decreased, or even avoided. Therefore, by Geiger and Raghunandan (2002, p 165), the following statement should be emphasized:
Information asymmetry among equity investors is significantly positively related to conservatism after controlling for contracting and other demands for conservatism. Further, changes in information asymmetry between equity investors cause changes in conservatism. The second result rejects the FASB’s proposition that conservatism produces information asymmetry among equity investors. An important implication is that, if the FASB were successful in meeting their stated goal of eliminating conservatism, they would increase information asymmetry between informed and uninformed investors, not reduce it. This outcome is inconsistent with the objectives of the Securities Acts.
In the light of this fact, it should be emphasized that the increased fair value decreases the conservatism levels in balance sheets. Nonfinancial companies without clearly stated financial liabilities are more subjected to this increase. This may be explained by the fact that fair value principles allow performing write-ups of financial assets. (Kuppusamy and Nazim, 2003) However, most companies do not have sufficient financial liabilities for performing fair value principles, and by FAS 159 principles, the absence of write-ups of financial liabilities may be the reason for higher values of net assets, as well as lesser balance sheet conservatism. (Penman, 2007)
Additionally, the increase of fair value levels reduces conservatism in income statements. The reasons for ISC decrease are explained by the fact that trading securities are considered in holding gains, while income statements are subjected to adjustments by financial assets accounting.
Effects of an Increased use of Fair Value in Financial Statement
As a rule, conservatism is measured by the Basu regression model; however, these measurements cause the regression of the return level, while the return coefficient may vary. In general, the expected incremental coefficient may be regarded as the conservatism measure, while the coefficient itself should be featured with negative returns. By the research by Mckee (2000, p, 318), the following statement should be emphasized:
It is expected that the increased use of FV reduces magnitudes of both the Basu coefficient and market to book ratio (to measure unconditional conservatism). However, signs of either measure do not change. Therefore, the reducing magnitudes of both measures result from the permission of the write-ups of FA (or the write-downs of FL), part of which recognize holding gains in the income statement.
In the light of this fact, it should be stated that regardless of the gains by some holdings, income statements are recognized as bypassing. The recognition of such holding gains may essentially reduce the use of fair value approaches, while the company will have to adjust financial assets or liabilities for suiting the historical cost to market values. (Klersey, Roberts, 2010) Moreover, it is often expected that the magnitudes of unconditional conservatism are decreasing the values of conditional conservatism, therefore, the Basu coefficient that is used as the market adjustment parameter is regarded as the necessary measure of conservatism applied within the financial accounting strategies of any company. (Broadley, 2007)
As for the matters of the increased use of fair values in financial statements, it should be emphasized that the cross-sectional regression analysis with application of the Basu coefficient is regarded as more effective in comparison with PIN score measuring. Therefore, companies with the increased asymmetry of the financial information flow tend to report more conservative earnings. It is hard to control these earnings, however, this is the nature of most conservative financial factors. Market-to-book ratio, leverage, firm size, regulation, and litigation factors should be considered for performing proper calculation of the Basu coefficient, as well as considering all the necessary conservative factors. As I am stated by Power (2010, p. 197):
The controls for the factors associated with conservatism generate a very strong test of the first prediction since those factors are all theoretically and empirically associated with the existence of growth options and information asymmetry.
Effects on Earnings Response Coefficients
These effects are clear only if the results of the coefficient application are applied. Therefore, the interpretation of such results is often performed with the asymmetric verification of the generated governance mechanism. As a rule, accounting and auditing principles involve the key values of asymmetric verification taken from balance sheet conservatism. (Camfferman and Zeff, 2007) Therefore, the effects of response coefficients often stay invariable, especially, if the company’s gains are subjected to asymmetric verifiability. Hence, more conservatism in accounting standards is achieved. In the light of this fact, the statement by Riahi-Belkaoui (2003, p. 112) should be emphasized:
When the information asymmetry between equity investors in a firm increases the application of the asymmetric verifiability standards following that increase generates more conservatism. This statement is consistent with the consideration that the greater the information asymmetry, the more conservative are the firm’s financial statements and that information asymmetry changes lead to conservatism.
