This document investigates the characteristics of firms that adopt financial conservatism as a policy in their financial practices. The role of corporate governance procedures has been specifically targeted to describe the concept, characteristics and different approaches to financial conservatism. …
In the first section, which serves as a background and motivation for this investigation; the empirical studies into financial conservatism and debate on its existing measures in a summarized form has been laid out. In this chapter, a detailed literature review is presented, which elaborates on the various schools of thought regarding conservatism. The next section describes about financial distress. The co-relation between financial distress and financial conservatism is discussed. The analysis has been carried out on financial models of Ericson (as an example from the literature), Alcatel-Lucent and England and Wales Cricket Board (their financial report) as case studies and the results have been discussed to establish that the financial conservatism has its standing and strengths in corporate governance to the modern corporate world. In addition, a comparison of the term Financial Distress with the Accounting Conservatism from the literature concludes that financially conservative firms do not depend on financial distress. To carry out this comparison, a sample of small firms that defaulted on their bank debt in UK and France is taken and analyzed. The last part is devoted to the conclusion of our analysis efforts. From this study, we conclude that financial conservatism is very independent of financial distress and provides more flexibility to the firms. We find that there are several reasons to use accounting conservatism in corporate governance and that current empirical evidence indicates that conservatism has increased in the last decades. Key terms; International Financial Reporting Standards (IFRS), Financial Conservatism, Cash conservatism, Leverage Conservatism, Regression Analysis, Statistical Mean, Empirical Measure/Model, Data, Cash Flow, Financial Distress, Bankruptcy and Proxies CHAPTER 1: INTRODUCTION OF CONSERVATISM 1.1 Introduction Conservatism is the most influential principle of valuation in accounting (Watts, 2003).It is defined as the differential verifiability required for recognition of profits versus losses. Firms employ this approach to restrict the risk factor by anticipating/ portraying lower profits along with higher losses. According to the principle of conservatism in accounting in case of doubt, the accounting alternative that is least likely to overstate assets and income should be chosen. (Schroeder et al., 2001, p.78). The conservative accounting method influences both on earnings and on net asset value. The effect on earnings will depend on whether the investments are growing, stable or decreasing. Conservative accounting always results in a lower net asset value of the company. Thus, conservatism of the firm can be evaluated based on either its leverage conservatism (low leverage firms) or cash conservatism (cash rich firms) or both. (Iona et al., 2004). It is employed to avoid any misunderstanding regarding the company’s financial standing with the internal as well as external shareholders. These stakeholders can be the business shareholders, debt holders and the management. 1.2 General Approaches to Financial Conservatism 1.2.1 Revenue Recognition Firms commonly impose a strict revenue recognition policy as part of their conservative policies. This ensures that the company does not over state its revenue, hence reducing the chance of inflated gross profits appearing in its financial statements. For this purpose, the revenue is recognized only when the products are sold/services completed; all transactions are realizable. 1.2.2 Overestimation of Allowance for Bad Debts This policy is placed to cater for a worst-case scenario ...
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