Table of Content

Introduction………………………………………………….………....3

Conservative Accounting………………………………….…………..4-5

Advantages…………………………………………………….……....6

Disadvantages……………………………………………....………....6-7

Neutral Accounting………………………………………....………....8

Advantages………………………………………………...……….....8-9

Disadvantages……………………………………………….………...9

Arguments……………………………………………………...…….10-11

The “conceptual framework”...............................................................12

Prudence………………………………………………………..…….12

Removal………………………………………………………….…..13

Reintroduction…………………………………………………….….14

Prudence in terms of Neutrality………………………………….…..15

Prudence in terms of Conservative……………………………….….15

Conclusion…………………………………………………………...16-17

1
Reference List……………………………………………………….18-20

Bibliography…………………………………………………………21-22

Introduction

Accounting “is the process of recording financial transactions” related to a firm (Tuovila, 2020),

it produces financial reports that are “based on reliable and quantified information derived from

past exchange” (dickhaut,2010 quoted in Marie-Therese, 2015). It helps determine interest rates,

asset and liability values, market values and cash flow predictions, which in turn helps the

management determine their new investment decisions and debt contracts (Marie-Therese,

2015). The process of financial reporting can either follow the conservative or neutral principle.

Conservatism and neutrality are guidelines for how the estimation judgements should be made

(Gaille, 2019), and each affects the company’s financial statements differently as each

accounting principle has different advantages, disadvantages and aims.

In the first section of this report, I will focus on conservative accounting; its definition,

advantages and disadvantages. The second section will be dedicated to neutral accounting. The

third section will highlight researchers arguments for and against implementing each accounting

principle. Then, in the final section of this report, I will discuss the term “prudence”, its

definition, relation to both accounting principles, and the reasons why it got removed from the

“IASB conceptual framework”.

2
Conservative Accounting

Conservative accounting is a method of bookkeeping that evolves under uncertain conditions,

requiring accountants to control signals by being cautious through estimating probability of

occurrence for doubtful debts, determining the “probable useful life” of the assets owned and

using systemic asymmetry when verifying recognition of news (Marie-Therese, 2015; Barker,

2015). According to researcher James H. Bliss, conservatism is “the anticipation of all losses but

no gains” (Bliss j.h, 1924, quoted in Marie-Therese, 2015), impling that for financial reports to

be conservative there should be “systemic differences between bad news and good news periods

in the timeliness and persistence of earnings” (Basu, 1997). When following the conservative

principle, recognition of uncertain liabilities occur as soon as they are discovered, unlike revenue

which gets recorded only after it is assured of being received, as it requires “a high degree of

verification before a company can make a legal claim on any profit” (Liberto, 2020). Researcher

Richard Barker identifies conservatism as “any method of accounting” that results in having an

equity’s economic value exceed its book value” (Barker, 2015), as a result of the understated

assets and revenue and overstated liabilities and expenses, and the need for accountants to

“choose solutions that yield inferior numbers” (Liberto, 2020).

There are 2 different types of conservatism; conditional conservatism which “refers to the

relative speed with which good and bad news about assets in place is reflected in financial

statements”. When in uncertainty, bad news is more timely recognized as the recognition of good

3
news requires higher level of verification (Mora and Walker, 2015), thus resulting in asymmetric

timeline in the valuation of information (Marie-Therese, 2015; Getting a Better Framework

PRUDENCE Bulletin, 2013). In conditional conservatism, possibilities of gain and overdue

receivables are ignored until they occur, whilst all potential losses are logged, thus creating a

more realistic approach to business cash flow, which provides early warning for when

performance starts declining as it highlights all possible risks that may occur in the next financial

period (Gaille, 2019;Liberto, 2020; Mora and Walker, 2015).

Unconditional conservatism on the other hand, is the “systemic understatement of net assets”

(Getting a Better Framework PRUDENCE Bulletin, 2013). In unconditional conservatism,

expenditure on intangible assets like investments are not capitalized, and are recorded as

expenses instead (Barker, 2015; Mora and Walker, 2015). Also, instead of using the economic

depreciation rate when determining an asset’s rate of return throughout its useful life,

accountants are required to use “the conservative depreciation rate”, which is determined before

investment-performance information is made available, which might cause future problems if

investment profitability expectations change once investment takes place (Marie-Therese,

2015;Mora and Walker, 2015). Unconditional conservatism is also “applied to inventory

valuation, dictating the lower historical cost / replacement cost as the monetary value”(Liberto,

2020).

