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Journal of Accounting and Economics 50 (2010) 287–295

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Journal of Accounting and Economics


journal homepage: www.elsevier.com/locate/jae

Discussion of ‘‘Implications for GAAP from an analysis of positive


research in accounting’’$
Richard Lambert n
Department of Accounting, 1307 Steinberg Hall-Dietrich Hall, The Wharton School, 3620 Locust Walk, University of Pennsylvania, Philadelphia, PA 19104, USA

a r t i c l e in fo abstract

Available online 1 October 2010 This paper discusses the paper ‘‘Implications for GAAP from an Analysis of Positive
JEL classifications: Research in Accounting,’’ by Kothari, Ramanna, and Skinner (in press). I discuss the role
M41 that information can play in efficiently allocating capital in the economy, and I argue
M44 that the GAAP is not primarily designed with the objective of addressing ‘‘control’’
M45 issues, i.e., resolving contracting problems between shareholders and managers or
between shareholders and bondholders. I also discuss the impact that conservatism has
Keywords: on the properties of accounting numbers, and on how it affects the usefulness of these
GAAP numbers in managerial incentive contracts and in contracts with bondholders.
Fair value & 2010 Elsevier B.V. All rights reserved.
FASB
IASB

1. Introduction

The paper by Kothari, Ramanna, and Skinner (KRS) (in press) begins with the premise that the role of accounting is to
aid in allocating resources efficiently in the economy. It then seeks to determine how accounting would be structured to
perform this task. While the KRS paper touches on many issues, my discussion will focus on two. First, the paper concludes
that the ‘‘control’’ role of accounting dominates the ‘‘valuation’’ role.1 Second, the paper concludes that conservatism and
verifiability are critical elements of accounting. I agree that control and stewardship issues are (or should be) important to
accounting, but don’t agree that that makes them the primary purpose of accounting. I strongly agree that conservatism
and verifiability are important elements of accounting, but not necessarily for the same reasons as the authors argue.
Further, I don’t believe these features of an accounting system should trump other characteristics of accounting that also
affect its usefulness.
It is not clear what the debate regarding conservatism and verifiability really is. More specifically, I don’t think the
debate is properly focused. There is no debate that conservatism is (and always has been) an important element of
accounting. For example, internally developed intangibles aren’t recognized. This is an example of unconditional
conservatism. Accounting rules forbid firms from writing up the values of many assets, but require write downs to be
recognized. This is conditional conservatism. Similarly, a fundamental tenet in accounting is that you can’t recognize

$
DOI of original article:10.1016/j.jacceco.2010.09.003
n
Tel.: +1 215 898 7782; fax: +1 215 573 2054.
E-mail address: lambertr@wharton.upenn.edu
1
While the term ‘‘control’’ could be viewed to encompass an extremely broad set of activities, the authors intend this to primarily refer to
performance measurement and stewardship. Even the term ‘‘performance measurement’’ is so broad that valuation could be viewed as a subcategory.
Unfortunately, there is no generally agreed upon name for the ‘‘non-valuation’’ role for accounting information. Stewardship is the term more commonly
used by standard setters in their discussions of the objectives of accounting.

0165-4101/$ - see front matter & 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2010.09.006
288 R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295

