Matthew Cranley Rachel Reynolds English 10600 20 November 2013 Article Analysis Ross L.

Watts is a retired Accounting and Management professor the Massachusetts Institute of Technology Sloan School of Management. He wrote a scholarly article,

Conservatism in Accounting Part I: Explanation and Implications, in 2003 speaking of the

conservatism in accounting that exists today. Extreme conservatism in accounting can be exemplified through the old adage, anticipate all losses, anticipate no profit. It says that no accountant should be expecting to make profit without reasonable belief. The ideas of conservatism is explained through Watts four major explanations: contracting, shareholder litigation, accounting regulation, and taxes. Most importantly, the concept that explains why conservatism is so prevalent is negotiating contracts. Conservatism can be simply defined as the idea to slowly and efficiently evaluate all concepts of accounting. It is promoted through contracts for many reasons as explained later. Watts explains the biggest reason is to eliminate opportunistic behavior in short term managers. Opportunistic behavior is is taking advantage of another person for ones own benefit. Conservatism in accounting contains this by making all parties of the contract deeply act within reason to evaluate a liable contract. The reason it must be done is because short term managers who know that they will soon not be with a firm anymore can make rash decisions and act negatively upon projects. They would make sure that all of the short term money would flow immediately to them and once they leave the firm their project

would fail because all of the money was withdrawn. Conservative actions must be taken while creating contracts or it would negatively impact everyone in the business world. In addition to Watts explanations, contracting is the prime explanation to why conservatism still exists in accounting today. Contracting is the legal agreement between two separate parties. The reason contracting is so necessary in business is because there are thousands of companies in the world that have transactions with other companies and people. Due to the plethora of contracts necessary to operate these companies, extreme care must be taken when creating these contracts. Except, contracts can only be created with verification. Verification is data that can be recognized by both parties. Verification must be necessary for the contracts to be enforced in the court of law. An example of non-verified data is data that assumes profit or losses. It is extremely difficult to be accurate in depicting losses versus profits. If a firm is operating and expecting future cash flows and places the cash flows into a contract, there is no legal liability for the cash flows. In end, this would make firms look over their verifiable claims. If it is not verifiable, it cannot be legally contracted. Verification is necessary for conservatism in accounting is because verification is extremely necessary in contracts. Also, verification enforces that conservatism exists in creating contracts in accounting by making each side of the contractual agreement sit down and evaluate the contract. If no verification was necessary, the contracts would be rushed and would most likely end up in favor of one of the parties. If conservatism never occurred in contracting and accounting, it would have a negative impact in all of the business world. Verification is necessary for creating contracts. Suppose that none of this was necessary. Firms would seen become lazy. With no reason at all to deeply evaluate contracts. Firms would only create contracts that benefited there own personal and

financial needs which would put the other end of the contractual agreement in unfavorable positions. This brings back up the concept of opportunistic behavior. Firms would only act in ways that would benefit their own company. If the hundreds of firms that exist today only worked to benefit themselves and not help any other companies receive profit, it would create mayhem in the business world. Weak and financially troubled companies would be forced into contracts that leaves them with an unfair and undeserved result of money. Business keeps the world functioning to what it is today. Countless of companies and firms have their own niches and ideas that keep them running. They all have conservatism in accounting in common. The reason is because conservatism in accounting is the only way that can keep the thousands of companies functioning at one time. Conservatism is best shown through its use in creating contracts. If the FASB successfully bans conservatism in accounting, it would have unintended consequences and managerial behavior. Consecrative actions must be taken in accounting to while creating contracts to have a positive effect in the business world today.