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Essay: Accounting Conservatism

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Theoretical background

2.1 Introduction

2.2 Accounting Conservatism

Accounting conservatism has a long history, it’s classified as one of the most important principle in accounting, which created a motivation to in-depth examine it by many researchers.  In this section, the definitions and classifications of accounting conservatism will be discussed.

2.2.1 Accounting Conservatism – History and Evolution

The early application of accounting conservatism was at the end of the medieval ages, Kam (1986) mentioned this story in his book about it, it was by a steward as mean of self-protection, when he soon realized that he must take a conservative position after his lord left the running of the estate to that steward, so he was not anticipating increasing in the value of assets, because he realized that if he failed to achieve this increasing, his lord will hold him all the responsibility and blame him accordingly. Other application of accounting conservatism derived from physical records was at the beginning of the fourteenth century, when a Tuscan businessman called Francesco di Marco Datini who works as a merchant valued his inventories at the lower-of-cost-or-market (Basu, 2009).

Later, the governments start to imply the conservatism in valuation inventories, (Basu) 2009 pointed out that Code of Commerce of (France in 1673, Prussia in 1794 and Germany in 1857) required to value the inventories at the at the lower of cost or market (Littleton, 1941; Schmalenbach, 1959).

During the 20th century, the academic discussions about conservatism have increased and have started early in U.S., it was primarily normative, Basu (2009) shed light on the debates between on one hand Gower (1920) who criticized lower-of-cost-or-market on the bases of inconsistency in recognition of gains and losses and on the other hand Finney (1923) that believed this criticism was unfounded. More and more researches discuss the accounting conservatism, some of them have classified countries as more or less conservative (e.g. Gray, 1980). Gray’s Subsequent research in (1988) examined whether these differences in conservatism could be explained by differences in culture.

2.2.2 Definition of Accounting Conservatism

Accounting conservatism is considered as one of the most important properties of financial reporting, Sterling (1967) rates the conservatism as the most ancient, probably the most pervasive and the most influential principle in accounting valuation. Recently, researches about conservatism have been flourished and most of them find that financial reporting in many markets is conservative (e.g., Basu 1997; Ball and Shivakumar, 2000a, 2000b, 2003). Nevertheless, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in 2010 had excluded the conservatism from the joint conceptual framework, it still appears not only to have survived in accounting for many centuries, but also to have increased in the last 50 years, because it plays an important role in financial reporting and decisions making (e.g. Watts, 2002; Hellman, 2008). So, it can be said that conservatism is existed when preparing financial reporting and making decisions even if there is no a formal existing in the joint conceptual framework.

There has been no comprehensive and all-inclusive definition has been presented about accounting conservatism. Many researchers try to prepare definitions about that, for example Bliss (1924) defines the conservatism in a constructive way as “anticipate no profits, but anticipate all losses” but this definition is too simple and it is considered as typical instruction that has often been used by older generations to impart wisdom to the new, therefore, accountants and academics want a better and stronger definition to be most commonly cited and widely accepted. Paton (1948) pointed out that conservatism in accounting apparently means to most accountants is the understatement of assets and the understatement of net income by various means, this definition is not wrong, it is simply not adequate for a subject of this importance, thus, a more general definition needs to be formulated in terms of expectations induced in the minds accountants who carry on such activities. Devine (1963) builds a relationship between accounting conservatism and accounting information users and firms’ goals by his definition as an accounting conservatism as a rule leading to lower average expectations of goal fulfilment in comparison with alternative measuring and reporting rules, although this definition is more formal, firms’ goals and the number of accounting information users are still unclear.

Regulators also devote attention to accounting conservatism. Statement of concepts No. 2 by the FASB (1975) defines conservatism as ‘[a] prudent reaction to uncertainty … If two estimates of amounts to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate’. (Basu, 1997; Watts 2003a, 2003b; Nichols et al. 2009)  agreed  that it as the differential verifiability (or asymmetric timeliness) required for the recognition of economic gains versus losses, which means that conservatism imply high degree of verification to recognize the profit rather than loss which need a low degree of verification to recognize it, in other words, when the firm increases investment, conservative accounting leads to reported earnings that are indeed lower than they would have been had management made more liberal accounting choices (Penman & Zhang, 2002). Chung and Wynn (2008) defines it as a decrease in the company’s value of net assets, prevention of potential risks and consequences resulting from lawsuits, and the presentation of more accurate data for all parties.

2.2.3 Classifications of Accounting Conservatism

Since Basu (1997), the concept of accounting conservatism becomes has two forms (unconditional and conditional conservatism), the scholars begun to distinguish between them and conduct more targeted research (Beekes et al. 2004; Beaver and Ryan 2005; Chandra 2011; ball et al, 2013; Kabir and Laswad 2014). First, conservatism can be unconditional (also called news-independent or ex ante) conservatism, means that the reducing of earnings and value of net assets are results to applying the accounting method and policies rather than to economic news. Examples of unconditional conservatism include immediate expensing of the costs of most internally developed intangibles, depreciation of property, plant, and equipment that is more accelerated than economic depreciation (hereafter accelerated depreciation), and historical cost accounting for positive net present value projects (Beaver and Ryan, 2005).

