Degree of Conservatism and Quality of Earnings

A review of financial statements, including the notes, indicates their conservatism in regard to accounting policies. Accounting policies that result in the slowest reporting of income are themost conservative. When a firm has conservative accounting policies, it is said that its earnings are of high quality. This section reviews a number of areas that often indicate a firm’s degree of conservatism in reporting income.

INVENTORY

Under inflationary conditions, the matching of current cost against the current revenue results in the lowest income for a period of time. The LIFO inventory method follows this procedure. FIFO, the least conservative method, uses the oldest costs and matches them against revenue. Other inventory methods fall somewhere between the results of LIFO and FIFO. For a construction firm that has long-term contracts, the two principal accounting methods that relate to inventory are the completed-contract method and the percentage-of-completion method. The conservative completed-contract method recognizes all of the income when the contract is completed; the percentage-of-completion method recognizes income as work progresses on the contract.

FIXED ASSETS

Two accounting decisions related to fixed assets can have a significant influence on income:the method of depreciation and the period of time selected to depreciate an asset. The conservative methods, sum-of-the-years’-digits and declining-balance, recognize a large amount of depreciation in the early years of the asset’s life. The straight-line method, the least conservative method, recognizes depreciation in equal amounts over each year of the asset’s life. Sometimes a material difference in the asset’s life used for depreciation occurs between firms. Comparing the lives used for depreciation for similar firms can be a clue as to how conservative the firms are in computing depreciation. The shorter the period of time used, the lower the income.

INTANGIBLE ASSETS

Intangible assets include goodwill, patents, and copyrights. Research and development (R&D) costs are a type of intangible asset, but they are expensed as incurred. The shorter the period of time used to recognize the cost of the intangible asset, the more conservative the accounting. (Goodwill is not amortized.) Some firms spend very large sums on R&D, and others spend little or nothing. Because of

the requirement that R&D costs be expensed in the period incurred, the income of a firm that does considerable research is reduced substantially in the period that the cost is incurred. This results in more conservative earnings.

PENSIONS

Two points relating to pensions should be examined when the firm has a defined benefit plan. One is the assumed discount rate used to compute the actuarial present value of the accumulated benefit obligation and the projected benefit obligation. The higher the interest rate used, the lower the present value of the liability and the lower the immediate pension cost. The other item is the rate of compensation increase used in computing the projected benefit obligations. If the rate is too low, the projected benefit obligation is too low. If the rate is too high, the projected benefit obligation is too high.