Conservatism in Accounting

Matthew R. Garrison

A thesis submitted in partial fulfillment

of the requirements of the University Honors Program

University of South Florida St. Petersburg

April 15, 2015

Thesis Director: Debra Sinclair, Ph.D.

Assistant Professor, Kate Tiedemann College of Business

University Honors Program

University of South Florida St. Petersburg

CERTIFICATE OF APPROVAL

___________________________

Honors Thesis

___________________________

This is to certify that the Honors Thesis of

Matthew R. Garrison

has been approved by the Examining Committee on April 22, 2015

as satisfying the thesis requirement of the University Honors Program

Examining Committee:

___________________________

Thesis Director: Debra Sinclair, Ph.D.

Assistant Professor, Kate Tiedemann College of Business

____________________________

Thesis Committee Member: William Sinclair

Instructor, Kate Tiedemann College of Business

Conservatism in Accounting 3

Abstract

The accounting principle of conservatism has its roots with bankers and debt financing.

Bankers have urged businesses to underestimate earnings and overestimate expenses in order for

the investors to make safer decisions in the future. Conservatism was relatively practical during

the rudimentary beginnings of business. However, due to changes in corporate finance and new

users of financial statements, conservatism has no place in financial accounting. Undoubtedly

judgments and estimates must be made, but conservatism is no longer an accounting principle

and the most accurate figure possible should be used with no bias in either direction.

4 Garrison, Matthew

Conservatism in Accounting

“The assumption is that human economies are built on reciprocal exchanges and

accounting concepts such as double entry, matching and conservatism are believed to be in

harmony with the way the brain functions. An example is the concept of conservatism where

gains are not anticipated but losses are.”

This quote is written in an introductory financial

management textbook specifically authored toward non-financial managers. It summarizes quite

well the prevailing reason how conservatism began in the accounting context and why it

continues to exist. When running an organization, it is important to maintain an adequate supply

of resources. In order to effectively plan for the future, one must be able to look at the accounting

records of the past and forecast what might happen later on.

Clive Marsh, the author of the above quote, is one of many who claim that there is a

logical, or perhaps even psychological, reason that accountants and lenders prefer to be

conservative in their figures. However, the main reason that conservatism has become so

pervasive in the field of accounting is the origin of the profession itself. Conservatism is an

inherent bias in financial reporting and in today’s environment it is no longer a necessary or

correct principle due to changes in corporate finance and users of financial statements.

In order to understand the significance of why one should care about conservatism

in the first place, it is crucial to understand and clarify the origins of the accounting profession

and concepts. Bookkeeping and accounting are the means by which businesses maintain records

of business transactions to measure past performance and ensure the accurate reporting of assets

and liabilities. Accounting has existed in one form or another since the very first farmer walked

Marsh, Clive. Financial Management for Non-Financial Managers, Kogen Page. Philadelphia 2012 p482

Conservatism in Accounting 5

outside one morning, counted his oxen, and compared that number to the number of oxen he

counted the night before. There are 7000 year old Babylonian and Assyrian accounting records

that have survived to the present; these records are the first written documents that show the use

of record keeping and the concept of credit. Ancient Egypt, China, Rome, and Greece all

maintained very effective systems of accounting that led to effective management of private

trade and government record-keeping. These accounting methods were very rudimentary, but

very effective for maintaining records of such things as interest returns and receivables.

The

struggle ancient accountants had in maintaining accurate accounting records seems to have been

inhibited not by a primitive thinking of mathematics or accounting concepts, but a lack of

efficient equipment such as paper and writing instruments. Michael Chatfield, Professor of

Accounting at California State University, emphasizes that point with his claim that the

accounting methods used by the American colonists thousands of years later were still “more

backward than that of ancient Egypt”.

Moving beyond accounting in antiquity, the practice of modern accounting is agreed by

scholars to be around 500 years old.

It began in 1494 when the Franciscan monk Luca Paciolo,

the “father of modern accounting”, published his text on mathematics and accounting titled The

Collected Knowledge of Arithmetic, Geometry, Proportions and Proportionality.

Even though

we have proof that many of the concepts he wrote about had existed over 200 years earlier, what

makes the post-Paciolo period so significant are the changes to concepts and the increasing

accuracy of accounting that followed. Before Paciolo, the methods and teachings he wrote about

Littleton, A. C. Accounting Evolution to 1900. University of Alabama: U of Alabama, 1981. Print. p.32

Chatfield, Michael, CPA. A History of Accounting Thought. Huntington, NY: Robert E. Krieger, 1977. Print. p.7

Hatfield, Henry Rand. Modern Accounting. New York: Arno, 1976. Print. p. 1

Chatfield, p.46

6 Garrison, Matthew

had seen limited use but even then were “used badly.”

His writing was primitive compared to

modern accounting theory, but it laid the foundation for the double entry method of accounting.

In doing that, he established the following equation:

Assets + Liabilities = Owners Equity.

Although transactions have increased in complexity and gotten more difficult to measure,

this simple formula still forms the basis for all accounting transactions today. Understanding its

significance is important to grasp the flaws in the conservatism concept which will be discussed

later.

The double entry accounting method was perhaps the most crucial step in the

development of accounting concepts.

