Accounting Conservatism Explanations

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Earnings Conservatism

Inherent in accounting standards

– Expense R&D and advertising
– Recognize post-retirement obligations but not
human assets
– Write down impaired goodwill but don’t recognize
internally generated goodwill.

SEC enforcement augments or diminishes it

– e.g., SAB 101’s strict revenue recognition criteria.

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Earnings conservatism measure:

Degree to which a firm’s accounting income

reflects expected losses in a more timely
fashion than expected gains (Basu 1997).

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Explanations for the existence of
conservatism

• Review Watts’ (2003) four explanations for

existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes

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Contracting Explanation for
Conservatism
Accounting measures are common in
contracts constraining managers in
expending resources and splitting returns
among firm claimants.

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Contracting I:
Management compensation agreements
Existence of Conservatism

– Managers with limited tenure have incentives to

inflate earnings to increase their bonus
compensation and increase the value of their
stock options.

– Earnings conservatism facilitates delivered

performance measurement (Barclay et al. 2000) by
deferring the recognition of gains until they are
verifiable.

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Contracting I:
Management compensation agreements
Negative P/B Association

– Decrease in P/B signals a decline in a firm’s future

growth opportunities, increasing managers’
preference for current vs. deferred compensation.

– Motivates managers to overstate current earnings

to increase bonus, stock option compensation.

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Contracting II: Debt contracts

Existence of Conservatism

– Debt covenants restrict firm from making unrecoverable

payments to shareholders and junior claimants (Leftwich,
1983).
• Recipients of excessive dividend payments do not generally
need to return them to the firm in the event of financial trouble.
– Limit dividend payments to “unrestricted” retained earnings.
– Restrict additional borrowing by placing upper limits on firms’
debt/equity ratios.
– Corporations laws say “dividend distributions neither make a
company insolvent nor impair its capital.”

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Contracting II: Debt contracts

Negative P/B Association – Earnings Constraints

– As P/B decreases, the probability of default increases

because the value of the firm’s expected future cash flows
(numerator) decreases vis a vis principal amount of debt.
– Following a decrease in P/B, debt holders wish to tighten
constraints on excessive payouts and additional borrowing.
– The contractual constraints protecting debt holders against
excessive payouts generally refer to earnings (often before
interest and taxes) based on GAAP, not market-based
earnings measures.
– Earnings conservatism directly constrains dividend and
compensation payouts based on earnings.
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Contracting II: Debt contracts

Negative P/B Association – Debt/Equity Constraints

– Constraints protecting debt holders against excessive

additional borrowing generally refer to a maximum D/E
based on book value equity measure.
– Earnings conservatism triggers impaired asset write-offs
and recognition of unrecorded liabilities in the income
statement, pushing the D/E closer to its maximum limit and
tightening the constraint on additional borrowing.
– Debt holders to rely on earnings conservatism increasing as
P/B decreases, more than offsetting managers’ increasing
incentives to overstate earnings, overstate assets, and
understate liabilities.

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Explanations for existence of
conservatism

• Review Watts’ (2003) four explanations for

existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes

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Shareholder litigation

Existence of Conservatism

– Earnings conservatism reduces the expected

present value of shareholder litigation costs

– Shareholders are much more likely to litigate

when earnings and net assets are overstated than
when they are understated Watts (1993, 2003),
Kothari et al. (1988), and Beaver (1993).

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Shareholder litigation

Negative P/B Association

– As P/B decreases
• It becomes more likely that net asset carrying values exceed
fair values.
• Probability of shareholder litigation increases because
shareholders can more readily substantiate claims that
assets are misleadingly overvalued.
• Likely magnitude of claimed damages increases as investors
can claim that asset carrying values are farther below fair
values.
– Hence, to reduce expected litigation costs, it is efficient for
both auditors and managers to increase the degree of
earnings conservatism as P/B decreases.

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Explanations for existence of
conservatism

• Review Watts’ (2003) four explanations for

existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes

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Regulation

Existence of Conservatism
– Investor losses from overvalued assets and
overstated earnings are more observable and
usable in the political process than forgone gains
due to undervalued assets or understated
earnings (Watts 1977, Benston 1969).

– Thus, standard-setters have incentives to set

conservatively worded GAAP; regulators like the
SEC have incentives to enforce GAAP in a
conservative fashion.
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Regulation

Negative P/B Association

– Low P/B ratios imply poor future prospects for companies and
are consistent with recent declines in values having occurred,
making it likely that investors will blame regulators for permitting
misleading accounting practices.
– Thus, both the wording and required implementation of many
accounting standards imply a negative association between
earnings conservatism and the P/B ratio.

Examples:
• Inventory at the lower of cost or market.
• SFAS 142 mandated goodwill impairment write-downs
• SFAS 5 contingent loss recognition

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Explanations for existence of
conservatism

• Review Watts’ (2003) four explanations for

existence of conservatism
1. Contracting
2. Shareholder litigation
3. Regulation
4. Taxes

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Taxes

Existence of Conservatism

– Incentives for profitable firms with taxable income

to defer income (be conservative) to reduce the
present value of taxes (Watts, 2003; Smith and
Watts, 1982; Watts and Zimmerman, 1979;
Guenther et al. 1997; Shackelford and Shevlin
2001)

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Taxes

Negative P/B Association??

Managers’ incentives
– Increase reported income to increase bonuses
– Decrease reported income to save corporate taxes

It is unclear (to us) how declines in P/B affect the

tradeoff.

So, one can limit the analysis of the implications of

Watts’ (2003) conservatism explanations to
contracting, litigation, and regulation.

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