The key conclusion that may be given after considering this statement is associated with the fact that the contracting demand for the conservatism values originates from asymmetric payoffs for various contractors. Anyway, an asymmetric informational flow that produces conservative accounting is impossible without debt contracts and earning-based compensations. (Cunningham and Harris, 2006)
Effects on Absolute Value of Discretionary Accruals
It is stated that most value-reducing managerial actions that are applied within most debt contracting cooperators are regarded as the required auditing value for assessing the discretionary accruals. The illustrative value-reducing actions, as the necessary restrictors of debt contracts, are regarded as the necessary procedures for originating the necessary dividends, and for understanding the origins of debt contracts that are the inevitable part of the decreased conservatism within the financial accounting procedures. (McConnell, 2000)
Effects on the Value Relevance of Financial Assets
Value relevance of financial assets is closely linked with the general values of FV accounting, while FAS principles emphasize the necessity to control the conservatism level in income statement accounting. Therefore, the actual importance of value relevance may be explained by the fact that these principles are performed considering potential losses or gains that are reported for the financial statements of a company. (Riahi-Belkaoui, 2004)
The sign of the metric will be changed by the increased financial statement value. This fact is emphasized by Walton (2006), who stated that in the case of two acceptable accounting alternatives, the necessary conservatism level will be directed to breaking the tie of accounting barriers. Therefore, the fair value level increases and unbiased objectives of fair value income statements define the key values of accountability principles. (Riahi-Belkaoui, 2007)
Conclusion
FASB stated principles of accounting rules and standards require corporations to resort to transparent accounting principles. However, the regarded conservatism levels simplify accounting processes for accountants, and they are mainly caused by the particular level of informational asymmetry. This asymmetry is caused by values of equity investment principles. Nevertheless, the sign of measuring principles changes if the Basu coefficient does not allow asymmetry.
The effects of conservatism on absolute value are regarded from the perspective of value-reducing actions that restrict debt contracts, thus, decreasing the level of accounting conservatism. Therefore, conservatism may be regarded as either positive or negative value of the accounting principles, while most are defined by the informational flow, as well as the investment data offered.
Reference List
Broadley, P. (2007). Discussion of ‘financial Reporting Quality: Is Fair Value a Plus or a Minus?’. Accounting and Business Research, 37(3), 45.
Camfferman, K., & Zeff, S. A. (2007). Financial Reporting and Global Capital Markets: A History of the International Accounting Standards Committee, 1973-2000. New York: Oxford University Press.
Cunningham, G. M., & Harris, J. E. (2006). Enron and Arthur Adndersen: the Case of the Crooked E and the Fallen a. 27.
Geiger, M. A., & Raghunandan, K. (2002). The conservatism of the Big Six Audit Firms and Going-concern Modified Audit Reports. Academy of Accounting and Financial Studies Journal, 6(1), 165.
Klersey, G. F., & Roberts, M. L. (2010). Audit Partners’ Individual Risk Preferences in Client Retention Decisions. Academy of Accounting and Financial Studies Journal, 14(2), 115.
Kuppusamy, K., Nazim, M. (2003). Audit Committees and the Blue Ribbon Committee Report: a Comparative Study. International Journal of Management, 20(4), 509.
McConnell, P. (2010). Response to ‘fair Value Accounting, Financial Economics and the Transformation of Reliability’. Accounting and Business Research, 40(3), 211.
Mckee, D. L. (2000). Offshore Financial Centers, Accounting Services, and the Global Economy. Westport, CT: Quorum Books.
Penman, S. H. (2007). Financial Reporting Quality: Is Fair Value a Plus or a Minus?. Accounting and Business Research, 37(3), 33.
Power, M. (2010). Fair Value Accounting, Financial Economics and the Transformation of Reliability. Accounting and Business Research, 40(3), 197.
Rainsbury, E. A., Bradbury, M. E. (2008). Firm Characteristics and Audit Committees Complying with ‘best Practice’ Membership Guidelines. Accounting and Business Research, 38(5), 393.
Riahi-Belkaoui, A. (2004). Value-Added Reporting: Lessons for the United States. New York: Quorum Books.
Riahi-Belkaoui, A. (2007). Performance Results in Value Added Reporting. Westport, CT: Quorum Books.
Riahi-Belkaoui, A. (2003). Value-Added Reporting and Research: State of the Art. Westport, CT: Quorum Books.
Walton, P. (2006). A Research Note: Fair Value and Executory Contracts Moving the Boundaries in International Financial Reporting. Accounting and Business Research, 36(4), 337.