Dating to the early 14

century and the Massari accounts

of Genoa,

it moved accounting away from counting physical things, such as animals, and into

the realm of finance and money. It should come as no surprise that the development of the

double entry method came about during the Renaissance and Venetian-Byzantine trade boom

when vast amounts of capital were being created and goods traded globally. Prior to this

expansion of trade, transactions were recorded much differently than in modern accounting.

Whereas today there is a single Sales account and a single Cost of Goods Sold account,

transactions prior to this time were conducted and recorded individually. An item would be

recorded for the amount of money it cost the seller with the profit from the sale of that specific

item being recorded with it. This method for recording transactions was very time consuming,

but it was very thorough as well. The need for independent accountants and elaborate transaction

Richard Brown, ed., A History of Accounting and Accountants (Edinburgh: Jack, 1905), 94

Hatfield, p. 1

Ibid. p.41

Chatfield, p.36

Conservatism in Accounting 7

methods to help verify balances was unnecessary due to the small scale of trade and intimate

knowledge the business owner would have had during that time.

“The majority of merchants were probably so intimately concerned with the details of

their own business affairs that they did not need elaborate accounting calculations to inform them

of the size of their fortunes or to acquaint them of the results of their enterprise. It is likely,

indeed, that the merchant’s knowledge of his affairs would have been so sound that he would

have been able to detect errors in the calculations of his bookkeeper.”

Another hypothesis for the lack of double entry bookkeeping being developed any earlier

was the lack of an effective numeral system. The Romans, Greeks, Egyptians, and Chinese did

not use the Arabic numeral system or any other numeral system that could be efficiently added

together neatly in columns or rows

. Because separate numbers couldn’t be arranged in any

practical way that would allow them to be added and effectively compared, there was no

incentive to create separate columns of debits and credits which are crucial to the double entry

method. Before the advent of currencies and complex business transactions there was very little

need for double entry accounting, but as commerce increased and businesses required more

effective record-keeping the advantages of double entry accounting became apparent.

Conservatism can be defined as “anticipate no profits and provide for all probable

losses.”

It is a cautious approach to uncertainty that is reflected in the financial statements and

accounting procedures. Some of the first documented cases of conservatism by accountants

Yamey, Basil S. Essays on the History of Accounting. New York: Arno Press, 1978. Print. p.111

Ibid. p.41

Littleton, Ananias Charles, and Basil S. Yamey. Studies in the History of Accounting: Edited on Behalf of the

Association of University Teachers of Accounting and the American Accounting Association. Homewood, IL: Irwin,

1956. Print. p. 20

Bliss, J. H. (1924). Management through accounts. New York: The Ronald Press Co.

8 Garrison, Matthew

occurred around the same time Paciolo developed the double entry method. While conservatism

may have been used for millennia beforehand, these cases from the medieval time period

involved deliberate and documented understatement of manorial income and expenses. The

manor’s self-sufficiency placed limits on what it could produce and sell. In order to prevent over-

extending its resources, conservative figures were used. Conservatism was used then as it is used

today, as a form of self-preservation for the business entity.

Medieval stewardship may have

also been a contributing factor. The steward of the lord’s property, out of concern for his

employment and lord’s welfare, was most likely conservative in recording financial records as a

form of self-protection. Walter of Henley, in the early fourteenth century, wrote that manorial

accounts should be “faithful and prudent.”

That stewards of property for rich, powerful lords

would be conservative in their figures should come as no surprise. Running out of materials and

stockpiles unexpectedly could lead to the steward being fired, or even executed.

It is no coincidence that Paciolo’s accounting work was published during the time of a

global explosion in trade and commerce; similarly, conservatism’s roots being intertwined with

the origins of modern accounting no doubt contributed to the proliferation of the concept. Just as

the increasing amount of business during the Renaissance created a need for new accounting

procedures, the Industrial Revolution produced a revived need for more accurate record keeping

to keep up with the vast amounts of information and wealth being exchanged. A.C. Littleton

explains it as follows:

“It is not without significance that bookkeeping appeared at the end of the fifteenth century,

nor that its birthplace was the Italian republics. We all know of the marvelous awakening of that

period, and particularly of the sudden expansion of commerce….But bookkeeping dozed for

Chatfield, p. 28-29

Basu, Sudipta. "Conservatism Research: Historical Development and Future Prospects." China Journal of

Accounting Research 2.1 (2009): 1-20. Web. 15 Feb. 2015. p.1

Conservatism in Accounting 9

several centuries, and it was not until about four hundred years after Paciolo’s book that a

startling awakening took place…Why this new prominence in a subject taught before 1500? The

answer is so obvious that explanation seems impertinent. The end of the nineteenth century,

more so than the end of the fifteenth, was marked by an extraordinary expansion of

business.”16

With this increasing need for accurate record keeping came an increase in the use of

external auditors. External auditors are hired by companies to provide assurance to their

stakeholders that the financial statements are free from material misstatement. While internal

auditors perform many similar functions to external auditors, auditors independent from the

organization produce audit opinions that are viewed as being more fairly represented due to the

separation that exists between company management and auditors. The modern need for external

auditors, financial statements, and unbiased, accurate record-keeping arose in England shortly

before the Industrial Revolution. Along with the immense wealth which tea, slavery, sugar,

steamships, railroads, and the textile industry brought England, there arose a great need for

impartial public accountants to validate financial statements of companies dealing in these

commodities.

