This paper examines the conservatism principle in accounting valuation, tracing its 500-year history and explaining why it remains the most widely used and influential accounting approach. The paper outlines four theoretical perspectives — contracting, litigation, income tax, and regulatory — and distinguishes between unconditional (balance sheet) and conditional (earnings) conservatism. It also reviews five empirical measures of conservatism, analyzes its effects on earnings quality, capital markets, and contracting efficiency, and compares conservative practices under U.S. GAAP versus IFRS. The paper concludes that conservatism is growing more prominent in the United States, offering legal protection against litigation while helping companies manage investor expectations and reduce the cost of capital.
Accounting is used to determine the financial health of a business or individual. As such, it is carefully regulated, and those who practice it for compensation are required to have appropriate education and certification. There are various rules, laws, and principles that govern the accounting profession and that are commonly used to ensure that accountants handle others' money and financial information correctly. Because there are only a few accepted methods of accounting, it is possible to learn them all and determine which one would be best for a client. That way, an accountant can help a client save the most money on taxes and create an accounting system that can be more easily used and maintained in the future. Among the principles that are often seen in the accounting profession is the conservatism principle, which is the focus of the information presented here.
In short, the conservatism principle states that when an accountant has the opportunity to choose between two specific solutions, he or she should select the choice that will be least likely to overstate the individual or company's income and assets (Ball, Kothari, & Robin, 1999). Furthermore, the principle indicates that expected gains should not be counted as gains, but expected losses should be counted as losses. Based on this, when stock closes it is valued at the market price or the cost price, whichever is less (Ball, Kothari, & Robin, 1999). Doubtful or bad debts have their own provisions, but each debt that is expected to occur is counted in order to underestimate how much money the company may have earned. When the recognition of gains is delayed and expected losses are acknowledged promptly, it is much easier for the company or individual to identify problems — and that will often allow the company to realize a final number better than what was anticipated by the accounting system in place.
Conservatism has been adopted in accounting because of the benefits it provides to agents that use, prepare, and/or regulate financial reporting (American Institute of Certified Public Accountants [AICPA], 1939). When a financial manager or accountant provides information to a client, and the client later sees that the company or portfolio has actually performed better than expected, that is obviously good news. By using conservatism, it is easy to be realistic about the debts being incurred and the income coming in without overestimating and ending up with figures that paint an inaccurate picture of the company's actual financial position. Accountants must be open and honest with their methods and must follow accepted practices. Despite that, there are ways in which they can use those practices to underestimate or overestimate the income and assets of a client (Chadwick, 2000).
Overestimating can be troublesome and can lead to problems with the bottom line (Ahmed et al., 2001). Underestimating is a better option because it requires clients to operate in a more conservative financial manner, meaning they will usually have more savings rather than more debt than they anticipated. All of the approved and commonly used ways of handling accounting are legal and acceptable, but that does not mean that they are equally valuable or effective. When accountants debate with their clients which method to use, conservatism is the most commonly suggested method because of the benefits it provides (Ahmed et al., 2001). A good accountant can discuss those benefits and demonstrate the value behind the proposed method so that everyone is on the same page financially.
The use of conservatism is long-standing and highly significant, with evidence of the practice dating back over 500 years (Ahmed et al., 2001). It has also been rated as the most significant and influential practice in accounting. Recent research has provided insight into the fact that accounting valuation has actually become even more conservative in recent years, which is surprising given the number of vocal critics of the practice. Because conservatism is resilient to criticism and has been widely used for such a long period of time, there are indications that critics are missing many of the benefits that others recognize in this style of accounting.
In order to determine why this is the case, the actual benefits must be examined. If conservatism is simply avoided, the concern is that doing so could have a detrimental effect on accounting in general and would be problematic for anyone who has relied on conservatism in their accounting practices.
In order to clearly understand conservatism, it is important to address the four perspectives that are encompassed within it. These perspectives — contracting, litigation, income tax, and regulatory — provide a more complete picture of how conservatism works in accounting and how it encompasses all aspects of the accounting profession. If only some of the perspectives are addressed, it becomes more difficult to demonstrate the full value of conservatism and to justify its use when providing services to clients.
