Reaching Into the Cookie Jar? Why Conservative Accounting Is Sometimes a Problem

• Date: 01 July 2015
• Published date: 01 July 2015
• Author: Dennis J. Chambers,Marcus L. Caylor
• DOI: http://doi.org/10.1002/jcaf.22066

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© 2015 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22066

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Reaching Into the Cookie Jar?

WhyConservative Accounting Is

Sometimes a Problem

Marcus L. Caylor and Dennis J. Chambers

INTRODUCTION

As the old adage

goes, “anticipate no

profits; anticipate all

losses.” Conservatism

is one of those prin-

ciples in accounting

that has managed to

persist through time

and has influenced

several accounting

conventions from

asset impairments to

the lower of cost or

market rule. Auditors

also have a tendency

to behave conser-

vatively by placing

a greater emphasis on adjust-

ments that prevent artificially

inflated income (or overstated

assets) relative to adjustments

that would prevent artificially

deflated income (or under-

stated assets). This behavior is

not surprising, as accountants

have generally been educated

to view conservatism as a desir-

able characteristic of account-

ing information.

In addition, since audit

firms design their audits to

minimize risks, such as poten-

tial litigation, auditors

naturally tend to be more

skeptical of items that would

increase income than those that

decrease it. In risk-based audit-

ing, the auditor evaluates the

company being audited, as well

as material individual accounts

and classes of transactions, for

directional risks. For

example, the overall

risk of the company’s

earnings is likely to

be for overstatement.

In this case, auditors

scrutinize income-

increasing accruals

more closely than

income-decreasing

accruals. For indi-

vidual accounts, the

directional risk may

be over- or under-

statement depending

on the account. For

example, bad-debt

expense assertions

are likely to be

deemed an understatement

risk. Consequently, overstated

bad-debt expense would be

less likely to draw attention.

In prior research, auditors

reported that a company’s

attempt to manage earnings

upward are reversed more

often (52% of the time) than

attempts to manage earnings

downward (38%) (Nelson,

Elliott, & Tarpley, 2003).

In this article, we discuss four financial statement

accounts in which overly conservative account-

ing has been used to create reserves for future

income-increasing earnings management. Due to

the multiyear nature of this activity and the role of

managers’ discretion in many accounting choices,

it can be very difficult for auditors to uncover

such behavior. We report and interpret academic

research demonstrating that this activity is some-

what common, and provide practical suggestions

that auditors can use to identify it. Our article

reinforces the notion that auditors need to be

equally skeptical of overly conservative account-

ing choices as they are of aggressive accounting

choices. © 2015 Wiley Periodicals, Inc.