revenue until it is earned. Verifiability has also always been important in accounting. For example, the relevance versus
reliability tradeoff is common in many discussions of accounting issues. All of these things are so important and
fundamental that we make sure to mention them on the first day of Accounting 101. However, the importance of these
concepts to accounting does not imply that the purpose of accounting is to contract with managers and debt holders.
Conservatism and verifiability can also be justified (in part) from a valuation perspective, as we will discuss below.
Moreover, it is important to recognize that conservatism and verifiability are not zero-one, or all-or-nothing variables;
they are continuous variables. Virtually every item on a balance sheet involves some degree of subjective unverifiable
projections by managers. This includes such ‘‘simple’’ assets as accounts receivable (what percent won’t be collected?) and
property plant and equipment (what is the correct useful life and residual value?). While many items in financial
statements are accounted for conservatively, many are not (e.g., many financial assets). In fact, the biggest change in
accounting over the past 20 years has been the increased use of fair value accounting.2 Fair values are neither conservative
nor (in many cases) easy to verify. Given the diversity of treatments for different items, the better and more interesting
question is what degree of conservativeness and verifiability is optimal? In particular, how are these qualities to be traded
off against other features of accounting information? For example, how unverifiable does an item need to be to justify
conservatism instead of ‘‘fair’’ value (or something else)? Where do we draw the line? What is the ideal combination of
conservatively measured and non-conservatively measured items? These are the more interesting questions, yet the
literature has almost no discussion of these questions.
Next, I turn to the issues of control and stewardship. There is no question that incentive problems between managers
and shareholders are important, and that there can also be substantial conflicts between the interests of bondholders and
shareholders. Accounting systems play a significant role in attempting to alleviate these problems (and sometimes play a
role in exacerbating them). The paper does a good job of summarizing and integrating research that discusses these
conflicts of interest and the role that accounting can play in controlling them. Indeed, much of the reason for requiring
financial statements to be audited by an independent party is because managers cannot be relied on to truthfully report on
the performance of the firm. I agree with many of the things the authors and the literature have to say about contracting
issues. In my discussion, however, I will focus on areas of disagreement and thereby try to provide an alternative
perspective on these issues.
While stewardship (or control or contracting more generally) is an important use of accounting numbers, does
(as opposed to should) the stewardship role dominate in its influence on the structure of GAAP? This is certainly not the
consensus of accounting standard setters. In fact, standards setters, in articulating the role of accounting and the objective
of accounting standards, explicitly reject the notion that the primary role of accounting is to aid in stewardship, or more
broadly to aid in contracting. More typically, the role of accounting is defined as to ‘‘aid decision making’’ and is often
explicitly intended to be ‘‘multi-purpose’’ in nature. When they are more specific, standard setters generally cite investors
and creditors and aiding the estimation of future cash flows as more important purposes in designing accounting.3
Moreover, it is important to note that these are not the views of a few ‘‘rogue’’ standard setters. These issues have been
debated for decades and in countries throughout the world. Both the FASB and the IASB are in the process of revising their
conceptual frameworks. Their decision-making processes actively seek feedback from all constituencies and they have
discussed these topics over many years. Their statements to date continue to explicitly reject the notion that they view
stewardship as the primary role for accounting standards.
Moreover, even a casual inspection of a set of financial statements would suggest that their primary role is not to
facilitate contracting with bondholders or with managers. The major financial statements are directed towards
shareholders’ financial interest in the firm. For example net income means income to shareholders, the balance sheet
nets to the financial position of shareholders, there is a statement of changes in stockholders’ equity. All of these suggest
that they are designed to inform shareholders as to how their investments are doing. Moreover, GAAP is not just a few
summary numbers (net income, total debt, total assets). Financial statements (annual reports, 10-K’s and 10-Q’s) are
frequently more than 100 pages and often contain thousands of numbers, dozens of assumptions and supporting
schedules, tables of sensitivity analyses, etc. Other information which is not part of GAAP itself, but is packaged with the
GAAP information in the Annual Report and 10-K’s, seems clearly to be valuation oriented, not control oriented. For
example, the Management Discussion and Analysis (MD&A) is also a critical disclosure that is carefully monitored by the
SEC yet it is hard to imagine this is used solely for contracting. If all of this ‘‘extra’’ material (beyond a few summary
statistics) is largely ignored for contracting purposes, why is it there? Stated another way, suppose we started from scratch
with the objective of raising money via debt on the most favorable terms. What information would we provide when debt

2
Standard setters no longer view conservatism as a desirable attribute of accounting information. The Conceptual Framework proposed by the FASB
and IASB (2008) continues to support this conclusion. For example, Chapter 2 states ‘‘Conservatism in financial reporting should no longer connote
deliberate, consistent understatement of net assets and profits. The Board emphasizes that point because conservatism has long been identified with the
idea that deliberate understatement is a virtue.’’ However, the Board does acknowledge that ‘‘the exercise of prudence is an appropriate response to the
uncertainties inherent in preparing financial statements y However y the exercise of prudence does not allow for deliberate understatement of assets
or income or overstatement of liabilities or expenses.’’
3
See the IASB Exposure Draft on the Conceptual framework (2008) and the FASB Statement of Accounting Concepts No. 1 Objectives of FASB
(Financial Reporting by Business Enterprises) (1978) and Statement of FASB (Financial Accounting Concepts No. 2 Qualitative Characteristics of
Accounting Information) (1980).
R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295 289

was being issued, what performance measures would we develop to use over the life of the debt, and how would we
measure them? It doesn’t seem likely that our current financial statements would be the result.
Similarly, as accounting educators, our primary focus in teaching accounting is much more in the direction of valuation
than in stewardship. For example, the number of elective courses (or class sessions within other courses) we teach in
financial statement analysis is hundreds or thousands of times as great as the number of course sessions we teach on
contracting. Much of the discussion in our courses is about the use of accounting numbers in valuation settings, in relating
accounting numbers to stock prices, to analyst forecasts, in discussing investment strategies to generate abnormal returns,
in predicting financial distress, etc. These are all large, well-established research fields in accounting also.
The remainder of my discussion is organized as follows. In Section 2, I discuss the paper’s orientation, including features
I wish had been given more emphasis. I then outline an alternative framework for thinking about the role of information in
allocating resources within the economy in Section 3. Section 4 discusses the role of aggregation and summary statistics in
decision-making. Next, I delve more deeply into the use of accounting numbers in contracting with managers (Section 5)
and contracting with bondholders (Section 6). In both sections, questions related to the value of conservatism and
verifiability are emphasized. Section 7 discusses a few miscellaneous issues, and I summarize my remarks in Section 8.

