Accounting Theory: Conservatism

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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. as 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 estimated 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....
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