Lesson 2 of 7 · 14 min
Conservative versus aggressive accounting
Aggressive choices make the current period look better and usually borrow from the future; conservative choices make the current period look worse and usually flatter later periods; neither is neutral, and both make analysis harder.
In short
- Aggressive choices raise current revenue, earnings or operating cash flow, or lower current expenses or reported debt. They tend to reduce reported performance later, which creates a sustainability problem.
- Conservative choices lower current revenue, earnings or operating cash flow, or raise expenses or reported debt. They tend to raise reported performance later.
- Earnings smoothing hides volatility: understate profit in good years to build (often hidden) reserves, then release them in bad years.
- Conservatism can be built into standards (research costs expensed, probable litigation losses accrued, insurance recoveries recognised only once acknowledged) or come from management judgement.
- Neutrality is the ideal. Conservatism conflicts with it, but it has claimed benefits: protection for less-informed parties, lower litigation risk, comfort for regulators and lower tax where book and tax rules are linked.
- Conservatism can be a disguise: big bath restructuring charges and cookie jar reserves shift profit into later periods.
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