2. Paper’s orientation

While the authors characterize their paper as positive in nature, it seems to have a normative flavor as well. The paper is
not designed to describe GAAP as it currently exists, or to explain the forces that make it what it ‘‘shouldn’t be.’’ Instead, the
paper argues for what GAAP should do, and what it should look like if it was designed to do that. It relies heavily on
elements of existing features of GAAP to support its arguments, but is selective about the elements upon which it relies. In
particular, many of the most important developments in GAAP over the past 20 years are ignored.
An alternative approach to a positive theory of accounting would try to explain why GAAP is the way it is today. That is,
what are the forces that led to the recent surge of pronouncements that require the use of fair value? If researchers feel that
recent shifts in the structure of GAAP are misguided, a positive theory would attempt to offer an explanation of why the
‘‘mistakes’’ were made. Ideally, such a theory would also offer some insights into the forces that would eventually undo
these mistakes.
While the paper emphasizes market forces in its development, accounting is a regulated activity in the real world, and it
has been so for nearly 80 years. A positive theory of accounting and financial reporting would ideally incorporate this into
its arguments to a greater extent. The paper acknowledges this, and it provides a short discussion of regulation in general.
As applied to accounting and disclosure in a resource allocation framework, the externalities and proprietary costs
motivation is likely to be an important one. Additional reasons for regulating accounting disclosure would stem from
concerns to reduce information acquisition and processing costs, both across firms and more importantly, for investors. In
particular, there are many potential benefits arising from providing information in a standardized and consistent fashion.
Of course, information asymmetries would be a prime ingredient in the model too. Some theories of regulation would
emphasize the role of information asymmetries between the buyer and seller of the service per se, which might be
interpreted as the firm itself and the accountants supplying the auditing expertise. However, I think the more compelling
type of information asymmetry here is the investors who are disadvantaged relative to insiders with respect to the
economic state of the firm.
In addition to considering the incentives of firms to voluntarily provide information on their own, a theory of mandated
disclosure would also consider the ability of users to demand information on their own, i.e., without the need to rely on
regulators. In fact, the exposure draft on the conceptual framework explicitly makes this point. When we think about
potential users – boards of directors, banks, loan syndicates, diffuse small shareholders, current shareholders, and
prospective shareholders – it seems likely that a regulatory approach would be more likely to consider the shareholder
groups as the ones most in need of protection.
A theory of accounting, especially a theory that attempted to tackle the issue of conservatism versus fair value, should
also consider the interests of auditors and regulators. For example, the incentives of auditors are largely driven by concerns
about their reputation and about legal liability. It is well accepted that the legal liability of auditors is generally asymmetric.
That is, auditors get sued when things go bad, not when things go surprisingly good. Auditors therefore have a natural
incentive to favor conservative standards, ceteris paribus. Moreover, many standard setters are former auditors/accountants.
While I’m not aware of much research on the incentives of accounting standard setters, it’s likely that their loss function is
also asymmetric. That is, standard setters are more likely to come under fire following bad surprises, not good ones. See
Watts and Zimmerman (1986) for additional discussion. Similarly, many of the items that show up on the agendas of
standard setters are reactions to some perceived abuse. Given all this, it’s not clear why standard setters would therefore be
the ones pushing for more and more fair values, unless they believed that this information was relevant enough and reliable
enough to be worth taking the hit when bad surprises occur. Theories of regulation often emphasize that regulators are
‘‘captured’’ by the very parties they are supposed to be regulating. Is there a party who has captured the FASB or the IASB and
has forced them to adopt fair value standards despite the adverse consequences of these decisions to everyone else?
The paper also addresses this issue of harmonization of accounting standards, and it argues that the IASB and US GAAP
should remain separate. The paper clearly articulates the potential for benefits when there is ‘‘competition’’ for accounting
290 R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295

