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Matching Principle and Conservatism
Topics
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Historical perspectives on income recognition, matching and conservatism
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Standard setters’ views: IASB and FASB historical and current perspectives
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Take-aways
Transcript
Introduction
Welcome to the Matching Principle and Conservatism scenic route video where you’re going
to learn about two concepts that traditionally had a profound impact on revenue and expense
recognition. Standard setters, regulators and auditors have largely abandoned these
concepts in favor of the approach discussed throughout this chapter which bases revenue
and expense recognition on asset and liability recognition and derecognition.
Still, like us, many preparers of financial statements learned accounting in the past, when the
matching principle and conservatism largely dictated revenue and expense recognition.
Importantly, applying these concepts generally doesn’t result in bad accounting, however the
concepts fail to explain many of the recent change that are occurring in accounting, which
are based on the broader asset-liability approach.
Our goal in this video is to briefly explain these concepts and more importantly, to explain
how they relate to the asset-liability approach followed here. This will prepare you for
discussions with colleagues who refer to the matching principle and conservatism.
Here’s our agenda. We’re going to start out with a discussion of historical income recognition
and we’re going to look at standard setter reviews and then some takeaways.
Historical Income Recognition
We begin with the discussion on historical revenue recognition, the way we were taught
years ago. We began with the primary criteria, revenue must be earned. Revenue must be
collected or collectible. If those two criteria were met, well, then we recognized revenue. And
over the years, increasingly, refinements have been made by standard setters as exactly
what is meant by “earned.”
In addition to these two primary criteria, there was a concept of conservatism with regard to
revenue recognition and it went like this. When there is significant uncertainty as to whether
these criteria have been met, that is earned and collectible, if you’re not quite sure, it’s better
to defer revenue recognition than to recognize revenue. And when there is significant
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uncertainty regarding the amount of revenue that should be recognized, it’s better to report
revenues in the lower range of possible outcomes.
So this is the idea of conservatism. When in doubt, don’t do it and if you’re going to do it but
there’s doubt about how much to take, well, pick a smaller number rather than a larger
number.
Now we go to historical expense recognition and the primary criteria was the matching
principle. We were all schooled on the matching principle. Resource cost should be matched
to the periods the resources’ benefits are realized and recognized as expenses in those
periods whenever the matching is reliable. Now, what does this mean? Well, resource costs
should be capitalized as assets when resources with reliably measurable future benefits are
acquired or created and subsequently matched to expenses as benefits are realized.
So you should make an asset here. As the benefits are achieved during the life of the asset,
it should match the cost of the asset to those benefits and recognized the expense. So you
spread the cost over the periods by matching the cost to the benefits.
Now, that was the asset rule for matching. And then there was a liability rule too. Resource
cost should be accrued as liabilities and expensed to when benefits are received before
resource providers are paid. So if you get the benefits back here but you’ve yet to pay, well
then you should accrue an expense.
And again, this may look very similar to what you’ve learned under the asset-liability
approach and that’s part of the objective here. We’ll come back and formalize that later.
Now, where did conservatism come in with regard to expense recognition? Because
remember, it played a role in revenue recognition and the matching principle is the primary
criterion but it goes side by side with conservatism.
Well, when there is uncertainty regarding matching the cost to acquire or create resources to
the future benefits, so when it’s difficult to make this match right here, well then you should
expense rather than capitalize an asset. So when in doubt, don’t make an asset. Take the
expense right up front. When there is uncertainty regarding the amount of an expense that
should be recognized, it’s better to report expenses in the higher range of possible outcomes.
So whereas we recognize less revenue when we’re uncertain about the amount, we
recognize more expenses when we’re uncertain about the amount and that gets to the idea
of conservatism. The overall effect of that is, be conservative when recognizing income.
Don’t recognize income before you have a fair amount of confidence that you’re going to get
that income.
Standard Setters’ Views
So what are standard setters’ views on conservatism? Well, first the IFRS. The conceptual
framework does not mention conservatism when discussing the qualitative characteristics of
useful information or anywhere else. So the IFRS is pretty silent on conservatism.
How about US GAAP? Well, historically and this goes way back to the accounting principles
Board in the 1950’s. This is a quote. “Frequently, assets and liabilities are measured in a
context of significant uncertainties.” Remember, that’s where conservatism comes from.
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“Historically, management, investors and accountants have generally preferred that possible
errors in measurement be in the direction of understatement rather than overstatement of net
income and net assets. This has led to the invention of conservatism.”
So what they’re saying is there’s an acceptance for understating numbers in the accounting
community and that is investors, accountants and everyone who deals with numbers.
