Conservatism is arguably one of the most prominent and prolonged characteristics in accounting practices (Basu, 1997). Over the centuries, many researchers have accomplished in-depth reports and thoughtful analysis regarding different focuses on conservatism. Literatures related are abundant and fruitful.
In next section, this paper will firstly give a brief review on a number of related literatures. Follows that, some of the most significant motivations to adopt conservatism such as contracting demand, litigation pressure, agency problem, tax implication, regulation concern and political economy will be discussed in section three. For the purpose of construction, ...view middle of the document...
The result that sensitivity of earnings to negative returns (bad news) is two to six times the sensitivity to positive returns (good news) evidently affirm the existence of conservatism in financial reporting.
Factors that affect accounting conservatism are also widely analyzed. Ball and Shivakumar (2005) proposed that conservatism helps to address agency problems. Lafoud and Roychowdhury (2008) found a negative correlation between managerial ownership and conservatism. Chi et al. (2009: 57) complemented their arguments by indicating that “conservative accounting serves as a substitute for other governance mechanisms in alleviating agency problems”.
From other perspectives, Bushman (2006) investigated the influence of legal and political institutions as incentives for conservative financial reporting. Li (2008) pointed out that the reduction in firms’ cost of debt and equity capital resulted from conservatism helped to explain the long existence of conservative reporting. And watts (2006) concluded that debt contracting is significantly associated with accounting conservatism.
As suggested by Watts (2003), accounting practices has become even more conservative in the last three decades. Clearly, this implies that the benefit of conservatism outweighs its shortcomings. Some of the motivations for firm to adopt conservatism will be identified and explained in the next section.
3.0 Motivation for accounting conservatism
3.1 Agency problem
As claimed by Watts (2002), the main objective for accounting conservatism is to alleviate agency problem (between shareholders and manager, or between shareholders and debt holders). For instance, if the owner or shareholders of a firm need to sign a contract with a manager, they must be in deep concern about whether the manager would acquire detectible overpayments or impair the company in pursue of his own interest because asymmetric information are inevitably involved between them (managers knows more about the firm than investors). As a result, investors (as well as debt holders) seek to be sheltered under a lower bound evidence of the effect of the manager’s actions. Fortunately, conservative reporting provides an estimation of the lower bound of net assets, which is a good proxy of the result of manger’s actions in the worst condition. Therefore, conservative reporting is partly a result from the agency problem and asymmetric information in the market.
3.2 Contracting explanation
Another motivation for conservatism is the contractual application of accounting measures. It is a fact that the court system can only enforce contracts which are written on verifiable information variables. Besides, one or more parties with asymmetric payoffs in the contract (e.g. debt holders can not benefit from the upward movement in firm value but must bear the downside risk) would demand higher verification requirements for good news. Consequently, for a contract to be optimally designed, verifiable...