The Accounting Conservatism Principle

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In this paper we analyze the relationship between the accounting conservatism principle and the effects of this principle in the Dutch banking sector during the economic crisis. We will focus on several financial institutions and other companies that subsequently performed well or disastrous. The main theme of our research paper is a investigation of economic consequences in the accounting science. We will discuss an accounting principle and then investigate the effects that this principle has on certain economic events. The sub theme of our paper is a further investigation of the well-known and the important accounting conservatism principle. We will use the conservatism principle to make a new analysis by researching this principle and its effects on the functioning of several Dutch financial institutions during this state of negative economic dynamics.

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1.2 Relevance

The main focus of this paper is to further investigate a relevant and well acknowledged sub topic in the accounting science, considering the multitude of previous scientific papers and our own interests we have chosen for the accounting conservatism principle. A brief definition of this accounting principle is: A accounting guideline that understates assets and revenues and overstates liabilities and expenses. (Dictionary of Accounting Terms, 4th edition, Joel G. Spiegel, Jae K. Shim) This means that expenses should be recognized directly while revenues should be recognized when its verifiable that will be realized. The conservatism principle holds that in reporting the financial statements a more pessimistic picture (understate) than a optimistic picture (overstate) will be described, due to this principle there is less chance of users of financial information being hurt by relying on prepared financial statements.

The accounting conservatism principle in of the most important principles in the accounting profession and science, Basu (1997,8) states that conservatism has influenced the accounting practice for more than 500 years. Watts (2003) wrote in his paper conservatism in accounting, that there is a great scientific benefit in further researching the accounting conservatism principle. In our opinion it would be a great opportunity to further explore the effects of this important and long lasting principle in combination with the recent financial crisis. The recent financial crisis emerged in 2007 and at the moment of writing the effects and economic consequences is still visible and active in today’s business world. We will briefly introduce this recent financial crisis in order to provide the necessary heuristics to the neutral reader. Due to various aspects this crisis has emerged and evolved and left its footmarks on the entire business world. We will discuss the important aspects that created the crisis and have made the crisis more sustainable that are given by several economic experts. First of all the financial crisis came into existence in the United States in the end of 2007. The most important cause of the financial crisis are the reckless and unsustainable lending practices of several top banks in the US [1] . Various US top banks sold financial products with high risk to their customers, especially real estate mortgages. These mortgages where covered by securities, which had risks that were hard to estimate.

A reaction to a more broad credit boom, increase in oil and food prices was a speculative bubble in real estate and equities, which served to reinforce the risky lending practices. [2] The emergence of high risk loan losses was the beginning of a financial crisis in 2007. In consequence of the loan losses and the fall of Lehman Brothers in September 2008 a financial panic brakes out. As result of massive declines in stock rates and real estate prices several large investment institutions and banks in both Europe and the United States came in serious financial trouble and some of them went bankrupt. This worldwide crisis has caused several economic consequences like; rapidly increasing unemployment rates, a decline of commodity prices, a fall of international trade and of the most important consequences of all is a lack of trust of public in financial institutions, banks and the public began to set question marks on management policies, strategies and ethical behaviour. The general consensus of economists is that this crisis is going to be the worst since the Great Depression of 1930 and that complete recovery of the market will be accomplished somewhere near 2010/2011 [3] 4. This global phenomenon is the basis for a lot of scientist and practitioners to investigate the causes, results, possible prevention methods and the way to structure these financial institutions in a way that such economic crisis could be prevented in the future.

In our research we will focus on the causes of the economic crisis, we will mention some of them while others that are more significant for our research will be presented more elaborately. Some practitioners and researchers claim that these are the main causes of the financial crisis: increase of oil prices, weakened regulation activities by the government, improper and inadequate functioning of CEO of the Federal Reserve Bank Alan Greenspan and over-leveraging (credit default swaps and collaterized debt obligations). To introduce our research question, we will further investigate one of the causes namely over-leveraging because this specific cause is of importance for our research. A lot of banks and investors miscalculated the level of inherent risk in the unregulated Collateralized debt obligation and Credit Default Swap markets. In this way banks and investors were able to take advantage of low interest rates and borrow huge sums of money that they only could pay back if the housing market continued to increase in value. [5

Banks were highly dependent on future earnings such as the profits they assumed to make of the mortgages, what they didn’t take into consideration is the fact that much of these mortgages carried a lot of risks and that the earnings were not verifiable and realized. So they overstated their future earnings and they massively pursued an optimistic view which led to an overstatement of their earnings. So having said this we know can see that the accounting conservatism principle was not applied by these banks. Having enriched ourselves with this information we were very interested in investigating why accounting conservatism which dominates as a solid theory for many years and is incorporated in the accounting regulations and in many scientific literature has not been applied in the banking sector.

Our research question thus states; What is the reason that the accounting conservatism principle didn’t succeed in the Dutch banking sector? This research paper will be especially of importance and value for practionners, financial analysts, accounting students and other generally interested readers. Practioners and scientists like Basu, Watts, Dietrich, Riedl, Mcleay and Raonic did an investigation in the relationship between accounting conservatism and for instance stock returns, but they do not investigate the relationship between accounting conservatism and the effects on the financial sector during a recession. Our research is unique because it is the first research of the accounting principle and the effects and relation on the Dutch banking sector during the recent (2007-2010/11) financial crisis. To measure the effects of accounting conservatism in relation with the performance of the Dutch banks during the recession.

Literature review

In this part of the paper we are going to study and present several scientific papers of well-acknowledged practitioners. We will define the accounting conservatism principle and we will view this principle from the point of view of different scholars and further more we will discuss the importance of the accounting conservatism principle and its effects on different business ratios.