4
Advantages

Conservative accounting enables timely recognition of bad news which “may serve to reduce

bankruptcy risk” (biddle et al 2014 quoted in Mora and Walker, 2015) as it “facilitates

monitoring debt contracts and reduces cost of debt”(zhang, 2008; beatty, 2012 quoted in Mora

and Walker, 2015), thus highlighting all the liabilities and the losses that may occur, enabling

them to set allowances for doubtful debts and reduce the effect bad debts would have on the

business’s financial statements when they occur (Gaille, 2019). Conservatism also encourages

more efficient investment decisions (Marie-Therese, 2015) as it reduces over-investment by

eliminating projects with “too optimistic forecast of cash-flow” (Marie-Therese, 2015) and

promotes “divesting poor performing investments” thus improving future profits (Gaille, 2019;

Mora and Walker, 2015). The delay in the recognition of good news also “limits opportunistic

earnings management” (Mora and Walker, 2015). However, researcher Scott B. Jackson believes

that conservatism leads to inefficient investment (jackson, 2008; jackson et al 2009 quoted in

Mora and Walker, 2015) and is “a potential constraint on innovation” (Mora and Walker, 2015)

as managers become too cautious and unwilling to take risks.

Disadvantages

Conservative accounting can be manipulated and used to misrepresent financial information thus

facilitating “earnings management and revenue shifting because the company’s profit recorded

influences manager bonuses and company’s tax burdens (Barker, 2015; Liberto, 2020;

5
Marie-Therese, 2015). It is said the “tax avoidance, regulatory gaming and litigation concerns''

and debt contracting are the main drivers of conservatism in accounting (Mora and Walker,

2015). Conservatism is not always reflective of a company’s tax liability as its emphasis on

overstating loss reduces the profit recorded resulting in a lower “tax-receipt” (Gaille, 2019). The

information asymmetry when reporting conservatively also leads to moral hazard as it affects the

asset allocation of potential investors and affects the firm’s management welfare (Marie-Therese,

2015). Researchers Penman and Zhang also argue “that unconditional conservatism creates

hidden reserves'' (Penman and Zhang, 2002 quoted in Mora and Walker, 2015) because if firms

can reverse past “conservative asset depreciation” schemes, then they would be able to create

“hidden reserves that can be released back into earnings when conservatism unwinds” hence

enable firms to “artificially smooth income” (Getting a Better Framework PRUDENCE Bulletin,

2013). However if firms are not able to reverse their commitment to the “conservative

depreciation” scheme for their assets entire life, then no earning management opportunities

would arise, thus de-incentivizing earnings management (Mora and Walker, 2015). Conservative

accounting requires strict verifications on the characteristics of transactions, thus limits

“managerial optimism and opportunism” (Gao, 2013 quoted in Mora and Walker, 2015).

Researcher Yapping also argues that “earnings management within reasonable bounds can be

beneficial for a company” and so even if earnings management occurs due to applying

consrvative accounting, it is not necessarily bad or illegal (Yaping, 2006 quoted in Needles Jr.,

Powers and Senyigit, 2018).

6
Neutral Accounting

Neutral accounting “refers to belief that the policy-setting process should be primarily concerned

with relevance and reliability” of financial statements “rather than the way a particular interest

group … might like it to be” (Wolk, Dodd and Rozycki, 2008). Ensuring that all the information

presented in the financial statements are reliable and relevant and that there is symmetry in the

recognition of earnings and the way they deal with each type of news. In neutral accounting all

the transactions that are carried out are presented in faithful representation as it is the best

method to reflect the balanced view of the firm’s activities (Ali, 2020; Maciuca, Hlaciuc and

Ursache, 2015; Neutrality and Accounting Ethics - Academic Master, 2018). According to

researcher Pobaschnig Marie-Therese, neutral accounting has to present information regarding

the true underlying conditions of a firm so that potential investors are fully aware of the financial

conditions of the firm, he also argues that the absence of bias should be guaranteed inorder to

maintain the neutrality of financial reports (Marie-Therese, 2015).

Advantages

Neutral accounting in its nature “leads to unbiased presentation about the economic performance

and conditions of a company” as it presents relevant and reliable information (Maciuca, Hlaciuc

and Ursache, 2015), and because it is “key to providing correct presentation of underlying

conditions” it prevents both bias in reporting and earnings being managed (in any

direction)(Marie-Therese, 2015). If the information used in the financial report is deliberately or

7
systematically biased, then the account’s neutrality is compromised (Ali, 2020). Like

conservative, neutral accounting results in assets book value to be less than the economic value

as it deducts economic rent out of the present asset value (Mora and Walker, 2015), but unlike

conservative, the book value of equity is also less than its economic value (Barker, 2015) as the

values are determined at market rates rather than being set by “entity specific orientation”

(Marie-Therese, 2015). However, it is suggested that “Neutrality is impossible to achieve”

(IASB,2015 quoted in Marie-Therese, 2015).

