Conservatism in Accounting

1. Conservatism in Accounting Ross L. Watts

2. Definition of conservatism • Accounting conservatism is traditionally defined by the adage “anticipate no profit, but anticipate all losses” (Bliss 1924). • The accountant’stend to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses” (Basu 1997, 7).

3. Definition of conservatism • Conservatism is the asymmetrical verification requirements for gains and losses. • The greater the difference in degree of verification required for gains versus losses, the greater the conservatism.

4. Definition of conservatism • An important consequence of conservatism’s asymmetric treatment of gains and losses is the persistent understatement of net asset values.

5. Definition of conservatism • Capital market regulators, standard setters, and academics criticize conservatism because this understatement in the current period can lead to overstatement of earnings in future periods by causing an understatement of future expenses • However, that usage does not fit with the conservatism definition employed here. • Conservatism refers to the cumulative financial effects represented in the balance sheet and to income or earnings cumulated since the firm began operation.

6. Contracting explanation • Contracting explains three attributes of accounting measures: timeliness, verifiability, and asymmetric verifiability

7. Contracting explanation-Timeliness • Contracts between parties to the firm use accounting numbers to reduce agency costs (Watts and Zimmerman 1986). • Agency costs arise when managers and other parties to the firm maximize their own welfare instead of 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.

8. Contracting explanation-Timeliness • Contracting parties demand timely measures of performance and net asset values for compensation and debt contract purposes • Timeliness avoids dysfunctional outcomes associated with managers’ limited tenure with the firm, often referred to as the manager’s limited horizon.

9. Contracting explanation-Timeliness • Earnings-based formulas are used in debt contracts to restrict dividend payments and maintain a minimum amount of net assets within the firm. • These restrictions provide a guaranteed backing or bond for outstanding debt and reduce the ability of the manager and shareholders to maximize their own payoff by paying a liquidating dividend at the expense of debt holders and total firm value (Smith and Warner 1979).

10. Contracting explanation-Verifiability • Verification is necessary for the contract to be enforced in a court of law. • since any earnings or cash flow measure has to be verifiable for the contract to be enforceable, contracts exclude nonverifiable future net cash inflows from earnings measures.

11. Contracting explanation-Asymmetric Verifiability 1. Conservatism and Debt Contracts 2. Conservatism and Executive Compensation Contracts 3. Conservatism and Firm Governance

12. Conservatism and Debt Contracts 1. Debt holders are concerned with the lower ends of the earnings and net asset distributions. They want assurances that the minimum amount of net assets will be greater than their contracted sum. 2. The importance of dividend covenants in debt agreements illustrates conservatism’s function. These covenants limit dividend payments to “unrestricted” retained earnings calculated on conservative accounting principles. Thus those restrictions force management to protect debt holders by maintaining, within the firm, assets with a given lower bound value.

13. Conservatism and Debt Contracts • In debt covenants, conservatism reduces the likelihood management will forgo 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.

14. Conservatism and Executive Compensation Contracts • Absent a verification requirement, the manager can bias estimates of those future cash flows upward, producing large payments under earnings-based compensation plans and possibly leading to negative net present value investments by the firm.

15. Conservatism and Executive Compensation Contracts • Without verifiable earnings measures the manager receives overpayments that leave shareholders with a lower share value, even after adjusting for the value added by the manager, and the shareholders are unable to recover the overpayment because of the manager’s limited liability. • Conservatively measured earnings provide some timely incentives and deferred compensation rewards managers for currently unverifiable future cash flows, as in some bonus plans managers earn compensation on earnings after retirement (Smith and Watts 1982).

16. Conservatism and Executive Compensation Contracts • In 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.

17. Conservatism and Firm Governance • Managers have incentives to hide losses to avoid being fired before their tenure is over. • Asymmetric verifiability speeds up the recognition of losses and provides the board of directors and shareholders with a signal to investigate the reasons for those losses. • Such investigations can lead to discharging the manager and eliminating projects that currently have a negative net present value. On the other hand, managers have incentives to provide information on projects that have positive net present value projects.

18. Conservatism and Firm Governance • In corporate 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.

19. The Flaw in the Information Perspective Criticism • Downward-biased estimates of net assets caused by asymmetric recognition of gains and losses lead to upwardly biased estimates of earnings in future years when those assets are realized. • Hence, it is said that conservatism now produces “nonconservative” earnings in future years. • This charge misses the point of conservatism in the contracting explanation.

20. OTHER EXPLANATIONS FOR CONSERVATISM • A Litigation Explanation for Conservatism • An Income Tax Explanation for Conservatism • A Regulatory Explanation for Conservatism