Conservatism

Introduction

Conservatism in accounting has been a topic of debate for a very long time. While some believe that conservatism arises naturally between contracting parties and is necessary as an efficient contracting mechanism, others have the notion that conservatism biases financial statements leading to inefficient decision-making.

Conservatism will be examined in two parts; (1) Effect on Financial Statements and (2) Effect on users of financial Statements.

Background

Australian Accounting Standards Board (AASB) uses the Statement of Accounting concepts (1990) and The Financial Accounting Standards Board (FASB) uses Statements of Financial Accounting Concepts (1980), these set consistent standards in the presentation of Financial Statements. Both the AASB and the FASB mention the role of conservatism in their frameworks, they have excluded it from the qualitative characteristics of accounting information.  

The AASB released in SAC3 the new ‘Qualitative characteristics of Financial Information’.  This included characteristics such as Relevance, Reliability, Materiality, Comparability and Understandability. According to SAC3, Para 21, Accounting conservatism can give rise to clash between neutrality and conservatism because misguided conservatism results in filtering of the information by the preparers of the statement and thereby taking away the rights of the users to make their own decision. It also mentions in Para 26, conservatism on the other hand is sometimes used in an acceptable manner, when used synonymous with reliability.

Effects on Financial Statements and its Users

The issue relating to conservatism can be separated in to two parts; (1) asymmetric timeliness in recognition of accounting gains versus losses and (2) systematic understatement of net assets (Chi, W. and Wang, C. 2008).

The main issue associated to the effect of conservatism in the presentation of financial statements is its impact on earnings quality. In this study we use the effect of conservatism in earnings quality by using the groups identified in Dechow et al. (2010):

Time-Series Property of Earnings

As the write-downs of accounting book values are a temporary event, conditional conservatism makes earnings less persistent in the bad news period. According to Basu (1997), operating losses are less persistent than operating gains, consistent with the idea that losses are conservatively reported in the form of write-downs. But in case of deferred gains, conditional conservatism would make earnings more persistent during good news periods, which results in a continuous stream of earnings. Studies conducted on the effects of conservatism on the time-series properties of earnings finds that conditional conservatism reduces earnings persistence and predictability (Givoly et al. 2000).