# How to measure conservatism in financial accounting

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As an accounting student it is important to know how the accounting really works. It is not only about numbers but it is also about trying to understand the underlying theories and how it all helped to define accounting as now we know it. Understanding the theories will also make you understand the accounting methods used nowadays and can give you some ideas to make future research or suggestions in the accounting field. For our Financial accounting 2 course we were given the following topic: Accounting conservatism.

Our research question is:

## "How can we measure conservatism in Financial accounting?"

This paper will point out some key issues, the current state and a critical review regarding accounting conservatism literature that we used. Our paper will be based on, among others, Ross L. Watts' [1] paper about conservatism in accounting and accounting conservatism and the efficiency of debt Contracts written by Frank Giggler, Chandra Canodia, Haresh Sapra and Ragu Venugopalan. [2]

## Accounting Conservatism

Definition

Ross L. Watts (2002,p.3) defines accounting conservatism as "'the differential verifiability required for recognition of profits versus losses. In its extreme form the definition incorporates the traditional conservatism adage: "anticipate no profit, but anticipate all losses.'''' [3]

Paton and Littleton suggest that (1940, p. 128): "â€¦it may well be noted that conservatism in stating the assets . . . is not a principle to guide calculations of net income, but a rule of caution in interpreting the results of accounting measurements made according to a coherent body of doctrine.''

So accounting conservatism means that we book costs when they are incurred and profits when the company receives the payments. We can in some degree compare it with the matching principle of accounting. Companies will use this method when the benefits of using this method or higher than the costs. We will address this further in the paper.

## Current state of conservatism in accounting

Conservatism and debt holders

When companies approach banks to borrow money, banks are likely to investigate if these companies have enough net assets to cover their loans. Banks are not interested in the future values of the assets but the present values, because future values are not verifiable or credible.

Gigler (2009) suggest that "conservatism results in timely loss recognition at the expense of timely gain recognition. Given the asymmetric payoff to debt holders, timely loss recognition is of much greater importance to them than timely gain recognition. Timely loss recognition results in earlier violation of debt contracts. Debt holders can exercise their contractual rights more quickly and can restrict the actions of managers.'' [4]

So accounting conservatism helps the bank to gain reliable information of the present value of the net assets of these companies. So we can make the assumption that accounting conservatism can enhances the efficiency of debt contracts.

Conservative accounting as information for equity investors

Conservative performance measures or numbers can be quite useful for equity investors. When faced with liquidation the conservative value of the net assets can be of great importance for the investors.. An important element of equity valuation is the abandonment option. When the

operating value of the firm falls below the liquidation value of net assets there is an opportunity for increasing the value of the firm by liquidating the assets and go out of business. This is just the practice that corporate raiders do. They buy companies when their operating value is below their net asset value and sell the net assets to make an arbitrage profit and therefore have been accused of taking over firms to do just that.

Watts (2002, p 13) stated that ''Even if the abandonment option is not in the money, the orderly liquidation value of net assets is relevant. In that situation there is frequently still a probability the option will be in the money in the future. In that case the option value affects the current valuation of equity.'' [5]

An income tax explanation for accounting conservatism

Income taxes have long been tied to reported earnings and as a result have influenced the calculation of earnings. Profitable companies have a tendency to use accounting methods to reduce reported earnings. So most of these companies use the accounting conservatism method that will likely reduce their profit. These lower reported profit leads to a decrease in tax payments.

This part will explain how conservatism is measured We will use this part so we can make a critical review of the literature.

Measuring Conservatism [6]

So Watts defines three types of measures for accounting conservatism:

Earnings/stock returns relation measures;

Net asset measures

Earnings/accrual measures.

Watts' research on measuring accounting conservatism:

" Earnings/stock returns relation measures

Conservatism is the requirement of a higher degree of verification for gains than for losses. Gains are increases in the value of net assets and losses are decreases in the value of net assets. Differences in the degree of required verification can be determined by first observing actual net asset gains and losses when they occur and then determining whether there is a difference in the speed with which those gains and losses are captured by accounting. Reasonably, Basu (1997) assumes that positive stock returns in a period generally reflect net asset gains and negative stock returns reflect net asset losses. If losses are subject to a lesser degree of verification than gains, Basu argues earnings will reflect net asset losses more quickly than net assets gains. The consequence is that stock returns and earnings will tend to reflect net asset losses in the same period, but stock returns will reflect net asset gains in earlier periods than earnings. In particular, Basu predicts that negative stock returns are more likely than positive stock returns to be fully reflected in earnings of the period in which those returns occur.