The majority of contracts seen between parties to an accounting firm use numbers that help to reduce the agency costs specifically associated with that firm (Brooks & Buckmaster, 1976). This can include contracts between the firm and debt holders, employment contracts, management compensation contracts, and cost-plus sales contracts. Parties to a contract generally expect — and often demand — that measures of performance and net asset values be provided in a timely manner. Timeliness helps to avoid outcomes that can otherwise be dysfunctional.
In contracts, earnings are used to restrict dividend payments to shareholders and to maintain a minimum level of assets within the firm, so that there is backing for the firm's outstanding debt (Bliss, 1924). Whether earnings decrease or increase, reporting that information in a timely manner helps to ensure that shareholders receive the right information. It also helps the firm manage its debt correctly, because creditors will be more aware of the firm's debt level based on its earning power and assets — which can affect credit ratings and the interest rate the firm is asked to pay on new or refinanced debt.
When a company estimates its future earnings, there is no way to verify that information. It may end up being correct, or it may be far off in either direction due to something unexpected. Since that is the case, it is highly possible for a company that is not using conservatism in accounting valuation to end up in financial trouble. By ensuring that conservatism is used, no verification is necessary because there is no speculation. Everything claimed as income or assets has already been acquired, and anyone wanting to verify that can easily do so.
The idea of litigation under the Securities Act generally encourages conservatism (Antle & Lambert, 1988). Litigation is far more likely to arise from the overstatement of assets and earnings than from their understatement. Since the costs of litigation are expected to be much higher with overstatement, it is wise for firms to err on the side of caution and significantly lower their litigation risk. The reduction of that risk is a strong incentive for auditors and management to understate both the net assets and the earnings held by the company.
Unlike the contracting perspective, which dates back hundreds of years, the litigation perspective only goes back to 1966 in the United States (Antle & Lambert, 1988). That was the year that significant changes were made to the Securities Act and the rules for bringing class action lawsuits were adjusted. Because of those changes, it became more important from a litigation standpoint to ensure that conservatism was used in accounting valuation. Because there are empirical differences between the contracting and litigation perspectives, there have been many discussions regarding them over the years, and that will likely continue well into the future. Each accounting firm must do what it feels is in the best interest of both itself and its clients, but the avoidance of lawsuits is a highly significant consideration when a company plans to focus on a particular accounting approach.
Because income taxes are so closely tied to earnings, it follows that there would be an accounting valuation issue related to conservatism where income tax is concerned (Ball & Watts, 1972). Income taxes often influence how earnings are calculated. Depreciation, for example, must be recorded as an expense due to changes requested by the U.S. Treasury. If it is recorded that way in all reported financial statements, it can also qualify as tax deductible. Now that depreciation laws are well established, they no longer directly influence taxable income — but accounting laws still have a strong effect on how the taxable income of any company or individual is reported (Ball & Watts, 1972).
There have been many court decisions over the years that have served as precedents for how income reporting and other accounting issues are handled. As long as a firm is showing a profit and has taxable income and positive interest rates, there is an incentive to defer income so that the present value of taxes can be reduced. This leads to the understatement of assets in many cases, so that taxes will be lower. This is not illegal. The income will be properly reported when it is received; it is simply not reported as speculation and is kept off the books until it is actually acquired. In this sense, the income tax perspective shares much with the contracting perspective, as both are interested in minimizing current reported assets for various legitimate reasons.
Regulators and those who set standards have reason to be conservative, because they know that overvalued assets and overstated income — and the losses those things frequently produce — are more easily observed by others than foregone gains resulting from understatement (Beaver, 1993). That does not mean understatement will never be noticed, but only that it is less observable and viewed as far less of a problem. It is one thing for a company to make more than the market expected; it is quite another for that company to make less than the market had anticipated.
