Finance Accounting Journal

Conservatism in Accounting

Written by Paula Widiastuti, SE, MSM on 9/12/2008

by. Ross L. Watts

Abstract
This paper examines conservatism in accounting. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. In its extreme form the definition incorporates the traditional conservatism adage: “anticipate no profit,but anticipate all losses.” Despite criticism from many quarters, including standard-setters, conservatism appears not only to have survived in accounting for many centuries,but also to have increased in the last 30years.

The paper lays out the various alternative explanations for conservatism: contracting; shareholder litigation; taxation and accounting regulation (e.g., SEC and FASB). It also summarizes the empirical evidence on the existence of conservatism and the extent to which it is consistent with the alternative explanations for conservatism. The evidence is consistent with both the existence of conservatism and its increase in recent years. Contracting and shareholder litigation explanations appear to be important in these results. The evidence on the effect of taxation and regulation is weaker, but is still consistent with those explanations playing a role. Earnings management could also produce some of the evidence on conservatism, but it is unlikely to be the major explanation.

The explanations and evidence have important implications for accounting
regulators (SEC and FASB). First, the contracting explanation implies that conservatism will exist even in the absence of formal contractual use of financial statements. As long as income and net asset measures have meaning and are used in a way that affects management’s welfare, conservatism is likely to be an optimal accounting principle. Absent differential verifiability, financial measures such as income and net assets are likely to be subject to sufficient manipulation to render them meaningless. Second, recent FASB moves to apply rules such as mark-to-market without appropriate concern for verifiability are likely to be disastrous for the FASB and capital markets. Third, attempts to introduce unverifiable estimates of future cash flows into the financial statements are likely to just as disastrous.

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Is Accounting Conservatism Due to Debt or Equity Markets?

Written by Paula Widiastuti, SE, MSM on 9/12/2008

by: Ray Ball, Ashok Robin and Gil Sadka

Abstract
We provide a simple test of “costly contracting” and “value relevance theories” of accounting, using data on the importance of countries’ debt and equity markets. Contracting (debt markets) theory predicts conditional conservatism, in the Basu (1997) sense of asymmetrically timelier loss recognition than gain recognition, a proxy for which is greater sensitivity of earnings to negative returns than to positive returns. Contracting theory also predicts the degree of asymmetry increases in the importance of a country’s debt markets, but not in the importance of equity markets. In contrast, value relevance (equity markets) theory implies a symmetric and strong relation between earnings and returns, regardless of the sign of returns. Furthermore, contracting theory predicts that unconditional conservatism, in the sense of unconditionally low earnings and book values, does not increase contracting efficiency, and thus is unrelated to debt market importance. Data from a small cross-sectional sample of 22 countries are consistent with all of the predictions of “costly contracting” theory.

Conclusions
Our analysis of data from twenty-two countries supports the hypothesis that financial reporting conservatism – in the Basu (1997) sense of conditional conservatism, or timelier loss recognition than gain recognition – originates in the reporting demands of debt markets, but not of equity markets. These results are inconsistent with the basic premise of the “value relevance” school of accounting thought, in which the sole criterion for financial reporting is the linear correlation between book values and some notion of underlying market or “true” value. The results are consistent with the “costly contracting” school of accounting thought, and in particular with the hypothesis that the reporting demands of the debt market exert a substantial impact on accounting practice. This hypothesis has origins at least as early as Gilman (1939), and more recently has been proposed by Watts and Zimmerman (1986), Watts (1993, 2003a,b) and Holthausen and Watts (2001).
Despite the centrality of this issue, we are aware of no direct test of the roles of
debt and equity markets in shaping financial reporting practice. Our test relates individual country measures of gain and loss recognition timeliness with the relative sizes of the countries’ debt and equity markets, scaled by their Gross National Products. These variables proxy for the relative importance of debt markets and equity markets in the countries’ economies. The rationale for this measure is that financial reporting is a costly activity, and the observed quantity of it in practice should depend on demand. If timely loss recognition is in lower demand in a country because it has more poorly developed capital markets, then that country will be less likely to expend costly resources in implementing it. Our measure of demand is market size. We find a significant positive relation between all measures of loss recognition and debt market size, but a negative or insignificant relation with equity market size. The loss recognition effect is economically as well as statistically significant, in that a one standard deviation increase in a country’s ratio of debt to GNP is associated with a 0.08 increase in the regression slope for accounting income on negative stock returns, which large in relation to the cross-country mean of 0.21. Further, we find no relation between gain recognition and either debt or equity market size. The asymmetry timeliness of between the loss and gain recognition results is inconsistent with “value relevance,” which predicts symmetry.

Finally, as predicted by costly contracting theory, we find no relation between unconditional conservatism and debt markets. We conclude that conditional conservatism (asymmetrically timely loss recognition) exists for efficiency of contracting in debt markets, and unconditional conservatism (low book values, independent of economic gains and losses) does not.

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