Accounting Theory: Conservatism

Introduction Conservatism has an undeniably significant influence in accounting field and has been practiced by most businesses for centuries until now. Basu (1997) found that as early as 15th century, conservative accounting had been practiced in trading partnerships in the Europe. Besides, it is also discovered that the theory of lower-of-cost-or-market-principle had been discussed long ago (Basu, 1997). Conservatism or prudence does not have its exact definition but there are heaps of interpretations made by researchers which contribute to a better understanding of this accounting principle.

Givoly and Hayn (2002) illustrate that conservatism is a practice of caution in recognizing and measuring income and assets. Generally, expenses and losses are recognized instantly once they are foreseen but revenues and gains are recognized later when they are actually realized. Besides, Lafond and Roychowdhury (2008) alternatively define accounting conservatism as “the use of stricter standard in recognizing bad news and losses than for recognizing good news as gains” (p. 102).

Another different version by Basu (1997) regarding to his own interpretation of conservatism is (p. 4): “I interpret conservatism as capturing accountants’ tendency to require a higher degree of verification for recognizing good news than bad news in financial statements. Under my interpretation of conservatism, earnings reflect bad news more quickly than good news”. However, Penman and Zhang (2002) interpret conservative accounting similarly but involving different subject i. e. s a matter of “choosing methods and estimates that keep book value and net assets relatively low” (p. 238). They further explain with an example of the application of (i) Last In, First Out (LIFO) versus First In, First Out (FIFO) which are vastly applied in inventory management and other financial matters. Additionally, they show the application of conservatism (ii) when businesses expense their research and development (R&D) cost rather than capitalizing and amortising it, (iii) when firms choose depreciation method that uses shorter stimated life and (iv) the practice of over-estimating allowance of doubtful debts. This definition somewhat coincide with Watts and Zimmerman (1986, cited in Ball & Shivakumar, 2005, p. 89) because they define conservatism as: “Conservatism means that the accountant should report the lowest value among the possible alternative values for assets and the highest alternative value for liabilities. Revenues should be recognized later rather than sooner and expenses sooner than later”.

Despite of the recent joint project between International Accounting Standard Board (IASB) and Financial Accounting Standard Board (FASB) which declares that conservatism should be excluded from the qualitative characteristics of accounting information, Chi (2008) suggests that conservatism being a cautious principle can actually mitigate information asymmetry problem as well as principle-agent or moral hazard problem that arose from information asymmetry.

Department of Finance and Personnel of United Kingdom defines information asymmetry in its website as the “differences in information held by parties to a transaction where this information is relevant to determining an efficient contract or a fair price or for monitoring or rewarding performance”. Hence, there is an obvious imbalance of relevant information available to both parties which can make the transactions go awry. Motivations in investigating accounting conservatism.

The issue of accounting conservatism is considerably an important issue to the modern world especially with the wave of corporate collapses and scandals transpired all around the world. Some notable corporate collapses are the liquidation of HIH Insurance which was Australia’s second largest insurance companies and the Enron’s Company corporate scandal which has led to its bankruptcy in 2001. These failures were deemed to occur because of fraud within the companies where the level of corporate governance was questioned and doubted.

An improper and unethical accounting practice which may ignore conservatism is the main reason that led to these failures. Chi et al. (2009) admit and conclude that companies with weaker governance are more conservative. The study of conservatism is also motivated by the desire to certify the level of reliability of information from companies’ financial reporting. With reliable information, well-informed decisions can be made by the users without any remorse. Barth et al. (2001, p. 4) suggest that “conservatism can be a by-product of applying the FASB’s reliability criterion”. Additionally, it is crucial to know whether the different application of conservatism results in varying quality of financial information by companies. Applying consistent and appropriate accounting principles will eventually reduce quality concern by users of financial statements. Hence, it is undeniable that accounting conservatism is one of the most important elements in financial reports.