While eventually laws would be written requiring public companies to be

audited, many companies in the 19

century instituted audit requirements not due to any legal

reasons but because it was a demand of shareholders. Gary F. Spraakman explains the origins of

the Hudson’s Bay Company’s external audit program as,

“The regulatory requirement for external audits in many industries in the last 40

years of the 19th century was a major event in the development of the public

accounting profession. Similarly, the 1866 introduction of external auditors was a

significant accounting event not just for the HBC but for other public companies as

the driving force was not regulation. It was the shareholders who saw the benefits

and who requested that the financial statements be audited to make them more

useful. In that way, it was an early example of shareholders and managers with

Littleton, Accounting Evolution to 1900, p. 9

Littleton and Yamey, p. 357

10 Garrison, Matthew

external auditors working together in pursuit of standardized and informative

audited financial statements. The purpose was to provide the shareholders with a

better understanding of the company's ability to pay dividends and to expand in

North America.”

Banks needed a way to verify a company was making as much profit, had as many assets,

and was successful as it said it was in order to lend money. The amount of money a bank would

loan, and at what interest rate, depended not only upon what the company’s financial situation

looked like but how accurate the numbers were. External audits on behalf of shareholders led to

lenders being increasingly dependent upon verified financial statements before making

investment decisions. As the employment of external auditors became commonplace and lenders

began to refuse service unless financial statements had been independently verified, regulations

were written requiring public companies to be audited.

The 19

century’s boom in industry and business allowed accounting to blossom

simultaneously. During this time, new methods and systems for cost and financial accounting

were developed for use by the titans of British industry. The use of these accounting methods

coupled with a change in the way businesses were run during this period would quickly change

the nature of the British economy; rapid industrialization and the widespread availability of fairly

represented financial statements were significant.

Incorporation without royal charter was first made possible in England by the Joint Stock

Companies Act of 1844. The 1844 Act was created in order to give those not belonging to the

aristocracy the ability to incorporate a business. This capability was sought by both individual

Spraakman, Gary F. "The First External Auditors of the Hudson’s Bay Company, 1866." Accounting Historians

Journal 38.1 (2011): 77. Web.

Ibid, p.75

Miranti, Paul J. Accountancy Comes of Age: The Development of an American Profession, 1886-1940. Chapel Hill:

U of North Carolina, 1990. Print. p. 30

Conservatism in Accounting 11

businessmen who wanted to incorporate, and the Crown which had overseen complex legal suits

in companies with thousands of owners. Because incorporation was not possible without royal

charter and limited liability did not exist, any time a company was named as a defendant in a

lawsuit or bankruptcy proceeding, each owner had to be individually named in the lawsuit. With

some companies having thousands of owners, this was extremely time consuming and made

effective liquidation of a bankrupt company’s assets extremely onerous.

The act also called for

accountants to maintain books of account and required them to be balanced. It required balance

sheets to be presented to shareholders and required external auditors to be given unrestricted

access to the information necessary to perform their audits.

This was remarkably modern given

that similar accounting laws in the United States were as recent as 1934, but it was also

primitive. The spirit of the law was to regulate minimum disclosure of companies and banks in

order to achieve a comprehensive financial picture. However, many of these requirements were

reversed for public companies by the Joint Stock Companies Act of 1856 and “compulsory

accounting requirements and compulsory audit for registered companies were abandoned.”

the face of this deregulation of public companies, banks were still required to have annual audits

and produce financial statements.

This lack of independent auditors and accounting requirements in 19

century British

industry is one of the most significant reasons for the rise of the conservatism principle in

modern accounting. It would not be until 1900, after a series of disastrous bankruptcies, that all

regulated companies would again be required to provide audited financial statements.

It is in

Littleton and Yamey, p.357

Ibid. p. 356

Ibid. p. 361

Miranti, p. 30

12 Garrison, Matthew

this frame of reference, the deregulation of business and overregulation of banks during a period

of tremendous growth, that we can begin to examine the origins of conservatism.

Similar to the situation of the medieval steward concerned for his wellbeing, even into

the 20

century accounting conservatism was rooted partly in fear. Replacing the medieval lord

was the court system, which consistently ruled in favor of plaintiffs suing accountants who were

not prudent (conservative) enough in their estimations. In Newton v. Birmingham Small Arms Co

Ltd (1906), the English court held “Assets are often, by reason of prudence, estimated and stated

to be estimated, at less than their probable real value. The purpose of the balance-sheet is

primarily to shew that the financial position of the company is at least as good as there stated, not

to shew that it is not or may not be better.”

Coincident with the deregulation of business in the mid-1850s, a vast series of

bankruptcies and lost investment funds occurred. A look at statistics of British start-up

companies provides an excellent tool with which to understand the harshness of British industry

at the time.

25.6 per cent of the companies formed 1856-65, 30.3 per cent of the companies

formed 1866-74 and 33.4 per cent of the companies formed 1875-83 ended in

insolvency. For the whole period 1856-83, the average is just over thirty per

cent. Of the companies formed 1856-65 half of the liquidations took place

within the first six years of existence; of the 1866-74 liquidations half took place

within the first five years of existence; of the 1875-83 liquidations half took

place within the first four years of existence.

Robert Parker, professor of accounting at the University of Exeter, asks if the initial

conservatism was natural or a product of the business environment. This question is significant;

Basu, 2

Parker, Robert H. Papers on Accounting History. New York: Garland, 1984. Print. p.23

Conservatism in Accounting 13

the opening paragraph of this paper refers to Marsh Clive’s statement that conservatism is in

harmony with the way the brain functions. However, it is clear that the origins of the modern

accounting profession took place in an environment where conservatism was not only rooted in

its history and encouraged, but necessary for survival.

