Essay on Conservatism in Accounting

5453 Words Apr 5th, 2011 22 Pages
Introduction
Accounting conservatism is traditionally defined by the adage “anticipate no profit, but anticipate all losses” (e.g., Bliss, 1924). Anticipating profits means recognizing profits before there is a verifiable legal claim to the revenues generating those profits. Conservatism does not imply that all revenue cash flows should be received before profits are recognized. Thus the issue is one of verifiability. In the empirical literature the adage is interpreted as representing “the accountant’s tendency to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses” (Basu, 1997, p. 7). Conservatism is the asymmetry in the verification requirements for gains and losses. This
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Basu (1997, p. 8) argues that conservatism has influenced accounting practice for at least five hundred years. Sterling (1970, p. 256) rates conservatism as the most influential principle of valuation in accounting. Recent empirical research on
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conservatism suggests not only is accounting practice conservative, but also that it has become more conservative in the last 30 years. These results are surprising given the vocal opposition of many capital market regulators, standard-setters and academics to conservatism.1 The long survival of conservatism and its apparent resilience to criticism strongly suggests conservatism has significant benefits that are missed by its critics. The puzzle is: what are those benefits? If regulator and standard-setter critics try to eliminate conservatism without understanding the puzzle, the resultant standards are likely to be seriously detrimental to financial reporting.
Researchers have advanced a number of explanations for conservative reporting and all of them suggest conservatism has benefits to parties associated with the firm that reports. One explanation is that conservatism arises because it is part of the efficient technology employed in the organization of the firm and its contracts with outside parties
(contracting explanation). Under this explanation, conservative accounting is a means of addressing problems due to parties to the firm having asymmetric information, asymmetric payoffs and limited

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