Disadvantages

“Neutrality is impossible to achieve” (IASB,2015 quoted in Marie-Therese, 2015). For reports to

be neutral, all the information presented must be guaranteed to be free from bias and reliable

while reflecting the balanced view of the company activities (Ali, 2020; Neutrality and

Accounting Ethics - Academic Master, 2018), however information cannot be fully “immune to

influences from the political process resulting from economic consequences”(Wolk, Dodd and

Rozycki, 2016). Researcher Richard Barker believes that the “neutral application of the IASB

framework is inherently conservative” (Barker, 2015), as neutrality should “neither include nor

disclude conservatism”, and because financial reports influence decision-making, it cannot be

considered neutral (Marie-Therese, 2015). However companies are not required to achieve 100%

neutrality, as being neutral to an extent is easier, cheaper and enables a company to retain

financial integrity while meeting IASB/other requirements (Neutrality and Accounting Ethics -

Academic Master, 2018).

8
Arguments

Many researchers aid netral accounting over conservative as it is more “reliable and relevant”.

According to researcher Richard Barker, financial reports are only reliable if they have been

recorded using “neutral accounting” (Barker, 2015). Researcher Pobaschnig Marie-Therese

argues that neutral accounting is “remedy against bias”. It equally provides all the information;

the good and the bad in financial statements, which is a sign of “faithful representation” and is

better for investors as it helps them make more informed investment decisions (Marie-Therese,

2015). However according to researchers Araceli Mora and Martin Walker, “accounting is bound

to be conservative at some level” because there will be times where investments would need to

“be treated like expenses” instead of capital, and assets would be “written-down” instead of

written-up (Mora and Walker, 2015), which is why researcher Richard Barker concluded that the

“neutral application of IASB framework is inherently conservative”(Barker, 2015).

However there are a number of other researchers who prefer conservatism. Daniel Liberto argues

that because of conservatism, lower future financial benefits are recorded, which is in fact an

advantage as it incentivizes managers to take greater care when decision-making and investing

(Liberto, 2020). Researcher Brandon Gaille also recognizes the benefits that arise because of the

overstatement of liabilities and expenses and the understatement of assets and incomes that occur

due to conservatism. He argues that because conservatism highlights a company’s “absolute

bottom line”, it sheds light on the company’s insolvency and provides an “accurate measurement

9
of risk involved”. In uncertain economic times, knowing a company’s bare minimum allows the

management teams to plan for the future accordingly and work on improving the situation as

they tackle their weaknesses (Gaille, 2019).

Researcher Pobaschnig Marie-Therese on the other hand, argues that there is no one practice that

is better than the other as it depends on the requirements of the business and the economic

situation. Conservative accounting helps “prevent future collapse of business” as it provides

early warning of declining performance and what the potential loss might be(mora and walker,

2015;Marie-Therese, 2015) due to its timely recognition of losses (Barker, 2015). However,

because it understates assets and income and overstates liabilities and expenses, in a rescission, it

will cause a “negative cycle” for the business, and so neutral

10
The Conceptual Framework

The “IASB conceptual framework” is a description of general reporting concepts that influence

the procedure of developing accounting standards and the preparation of financial statements. It

discusses the characteristics and objectives of financial reporting by providing definitions,

measurement guidelines, presentation suggestions and solutions that help create efficient and

reliable financial reports (Cooper, 2015; Getting a Better Framework PRUDENCE Bulletin,

2013; Marie-Therese, 2015). According to researcher Richard Barker, the “IASB conceptual

framework is inherently conservative” which creates demand in financial reports for prudence

(Barker, 2015).

Prudence

Prudence is an “aspect of reliability” (IASB,2010), it is a precautionary principle that arises

under uncertainty, it promotes cautious judgement when making estimates for the financial

reports (Maciuca, Hlaciuc and Ursache, 2015; Marie-Therese, 2015; Mora and Walker, 2015).

Prudence limits false optimism and contributes to the credibility of the financial statements as all

the profits mentioned are almost certain, however it might recognize uncertain losses too, which

harms the sustainability of reports. Not applying prudence when reporting results in imprudent

statements; which results in overstated assets and “illusory profits” (Getting a Better Framework

PRUDENCE Bulletin, 2013), which in researcher Steve Cooper’s view, is what happened in

11
2010 when the IASB removed prudence from their conceptual framework as instead of

encouraging the reports to become more neutral, they became imprudent (Cooper, 2015).

Removal

Prudence was removed in 2010 from the “IASB conceptual framework” for many reasons. First

was because of its ambiguous definition in the framework, which confused many as each had a

different interpretation of what it is and the uncertainty arose on how to imply it to practice

(Cooper, 2015). Another reason why prudence was removed was because it was said to be

“incompatible with neutrality” (Mora and Walker, 2015). Neutrality of financial statements is

important as it makes the statements reliable, trustworthy and relevant, and so the IASB could

not risk compromising its statements’ credibility. Prudence is said to involve asymmetric

valuation and promotes systemic bias towards the undervaluation of net assets as it has a greater

emphasis on not overstating liabilities and expenses, compared to not understating assets and

income, thus contradicting the purpose of neutrality which emphasizes the need to uniformly

evaluate all aspects of the financial reports (Cooper, 2015; Maciuca, Hlaciuc and Ursache, 2015;

Marie-Therese, 2015). Also, according to researchers Geanina Măciucă, Elena Hlaciuc and

Antonela Ursache, the basic essentials of prudence are intact and visible throughout the standards

of the framework, and so the removal of prudence as an independent principle shouldn’t create

great impact on the method of financial reporting (Maciuca, Hlaciuc and Ursache, 2015).