While accountants did very well during

the boom years of British trade, when a massive downturn of the economy in the mid-19

century occurred, they were blamed as the reason that no one saw the rash of bankruptcies

coming. With such alarming numbers of bankruptcies, any tendency to overestimate profits

would be met with harsh scrutiny by the government, banks, and shareholders. Anthony

Sampson describes this origin as having a history filled with a “vivid sense of disaster”

which

no doubt contributed to conservatism in the issuance of financial statements.

The British belief that conservatism was necessary quickly made its way to America.

“Following the American Civil War, the United States quickly emerged as a rapidly growing

industrial power. Throughout the 1870s, and especially the 1880s, British capitalists invested

heavily in the robust American economy. To oversee their financial interest, British investors

increasingly engaged their accounting firms to make periodic visits to the United States.”

British investment in America was nothing new; after all, the United States had formerly

been one of Britain’s chief sources of timber, tobacco, and cotton. However, it was not until the

Industrial Revolution was in full swing that massive amounts of foreign capital begin to pour in

from the United Kingdom.

“Though accountancy as a business function dated back to antiquity, the

organization of a substantial service industry to provide counsel about these

Parker, p.24

A. Sampson, Anatomy of Britain Today, London, Hodder & Stoughton, 1965 p.525

Allen, David Grayson, and Kathleen McDermott. Accounting for Success: A History of Price Waterhouse in

America, 1890-1990. Boston: Harvard Business School, 1993. Print. p.3

14 Garrison, Matthew

matters was one of the many new outgrowths of the nation’s industrialization.

Initially organized in Britain more than a generation earlier, the profession of

public accountancy first flourished in America during the 1880s as a result of the

growing need among businessmen and investors for objective economic

data.”

When British shareholders started encouraging their operations overseas be audited and

examined by British accounting firms, firms such as Price, Waterhouse & Co. (PW) began to do

business in the United States.

PW’s first visits to the United States were as early as 1873, but

“despite his strong disinclination to create branch offices, Waterhouse acknowledged by 1887

that ‘the business was growing and an American connection was springing up which made it

necessary for us to send Mr. Sneath, or a principal clerk, frequently across the Atlantic.’”

Even

still, it would not be until 1901 that PW established a self-sustaining office in America.

While

accounting and accountants had existed long before British professional firms influenced the

American accounting profession, their influence was very significant and lasting. The practices

and concepts that were brought with these British accountants to the New World would

proliferate quickly among their American counterparts. British accounting has made enormous

impacts on the American profession and to this day two of the Big Four accounting firms remain

headquartered in London despite earning a sizeable portion of their revenues in the United

States.

Why is adding or removing an accounting concept necessary at all? Given the trust that

stakeholders place in fairly represented financial statements, the importance of ethical conduct

Miranti, p. 25

Ibid. p.12

Ibid.

Ibid. p.27

"PwC London HQ Achieves Highest Ever Environmental Rating for a UK Office. - Press Room." PWC Headquarters.

PWC, n.d. Web. 20 Nov. 2014. "EY Facts and Figures." EY Facts and Figures. Ernst and Young, LLP, n.d. Web. 20

Nov. 2014.

Conservatism in Accounting 15

cannot be understated. Although there have been claims of negligent accountants from antiquity

to Enron, the profession as a whole has enjoyed a very positive reputation among businesses,

governments, and the population for being trustworthy. Stakeholders have relied on the word of

accountants for investment decisions for centuries. This positive perception is based on, and

influenced by, the adherence to codes of conduct set forth by the profession itself. For

generations before Sarbanes-Oxley

, the profession was self-regulated by professional

organizations of accountants.

The success of the early chartered accountants also stemmed, in part, from their ability

to build confidence among other important social groups. Accountants had to convince them

that their new concept of professionalism was a valid substitute for older sources of authority ,

which were breaking down because of the changes brought by industrialization…The wealthy

classes in British society needed new technical experts to certify the truthfulness of the

information that influenced key investment decisions; they needed experts who possessed the

same degree of personal integrity and honor expected from the older, local sources of

authority.

The significance of professionalism and integrity among accountants can be found in the

tendency for professional organizations to be formed worldwide as the profession developed.

The oldest society of professional accountants, the Collegio dei Rexonati, was founded in Venice

in 1581, less than a hundred years after Paciolo’s Summa. This society required a 6 year

apprenticeship, and a two-thirds vote of approval for new members to be admitted. “By 1669 the

college had become so powerful that no Venetian could do accounting work, either in connection

with public administration or the law, unless he was a member.”

Passed by Congress in 2002, the Sarbanes-Oxley Act was written to protect users of financial statements from

fraud and accounting misstatements.

Miranti, p. 31

Brown, p. 177

16 Garrison, Matthew

Centuries later in Britain, this process continued in an almost identical fashion. The

profession ensured that only “reliable” men would become accountants (and they were all men).

“Through professional associates, chartered accountants built confidence that their members

were both technically competent and morally fit. To this end, candidates for admission were

required to serve a five year apprenticeship under the direct guidance of a chartered accountant

and successfully complete a rigorous four-part examination administered by the Institute of

Chartered Accountants.”

