In accounting, businesses have some degree of discretion in the methods they use to evaluate and report their financial performance. Investors are often concerned with whether an accounting method used by one of their invested companies is more aggressive or conservative, as this will affect the investors' ability to determine the company's value. Understanding the distinction is important for all investors, but is especially useful for those who rely heavily on financial statements to make choices for their portfolio.
Conservative accounting uses methods that are more likely to understate, rather than overstate, financial performance. In most cases, managers and investors want their businesses to be conservative in their accounting practices. This is because conservative accounting is more likely to undervalue investments rather than overvalue them, leading to management that is more likely to carefully manage risks and exceed expectations. A business that plans conservatively for growth essentially builds in considerable room for error.
Aggressive accounting, by contrast, might employ more creative techniques that result in overstated financial performance. Unfortunately, many companies are often pressured to do this so they can present the company's performance in the best light for investors and analysts. Nonetheless, aggressive accounting exposes investors and managers to more risk because they are less likely to manage carefully for risks if they're more comfortable with their performance. In addition, aggressive accounting is more likely to result in restatements of performance, which can diminish the credibility of a company's management.
Some of the accounting methods that lend themselves to more aggressive assessments of performance are easy to recognize. For example, if a business accounts for assets as having a long usable life, they are likely to understate depreciation expenses, leading to an overvaluation of earnings. Similarly, a business that books more of its expenses as capital asset purchases, rather than normal expenses, is likely to undervalue its expenses. Finally, a business that regularly finds itself selling assets to secure gains will tend to look more profitable than one that relies primarily on revenue to generate earnings.
Uses and Cautions
For an investor, keeping an eye out for aggressive or creative accounting methods is valuable because it protects them from risk that can arise in an overvalued or poorly managed investment. At the same time, it is important to remember that aggressive accounting is necessary in some cases to provide a more accurate assessment of value. Red flags should go up if the accounting practices of a given firm deviate considerably from the industry or sector standard, or if they could have the effect of providing less accurate, rather than more accurate, financial statements. Other warning signs include frequent changes of auditors or the adoption of accounting changes either before or after the rest of the market.