The second form is conditional conservatism (also called news-dependent or ex-post) conservatism, means that book values are recorded under sufficiently adverse circumstances but are not recorded under favourable circumstances. In other words, requires stricter verification requirements for good news relative to bad news, resulting in more timely recognition of losses compared to gains. Examples of conditional conservatism include lower of cost or market accounting for inventory and impairment accounting for long-lived tangible and intangible assets (Ji 2013). Both types of conservatism lead to the book value of net assets being understated relative to their market value (Kabir and Laswad 2014). It can be noticed that the conditional conservatism reflects new information and current firm’s economic environment to recognize the economic losses in a more timely manner than economic gains (Ball et al. 2013a). Although that Ball and Shivakumar (2005) point out that conditional conservatism can improve contracting and investment efficiency through the timely recognition of losses, which indeed restrict managers’ opportunistic actions, unconditional conservatism would not only prevent such conditional conservatism from these improving and could even distort financial reporting used by investors, because there is an empirical evidence that conditional conservatism and unconditional conservatism have a negative relationship and play different roles in firms according to (Qiang, 2007).

Other classification of accounting conservatism was mentioned by Lawrence et al. (2013), they distinguish between discretionary and non-discretionary conservatism similar to the case of discretionary and non-discretionary earnings. They formally define non-discretionary conservatism as results from the unbiased application of accounting rules and standards and define discretionary conservatism as conservatism arising from purposeful intervention in the financial reporting process to adjust the amount and timing of conservatism accounting. Roychowdhury and Martin (2013) discusse this classification and documents that non-discretionary conservatism or (normal conservatism) is determined by the firm’s economic circumstances. Then they document that discretionary conservatism is a deviation from the normal level of conservatism.

2.2.4 Explanations for Accounting Conservatism

Although that many studies prove benefits of conservatism in improving firm’s financial reports and accounting practices, the opponents still criticize it and describe conservatism as a poor method and its completely distortion the accounting data (e.g. Hendriksen 1982, P. 83). Watts was a the most prominent person in providing a pioneer papers (Watts 2003a, 2003b) contained four explanations for accounting conservatism to convey the message that if regulator and standard-setter critics try to eliminate conservatism without realizing its benefits, the resultant standards are likely to be seriously detrimental to firm’s financial reports. Thus, it’s valuable to review these explanations (contracting, litigation, taxation and regulation): Contracting Explanations for Conservatism

Based on the contracting explanations for conservatism (Watts and Zimmerman 1986, 1990; Watts 1993, 2003a, 2003b, 2006; Basu 1997; Ball et al. 2000; Ball 2001; Holthausen and Watts 2001; Ball and Shivakumar 2005, 2006; Armstrong et al. 2010; Kothari et al. 2010; Christensen et al. 2016; Watts and Zuo 2016), it’s predicted that accounting conservatism reduces potential underinvestment by improving borrowing capacity by better terms of borrowing. Watts (2003a, 2003b) examines the contracting explanation in a profound way, he suggests three attributes of accounting measures related to contracting explanations. The first attribute is timeliness, due to the agency theory (Jensen & Meckling, 1976), which mainly, about the conflict of interests between the agent (managers) and the principal (shareholders), this conflict appears when managers and other parties to the firm maximize their own welfare instead of firm value, thus, reducing the agency costs will increase the firm value. Agency cost-reducing contracts include debt contracts between the firm and holders of the firm’s debt, management compensation contracts, employment contracts, and cost-plus sales contracts. The importance of timeliness here is that the contracting parties demand timely measures of performance and net asset values in order to make decisions for compensation purposes from the one hand and for debt contract purposes from the other hand. Also, Watts (2003a, 2003b) suggests that timeliness helps in evaluating the performance of management and its reflection on firm’s value during the period in which the actions are taken and helps in avoiding dysfunctional outcomes in the management’s limited horizon.

The second attribute is verifiability, verification is necessary for the contract to be enforced in a court of law, because if there is a new product for example with future net cashflow, the contract’s parties cannot agree upon this future net cashflow because it depends on the estimations of the experts, so, to be timely, the ideal performance measures include the future net cash inflows from current management actions, including the future cash inflows due to new product development. However, since any earnings or cash flow measure has to be verifiable for the contract to be enforceable, contracts exclude non-verifiable future net cash inflows from earnings measures (Watts 2003a, 2003b).

The third attribute is asymmetric verifiability, because of relevant parties to the firm have asymmetric payoffs from the contracts, accounting conservatism has play roles to protect the other party’s rights. Watts provides three parts describe the efficient of accounting conservatism in face the problems result from this asymmetric verifiability:

1- Accounting conservatism and debt contracts, conservatism reduces the likelihood management will forego positive net present value projects, overstate earnings and assets, and make what is effectively a liquidating dividend payment to shareholders at the expense of debt-holders.

2- Conservatism and executive compensation contracts, conservatism reduces the likelihood that managers will exert effort to overstate net assets and cumulative earnings in order to distribute the net assets of the firm to themselves instead of exerting effort to take positive net present value projects.

3- Conservatism and firm governance, conservatism provides timely signals for investigating the existence of negative net present value projects and taking appropriate actions if they exist. Conservatism protects the shareholders’ option to exercise their property rights. Litigation Explanation for Conservatism

2.2.5 Criticisms of Accounting Conservatism

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