standards. Of course, these benefits would have to be traded off against the costs imposed by lack of consistency and
standardization. I do not see how a theory paper can compare the magnitude of these two forces to conclude which one is
dominant in terms of the net effect on efficiency. I can, however, observe empirically that the world has moved in the
opposite direction as the paper’s theory predicts. It used to be the case that every country had different standards. We have
not moved in the direction of allowing all of these standards to be acceptable in all countries, so that companies can choose
which ones to use. This would be the ultimate in competition for accounting standards. Instead, we’ve moved the other
way, so that, for example, European Union countries all report using IFRS, the IASB and FASB cooperate on the development
of many accounting standards, and they are moving closer to harmonization. Whether full harmonization is eventually
achieved is still anyone’s guess, but certainly we have moved in this direction. A positive theory of accounting would
develop arguments for what the economic forces are that make this movement an efficient one. If there are forces which
have (perhaps temporarily) moved things in the opposite direction of efficiency, it should clearly articulate what those are,
what parties benefit from this, and how they are able to impose their will on the rest of the world.
Finally, a positive theory of accounting should ideally be broad enough to consider dynamic issues. The world changes
over time, and the role of accounting and the structure of accounting is likely to evolve over time accordingly. The
complexity of the things firms do and the breadth of their operations over the entire world has created enormous
information challenges. Firms’ organizational structures, governance mechanisms, the dispersion of ownership, and the
accessibility of capital markets globally have all also dramatically changed. The advances in finance in general, and in
valuation models and techniques in particular, have been remarkable. The mechanisms for collecting data, for
communicating information, the invention of television, computers, the internet, etc. have changed the world, and have
changed accounting significantly. Given all these changes, it is quite possible that the role accounting plays in various
economic decisions is considerably different than it was 100 years ago, just as the role of, say, horses has changed during
this time period. As a result, care must be taken to not over-interpret historical studies of firms’ accounting choices as
evidence of how such choices might be made today. By the same token, it is likely that the role of accounting in the future
could be different than it is today. For example, in order to be effective in a valuation role, accounting systems will have to
continue to compete effectively with other potentially more timely sources of information, or with information
intermediaries that take raw data and process it in alternative ways. These comments are not intended to be criticisms of
the authors’ summary of the existing literature; instead they are avenues for future research in this area to explore.

3. Information in resource allocation

While the authors argue that objective, verifiable, conservative information is best in helping to allocate resources
efficiently, there are alternative perspectives that lead to the opposite answer. In particular, resource allocation is done
based on the present value of future cash flows. This suggests that information should be forward looking to be valuable.
Moreover, to be most valuable, information should be the most precise where it impacts decisions the most. I argue below
that this is on the good news (the profit) side, not the bad news side.
To see, this, consider first the decision to invest in new projects. If information suggests a project is profitable, then
more detailed information is valuable because, in general, the more profitable the investment, the more you’d invest in it.
On the other hand, if information suggests that a project is unprofitable, there is relatively little value to more precise
information. This is because your decision will be the same – invest nothing – regardless of whether the information
indicates the project is very bad as opposed to just bad. That is, it doesn’t matter how unprofitable the project is, you’re not
going to invest. How profitable it is though does matter, because this impacts how much you invest. Next consider existing
projects. Here your decision is to invest more (expand more) the more profitable the project looks and to withdraw more
the more unprofitable the project looks. However, the amount you can withdraw is bounded above by the amount you
have invested in it, whereas the amount you can invest is (relatively) unbounded.
Therefore, decisions are more sensitive to information in the upper tail for claimholders as a whole, which is what
efficiency is about. To reverse this, it must be the case that the cost of obtaining information in the upper tail is higher than
the cost of obtaining information in the lower tail. This could be because there is greater uncertainty in the upper tail than
the lower tail, or because there are greater agency problems on one side than the other, or because there is greater legal
liability on one side than the other. Within this more general framework, the contracting literature focuses mainly on one
aspect of resource allocation problems: the use of information to aid the withdrawal of resources from bad projects, and
mostly for the protection of debt holders. To its credit, the literature conducts its analysis in a ‘‘second best world,’’ where
conflicts of interest are explicitly considered.
To properly compare and contrast the valuation ‘‘versus’’ stewardship roles for accounting, it is useful to define them. In
the valuation role, the objective is to provide information to help in estimating future cash flows. Providing better
information helps decision-makers better estimate future cash flows, which allows them to allocate their resources more
efficiently, i.e., to projects with more favorable risk-return tradeoffs. However, even under a valuation perspective, the
objective of accounting is not to value the firm per se. For example, the FASB’s conceptual framework explicitly states that
this is not the objective. Accounting is an input into the valuation process, not the output. Moreover, reporting ‘‘fair values’’
does not automatically follow from this purpose. Therefore, the ‘‘failure’’ of accounting to even attempt to fair value
R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295 291

