Question

The primary emphasis in statutory accounting is supposedly on financial conservatism. However, some statutory techniques violate this principle. Discuss three ways in which statutory accounting is ultraconservative and two areas where the principle of conservatism is violated.

Answer 1

ways in which statutory accounting is ultraconservative

1. Conservatism: Conservative valuation procedures provide protection to policyholders against adverse fluctuations in financial condition or operating results. Statutory accounting should be reasonably conservative over the span of economic cycles and in recognition of the primary responsibility to regulate for financial solvency.
2. Recognition: The ability to meet policyholder obligations is predicated on the existence of readily marketable assets available when both current and future obligations are due. Assets having economic value other than those which can be used to fulfill policyholder obligations, or those assets which are unavailable due to encumbrances or third party interests should not be recognized on the balance sheet but rather should be charged against surplus when acquired or when availability otherwise becomes questionable.
3. Consistency: The regulators' need for meaningful, comparable financial information to determine an insurer's financial condition requires consistency in the development and application of statutory accounting principles.

Areas where the principle of conservatism is violated

1. It always underestimates the future value of an organization.

Using the conservatism approach in financial accounting means that you are always logging a potential loss and never recognizing the possibility of a future gain. Even if you know with certainty that a payment is coming through for you, this principle dictates that you do not count it on your books until you have it in your hands. Since debts occur faster than profits for most organizations, there is always less future value when looking at a company. Although this offers a sense of “realism,” it is important to remember that not all future debts become reality either.

2. It may not be reflective of your tax liabilities.

When you take a conservative approach to your financial situation, then the emphasis on losses will always create lower profits that you would report. That design runs counter to what the tax authorities in most countries need because the lower income levels create less in tax receipts at the end of the year. There may be specific rules in place for some organizations where this approach is not permitted for official reporting purposes, even if this is the method that is used within the company.