With the activity and influence of British accountants in America, it is not unreasonable

to presume these organizations would make their way to the United States. While more fluid,

dynamic, and politically involved than their brother organizations across the pond, American

accounting organizations still promoted this concept of self-governance and self-regulation.

The perception stakeholders have of accountants as unbiased professionals who adhere to rules,

ethics, and morals makes having an illegitimate accounting principle harmful. Accountants are

bound to an ethical code of conduct both voluntarily and legally which stems from the idea that

accountants are the gatekeepers for highly reliable financial information. The public places an

enormous amount of trust in the opinions issued by external auditors, and having the accounting

principle of conservatism that introduces bias and errors into financial statements conflicts with

fairly presented financial statements on which users depend.

One example of this adherence to a principle in contrast to ethical values is the lower of

cost or market concept (LCM). This concept requires recording assets at either their cost to the

company or the current market price – whichever is lower. This is done in order to ensure the

Miranti, p. 31

Ibid. p. 6

Conservatism in Accounting 17

assets (and therefore the company) are not overvalued. However, even in the early years of lower

of cost or market, people understood the need to account for their inventory accurately, rather

than merely guessing on the safe side. “Alexander Malcom (1731) preferred cost to using ‘the

current Rates’ since ‘it seems more reasonable to value goods as they cost you; for otherwise you

bring in Gain or loss into your accounts, which has not yet actually happened and may, perhaps

not happen.”

Clearly, conservatism in America and Britain should have never existed. The idea that

accounting records should show the most accurate figures was not anything new. A.C. Littleton

explains, “Whereas value is an estimate of what price ought to be, price itself is an established

fact…When accounting is loosed from this anchor of fact it is afloat upon a sea of psychological

estimates which, however important they may be to business management, are beyond the power

of accounting, as such, to express.”

The need for objective economic data outweighed the need of the company to estimate

conservatively, yet there are numerous examples, such as LCM, of accounting concepts and

procedures that were based on conservativism that led to companies being unable to obtain

financing and to opportunities for fraudulent reporting. Despite conservatism largely being a

result of heavy debt financing and banking requirements, conservative estimate requirements

may have hurt banks as well by disallowing companies that were otherwise capable of repaying

the loans from obtaining financing.

Despite attempts by Parliament to regulate business financial reporting, conservatism was

still entrenched in business. The British practice of conservatism became even more standardized

Parker, Robert H. Papers on Accounting History. New York: Garland, 1984. Print. p.20

A.C. Littleton, Value and Price Accounting, Accounting Review, Vol 4 1929 pp 149, 150

18 Garrison, Matthew

in America because bankers were the most powerful users of financial statements. Businesses

were extremely keen on issuing conservative financial statements in order to obtain good

financing rates as well as using conservative reserves for income smoothing. It was not unknown

to those in charge of writing accounting regulations that conservatism made possible the earnings

manipulations that permeated businesses at the time, but the importance of conservativism for

debt financing overruled these accounting discrepancies. “The possibility of deliberate under-

statement of income did not receive attention in the legislation, though the fact that profits of

earlier years – possibly undisclosed at the time they were made – might be used to deceive the

investing public later when profits were lacking did not, as we have seen, escape all notice.”

The allowance for doubtful accounts figure is an estimate that was instrumental in

income smoothing schemes. This estimate is decided by management and creates a fixed reserve

that is used to offset uncollectible receivables as they occur throughout the fiscal year. This

reserve provides management an excellent backdoor way to meet analysts’ earnings per share

targets. By conservatively estimating future bad debts management can release these reserves

into earnings to meet targets. Other methods such as accelerated depreciation methods,

expensing advertising costs are also unconditional.

They are conservative in nature and applied

consistently regardless of timing.

These methods all provide opportunities to deliberately mislead financial statement users,

and contribute to an undervalued organization on the books. Expensing certain costs eliminates

them from the balance sheet and makes them appear to no longer benefit the organization. “For

example, R&D expenditures could provide future benefits to the firm in the form of future sales.

Littleton and Yamey, p.356

Ruch, George W., and Gary Taylor. "Accounting Conservatism: A Review of the Literature." Journal of Accounting

Literature 34 (2015): 17-38. Print. p.21

Conservatism in Accounting 19

However, the immediate expensing of R&D under conservative accounting ignores these future

benefits by prohibiting accounting from capitalizing the expenditures.”

Similarly, book

depreciation methods that write down assets more quickly than their actual depreciation

(meaning, the physical deterioration of the equipment) skew the perception investors have of the

company’s fixed assets.

Yet another example of earnings management made possible by conservatism is the

manipulation of profit to reduce income tax expense. In the early 20

century, when countries

began taxing corporations via income tax, corporations realized that by exercising unconditional

conservatism they could limit their tax expense. “The introduction of corporate income taxes in

the early 20th century generated a demand for unconditionally conservative accounting methods

to minimize taxable income, and these new methods influenced financial reporting. As Ball and

Shivakumar (2005) point out, the muddling together of conditional and unconditional

conservatism probably caused more confusion about the desirability of conservatism.”

