Watts_Conservatism_I - Accounting Horizons Vol 17 No 3...

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207 Accounting Horizons Vol. 17, No. 3 September 2003 pp. 207°221 Submitted: October 2002 Accepted: May 2003 Corresponding author: Ross L. Watts Email:[email protected] Conservatism in Accounting Part I: Explanations and Implications Ross L. Watts SYNOPSIS: This paper is the first in a two-part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their impli- cations for accounting regulators. Part II summarizes the empirical evidence on conser- vatism, its consistency with alternative explanations, and opportunities for future research. The evidence is consistent with conservatism°s existence and, in varying degrees, the various explanations. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: ±anticipate no profit, but anticipate all losses.² Despite criticism, conservatism has survived in accounting for many centuries and appears to have increased in the last 30 years. The alternative explanations for conservatism are contracting, shareholder litiga- tion, taxation, and accounting regulation. The evidence in Part II suggests the contract- ing and shareholder litigation explanations are most important. Evidence on the effects of taxation and regulation is weaker, but consistent with those explanations playing a role. Earnings management could produce some of the evidence on conservatism, but cannot be the prime explanation. The explanations and evidence have important implications for accounting regula- tors. FASB attempts to ban conservatism in order to achieve ±neutrality of information² without understanding the reasons conservatism existed and prospered for so long are likely to fail and produce unintended consequences. Successful elimination of conser- vatism will change managerial behavior and impose significant costs on investors and the economy in general. Similarly, researchers and regulators who propose the inclu- sion of capitalized unverifiable future cash flows in financial reports should consider the costs generated by their proposal°s effect on managerial behavior. Ross L. Watts is a Professor at the University of Rochester. This paper was written while I was visiting the Sloan School of Management at the Massachusetts Institute of Technology. Financial support from the Sloan School and the Bradley Policy Research Center, William E. Simon Graduate School of Business Administration is gratefully acknowledged. I am also grateful for the helpful comments of Sudipta Basu, George Benston, Elizabeth Demers, Richard Frankel, Carla Hayn, Ludger Hentschel, S.P. Kothari, Richard Leftwich, Thomas Lys, Stan Markov, Stewart Myers, Suresh Radhakrishnan, Charles Wasley, Greg Waymire, Joseph Weber, Joanna Wu, Peter Wysocki, and Jerold Zimmerman.
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