Basu illustrates his prediction with the earnings effects of a change in the estimated useful life of a fixed asset. When the estimated life drops, the asset's value drops and the asset is written down to leave the estimated depreciation of future years unchanged.

All of the loss appears in earnings of the year of the loss. Earnings of that year are lower and the expected earnings of future years are unchanged. However, when the estimated life increases (the value of the asset increases), the gain is not taken. Instead, the remaining book value of the asset is spread over the increased number of remaining years of the asset's life, reducing depreciation for those future years. The effect is to increase the earnings of the year of the gain and the earnings of future years by a fraction of the increase in asset value. Only a small fraction of the gain occurs in the earnings of the year of the gain.

To provide estimates of his conservatism measure Basu (1997) regresses annual earnings on stock returns of the same year. The R2 of this regression is predicted to be higher for a sample of firms with negative stock returns than for the sample of firms with positive returns. Likewise the coefficient of stock returns is predicted to be higher for the negative stock return sample. This latter prediction is illustrated by the full loss appearing in earnings in the year of loss in the estimated life example while only a fraction of the gain appears in earnings. If stock returns measured the gain or loss only then the coefficient would be one for the negative return sample and 1/n for the positive return sample (where n is the remaining life of the asset)

Consistent with the conservatism predictions, using US data, Basu (1997) finds that both the R2 and estimated coefficient of stock returns in a regression of a current period's earnings on stock returns are higher for samples of negative returns. Using variations on this methodology, the result has been replicated in other studies including, among others, Ball, Kothari and Robin (2000), Givoly and Hayn (2000), Holthausen and Watts (2001) and Pope and Walker (1999).

Net asset measures

Valuation model measures. Conservatism's differential verification of gains and losses causes there to be more unrecognized gains than losses and so understates net assets. A number of valuation studies estimate the level of net asset understatement (conservatism) using equity valuation models. The valuation models are either Feltham- Ohlson valuation models or models of the ratio of book value of equity to market value of equity (book-to-market ratios).

The Feltham-Ohlson models (Feltham and Ohlson, 1995 and 1996) include parameters that reflect the degree of understatement of operating assets (due to the accounting rate of depreciation exceeding the economic rate). Estimates of those conservatism parameters are generated from estimation of the valuation model itself and also from time series estimation of the relation between variables that are inputs to the valuation model. The valuation model estimation parameter is obtained from cross-section regressions of value on abnormal earnings, assets and investment. An example from Ahmed, Morton and Schaefer (2000) is the regression of firms' estimated goodwill on abnormal earnings, lagged operating assets and contemporaneous investment in operating assets. The coefficient of lagged operating assets should be positive in the presence of conservatism. The other parameter is obtained from the time series regression of abnormal earnings on lagged abnormal earnings and lagged book value of operating assets (see Myers, 1999). Again, the coefficient of lagged operating assets

should be positive if conservatism exists. To obtain the intuition for these predictions, note that the more understated the operating assets (due to excess depreciation), the greater the coefficient that will have to be applied to the lagged operating assets to obtain either estimated goodwill or abnormal earnings.

Stober (1996), Dechow, Hutton and Sloan (1999), Myers (1999) and Ahmed, Morton and Schaefer (2000) find that the conservatism parameter estimated from the abnormal earnings regressions tend to be negative, not positive as predicted. The authors attribute this inconsistency to the misspecification of the relation between the variables. The specification of the relation is arbitrary and is not guided by any theory of conservatism or accruals other than the assumption that the depreciation rate is too high. As a result the specification ignores other known relations in the time-series of earnings. In particular, it ignores the negative serial correlation that conservatism generates in earnings and earnings changes because of conservatism (see below) or because of accrual estimation errors (see Ball and Watts, 1972). The estimated conservatism parameter in the valuation regression is less subject to these effects and is generally positive as predicted.

Book-to-market measures.

Beaver and Ryan (2000) measure conservatism using firms' book-to-market ratios. Using pooled time series and cross sectional data they regress book-to-market ratios on individual year and firm dummy variables and on individual firm stock returns for the current and previous five years. The estimated coefficient of an individual firm's dummy captures the persistent portion of the difference between the firm's book and market values of equity. The lower the coefficient, the more conservative the firm (the more book value is biased downward). By construction, the mean coefficient is zero so the coefficient is a measure of relative conservatism and not aggregate conservatism. The measure is used to proxy for the extent to which conservatism varies across firms.

