This removal was due to a deliberate underestimation of net income and asset that can be understood as a bias against neutrality . Some opponents of conservatism argued that conservative accounting could violate the matching principle, as it anticipates and recognises future Accounting Conservatism Definition costs and losses while postponing the recognition of income due to uncertainty (Chen et al., 2014). By investigating the amount of allowance considered for uncollectible earnings, Jackson and Liu found that conservative accounting could help earnings management.
- For example, should firms write up goodwill on acquisition if a merger turns out more successful than expected?
- Against these generally positive findings, there is some evidence that conditional conservatism may increase earnings volatility, reduce earnings persistence and make the forecasting of earnings more difficult.
- Companies with prospector strategy face a higher level of uncertainty in comparison with defender companies since prospectors formulate an aggressive strategy, which, in turn, increases their business risk .
- There is a relative paucity of literature on the causes and consequences of unconditional conservatism.
- GAAP is a common set of generally accepted accounting principles, standards, and procedures.
This subsection provides an overview of the empirical literature on the effects of accounting conservatism. We divide our main discussion between papers concerned with the stewardship/cash flow influencing/contracting roles of conservatism and the effect of conservatism on value relevance and capital market transparency. Absent the exercise of discretion, fair value measurements incorporate unrealised gains and unrealised losses symmetrically, inconsistent with the application of conditional conservatism. However, they argue and provide evidence that firms exercise whatever discretion they have over fair value measurements and they are conditionally conservative. These effects are stronger for firms that have greater incentives to report conditionally conservatively. In addition, timely loss recognition can play an important disciplining role as it may increase the incentives of managers to abandon losing investments and reduce the incentives of managers to adopt negative net present value projects. According to the above table, the coefficient β19 was positive and statistically significant.
While acknowledging other uses of financial statements, this view assumes that performance evaluation and stewardship are not objectives but consequences of the economic forces shaping GAAP. To some extent the case for accounting conservatism to be incorporated into accounting standards is related to the question of whether accounting standard setters should take into account the demand for information for stewardship and contracting purposes.