Conservatism in Accounting - Part Ii: Evidence and Research Opportunities
Ross L. Watts
Massachusetts Institute of Technology (MIT) - Sloan School of Management
August 21, 2003
Simon Business School Working Paper No. FR 03-25
This paper is Part II in a two part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their implications for accounting regulators (SEC and FASB). Part II summarizes the empirical evidence on the existence of conservatism, conservatism's increase over time and conservatism's alternative explanations. It also discusses opportunities for future research on conservatism.
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, the formal evidence suggests conservatism not only exists in modern day financial reporting, it also suggests conservatism has increased in the last 30 years
The empirical literature uses a variety of conservatism measures in time-series and cross-sectional tests of contracting, shareholder litigation, taxation, and accounting regulation explanations for conservatism. The tests' results suggest the importance of all four explanations. Two non-conservatism explanations (earnings management and the abandonment option) cannot individually or jointly explain the observed systematic understatement of net assets that is the hallmark of conservatism.
Researchers should note that accounting's effects on managerial behavior play a central role in the evolution of both accounting and financial reporting. Assessing the relevance of an accounting method to financial statement users' decisions requires assessing managers' abilities to use that method to manipulate accounting numbers and commit fraud. The evidence on conservatism suggests asymmetric verifiability is critical to constraining manipulation and fraud.
Number of Pages in PDF File: 36
Keywords: accounting conservatism, financial reporting, accounting standard-setting, contracting, corporate governance
JEL Classification: M41, M43, M44, M49, G34, K22
Date posted: August 27, 2003