As mentioned by Sudipta Basu above, conditional conservatism is applied differently

than unconditional conservatism. An example of conditional conservatism is the asymmetry

between gain and loss contingencies. Firms are required to recognize losses as soon as they are

probable and the amount can be reasonably estimated, however the standard for gain

contingencies borders on absurdity with respect to the requirements that must be met to even

disclose them in the financial statements. Generally speaking, a gain must be realized before it

can be reported whereas a loss is reported as soon as the amount and nature of the loss are known

to the company. This creates a discrepancy in the financial statements; they may have recorded

Ibid. p. 25

Basu, Sudipta. "Conservatism Research: Historical Development and Future Prospects." China Journal of

Accounting Research 2.1 (2009): 1-20. Web. 15 Feb. 2015. p.3

20 Garrison, Matthew

or disclosed losses, which need to satisfy a much lower standard, but miss gains that will be

realized that have not yet met the standard for disclosure.

While some unscrupulous businesses undoubtedly enjoyed the ability to manage earnings

by using conservatism, the confusion that emanated from “conditional” and “unconditional”

conservatism has served to hasten the demise of conservatism among ethical and academic

accountants. American bankers, the most powerful users of financial statements, were protected

by conservatism. This created a system where conservatism was encouraged in spite of the

knowledge that it was inappropriate. Accountants were sued for not being conservative enough,

and businesses faced high interest rates or outright denial of financing if their financial

statements did not abide by bank standards of conservatism. Indeed, even today accountants risk

being sued for failing to find financial misstatements during audit. “Today, the emphasis on

assistance to management has been overshadowed by the specter of liability to third parties.

Indeed, some CPAs would assert the pendulum has swung too far toward an adversarial

relationship between independent auditors and management…”

This fear may be responsible

for knowledgeable accountants to continue using conservative estimates.

To understand the influence banking and debt financing had on conservatism’s origins

and pervasiveness in accounting, it is necessary to understand the origins of corporate finance.

Going back to antiquity, business ventures were financed with debt. An individual, government,

or bank financed a company on the basis that they were to be paid back over a period of time.

This form of finance requires a degree of trust that the company or person to whom the money is

Olson, Wallace E. The Accounting Profession: Years of Trial, 1969-1980. New York: American Institute of Certified

Public Accountants, 1982. Print. p. 15

Conservatism in Accounting 21

loaned will be able to pay the lender back. This form of finance was the most significant reason

that financial statements and auditors became necessary.

Lenders wanted to be able to see the company’s performance and wanted some sort of

independent verification that the company was doing well. This method of raising capital also

contributed to the conservatism principle being applied in the accounting records. Lenders

wanted to know that the financial statement figures they were looking at were not overstated in

any way. In The History of Corporate Finance, Jonathan Baron Baskin and Paul Miranti Jr.

explain the dependence upon debt as a source of corporate capital, and relatively infrequent use

of common stock before the early 20

century.

“Besides providing the primary source of seed capital, debt was also the means by which

most additional funds were solicited from the public. Nominal funded debt in 1913, for example,

amounted to $11.2 billion, compared with $7.2 billion of par value common stock. But these

figures actually understate the heavy reliance on debt.”

This reliance on debt continued through

the 1960s when Miranti claims that “managements of center firms were generally loathe to

finance their activities by issuing equity.”

This partly stemmed from issues pertaining to

diluting ownership of companies among current owners. Managers of corporations were strongly

disinterested in any changes that may upset their ability to manage effectively.

Common stock only became a major source of corporate finance relatively recently.

While the practice of investors owning stock in companies had existed for hundreds of years, it

was not until the late 20

century that public shares of corporations began to raise significant

Baskin, Jonathan Barron, and Paul J. Miranti, Jr. A History of Corporate Finance. Cambridge: Cambridge UP, 1997.

Print. p. 150

Ibid, p. 244

Ibid, p. 15

22 Garrison, Matthew

capital. “Total annual share turnover rose from 159 million in 1900 to 1.1 billion at the height of

the 1929 boom; the value of preferred and common stocks underwritten amounted to $405

million in 1910 and increased to $9.5 billion in 1929…”

This growth in equity was quickly

stunted by the Great Depression, and only began increasing again in the 1950s and 1960s. Once

equity financing did become popular again, conservatism became less and less accepted by

financial statement users.

Debt financing strongly affects the financial statements which is why conservatism was

so deeply entrenched in the fabric of financial reporting. In Is Financial Reporting Shaped by

Equity Markets or by Debt Markets?, Ray Ball, Ashok Robin, and Gil Sadka analyze 78,949

annual earnings reports from 22 countries regarding the effect debt has on financial reporting.

They conclude, “These results are inconsistent with the basic premise of the influential “value

relevance” school of accounting thought, in which financial reporting exists primarily to inform

equity markets. This viewpoint is implicit in studies that use the R2 measure of association

between market prices and financial statement variables as a financial reporting criterion. In

contrast, the results are consistent with the “costly contracting” school of accounting thought,

and in particular with the hypothesis that the debt market exerts a substantial impact on

accounting practice.”

As implied earlier, conservative accounting practices have some debt-related benefits.

Jieying Zhang’s research indicates “...that lenders lower the interest rates they charge to

conservative borrowers.”

For companies which are not public where the risk of misinforming

Ibid, p. 168

Is Financial Reporting shaped by debt Ball Robin etc p.34

Zhang, Jieying. "The Contracting Benefits of Accounting Conservatism." Journal of Accounting & Economics 45

(2008): 27-54. Science Direct. Web. 20 Mar. 2015. p.28

Conservatism in Accounting 23

owners and users of financial statements is low (i.e. sole proprietorships) and for banks issuing

loans to such companies the ability to have a “worst case” balance sheet and income statement

may be seen by some to reap tangible benefits for both parties with minimal risk.