However prudence was reintroduced back into the conceptual framework in 2015.

12
Reintroduction

Prudence got reintroduced as one of the characteristics that make the IASB financial statements

useful to investors (Cooper, 2015). However, the new definition of prudence does not include

asymmetry in the verification needed to recognize gain and loss and states that prudence should

be “consistent with neutrality”, hence the deliberate overstatement and or understatement of

assets and liabilities are not allowed (Barker, 2015; Marie-Therese, 2015). However there are 2

different types of prudence, “cautious prudence” and “asymmetric prudence”. “Cautious

prudence counter-acts natural optimistic bias of the management” (Wagenhofer, 2015) thus is “a

factor in giving a faithful representation of asset, liability, equity, income and expense” (IASB,

2015 quoted in Marie-Therese, 2015).

13
Prudence in terms of neutrality

The application of prudence insures the neutrality of financial statements as it limits management

optimism due to uncertainty, for it encourages managers to become more cautious when making

judgments in uncertain economic situations (Cooper, 2015; Marie-Therese, 2015; Mora and

Walker, 2015). Prudence also does not allow the creation of hidden reserves, excessive

provisions and the “deliberate understatement of assets and income and overstatement of loss

and liabilities” as they “compromise the financial report’s neutrality” making the reports

unreliable and un-relevant (Barker, 2015).

Prudence in terms of conservatism

“Conservatism is associated with the need for “prudent reporting” which ensures readers are

informed about uncertainties and risks” (Wolk, Dodd and Rozycki, 2016), however reports “can

be conservative but not prudent” because the new definition of prudence does not accept they

asymmetric treatment of assets and liabilities as it compromises the neutrality and reliability of

the financial report (Barker, 2015). However “not all asymmetry is inconsistent with neutrality”

(IASB, 2015 quoted in Marie-Therese, 2015), as “asymmetric verification” does not necessarily

“need to be biased” (Barker, 2015). Both conservative accounting and prudence could result in

pessimistic estimates in the financial reports (Cooper, 2015), however investors are more

concerned with downside risk than upside potential and “prudence helps address that concern”

(IASB,2015 quoted in Marie-Therese, 2015).

14
Conclusion

Overall, the focus of this report is to highlight the advantages and disadvantages of both neutral

accounting and conservative accounting, and the definition of prudence and why was it removed

in 2010.

Conservative accounting is an accounting principle that goes by the “the anticipation of all losses

but no gains” (Bliss j.h, 1924, quoted in Marie-Therese, 2015), thus encourage accountants to be

“cautious when estimating values and require high degree of verification when recognizing

gains” (Liberto, 2020). There are two types of conservative accounting: conditional which

“refers to the relative speed with which good and bad news about assets in place is reflected in

financial statements” (Mora and Walker, 2015) and unconditional which is the “systemic

understatement of net assets” (Getting a Better Framework PRUDENCE Bulletin, 2013).

Conservative accounting promotes bias and asymmetry in financial reports, while neutral

accounting promotes unbiased and symmetric presentation of a business’s performance. Neutral

accounting is the principle that ensures the reliability, credibility and relevance of the financial

statements.

It is argued that conservatism “compromises the integrity of accounting” (Neutrality and

Accounting Ethics - Academic Master, 2018) as it is biased and leads to “pessimistic

assessment” (Marie-Therese, 2015). However, this does not make it less efficient or unfavorable

as conservatism’s “timely recognition of loss” reduces risk of insolvency and the delay in the

recognition of good news limits the ability for earnings management (Mora and Walker, 2015).

15
Neutral accounting on the other hand ensures financial reports remain reliable and relevant,

however it is said to be “impossible to achieve”(IASB,2015 quoted in Marie-Therese, 2015).

The “conceptual framework” contains the “descriptions of the objectives and concepts for

general purpose financial reporting” (Cooper, 2015), and sets the guidelines to financial

reporting (Liberto, 2020). Prudence is the exercise of caution when making judgments and under

conditions of uncertainty” (IASB, 2015 quoted inCooper, 2015). It was removed from the

framework in 2010 because of its “incompatibility with neutrality” (Mora and Walker, 2015),

then was reintroduced again, but was adjusted to become compatible with neutral accounting.

16
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