Financial Accounting: In an Economic Context

THE CONSERVATISM RATIO

An important theme in this text is that meaningful financial statement analysis cannot be conducted without assessing the extent to which management has used its discretion when preparing the financial statements. We have often noted that such discretion can be used to understate (report conservatively) or overstate the financial condition and performance of a company. A measure of the extent to which reported income is conservative, called the conservatism ratio, can be constructed from information disclosed in the annual report and is as follows.

Conservatism Ratio: Reported Income before Taxes/Taxable Income

The intuition underlying this ratio is based on the premise that for tax purposes companies accelerate tax-deductible expenses and defer taxable revenues as long as is allowable under income tax laws. Thus, taxable income (taxable revenues – tax-deductible expenses), the denominator of the ratio, reflects a very conservative measure of a company's income in a particular year. The extent to which reported income before taxes, the numerator of the ratio, exceeds (or is less than) taxable income indicates how conservative reported income is. Ratio amounts around 1.0 or less indicate relatively conservative levels, while reported income becomes increasingly less conservative as the ratio grows larger than 1.0.

Figure 10B–4 provides 2008 conservatism ratios for three major U.S. companies. Assuming that all three companies reported conservatively to the ...