‘‘everything’’ does not, in itself, imply that its objective cannot be one of aiding valuation. Similarly, such a failure does not,
by default, imply that accounting’s objective must be to fulfill a stewardship role.
In contrast, the stewardship role (a term I don’t like) is about using information to affect future cash flows. While there
are many dimensions to this, most of the contracting literature pays considerable attention to value preservation, i.e.,
ensuring that value is not extracted by the firm’s managers from shareholders, or by shareholders from bondholders. More
generally, stewardship would also incorporate the use of information to enhance the value of the firm by motivating better
operating, financing, and investing decisions.
While the valuation and stewardship roles for information are not the same, there are many instances where
information that is useful for one is also useful for the other. Accurate valuations can also help guide managers’ decisions,
aid others in assessing whether managers have made good decisions, and help investors evaluate managerial talent.
Moreover, both conservatism and verifiability can be useful attributes even in a valuation role for accounting. For example,
if managers have incentives to overstate income, and accounting is conservative to combat this incentive, the result could
be more accurate and more informative numbers. Under this scenario, even though the reason for conservatism is because
of stewardship issues, the objective of conservatism is for valuation purposes. Similarly, verifiability is an element of the
reliability of an information signal. The relevance vs. reliability trade-off should ideally consider all factors that influence
these characteristics, including the fact that agency problems with managers can influence the reliability of a number.
Allowing managers the discretion to report a potentially relevant number might in some instances inject ‘‘too much noise’’
because of managerial incentives to distort it. Therefore, excluding the number entirely could be more informative than
including it. The same arguments can be applied if the degree of verifiability is different on the ‘‘up side’’ than the ‘‘down
side’’

4. Summary statistics (or aggregation) in decision-making

Aggregation is an important property in accounting. Aggregation tends to work best when the information signals being
aggregated have similar properties (level of precision, persistence, bias, etc.). Adding signals with different information
properties distorts the properties of the sum. For example, adding a sufficiently imprecise signal can reduce the
informativeness of a summary statistic. As discussed above, this can be a potential motivation for excluding unrealized
gains from earnings if they are viewed to have substantially different information properties from ‘‘regular’’ earnings.
However, it is also important to understand that write-downs and unrealized losses, which are common outcomes
under conditional conservatism, have different information properties than ‘‘regular income’’ items even if these
unrealized losses or write-downs are accurately measured. In particular, they differ in their persistence. As a result,
including these items in a summary statistic like net income can significantly alter the information properties as well as
the economic interpretation of these numbers. This could make these numbers worse for decision-making purposes.
Moreover, this can be equally true whether the intended purpose of the accounting number is to aid in valuation or to aid
in contracting.
When signals have different information properties, it is important to be able to distinguish them. There are many ways
that this can be done, including placement: for example by putting them into separate sections of the financial statements
such as the income statement vs. other comprehensive income vs. the footnotes. Within the income statement, this can be
accomplished by grouping items into sections or by individual line item disclosure. These procedures allow decision
makers to weight things differently (or even exclude things) to suit their purpose. An extreme version of ‘‘placement’’
would be to exclude the signal from the financial statements entirely, and rely on some other mechanism for
communicating this information.

5. Accounting, conservatism, and managerial contracts

Given the emphasis in the paper on the stewardship role, it is surprising that there are (almost) no references to the
principal-agent literature. The survey by Armstrong et al. (this issue) provides some discussion of this literature, and there
are numerous other surveys in the literature. Research finds that there are many desirable features of performance
measures (informativeness, congruity, precision, etc.). Given that conservative is but one of many valuable features of a
performance measure, the interesting question is again, how are these traded off?
In principal-agent models, evaluation of a manager and valuation of a firm are different because factors other than the
managers’ actions affect firm value. The effect of these other factors is noise from the perspective of evaluating the
manager, but not noise from the perspective of valuing the firm. Therefore, a major implication of the difference between a
stewardship versus a valuation perspective on accounting would seemingly be to ‘‘take out’’ the impact of this value-
relevant noise. The use of historical cost instead of fair value certainly reduces the volatility of the numbers, but it is
unclear how much of this volatility is solely due to exogenous factors versus how much is informative about managerial
actions. For example, would it be different for gains and losses on Level 1 assets vs. Level 3 assets?4 What about realized

4
These are defined in FAS 157 based on the degree of objectivity used to determine the inputs used in valuing the security. Level 1 securities are
those for which the inputs are quoted prices in active markets for identical assets or liabilities, whereas Level 3 must rely on unobservable inputs.
292 R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295