However, ideas such as these are still problematic. Private companies, even more so than

public companies, must do their best to keep their books at the fairest value possible. This is

necessary due to the possibility and ease with which privately owned companies may be sold. In

such cases it is necessary for both the buyer and seller to obtain a true valuation of the company,

but this true valuation is hampered by conservative accounting.

With worst case balance sheets the banks are receiving information that can point to a

default at the earliest time possible. The point in time at which a loan covenant is violated is

always going to be earlier if conservatism is used because the financial statements are always

portraying the worst possible scenario. If bankers are quick to learn of impending default, they

stand to recoup more of their loan amount. Zhang expands on this idea by explaining that

conservative accounting practices reduce the amount of fees and costs associated with

renegotiating loan covenants and recovering losses. This ends up being a net positive for lenders

as the likelihood of default is lowered.

However, Zhang’s research does not include a broad enough spectrum of conservatism.

There was no research conducted of companies financially able to pay off debts which were not

afforded opportunities for financing due to onerously conservative lending requirements and

accounting practices. While Zhang’s research shows that conservatism does indeed reduce

interest rates for borrowers, it does not show other negative aspects inaccurate financial reporting

has on the company’s bottom line. Additionally, the type of research necessary to understand if

banks are losing money by refusing financing to capable companies is impossible to perform

24 Garrison, Matthew

(due to lending requirements). The research also completely ignores the possibility that

companies using conservatism in financial reporting may be doing so in a manner that is solely

intended to meet specific requirements of lenders.

Zhang’s claim that “the evidence in this paper has implications for standard setters when

they consider the tradeoff between relevance (which favors fair value) and reliability (which is

often associated with conservatism in practice)”

implies that lower interest rates and early

detection of default risk are more important than fairly presented financial statements. This line

of thinking is consistent with the scenario when debt financing and bankers were the primary

influencers of accounting regulations, but with today’s use of equity financing there are negative

aspects to conservative reporting that outweigh any potential interest rate savings.

Just as debt financing’s influence on accounting led to conservative accounting

principles, banking’s influence on the profession was equally strong. Until the 1970s, the lack of

independent oversight over the accounting profession itself and the influence of bankers was

significant. The Financial Accounting Standards Board (FASB) was created in response when it

was appointed by the SEC in 1973 to replace the Accounting Principles Board. Generally

speaking, FASB is now responsible for writing the Statements of Accounting Concepts which

form the Generally Accepted Accounting Principles (GAAP) that regulate the procedures used in

the accounting profession. The board has its roots as a subsidiary of the Financial Accounting

Foundation (FAF) in the 1950s when, after World War II, the increasingly complex

modernization and global integration of business began to require accounting procedures that

were globally compatible.

As mentioned above, before this time the profession of accountancy

Ibid. p28

“Comparability in International Accounting Standards—A Brief History” Financial Accounting Standards Board

FASB, September, n.d. Web. 5 March 2014.

Conservatism in Accounting 25

was overseen by internal organizations such as the American Institute for Certified Public

Accountants’ Accounting Standards Board.

There was a belief, especially in the United States, that accounting was strictly “in-

house” business. This was due in part to CPAs not wanting to create rules that may harm current

clients, and an overall feeling that the profession should not be significantly regulated by outside

entities. However, as the economies of different countries became more intertwined with the

economy of the United States, a set of accounting principles that were generally accepted among

all firms became necessary to allow for financial statement comparison. These changes began

taking root when FASB was created.

“Unlike predecessor bodies, which had been exclusively controlled by the accounting

profession, the FAF was supported by a host of statement user and issuer groups. In addition, the

seven-member FASB included three voting members drawn from outside the public accounting

profession. The FASB was served by a large professional staff, which did research in support of

prospective practice standards; it also undertook an ambitious project to define the basic

conceptual framework for financial accounting”

This change was significant as it created a

formal body, which included professionals other than accountants and bankers, that could create

and amend accounting rules by which all firms would abide. These changes were crucial to the

accounting profession, as before this time there were no principles accepted on a large scale.

This change included an acknowledgment that conservatism had no place in financial statements.

It is worth noting that the first volume of Accounting Principles, published the same year

FASB became the focal point for standardization

, mentions the following with regards to

Miranti, p 228

Ibid, p 229

26 Garrison, Matthew

conservatism: “A write-down of assets below amounts which are likely to be realized thereafter,

though it may result in conservatism in the balance sheet at the readjustment date, may also

result in overstatement of earnings or of earned surplus when the assets are subsequently

realized. Therefore, in general, assets should be carried forward as of the date of readjustment at

fair and not unduly conservative amounts…”

As the influence of bankers began to wane, equity financing became more popular, and

professional users of financial statements began to use financial statements as forward looking

items, the degree of conservatism tolerated in financial statements decreased quickly and

substantially. Less than a decade after the formation of FASB, in the Statement of Financial

Accounting Concepts No. 2, FASB argued “There is a place for a convention such as

conservatism—meaning prudence—in financial accounting and reporting, because business and

economic activities are surrounded by uncertainty, but it needs to be applied with care.”

The 1996 GAAP

accepts an understanding that conservatism can lead to issues with

financial statements in the future. “Conservatism in accounting may mislead users if it results in

a deliberate understatement of net assets and net income. Such understatement is undertaken to

minimize the risk of uncertainty to outside lenders. Unfortunately, such understatements often

lead to overstatements in subsequent years, produce biased financial statements, and conflict

with the characteristics of representational faithfulness, neutrality, and comparability.”

