Aggressive and Conservative Accounting Policies


What You Will Learn

  • The importance of understanding the language of business and investing
  • How to detect aggresive and conservative accounting and why it can save you from investing in losers

Aggressive and Conservative Accounting Series

For other articles in the series, click on the links below.

How to sniff out Aggressive Conservative Accounting

Lacking formal training in accounting, I always have a desire to learn more and get better at accounting. Accounting is a skill that you can never be good enough at. It is also one of the greatest skill any investor can obtain as it allows you to view the investment from both an accounting and business point of view.

By accounting, I do not just mean learning how to balance entries in the financial statements and figuring out what goes where, but I am always looking to find new methods of analysis to detect creative accounting and the methods management can take in order to make their company look better than it really is.

GAAP and its Issues

All financial statements are prepared according to Generally Accepted Accounting Principals (GAAP). The key word is “Generally” which means that there is a variety of alternative policies and procedures the company can use in creating its financial statements.

The selection of accounting policies can tell you a lot about management and the company. Whether it is being conservative or aggressive. Whether earnings is being recognized quickly to show growth when in fact it has not happened, or whether earnings is being deferred / reserved for a rainy day.

Alternative Accounting Policies and Procedures

Here is a table listing the alternative accounting policies management can choose from.

Next time you read the annual reports, go over the accounting policies and compare with competitors to see whether the accounting policies are in line with industry standards.

aggressive conservative accounting

Aggressive Conservative Accounting

from: Financial Statements by Thomas Ittelson

In the coming series, I will take a look at the accounting policies to discuss how it can be use creatively by management in financial reporting.

  • Adam

    Jae,

    The Depreciation Method section is the opposite to how I view it. Faster depreciation results in lower net income in the earlier years and could be considered conservative while slower depreciation, which would increase net income in the early would be considered aggressive. The slower the depreciation, the slower the expenses are recognized and the more likely that the carrying value on the balance sheet is overstated. A management team deciding to slow depreciation would raise much higher red flags for me than a management team who was deciding to speed it up.

  • Each item listed can be considered bad depending on how it is used. That’s what makes accounting so fun, because there is no set rule of what is bad or good.

    You make a good point. With depreciation, it comes down to what asset is being depreciated. Furniture is usually 7 years, so if the company decides to depreciate it at 14 years, that is just as alarming as a company trying to depreciate it over 3 years.

    All comes down to what management is trying to achieve. If management is trying to create one horrific year by speeding up expenses so that they can start with a “clean slate” the following year, that can’t be considered good accounting practices.

  • Anon

    I can’t discuss US GAAP, as I deal in IFRS (which admittedly is quite different). However, the analysis that you have provided is not correct (in all cases).

    Conservatism (or prudence) should be considered when there is a risk of uncertainty. When the best way to account for something is unknown, a conservative approach should be used. Example: XYZ launches a new product which is theoretically more susceptable to warranty claims. As such, the company chooses to err on the side of caution and give a larger warranty expense for that product. That is a conservative accounting policy.

    Now take another scenerio. A company has a historical 2% warranty claim rate. There is no reason to believe warranties will change substantially this year. Would a 3% rate be conservative? No. Why? Because it doesn’t reflect the nature of the entity. People are using those financials to make capital allocation decisions. 3% would lead to people making sub-par decisions, wouldn’t it?

    Let me run down your list of aggressive vs. conservative accounting policies.

    1) Revenue recognition – For most industries, the best case is usually at the point of sale. This is because the entity has performed all of the necessary duties. The exception to this is if there is a high likelihood of returns or problems with collectability.

    2) COGS – LIFO isn’t even available as an option outside the US because LIFO doesn’t reflect the economic reality. Think about it this way. If you had metal ore 20 years ago worth $100/lb, and the price is now worth $500/lb, should you have it on your books at $100? It doesn’t really make sense.

    3) Depreciation – Adam has a valid point above.

    4) Reserves, Estimates, etc…. – I will discuss this later.

    5) Contingent Liabilities – Typically, they will have to be listed on the balance sheet if they are likely and measurable. But in the event that they aren’t, the user has the responsibility to read the notes. Remember: The F/S are absolutely useless without the notes (and I would argue, MD&A)

    6) Advertising and Marketing – This can’t be done in IFRS, but I understand that it can be done in some circumstances under US GAAP. I tend to agree with the IFRS argument that while there is future benefit to advertising, it is impossible to quantify, and is probably lower than you would expect. Any amount capitalized would raise a flag to me to research further. If the balance is small, I wouldn’t care. If the balance is large, I would probably stay away from that company. It sounds like it is VERY agressive.

    4) Reserves and allowances – This is where significant judgment is required on the part of management. They have the most ability to influence these estimates, and they will likely be material. You can typically use these numbers to determine if the F/S as a whole are conservative or aggressive (if estimates are aggressive, then the F/S are likely to be more aggressive).

    To determine how well they are done, look at the estimates year over year. Are the consistent? Sometimes they should be, other times not. An example may be allowance for doubtful accounts. If they have a significantly lower AFDA, it will likely be discussed in the notes. If not, I would factor in a more reasonable amount. Considering the 2008 economic crisis, I would look back a few years. Ratios could just be reverting back to normal. You will see this with other estimates as well (eg. warranty claim rates may go down, not because of less faulty equipment, but because people have more money and replace equipment sooner).

    If you want to learn conservative vs. aggressive accounting, I would consider reading the notes to the F/S for some good companies with a known bias. See how they account for their revenues and COGS (two single largest balances and usually there is a bunch of disclosure). You want to consider if the way they are accounting for it is in line with the economic reality of the transaction. Is revenue recognized too early? Does it reflect the reality of the sale (risks and rewards are transferred to purchaser).

    Just some things to think about.

  • I have a web site where I research stocks under five dollars. I have many years of experience with these type of stocks.I would agree that accounting methods can be used to create the impression that a company is sound when in fact it may not be at all.

  • Agree with Anon in most cases. I don´t agree that FIFO is aggressive accounting style. It really depends on the circumstances, actual situation, type of business, etc. If I have FCMG business using FIFO is quite conservative, if I sell huge industrial parts, using FIFO would probably be not that good.
    And in Europe, LIFO is usually prohibited in many countries, so FIFO is quite normal and not aggressive.

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