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Conservatism In Accounting Essay

5452 words - 22 pages

Introduction
Accounting conservatism is traditionally defined by the adage “anticipate no
profit, but anticipate all losses” (e.g., Bliss, 1924). Anticipating profits means
recognizing profits before there is a verifiable legal claim to the revenues generating
those profits. Conservatism does not imply that all revenue cash flows should be
received before profits are recognized. Thus the issue is one of verifiability. In the
empirical literature the adage is interpreted as representing “the accountant’s tendency to
require a higher degree of verification to recognize good news as gains than to recognize
bad news as losses” (Basu, 1997, p. 7). Conservatism is the asymmetry in the ...view middle of the document...

Conservatism’s influence on accounting practice has been both long and
significant. Basu (1997, p. 8) argues that conservatism has influenced accounting
practice for at least five hundred years. Sterling (1970, p. 256) rates conservatism as the
most influential principle of valuation in accounting. Recent empirical research on
2
conservatism suggests not only is accounting practice conservative, but also that it has
become more conservative in the last 30 years. These results are surprising given the
vocal opposition of many capital market regulators, standard-setters and academics to
conservatism.1 The long survival of conservatism and its apparent resilience to criticism
strongly suggests conservatism has significant benefits that are missed by its critics. The
puzzle is: what are those benefits? If regulator and standard-setter critics try to eliminate
conservatism without understanding the puzzle, the resultant standards are likely to be
seriously detrimental to financial reporting.
Researchers have advanced a number of explanations for conservative reporting
and all of them suggest conservatism has benefits to parties associated with the firm that
reports. One explanation is that conservatism arises because it is part of the efficient
technology employed in the organization of the firm and its contracts with outside parties
(contracting explanation). Under this explanation, conservative accounting is a means of
addressing problems due to parties to the firm having asymmetric information,
asymmetric payoffs and limited liability. Even if contracting and managerial accounting
were separated from financial reporting, these problems would still exist as long as the
reports’ accounting measures informed investors about managerial performance and so
affected investors’ asset allocation decisions and managers’ welfare. The contracting
explanation implies conservatism is beneficial from the investor information perspective
that is usually adopted by accounting standard-setters and academics.2
In recent years, shareholder litigation is another potential source of conservatism.
Litigation also produces asymmetric payoffs: overstating net assets is more likely to
generate litigation costs than understating net assets. Conservatism, by understating net
assets, reduces the firm’s expected litigation costs.
The links between taxation and reporting can also generate conservatism in
financial reporting. Asymmetric recognition of gains and losses enables managers of
profitable firms to reduce the present value of taxes. Delaying the recognition of revenues
and accelerating the recognition of expense defers tax payments.
1 For examples of the opposition of regulators, standard-setters and academics to conservatism see Levitt
(1998), FASB(1980, paragraphs 91-97) and Devine (1963, p. 127).
3
Finally, financial reporting standard-setters and regulators have their own
incentives to induce conservative accounting and...

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