By the 2000s FASB and others were beginning to analyze the effect conservative

reporting had on equity users of the financial statements. Conservatism was driven by debt

APB Accounting Principles, as of June 30, 1973. Vol. 1. Chicago: Commerce Clearing House, 1973. Print. p.5581.04

"Statement of Financial Accounting Concepts No.2" Financial Accounting Standards Board FASB, May 1980. Web.

5 March 2014.

GAAP Interpretation of Generally Accepted Accounting Principles Delaney 1996 John Wiley Sons Inc. New York

Conservatism in Accounting 27

investors who wanted a worst case scenario of the financial statements in order to ensure the

company would remain a going concern. However, equity investors’ interests lie in seeing that

the company is profitable and, more recently, that the earnings per share figure is correct and as

high as possible. In Accounting Conservatism and the Cost of Equity Capital: UK Evidence, Ann

Chan, Stephen Lin, and Norman Strong acknowledge the following:

Supporters of ‘‘normative’’ accounting theory widely believe that a firm with a

higher degree of conservatism should be associated with higher quality earnings

and therefore a lower cost of capital. Recent empirical evidence, however, does

not fully support this view. Givoly and Hayn (2000, 2002) find that earnings

conservatism increased in the USA during 1950-1998, contributing to a decline in

reported profitability and an increase in earnings dispersion, and coinciding with

declining earnings quality (Francis and Schipper, 1999; Barth et al., 1998; Collins et

al., 1997). Penman and Zhang (2002) examine the effect of the interaction

between conservatism and changes in investments on the quality of earnings.

They find that when a company practices conservative accounting and its change

in investments is temporary, current earnings are depressed or inflated and

therefore are not a good indicator of future earnings. Thus, conservative

accounting practice may not necessarily lead to good quality earnings, measured

by earnings persistence and predictability.

They put together compelling evidence showing that conservatism’s effects, at least in

conditional conservatism (what the authors refer to as earnings related or ex post), are

detrimental to equity users of the financial statements primarily due to the ease which

management can manipulate earnings. It is relatively well documented that earnings related

conservatism may result in investor scrutiny of financial statement figures as it allows for

relative ease of accounting figure manipulation. While their research indicated that unconditional

(balance sheet or ex ante) conservatism did contribute to higher quality financial information

even when accounting for ex post, they recognize that other research has shown the opposite of

Chan, Ann L.-C., Stephen W.j. Lin, and Norman Strong. "Accounting Conservatism and the Cost of Equity Capital:

UK Evidence." Managerial Finance 35.4 (2009): 325-45. Web.

28 Garrison, Matthew

their conclusion in that “conservative accounting practice may not necessarily lead to good

quality earnings, measured by earnings persistence and predictability.”

The difference of

whether or not ex post conservatism simply outweighs ex ante conservatism and results in these

earnings inconsistencies is an opportunity for future research.

This discussion of equity financing and conservatism’s role in the future culminated in

Accounting Concept Statement No. 8, published in 2010 which supersedes Accounting Concepts

Statements No. 1 and No. 2. This concept further delegitimized conservatism by clarifying that

financial reporting should be a faithful representation of the company’s true financial situation.

While accounting procedures such as LCM, accelerated depreciation, and others still resulted in

conservative reporting through their use, conservatism itself was discarded as a generally

accepted accounting principle with this concept.

Deliberately reflecting conservative estimates of assets, liabilities, income, or

equity sometimes has been considered desirable to counteract the effects of

some management estimates that have been perceived as excessively optimistic.

However, even with the prohibitions against deliberate misstatement that appear

in the existing frameworks, an admonition to be prudent is likely to lead to a bias.

Understating assets or overstating liabilities in one period frequently leads to

overstating financial performance in later periods—a result that cannot be

described as prudent or neutral.

By removing “prudence” as an aspect of reliability, the emphasis has shifted

to verifiability. Prudent estimates

and accounting practices introduce bias into the

financial statements which makes them inherently unfair.

Ibid.

"Statement of Financial Accounting Concepts No.8" Financial Accounting Standards Board FASB, September

2010. Web. 20 March 2014.

Reckless and overly optimistic estimates contribute to bias in the financial statements as well, but the emphasis

is on accuracy and verifiability – absent bias in either conservative or optimistic directions.

Conservatism in Accounting 29

Conservatism is no longer a principle of accounting. It developed as a result of the

influence that banking and debt financing had on the accounting profession and industry as a

whole. Early on, it became apparent that conservatism was being used as a tool for managers to

store reserves and smooth earnings. Conservatism also introduces a measure of unpredictability

into financial statements that prevents accurate record keeping. With conservative estimates

being made, users have no idea how much conservatism is in a given financial statement, and

whether that degree of conservatism is consistent with the user’s own judgment. Now that users

of financial statements other than bankers have influence in writing accounting regulations, we

have seen the beginnings of a codified escape from conservative doctrine. Accountants are the

scorekeepers and must provide an objective, faithful, and accurate assessment of a company’s

business using widely accepted principles. These assessments must allow investors and managers

to make rational judgments without shaving points for either team. While this has been known

for centuries, it’s about time that it has been put into practice.

30 Garrison, Matthew

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