Watts03-2 (r) - University of Rochester William E Simon...

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University of Rochester William E. Simon Graduate School of Business Administration The Bradley Policy Research Center Financial Research and Policy Working Paper No. FR 03-25 August 21, 2003 Conservatism in Accounting Part II: Evidence and Research Opportunities Ross L. Watts Simon School of Business, University of Rochester This paper can be downloaded from the Social Science Research Network Electronic Paper Collection:
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Conservatism in Accounting Part II: Evidence and Research Opportunities Ross L. Watts William E. Simon Graduate School of Business Administration University of Rochester Rochester, NY 14627 August 21, 2003 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 William Baber, Sudipta Basu, George Benston, Richard Frankel, Carla Hayn, Ludger Hentschel, S.P. Kothari, 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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Conservatism in Accounting Part II: Evidence and Research Opportunities SYNOPSIS This paper is Part II in a two part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their implications for accounting regulators (SEC and FASB). Part II summarizes the empirical evidence on the existence of conservatism, conservatism’s increase over time and conservatism’s alternative explanations. It also discusses opportunities for future research on conservatism. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. In its extreme form the definition incorporates the traditional conservatism adage: “anticipate no profit, but anticipate all losses.” Despite criticism from many quarters, the formal evidence suggests conservatism not only exists in modern day financial reporting, it also suggests conservatism has increased in the last 30 years. The empirical literature uses a variety of conservatism measures in time-series and cross-sectional tests of contracting, shareholder litigation, taxation, and accounting regulation explanations for conservatism. The tests’ results suggest the importance of all four explanations. Two non-conservatism explanations (earnings management and the abandonment option) cannot individually or jointly explain the observed systematic understatement of net assets that is the hallmark of conservatism.
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Researchers should note that accounting’s effects on managerial behavior play a central role in the evolution of both accounting and financial reporting. Assessing the relevance of an accounting method to financial statement users’ decisions requires assessing managers’ abilities to use that method to manipulate accounting numbers and commit fraud. The evidence on conservatism suggests asymmetric verifiability is critical to constraining manipulation and fraud.
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