Making more indicates that the company was actually doing better than expected. Making less indicates that the company was not performing well but was trying to convey a good performance until it was no longer able to do so (Beaver, 1993). There have been several cases of companies doing this illegally in the past, though there are also more legal ways for such outcomes to occur. Avoiding this situation is by far the best choice for companies, all of which should be focused on handling their earnings in a conservative manner.
Accounting overvaluation was even blamed for the events of the Stock Market Crash of 1929 (Beaver, 1993). Since history has shown how badly that turned out, more and more regulatory bodies are leaning toward remaining conservative with virtually all accounting practices.
In order to address the empirical approach to this issue, it is important to understand that there are two different types of conservatism: unconditional (balance sheet) conservatism and conditional (earnings) conservatism. These are very different in how they are applied, and those who work in accounting must be clear on the differences so that both approaches can be used properly.
In unconditional conservatism, there is a greater focus on expensing the costs of most intangibles (Benston, 1969; Carhart et al., 2002). This can include the costs for research and development, intellectual property, and other items that are generally not tangible and are not part — in a physical sense — of the finished product or service. Intangibles are not things that a company can touch, but they are certainly very real and must be clearly and properly addressed in order to be used by the company as an accounting device. When looking at the balance sheet, it is essential to ask whether all costs are included and whether intangible costs are being priced fairly and equitably. Research and development, as well as other intangibles, are expenses seen by the vast majority of companies — and those companies will need to show those as real expenses when they occur (Basu, 1995; Basu, 1997). If money has been paid out for something, or a debt has been acquired in relation to something intangible, showing that right away is vital to proper conservatism in accounting.
With conditional conservatism, there is less of a focus on the balance sheet and costs, and more of a focus on the earnings side of the issue (Basu, 1997). Conditional conservatism can help to balance out the asymmetry that is often seen in the recognition of earnings and that is also often present with unrealized gains and losses. Asset impairment is one example. If assets are not functioning correctly and cannot be used — such as broken, malfunctioning, or obsolete equipment — they can quickly shift from providing gains to providing losses for the company that must repair or replace them.
By having timeliness in both gains and losses, a company is better able to show how its financial bottom line really looks to Wall Street and to potential investors and creditors (Ball, Kothari, & Robin, 2000). The goal is to be honest about finances, while also presenting the company in the best possible legal light. By keeping accounting both timely and conservative, any company can have a bottom line that accurately reflects what it has to offer and that will not decrease significantly because of unexpected or unrealized gains and losses. It is never good practice to show income or assets that have not actually been acquired, or to claim ownership of something on which the company still carries a debt load, as doing so fails to provide an accurate portrayal of the company's financial strength.
One theoretical approach seen with conservatism in accounting valuation is the signaling model. In that model, market investors use signals picked up from the decisions that managers make (Ball, Kothari, & Robin, 2000). From those decisions, investors are able to infer more private information about the firm, which can lead them to predict the firm's future value more easily. There are still no easy ways to make reliable predictions about how a firm will perform, however, because there may be other influences that are not visible to investors.
Still, the signaling model is relatively reliable and is one of the best ways to gain information and make decisions when one does not work in the inner circles of a company or have inside information about its future plans. The signals given off by managers through their decisions can be very telling for someone who is skilled at reading them, but it takes practice and analysis to understand what those decisions really indicate.
Sometimes, managers appear to make decisions that do not seem to be in the best interests of the company. When that is the case, investors may need to wait and observe what the manager does next. It is possible that the decision was part of a broader and often very effective plan that investors cannot see from their vantage point, so speculation may have to wait until more information becomes available.
There are several different ways in which conservatism can be measured, and they all have value to the accounting profession. Five of those measures are addressed below.
Asymmetric timeliness of earnings is part of measuring conservatism (Ball, Kothari, & Robin, 2000). In some accounting models, earnings become overstated because they are placed on the company's balance sheet as an estimate before they are actually earned. This is a relatively common practice, especially with large companies. However, if the earnings that are actually received are significantly lower than what the company projected, that can spell real trouble. Failing to meet earnings estimates is one of the biggest problems companies can face. One of the best ways to overcome that problem is to focus only on earnings that have actually been received, rather than using estimated earnings as a measure of income. Since earnings are not factual until they have been collected, keeping them symmetrical based on when they are received is the best way to avoid overestimation.