The subsequent contents of this research essay will be about motivations that encourage firms to adopt conservative financial reporting practices, critical analysis and descriptions about the empirical method employed by researchers in determining and measuring conservatism, a discussion about the association between conservative financial reporting and information quality and finally, a conclusion. Motivations for firms to adopt conservative financial reporting. There are several reasons why companies adopt conservative financial reporting practices.

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The most unavoidable problem in a company is its inherent agency costs which arise due to the existence of agency problems originated from the separation of ownership and control but it is found that this problem can be reduced if conservative accounting is comprehensively practiced within companies (Lafond & Roychowdhury, 2008). Severe agency problems imply weaker corporate governance which increases the need and demand of conservative accounting (Chi et al. , 2009).

Watts (2003) also agrees that being conservative in preparing financial reporting can make contracting process between managers and shareholders less complicated even with the existence of agency problems. This is supported by Ahmad and Duellman (2007, cited in Chi et al. , 2009, p. 48) that conservatism help directors in mitigating firms’ agency costs. Moreover, newly established firms with lax governance tend to be more conservative in order to solve their agency problem (Khan and Watts 2007, cited in Chi et al. 2009).

Besides, Watts (2003) also suggest that conservatism in accounting can also prevent the problem of limited horizon which normally occurs among managers who are approaching the end of their tenure whom tend to transfer wealth from shareholders to themselves. Plus, firms also practice conservatism due to a low managerial ownership within the companies (Lafond & Roychowdhury, 2008). Managerial ownership is the ownership of shares by members of the board of directors (Short & Keasey, 1999) measured by the percentage of the companies’ shares owned by key managers (Lafond & Roychowdhury, 2008).

To explain further, there is a negative correlation between the level of conservatism applied within a company and its structure of managerial ownership. On the other hand, there is a positive correlation between the timeliness good news are announced and companies’ managerial ownership. Accordingly, it can be conclude that there is an increase in demand for conservatism among shareholders when there is a significant separation of ownership and control and a big diversion between managers’ and shareholders’ interests which implies a low managerial ownership (Lafond & Roychowdhury, 2008).

Another reason which encourages companies to exercise extra caution in accounting treatment is due to the increase in litigation in their respective countries. Givoly & Hayn (2002) discover that a more litigious US accounting environment has induced auditors and companies’ managers to apply a more conservative reporting. This is done in order to avoid any expected future legal liability which may arise when firms exhibit very high reported earnings (Chung & Wynn, 2008). They also conclude that less managerial legal liability coverage leads to higher earnings conservatism in companies.

Further, there is an evidence by Lobo and Zhou (2006) that accounting conservatism increases in the US particularly after the implementation of the Sarbanes-Oxley Act in 2002. Similarly, Bushman and Piotroski (2006) agree that legal and political institutions do influence the level of conservatism applied within companies. In terms of legal systems, companies in countries with strong investors’ protections and high quality judicial systems reflect bad news in reported earnings numbers in a timelier manner. Further, in terms of securities law, a stronger public enforcement defers the recognition of good news in companies’ reported profit.

Political economy also plays a big role in conservatism but, a high involvement by state government (particularly in common-law countries) in the economy leads to an instant recognition of good news but a later recognition of bad news in reported earnings and the opposite occurs in code-law countries. Ball et al. (2000) proves that companies operating in common-law countries incorporate significantly greater timeliness of loss recognition into their accounting income than companies operating in code-law countries. Ball et al. (2000) also infers that “enhanced common-law disclosure standards reduce the agency costs… (p. 2) while code-law countries are exposed to greater political influence which may discourage firms to be more conservative in their financial reporting. Besides, companies need to apply conservative accounting because different degree of conservatism will vary the outcome of their respective debt contracting (Lafond & Roychowdhury, 2008). Zhang (2008) supports that ex ante benefit of conservatism leads to a lower debt cost for borrowing firms although ex post benefit benefits lenders as it gives timely signal of default risk via accelerated violation of covenants.

