Conservatism in accounting part I: Explanations and implications

Abstract

This paper is the first in a two-part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their implications for accounting regulators. Part II summarizes the empirical evidence on conservatism, its consistency with alternative explanations, and opportunities for future research. The evidence is consistent with conservatism's existence and, in varying degrees, the various explanations. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: "anticipate no profit, but anticipate all losses." Despite criticism, conservatism has survived in accounting for many centuries and appears to have increased in the last 30 years. The alternative explanations for conservatism are contracting, shareholder litigation, taxation, and accounting regulation. The evidence in Part II suggests the contracting and shareholder litigation explanations are most important. Evidence on the effects of taxation and regulation is weaker, but consistent with those explanations playing a role. Earnings management could produce some of the evidence on conservatism, but cannot be the prime explanation. The explanations and evidence have important implications for accounting regulators. FASB attempts to ban conservatism in order to achieve "neutrality of information" without understanding the reasons conservatism existed and prospered for so long are likely to fail and produce unintended consequences. Successful elimination of conservatism will change managerial behavior and impose significant costs on investors and the economy in general. Similarly, researchers and regulators who propose the inclusion of capitalized unverifiable future cash flows in financial reports should consider the costs generated by their proposal's effect on managerial behavior.