Well, what’s the current policy under US GAAP? Now, we look at the FASB’s concept
statements, there are two important quotes here. First, “There is a place for the conventional
conservatism, meaning prudence (so you need to be careful) in financial accounting reporting
because business and economic activities are surrounded by uncertainty but it needs to be
applied with care.” That is, the convention of conservatism. And following that quote is
another that’s really right to the point.
“Conservatism in financial reporting should no longer connote deliberate, consistent
understatement of net assets and profits.” Otherwise what the prior Board was willing to
accept as part of the convention, no longer should be what we do. “The Board emphasizes
that point because conservatism has long been identified with the idea that deliberate
understatement is virtue. That notion became deeply ingrained and is still evidenced despite
efforts over the past 40 years to change it.”
So there is in practice this notion of conservatism. Better not to recognize income until you
have a fair degree of confidence and better to understate income when there’s uncertainty.
Well, the Board no longer agrees with that. The SEC no longer agrees with that and the big
four accounting firms are generally taking the same position so at least everyone is saying
they’re opposed to conservatism.
And what’s the standard setters’ views on the matching principle? Well, the FASB and IASB
members have indicated that matching principle has no impact on the way they analyze
expense recognition decisions.
In fact, a few Board members have even said that matching principle is dead. They’ve raised
the following concerns. The matching principle could be dysfunctional. What the Boards have
realized from time to time is that assets and liabilities have been recognized in the past when
expense recognition was motivated by the matching principle even though the definitions of
assets and liabilities were not satisfied.
So the matching principle led to recognizing assets when it didn’t meet the definition of an
asset. So the Board said, “We’ve got to straighten this up,” and for consistency, they went
with the asset-liability approach that we’ve been discussing throughout this chapter.
Second point of concern, the matching principle is incomplete. It simply doesn’t provide
guidance for recognizing impairments and many other expenses and issues that arise under
what’s called fair value accounting. So the matching principle is based on the historical
accounting perspective of measurement but when you get into other measurement attributes
like fair value rather than adjusted historical cost, well, the matching principle doesn’t help us.
The matching principle is redundant. In addition to all these concerns, you really don’t need
it. We saw a little bit of this earlier on. The matching principle states cost should be
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capitalized as assets when resource with reliably measurable future benefits are acquired
and subsequently matched to the expenses when benefits are realized. Well, this is just
another way to say assets should be recognized when they can be measured reliably and
derecognized when their benefits are realized. That’s exactly what we’ve been doing
throughout the chapter.
On the liability side, the matching principle states cost should be accrued as liabilities and
expensed when benefits are received before resource providers are paid and thus cost
should be matched to benefits but again, this is just another way to say liability should be
recognized when companies become obligated to make future payments. So standard
setters have raised several concerns about the matching principle yet it’s pretty dominant in
practice.
Take-aways
So what would we have you take away from this very short video? There’s the declining
influence on standard setters and regulators of these concepts. Historically conservatism
significantly affected revenue recognition and the matching principle and conservatism
significantly affected expense recognition.
Currently, conservatism and the matching principle don’t affect standard setting and
conservatism should only affect practice in that managers should be prudent, careful, when
deciding whether revenues or expenses should be recognized.
But you know, it’s persistent in practice especially conservatism. Not withstand the concerns
about the matching principle raised by standard setters and others, many expenses based on
asset and liability recognition criteria can be, and often are explained by the matching
principle.
If you’re in practice, you’re going to hear people talk about the matching principle all the time
and this is not necessarily bad because often matching principle is fine. It works. Similarly,
not withstanding standard setters’ and regulators’ concerns about conservatism, it still seems
to have a significant impact on practice. There are very few lawsuits for overly conservative
revenue or expense recognition, it hardly ever happens, suggesting a preference for a
conservative numbers and I might add, there are very few SEC enforcement actions for
companies understating their income. Almost all of these are for companies overstating
income. Now there’s a second reason why we see conservatism in practice.
Creditors generally prefer conservative numbers because they are more concerned about the
downside than the upside. A creditor is not going to benefit when a company does real well
but they’re going to get hurt when a company does poorly so they’re focusing on the
downside. They’d much rather have a company that has conservative numbers.
And the third reason why I think the conservatism principle hangs on in practice. Some
analyst believes that managers who make conservative accounting decisions are more likely
to make conservative business decisions. Now, I think the FASB and the SEC and everyone
else would agree that’s a good thing if we mean by this careful, prudent decisions as
opposed to understating your numbers.
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Hope you’ve enjoyed this video. All we’ve try to do here is give you a pretty good sense of
how to communicate with folks that have learned accounting using the matching principle
and conservatism.
See you in the next video.