Initially, Gigler et al. (2008) also agree that immediate losses recognition which causes prompt breach of debt covenants leads to an efficient debt contracting since the debtholders are able to exercise their rights by demanding immediate payment or limit managers’ actions. However, Gigler et al. (2008) later exhibit an opposing view that accounting conservatism and efficiency of debt contracting have negative relationship.

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It has been claimed that conservatism deems to dilute information content of accounting reports which subsequently reduce the efficiency of contracting process because conservatism is being blamed to create false alarm. The level of interest rate is used as a proxy in determining the efficiency of debt contract. Ball, Robin and Sadka (2005) also disagree with the ability of conservatism in increasing contracting efficiency because they discover that a low earnings and book value as a result of the application of conservatism because unconditional conservatism in particular, involves a certain level of bias (Guay, 2008).

Additionally, it is worth knowing that other than being conservative in financial reporting, firms simultaneously apply conservatism in debt covenants adjustments (to mitigate agency problem with lenders) due to lenders’ demand of specialized information (Guay, 2008). The adoption of a more conservative accounting principle is more obvious especially after companies experience restatement of financial reports. Via the adoption, companies show their effort to restore the credibility of their financial reports and at the same time, improving corporate governance. Chang, 2009) According to Investopedia, “restatement” is a “revision in a company’s earlier financial statement” which could be due to “fraud, misrepresentation or a simple clerical error”. Without appropriate steps, firms will continuously suffer with severe costs of restatement such as reduction in future earnings, a higher rate of return, a bad reputation etcetera. A severe occurrence of restatement could be due to extensive discretionary accruals made by company’s management. Conservative accounting treatment can gradually reduce management’s manipulation in determining those accruals.

Hence, the level of discretionary accruals that exist within a firm is able to determine the level of conservatism practiced in firm’s operation. (Chang, 2009) Another reason that encourages companies to be more conservative is the problem relating to their dividend policy which forces them to a severe application of conservatism. At the same time, a higher level of conservatism leads to a better debt rating hence, a lower cost of borrowing due to a lower level of risk. So, conservatism which is claimed to produce a better quality financial report, in other way, influences firms’ debt contracting among lenders.

From that, it can be deduced that conservatism can reduce bondholder-shareholder disagreements towards dividend policy hence, lessening cost of borrowing (Ahmed et al. , 2002). This is true because bondholders being fixed claimants will feel less risky when companies do not pay excessive dividends to their shareholders whom are entitled to residual claim. If the companies decide otherwise, the excessive payment will eventually transfer wealth form bondholders to shareholders and increase the probability of default risk to bondholders.

According to Investopedia, bondholders whom have higher priority than common shareholders during liquidation of related companies are attributed to regular interest payments and principal payment during maturity. To explain further, conservatism works well in addressing the dividend policy dispute as a fall in reported earnings leads to a similar reduction in dividend distribution among holders because currently, there is limited amount of profit attributable for dividend payment. Empirical method: determining and measuring conservatism.

One of the earliest methods in gauging the degree of conservatism was developed in Basu (1997). Although the method is widely accepted by many literatures, there are some opposing views from other researchers. However, they do not wholly reject Basu (1997) model, in fact they suggest some ways to improve the original model hence minimising its weaknesses. Roychowdhury and Watts (2007) suggest that Basu’s model is better in gauging the level of conservatism if many periods are collectively involved. This is because any bias from rents changes can be eliminated over longer periods.