The income that has been accrued is not necessarily equal to cash flow. Conservatism reduces reported earnings cumulatively over time, so some researchers have suggested that the magnitude of accumulated accruals — or even the signs of them — are among the ways in which conservatism can be measured (Dechow, Hutton, & Sloan, 1999). For example, if a company were in a completely steady state with no growth and no conservatism, earnings would converge into cash flows and periodic accruals would converge to zero. Negative accruals over a long period of time show a pattern of conservatism, while the rate of those accruals shows how conservatism has shifted in degree over time.
Some researchers use market-to-book (or book-to-market) ratios to measure conservatism (Dechow, Hutton, & Sloan, 1999). These researchers look at cross-sectional data and pooled time series. Using that information, they can regress market-to-book ratios for each year individually and examine dummy variables and stock returns for the current year and the five preceding years. The differences between the firm's market value and book value of equity are considered, and the lower the coefficient, the more conservative the firm is thought to be. Of course, the coefficient measures only relative conservatism and cannot be used to measure aggregate conservatism (Beneish & Press, 1993). It can, however, show the extent to which conservatism varies across firms — a useful comparison even when absolute levels of conservatism differ.
Legally, companies must declare all of their income and assets (Beneish & Press, 1993). However, that does not mean there are no ways in which reserves can be built up or protected. One such way is through conservatism, because the accounting firm can use this method to ensure the company does not show income and assets it has not yet acquired. When companies avoid listing anticipated earnings, they set their expected earnings much lower. That means Wall Street and investors also set that company's expected earnings lower. Since that is the case, the company may end up with a higher level of earnings than it was showing. This can allow it to effectively "hide" its reserves — or surplus income and assets — because they were not expected in the first place. The company ends up having more to its name than most people think, even though nothing is being hidden for tax purposes.
Negative accruals are another way that conservatism can be identified in a company or an accounting firm (Beneish & Press, 1993). When the company does not appear to be accruing anything and instead appears to be losing money or moving backward financially, it is possible that the company is actually being overly conservative in its accounting. The odds are high that it is actually making some money, or it would not still be in business, but its balance sheet or income statements may show little income because too many expenses and debts are being recorded and not enough areas of income are being recognized (Beneish & Press, 1993). The company may look that way on paper because it does not want to overestimate its earnings, but it may have enough income to survive and may ultimately beat investor estimates.
"Impacts on earnings quality, capital markets, contracting"
"Comparing conservative standards across accounting frameworks"
Overall, conservatism is becoming more common in the United States, a trend that has been visible for approximately the last thirty years. Conservatism in accounting has existed for much longer but has not been as obviously practiced until recently. Some of the regulatory changes made in the last three decades have made it easier and more attractive for companies to embrace conservatism in order to avoid certain financial and legal problems. Litigation was a particularly significant issue for companies that overstated or overestimated their earnings, and companies wishing to avoid that exposure are much more likely to practice conservatism so that they do not need to worry about being sued for failing to meet expectations they set themselves.
In the future, it remains likely that further conservatism measures will be taken for companies in the United States, while it is unlikely that this trend will transfer as strongly to the rest of the world. U.S. companies must be aware of what they can and cannot do under applicable accounting rules and regulations, and they rely on their accountants to handle that for them. Still, the more they understand about accounting rules, the better off they will be, because even the best accountants can make mistakes. As the rules change and conservatism becomes increasingly the norm despite its critics, individuals and companies should keep themselves informed about changes in the rules and how they may be affected, so that they are better able to handle any issues or concerns that arise. Overall, conservatism in accounting makes sense for the majority of companies in the largest number of cases. However, there are always exceptions, and it is wise to consult with an accounting firm to determine the best accounting method for any particular business.
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