gains and losses that are due to market-wide effects? Accounting clearly does not try to ‘‘remove’’ these. But contracts can
do this if it’s viewed to be a useful thing.
When the literature claims that conservative accounting helps with agency problems, it is important to be clear about
which agency problem we’re referring to. In theory, conservative performance measures can help with incentives of
managers to (i) hold on to bad projects too long, and/or (ii) over-state the profitability of their projects. However,
conservative performance measures create (or make worse) underinvestment problems when projects have costs are
incurred now but whose benefits do not occur till far into the future. This is especially true when the manager’s decision
making horizon is shorter than that of the principal. While numerous agency papers analyze various dimensions of these
types of incentive problems, the ‘‘residual income’’ literature is most directly applicable.5 This literature shows that in
order to motivate proper investment incentives, it is critical that costs be properly matched to the benefits. In particular,
expensing investments will not accomplish this. For example, immediate expensing of intangibles gives managers less
incentive to invest in them. Similarly, writing down losses quicker than writing up gains will also result in
underinvestment in risky projects that have positive net present values.
An under-appreciated problem in the agency literature is a different type of matching: that of matching compensation to
when the performance is delivered (see Barclay et al., 2005). Stock Prices (and fair values) capitalize the anticipated effects of
actions the agent has not yet taken. What happens if the manager does not fulfill these expectations, i.e., what if he doesn’t
take these actions? Is it more efficient to pay the manager now and try to get it back if he doesn’t perform, or to delay
payment until it can be verified that he has performed? Moreover, is it more efficient to do this through the construction of
the performance measure itself, or through the structure of the contract (e.g., though vesting or bonding restrictions)?
While agency problems with managers are undeniably important, it’s not clear why standard setters would choose to
focus on this problem in developing GAAP. Why can’t the board of directors impose its own requirements on what
performance measurements it wants? Given that the GAAP number is already being calculated, it’s understandable why it
might also be cost-effective to use it for contracting purposes. However, firms rarely rely solely on the bottom-line
accounting number in contracting with managers. Contracts often add new measures (including non-financial measures)
as a basis for making bonus decisions. Many features of managerial contracts are implicit, and can be adjusted based on
numerous pieces of information. Even explicit portions of contracts allow for discretion and judgment to be used. For
example, firms often ‘‘take out’’ the effects of restructurings or write-downs in calculating income for compensation
purposes. This type of adjustment explicitly undoes the result of conservatism being applied to the accounting number in
the first place. This does not seem consistent with the idea that GAAP accounting numbers are designed to aid in
contracting with managers or with the idea that conservatism makes them even more valuable for this purpose.
In discussing contracting with managers, it’s also important to be clear about what level of management we’re referring
to. At lower and middle levels of management, is the GAAP number for the firm as a whole that useful? Casual empiricism
suggests that these managers are not compensated on the basis of GAAP-mandated accounting numbers, whether the
numbers are for the firm as a whole or for the subunit of the firm that they manage. At the top level, GAAP accounting
numbers unquestionably play a role in management compensation, but how much is really accounting-based? Empirical
evidence suggests that in most firms, the lion’s share of compensation and incentives is based on stock price, not
accounting numbers. Presumably, one reason for this is because stock price is more forward-looking and ‘‘fair value’’
oriented than accrual accounting. That is, the conservative nature of accounting numbers is viewed to be a disadvantage of
the numbers, not an advantage. In fact, in industries where accounting is more conservative, compensation is less
accounting oriented (e.g., in high tech industries).

6. Accounting, conservatism and debt contracts

There is a large literature in accounting which has generated many insights into the use of accounting numbers in debt
contracts. For the most part, this literature focuses on the explicit use of accounting numbers in various aspects of debt
contracts, such as in debt covenants or performance pricing features. While these are significant features in contracting
with debtholders, by far the most important dimensions to debt contracts are (i) how many dollars of debt? and (ii) at what
interest rate? Clearly these decisions are based on valuation analyses (estimating the expected value and riskiness of future
cash flows). Moreover, all the assets of the firm that can generate cash flows over the term of the debt are relevant in these
decisions. This includes all intangible assets (including goodwill and internally developed intangibles) because these also
generate cash flows which can be used to pay off debt.6 Bond ratings, yields, etc. are not simple mechanical functions of a
few summary statistics generated via GAAP. For example, ratings agencies explicitly search for off balance sheet financing

5
See Rogerson (1997), Reichelstein (1997), Dutta and Reichelstein (2003).
6
Goodwill is often recommended to be excluded in debt contracting, largely because it is not considered to be saleable. Yet the reason it is on the
balance sheet in the first place is because you purchased it from someone else. Goodwill can help generate cash flows while it is ‘‘used,’’ but it can also
generate cash flows to the extent its existence increases the price you receive when you sell off parts of the firm. Of course, it is generally not saleable as a
separate item. Moreover, the value of goodwill often declines considerably in the same states of the world where a firm is likely to be in financial distress.
However, even if we grant that goodwill provides little or no payoff to debtholders in the event of financial distress, to the extent it helps generate cash
flows in other states of the world makes it relevant to consider in debt valuation.
R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295 293