Moreover, longer periods can eventually reduce the dependency of the model on equity value at the beginning of the period. One of the contradicting features of Basu (1997) model is documented by Gigler et al. (2008). Basu (1997) found that when stock returns are negative, correlation between accounting profit and stock returns is stronger than during positive stock returns. This inference is made with his assumption that all relevant events are instantaneously incorporated into stock prices and financial reports do not have new information to the market. Nevertheless, Gigler et al. 2008) argue that financial reports actually have valuable information to the market. A favourable reported profit is apprised to have greater information content than an unfavourable profit. Ball, Kothari and Robin (2000) infer that Basu’s regression model may result in different outcomes if applied in various countries because of international differences especially in their respective common law. Hence, it can be seen that his method is not flexible and should be amended to suit various regulation, taxation and litigation within the countries. Plus, Ahmed et al. 2002) also disagree with Basu’ method as they claim that “his measure and the conservatism of accounting choices is unclear” (p. 872). Shon (2000, cited in Ahmed et al. 2002) also criticizes as he found that companies that apply a more conservative method in accounting are assessed to be less conservative when Basu’s method is utilized. According to Ball et al. (2005), there are two limitations of Basu’s model being highlighted. The model is said to not able to differentiate components of transitory gain or loss in earnings which “cause negative serial dependence in income changes” (p. 3). Moreover, the model can only verify the presence of transitory gain and loss without determining their timeliness. On top of Basu (1997) model, Givoly and Hayn (2002) utilise a few other methods to estimate the degree of conservatism namely (i) the level and rate of accumulation over time of negative non-operating accruals, (ii) measures based on the earnings-return association during periods of good and bad news, (iii) the skewness and variability of the earnings distribution relative to the cash flows distribution and (iv) changes in the market-to-book ratio (p. 8). Additionally, Zhang (2008) also utilises the measure of sensitivity of earnings to bad news relative to the sensitivity of earnings to good news (p. 27). Empirical evidence: association between conservative financial reporting and the information quality. The existence of optimal level of conservatism and less problem of information asymmetry i. e. better transparency within a company are highly likely to produce a prominent financial report with high quality.

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Reporting quality as explained by Ball and Shivakumar (2005) is about the “usefulness of financial statement to investors, creditors, managers and all other parties contracting with the firm” (p. 84). Further, they point out that timely recognition of economic losses can generally increase the usefulness of financial report hence its quality. On the other hand, Penman and Zhang (2002) conceive that high quality of earnings are those which can give a picture about companies’ future earnings and sustain throughout certain periods.

Early researchers such as Imhoff (1992, cited in Ku Ismail & Abdullah, 1999) also agrees that accounting quality and high earnings information are positively correlated meanwhile, Graham (1994, cited in Ku Ismail & Abdullah, 1999) agrees that extensive conservatism and high earnings information are positively correlated. From that, it can be otherwise explained that accounting policies that are more liberal or subject to management’s discretionary are less conservative hence resulting in lower earnings quality as supported by Bernstein and Siegel (1979, cited in Ku Ismail & Abdullah, 1999).

Despite of the logically accepted fact that earnings persistence denotes high quality of earnings (Penman & Zhang 2002), it is worth noting that it is not always the case. This is true since poor quality financial reports do not necessarily indicate sub-optimality especially in the case of private companies where market demands lower quality of financial reporting from them in comparison of public companies regardless of being produced under the same regulations (Ball & Shivakumar, 2005).

At most of the time, the problem of information asymmetry in contracting is overcome by an “insider access” model instead of relying on their published but not widely distributed financial reports. For that reason, a high level of conservatism applied within companies does not necessarily guarantee a high quality of accounting information which may be of good use to investors and other stakeholder in making their best informed decisions. Conclusion. All in all, conservatism is considerably one of the most important accounting principles and is prevalently applied ever since centuries ago.

It is undeniably a good principle in mitigating the inherent information asymmetry problem faced by nearly all types of principle-agent relationships. In the case of accounting, the absence of conservatism may lead to worsen quality of financial reporting being produced hence misleading the users. Companies are not at disadvantage in conjunction with the application of conservatism. In certain cases, it may distort their earnings and performance but in the long run, the downside gradually vanishes. Empirical evidences also support the positive correlation between accounting conservatism and earnings quality.