Conservatism and Accounting Earnings

Abstract

The article refers to accounting conservatism and its relation with accounting earnings. After providing the conceptual background of the prudence concept, which is the basis of accounting conservatism, the paper introduces some more empirically testable concepts, known as conditional and unconditional conservatism. It also explains the economics behind this accounting practice, mainly associated to contracting due to the asymmetric information between managers and external stakeholders, but also linked to litigation risks, taxation, political and regulatory processes. After providing a brief explanation of the empirical measures of conservatism, it gives a summary of the vast empirical research that has evidenced the widespread use of conservatism in financial reporting and, in particular, the so‐called conditional conservatism, which suggests that bad news is included in accounting earnings in a more timely fashion than good news.