The implications of research on accounting conservatism for accounting standard setting

Abstract

This paper provides a commentary on the academic literature on accounting conservatism with a view to highlighting the insights of that literature that are potentially useful for accounting standard setters. We begin by introducing the basic concepts of conservatism focusing on the distinction between conditional and unconditional conservatism. We then briefly discuss the objectives of financial reporting and the economics of information, paying particular attention to the role of stewardship in the Conceptual Framework, and the economic concepts of adverse selection and moral hazard. The two middle sections of the paper provide overviews of, respectively, the theoretical and empirical literatures on accounting conservatism. Having summarised the theoretical and empirical literatures, we then try to synthesis the implications of the literature for standard setters, paying particular attention to understanding the costs and benefits of conservatism, implications for the Conceptual Framework, highlighting the particular demands of public debt markets for conservatism, and explaining how accounting standards might be adapted to allow some degree of flexibility in conservative accounting choice. The final section discusses the limitations of the academic literature from the practical point of view of standard setters, and highlights areas for new research that may be of more direct value for policy-making.

Conservatism, prudence and the IASB's conceptual framework

“…These definitions have in common an emphasis on verifiability and, in that respect, on asymmetry between gains and losses (Barker and McGeachin 2013). There is, in the literature, considerable empirical evidence that these definitions are consistent with conservatism in accounting practice (Watts 2003b, Kothari et al 2010, Shivakumar 2013, Mora and Walker 2014, and also that they are also consistent with the actual requirements of IFRS (Barker and McGeachin 2015). 1 The policy implications of this academic perspective seem to be largely shared with the practitioner community, which has for the most part been critical of the position taken by the IASB.…”

An Analysis of Concepts and Evidence on the Question of Whether IFRS Should be Conservative

“…For the most part, this explanation supports the view that conservatism is a mutually efficient response to the presence of information and incentive asymmetry (Armstrong et al, 2010;Shivakumar, 2013), although such a view is not universal, and in the analytical literature in particular, the case for conservatism is more nuanced. For example, Gigler et al (2009) demonstrate the logical possibility that debt contracting is less efficient in the presence of conditional conservatism, while the model in Göx and Wagenhofer (2009) leads to the opposite conclusion and, in general, Mora and Walker (2014) advise caution in seeking definitive prescriptions from this literature, emphasizing that different contracting contexts will vary the value of conditional conservatism. There is on balance, however, a degree of theoretical and empirical support for conservatism in the literature overall, at the heart of which lies a rationalization grounded in agency and contracting (Mora and Walker, 2014).…”

“…Most obviously, the estimation of Basu's (1997) differential timeliness coefficient, which motivated and remains the mainstay of much of the empirical conservatism literature, is grounded in the relationship between earnings and returns only; it is silent on whether and how accounting standards influence the extent of accounting conservatism in practice. In addition, the Basu model is not without its critics, and several papers have questioned the validity of its approach to the measurement of conservatism (e.g., Dietrich et al, 2007;Givoly et al, 2007;Patoukas and Thomas, 2011;Mora and Walker, 2014), while other papers have sought to revise the basic model (e.g., Khan and Watts, 2009). Furthermore, the logic of a positive methodology, on which the archival-empirical literature is based, is the explanation of market-determined outcomes, and suggests in the extreme that the non-market intervention of standard setting might hinder, and does not help, the optimal development of accounting practice.…”

Conditional conservatism and disaggregated bad news indicators in accrual models

“…Conservatism research shows that asymmetric timeliness is pervasive (see reviews by Watts 2003b; Mora and Walker 2015;Ruch and Taylor 2015) and that it varies predictably with various drivers of conservatism (Watts 2003a), such as litigation exposure (Basu 1997;Holthausen and Watts 2001;Qiang 2007;Chung and Wynn 2008), country and industry characteristics (Pope and Walker 1999;Ball et al 2000Ball et al , 2008Dhaliwal et al 2014), corporate governance (Garcia Lara et al 2009), managerial stock ownership (LaFond and Roychowdhury 2008), debt contracting (Zhang 2008;Wittenberg-Moerman 2008;Nikolaev 2010;Jayaraman and Shivakumar 2013), and information asymmetry (LaFond and Watts 2008).…”