The conservatism principle arises because of concerns about management's incentives to overstate the firm's performance. Joe Banks argues, "We could get rid of conservatism and make accounting numbers more useful if we delegated financial reporting to independent auditors rather than to corporate managers.". Do you agree? Why or why not?

Answer 1

We don't agree with Joe Banks because the delegation of accounting decisions to auditors may reduce the quality of financial reporting. Auditors possess less information and firm-specific business knowledge than corporate managers when portraying the economic reality of a firm. The divergence between managers' and auditors' business assessments is likely to be most severe for firms with distinctive business strategies or ones which operate in emerging industries. With such an information disadvantage, even if auditors report truthfully without having any incentive problem, they cannot necessarily choose "better" accounting methods and accruals than corporate managers do.
Auditors also have their own incentive to record business transactions in a mechanical way, rather than using their professional judgment, which leads to poor quality of financing reporting. For example, auditors are likely to choose accounting standards that require them to exercise minimum business judgment in assessing a transaction's economic consequences, especially given their legal liability risk. The current debate on market value accounting for financial institutions illustrates this point. While there is considerable agreement that market value accounting produces relevant information, auditors typically oppose it, citing concerns over audit liability.