Conservatism In Accounting Analysis

The paper “Conservatism in Accounting Part 1: Explanation and Implications” is the first part of a two part series written by Ross L. Watts, where it seeks to examine conservatism in accounting. Part I of Watts’ paper “examines alternative explanations for conservatism in accounting and their implications for accounting regulators” (Watts 2003). Watts defines conservatism as “the differential verifiability required for recognition of profits and losses”. The conservatism adage: “anticipate no profit, but anticipate all losses” can be stated as the precept or motto behind conservatism. Essentially, what Watts is implying is the idea that in order to make a legal claim on any profit or gain a higher degree of verification is required while less

What Watts is essentially trying to say is that, if a firm overstates net assets they will increase litigation costs than if they understate their net assets. So conservatism decrease litigation cost to the firm and limits management’s opportunistic behaviour. If a firm is reporting continuous profits and then goes bankrupt a shareholder is likely to sue but if a firm is reporting losses and then goes bankrupt shareholders will sell their shares eventually. Basically, firms are more likely to be used if they are being less conservative and less likely to be used if they are being more conservative.
Watts’ accounting regulation explanations and evidence have important implications for accounting regulators (Watts 2003). Asymmetry in litigation leads to asymmetry in regulator’s cost. In essence, what Watts is saying is that, conservatism cuts the political expenses on regulators and standard setters. Moreover, to decrease taxes and increase a firm’s value, there must be an asymmetry between gains and losses. If a firm under report profits they will pay less money, hence there is a direct link between profits and

Conservatism magnifies lower revenue and this is not just considered as a practical reason for the undesirable conservatism, it generates disorders in the process of recognizing revenue. Lafound and Watts, “states that conservatism is a conflict of interest among investors and creditors and they prefer to use less conservative approaches”. However, IASB and FASB conclude that conservatism should be excluded from the qualitative characteristics of accounting information (Chi 2008). Nevertheless, if these demands are carried out, this exclusion can change the development of future accounting standards. If the FASB was successful in eliminating conservatism, then it would increase information asymmetry between investors, not reduce it. If these accounting setters eliminate conservatism, a company’s uncertainty with preparing accounts will grow. Additionally, the IASB or the FASB have not taken into consideration academic inputs, how they will compensate lenders and borrowers as well as stakeholders for the lost of