Earnings/accrual measures

Earnings measures. Basu (1997) and Watts (1993, p. 11) predict negative earnings changes are more likely to reverse in the next period than positive earnings changes. The reason is that (by selection) negative changes are likely to include more asset write-offs and write-ups of liabilities. Since these reductions in earnings and net assets anticipate future cash flow effects, next period's earnings will not on average have such write-offs and will increase. On the other hand, the implications of positive earnings changes are not fully incorporated into current earnings producing positive dependence in positive earnings changes. This prediction can be extended to earnings levels. Again by selection, negative earnings are more likely to include asset write-offs and liability write-ups. Given these charges are of a one time nature, next period's earnings are less likely to be negative. Positive earnings will be less likely to have these reversals. Givoly and Hayn (2000) point out that this asymmetric effect on earnings will produce negative skewness in the earnings distribution.

Evidence that negative earnings changes are more likely to reverse than positive earnings changes already existed in the literature before Basu (1997), in particular in Brooks and Buckmaster (1976) and Elgers and Lo (1994). Basu also finds this result. He regresses earnings changes deflated by beginning-of-period price on lagged deflated earnings changes. The estimated slope coefficient for positive earnings changes insignificantly different from zero, consistent with positive earnings changes being permanent and not reversing. The estimated slope coefficient for negative earnings changes is significantly negative (-.69), but is not significantly different from minus one, the value expected if negative earnings changes are completely transitory. This result is consistent with write-offs due to conservatism causing earnings changes. If those write-offs capture all expected future losses on the assets, they would be completely transitory.

Accrual measures

Givoly and Hayn (2000) note that conservatism reduces cumulative reported earnings over time. They suggest the sign and magnitude of accumulated accruals over time are measures of conservatism. In a steady state (no growth) with no conservatism, earnings would converge to cash flows and periodic accruals would converge to zero. "A consistent predominance of negative accruals across firms over a long period is, ceteris paribus, an indication of conservatism, while the rate of accumulation of negative accruals is an indication of the shift in the degree of conservatism over time" (Givoly and Hayn, 2000, p. 292). Consistent with conservatism, Givoly and Hayn (2000) find that the distribution of return on assets (whether derived from time-series of individual firms or the cross-section of firm-years) is negatively skewed for most of the period they examine (1956-1999). Givoly and Hayn also find that over the period 1965-1998 accruals (excluding depreciation) cumulate to an amount that represents 16% of cumulative earnings over the same period. This accumulation occurs from 1982-1998, consistent with the timing of a large increase in conservatism observed using the earnings/stock return. ''

So this is what Ross L. Watts

In the next section we are going to give our conclusions, critique on above mentioned literature and we will try to formulate research questions on this topic.

## Conclusion

After an intensive review of the available literature we can answer our research question:

## "How can we measure conservatism in Financial accounting?"

In the literature there are three main measures for conservatism in financial accounting. First, the earnings/stock returns relation measure. Conservatism is the requirement of a higher degree of verification for gains than for losses. Differences in the degree of required verification can be determined by investigating whether there is a difference in the speed with which those gains and losses are captured by accounting.

Second, the net asset measures, in particular the Feltham-Ohlson models (Feltham and Ohlson, 1995 and 1996). Feltham and Ohlson (1995) use their models to illustrate the effect of conservative accounting on the relation between equity value, accounting book value and future earnings.

Last, the earnings/accrual measures. Givoly and Hayn (2000) note that conservatism reduces cumulative reported earnings over time. They suggest the sign and magnitude of accumulated accruals over time are measures of conservatism.

Now we have described the different measures for conservatism in financial accounting, we are going to discuss potential issues on this subject for further research. As we mentioned before, conservatism is the requirement of a higher degree of verification for gains than for losses. Interesting question for future research could be to which extent the requirement of a higher degree of verification for gains should be to call it accounting conservatism. Another interesting subject to research is the relation (or not) between conservatism and earnings management. Other possible questions for further research are:

If conservatism can lead to a decrease in taxes how can this have an effect on the economy?

How can the government address this problem and to which extent should the government be involved with the accounting methods used in the country?

How should the FASB and IFRS address this issue if the government is going to take action?