Paper2—Watts 2003 AH Part1.pdf

Accounting Horizons Vol. 17, No. 3 September 2003 pp. 207-22 1 Conservatism in Accounting Part I: Explanations and Implications Ross L. Watts SYNOPSIS: This paper is the first in a two-part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their impli- cations for accounting regulators. Part II summarizes the empirical evidence on conser- vatism, its consistency with alternative explanations, and opportunities for future research. The evidence is consistent with conservatisms existence and , in varying degrees, the various explanations. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: anticipate no profit, but anticipate all losses. Despite criticism, conservatism has survived in accounting for many centuries and appears to have increased in the last 30 years . The alternative explanations for conservatism are contracting, shareholder litiga- tion, taxation, and accounting regulation. The evidence in Part II suggests the contract- ing and shareholder litigation explanations are most important. Evidence on the effects of taxation and regulation is weaker, but consistent with those explanations playing a role. Earnings management could produce some ofthe evidence on conservatism, but cannot be the prime explanation. The explanations and evidence have important implications for accounting regula- tors. FASB attempts to ban conservatism in order to achieve neutrality of information without understanding the reasons conser