(e.g., operating leases) in making their assessments. Debt is often valued using an option pricing formulas using market
data, where one important input is the market value of assets.
Therefore, in calculating the expected payoffs to debtholders, it is important to think about the ability of the firm to
generate profits and cash flows in order to pay back the debt, and also to think about the protection that debtholders
receive in the event unfavorable outcomes occur. Much of the accounting literature focuses on this latter aspect,
particularly, identifying in a timely manner whether things have gone badly. These two different roles for information in
bond contracting also have differential implications for how assets should be measured. When debt is being issued and the
market is attempting to assess the probability the firm will be able to pay off the debt, market values seem more relevant,
assuming market values could be reliably obtained. Liquidation values and historical values are largely irrelevant at this
point. However, liquidation value becomes relevant if the debt approaches distress. While liquidation values are generally
lower than fair value, they can certainly be higher than historical cost. It is not clear how relevant measures like lower of
cost or market are relative to these other measures.
Another important aspect in understanding debt contracts is better appreciation of how ‘‘simplistic’’ versus sophisticated
the covenants actually are. Empirically, covenant violations are often waived.7 Clearly other information besides the numbers
that triggered the covenant violation is used to decide whether to waive the violation. Covenants are also often written based
on ‘‘adjusted’’ accounting numbers. For example, if you don’t want goodwill or unrealized gains included in a debt covenant
contract, exclude them. It’s hard to imagine that it very costly to write such a contract, especially if the adjustments are based
on things already disclosed in the financial statements. If the cost is not large, and yet it is not viewed to be cost effective to
do so, this implies that benefits to making these types of adjustments cannot be large. Moreover, we’re seeing many
covenants and performance pricing features being written in terms of numbers outside the financial statements, such as the
bond rating (see Kraft, 2010). Bond ratings have the advantage of incorporating substantially more information that a small
set of accounting ratios, especially if these numbers are used mechanically in the contract.

7. Other issues

A key feature of conservatism is the asymmetric recognition of good news vs. bad news. An important assumption in
justifying this is that somehow good news can get to the market via some other mechanism. It’s not clear exactly how this
can be done credibly. That is, how is ‘‘truthful’’ good news distinguished from ’’untruthful’’ hype? If a manager’s good news
is so unverifiable it can’t be trusted enough to include in financial statements, how does voluntary disclosure magically
make it credible? How do ‘‘market forces’’ work when there are, by definition, no markets? Certainly we observe
empirically that not all good news is disclosed. Part of this is undoubtedly because of concerns regarding legal liability or
proprietary costs. Moreover, while it seems clear that the most common (and most serious) type of earnings manipulation
is to increase earnings, we do not observe that all ‘‘lies’’ are upward. The ‘‘big bath’’ is a common example of earnings
management in the opposite direction.
Similarly, managers do already have some incentives to disclose bad news, namely via legal liability. Moreover legal
liability is asymmetric. Finally, it is important to note that it is (current) shareholders, not managers, who pay much of
costs of law suits from ex-post overstatements. Therefore, shareholders have incentives to discourage managers from
overhyping the firm’s future prospects. All of these factors make it questionable as to whether, in equilibrium and
considering all communications mechanisms, good news is disclosed as fully as bad news.
There are also many interesting unresolved questions as to how conservatism is (or should be) applied. For example,
assume we agree that the degree of verifiability is a continuous variable. If one item (or transaction) is slightly less
verifiable than another, do we apply slightly more conservatism to it? Would we do this by reducing the asset value by
only a little? Or do we establish a threshold of verifiability that must be met, and then switch from Method A to Method B
(e.g., capitalize to expense) when we cross this line?
A second interesting issue is whether conservatism is operationalized at the ‘‘transaction’’ level or the ‘‘firm’’ level or
somewhere in between. Doesn’t it make more sense to do this at the firm level if contracting on firm-level summary
statistics is the purpose? Consistent with this view, many of the tests of conservatism (Basu, 1997, etc.) are operationalized
at the firm level. Yet, for the most part, the accounting rules that result in conservatism are written at the transaction level
or within account ‘‘types.’’ One drawback to operationalizing conservatism at the individual transaction level could be that
it leads to too many ‘‘false positives’’ in, say, bond covenant contracts. This could explain why so many covenant violations
are simply waived. It would be interesting to estimate the costs of these ‘‘false positives.’’
Historically, there have been some exceptions to accounting rules defining conservatism at the transaction level. For
example, it used to be the case that when we applied lower of cost or market to marketable securities, we did this at the
portfolio level, not security by security. Similarly, current rules require a two step impairment test for goodwill. In
particular, we look at the fair value of the reporting unit as a whole first, and if this is not impaired, we don’t check to see if
the goodwill is impaired.

7
See Gopalkakrishnan and Prakash (1995), Chen and Wei (1993), and Dichev and Skinner (2002) for evidence. One potential cost of using overly
conservative accounting numbers as part of defining when debt covenant violations occur is that ‘‘false positive’’ violations will happen. It would be
interesting to obtain evidence on the magnitude of these costs.
294 R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295

The level at which concepts like conservatism are applied is especially important because many important economic
decisions made within firms are intended to manage the relationship between different accounts and transactions. Hedging is a
common example of this. Clearly it doesn’t make sense to apply conservatism separately to each side of a hedge, and as a result
always write down the side that incurred the unrealized loss and leave unchanged the side that incurred the unrealized gain.
Finally, even if we agree that conservatism and verifiability are important for the reasons outlined above, it is not clear
that the right cut off point at which to ‘‘recognize losses, but not gains’’ is relative to the historical cost (or at zero), or that
all investors would agree as to what the right ‘‘cut off point’’ should be. When investors buy shares in a firm, the price that
they pay is frequently higher than the accounting book value per share. By definition, this means that the investors view
the firm’s net assets as being more valuable than the accounting system recognizes. It is this market value that investors
are interested in protecting, not the book value. If conservative accounting systems have not recognized the value of these
assets in the first place, they cannot now recognize declines in the value of these assets. As a result, managers can take
actions that destroy substantial amounts of value before the accounting system would have any way to detect this. Such a
shareholder would likely prefer the conservatism ‘‘cut off point’’ to be re-calibrated based on his purchase price. With
markets trading continuously, virtually every shareholder would want a different cut-off point. A mark-to-market system
seems potentially more suitable in addressing at least part of this problem because it re-calibrates the book value. That is, a
decline in market value from $16 to $14 for an asset originally purchased at $10 would be detected in a mark-to-market
system, whereas it would not under a historical cost-based system. This would be of interest to all shareholders, whether
they purchased their shares at $10, $12, $14, $16, $18, etc.
The paper has a short discussion of rules-based vs. principles-based accounting standards. I agree with the authors that
the difference is overblown. In the end, someone has to make a decision. There are advantages and disadvantages to each
system. A principles-based system will require auditors to use more judgment and require them to stand up to their clients
to a much greater extent than they appear to do now. If different audit firms or even partners in the same firm draw the
line at different places, consistency is hurt. Given the litigious nature of the US, it is likely that courts will end up deciding
where the line is. Who do you want to decide what a standard really says—accounting standard setters or courts?

8. Conclusion

The authors’ review paper concludes that the ‘‘stewardship’’ role of accounting dominates the ‘‘valuation’’ role. Yet this
is the opposite of what standard setters say they do. Clearly, accounting is used for both purposes. While there are
important differences in the two views on the role of accounting, in many ways the two ‘‘competing’’ roles are closer than
often thought. Even if the purpose is to assist valuation, contracting problems should play a role in GAAP, and conservatism
and verifiability should play a role in GAAP. Conversely, fair values are more important than often given credit in
addressing contracting problems. Moreover, neither valuation nor contracting relies mechanically on ‘‘the bottom line.’’
While adjustments are costlier in contracting, there is little evidence on how costly these are.
To their credit, researchers working on the stewardship role of accounting have at least begun to develop a theory for
how accounting impacts (makes better or makes worse) incentive problems. The same cannot be said for research into the
valuation role of accounting, which is largely empirical (e.g., the enormous ‘‘information content’’ and ‘‘value relevance’’
literatures). The closest to developing a valuation-oriented theory are the papers that emerged from the Ohlson (1995) and
Feltham and Ohlson (1995) line of papers. Even here, accounting does not really aid in the valuation of firms; it merely acts
as a set of summary statistics of the information that is available to use to value the firm. There are also papers that analyze
accounting from a measurement perspective (see Sunder, 1987, 2007).
Conservatism and verifiability are important features of accounting systems, but not just for making contracting better.
Conservatism is a response to measurement problems, not a desired attribute of accounting per se. In moving forward, the
more interesting questions are not whether accounting is (or should be) conservative, but the degree to which accounting
is (or should be) conservative. Similarly, verifiability is a continuous variable. How verifiable does an item need to be to be
worthwhile to include? Accounting is not ‘‘all fair value’’ or ‘‘all historical cost’’, or ‘‘all conservative.’’ No one (seriously)
advocates the extremes of reporting only the cash vs. fair valuing everything. Where do we stop? Is it at the Level 1, Level 2,
or Level 3 financial assets and liabilities? Do we also fair value physical assets? If we do, do we use value in use or resale
value? Do we include intangible assets? How about fair valuing the ‘‘ongoing business?’’ For many firms, a substantial
portion of their value comes from the present value of revenues on units they haven’t made yet and from products they
haven’t even thought of yet. No one (that I know of) advocates calculating a fair value for these things and including them
as part of the GAAP financial statements. Similarly, growth options can be very important in valuing a firm, yet are unlikely
to show up on the balance sheet as an asset.
In the resulting multi-attribute system, items have different information properties. If items with different properties
can be kept in separate line items, decision makers and contracts can presumably adjust for these differences. But if they
are aggregated together within the same line item, or if these items are aggregated to form important and highly visible
summary statistics such as net income and total assets, what do these summary statistics mean economically? When faced
with information of questionable reliability, when is it better to disclose it or include it within a line-item and potentially
force people to ignore it or take it out if they don’t find it useful, and when is it preferable to not disclose it and force people
to guess or obtain this information elsewhere if they think they might find it useful?
R. Lambert / Journal of Accounting and Economics 50 (2010) 287–295 295

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