Accounting Conservatism

Conservatism is defined as the differential verifiability required to recognize profits versus losses. (Watts,2003) Watts stated that conservatism is the asymmetrical verification requirement for gains and losses. It means there is a difference in verification requirements for recognizing gains and losses. The asymmetrical verification interpretation is incorporated in the definition of Watts as differential verifiability. Conservatism also has an extreme form this form is also referred to as the traditional conservatism adage: “anticipate no profit, but anticipate all losses” (Bliss, 1924) This means that a company should not recognize profits before there is a legal claim to the revenues generating them and that the revenues are verifiable. All losses should be recognized by the company even when they aren’t completely verifiable. Basu interpreted the conservatism adage as: “the accountant’s tendency to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses. He deducted this interpretation from several accounting concepts, procedures and principles. For instance, the Statement of Financial Accounting Concepts ( SFAC) No.2 (FASB, 1980) paragraph 95 states: “if two estimates of amounts to be received or paid in the future are about equally likely, conservatism dictates using the less optimistic estimate”.

He also mentioned some conservatism examples in the Accounting Research Board(ARB). ARB 45 states: a company should immediately recognize changes in cost estimates if they result in future expected losses on long-term contracts, but not if they result in increased future profits. Thus conservatism results in a greater probability of timely accounting recognition of bad news than for good news. (Basu, 1997) An alternative definition of accounting conservatism is of Belkaoui (1985). He claims that conservatism “implies that preferably the lowest values of assets and revenues and the highest values of liabilities and expenses should be reported” More broadly this means that accountants prefer accounting methods that lead to lower reported values for shareholders. To explain the roots of the accounting conservatism principle we will discuss the historical developments, theories and explanations of conservatism. The influence of conservatism on the accounting practice has been for centuries.

Basu argued that this principle significantly influenced the accounting practice for at least 500 years.(Basu,1997) Historical records from trading deals in the 15th century show that accounting in medieval Europe waws In our opinion the traditional accounting conservatism adage is not suitable for our research, in today’s economic environment it would to extreme to think that one managing a company could apply this traditional principle. The first definition of Watts is the most suitable for our research because it is the broadest, simple and it captures in a glance the fundamentals of the accounting conservatism principle.

Literature table:

Paper Title Author Object of study Sample(size, country, period) Methodology Conclusion 1 Conservatism in Accounting Part I: Explanations and Implications Ross L. Watts Examination of alternative explanations for conservatism in accounting and their implications for accounting regulators. This paper is based on existing literature(literature study), thus there is no test information included, September 2003 This paper studies conservatism in accounting and is divided in two parts. The first Part discusses explanations for conservatism and draws implications for regulation and standard setting. The paper draws a general contracting explanation for conservatism and predicts that other contracts employed within the firm, will also generate conservatism. It offers also a new argument: that an information perspective produces conservatism once the information costs of changed managerial behavior are introduced even without contracting considerations. The main conclusion of this paper is that conservatism is essential.

Managers will bias and noise value estimates, because there is a lack of verifiability, managers have limited tenures and limited liability’s. If regulators want to improve financial reporting, they must recognize the importance of verification, problems that conservatism’s asymmetric requirement evolved to address and regulators should concentrate on the accounting’s core competence. 2 Conservatism in Accounting Part II: Evidence and Research Opportunities Ross L. Watts Summary of the empirical evidence on conservatism, its consistency with alternative explanations, and opportunities for future research. This paper is based on existing literature(literature study), thus there is no test information included, September 2003 This is Part II of the literature study of conservatism in accounting. This part summarizes the empirical evidence on the existence of conservatism. Ross L. Watts elaborates several measurements for conservatism, draws evidences on alternative conservatism explanations and on non-conservatism explanations. Further this article discusses some research opportunities. In this paper the writer concludes that existing evidence for accounting conservatism is most consistent with the contracting and litigation explanations.

Further the writer concludes there is a reason to believe that the four explanations for conservatism (contracting, litigation, tax and regulation) are not independent. Also conservatism is driven by a concern with overpayment by contracting parties, courts and government and this principle will not exclude earnings management or abandonment options. 3 The conservatism principle and the asymmetric timeliness of earnings Sudipta Basu Re-examination of the conservatism principle. Investigation of the effects of the conservatism principle on reported financial statements. The samples implemented for the test in this paper consist of all firm-year observations from 1963 -1990 with returns data on the center for research in security prices NYSE/AMEX monthly files, and with necessary accounting data on the compustat annual industrial and research files. (United States). The paper extends research on the timeliness of earnings by pointing out that the timelines is asymmetrically greater for bad news than for goods news. S. Basu states that in efficient markets, stock returns symmetrically and quickly reflect all publicly available news, so he uses returns to measure news. The research of the conservatism principle is based on four predictions. For the first prediction: earnings is more timely or concurrently sensitive in reflecting publicly available bad news than good news the researcher used negative and positive unexpected annual stock returns to proxy for bad news and good news. For the other three predictions S.Basu used empirical tests. S. Basu investigated the effects of the conservatism principle on reported financial statements and interprets conservatism as resulting in earnings reflecting bad news more quickly than good news. He indicated that the concurrent sensitivity of earnings to negative returns is two to six times as large as the concurrent sensitivity of earnings to positive returns and he also showed that positive earnings changes tend to persist whereas negative earnings changes show a marked tendency to reverse.

The conclusion of this paper is that earnings are timelier in reporting publicly available bad news about future cash flows than good news. 4 Discussion of “Conditional and Unconditional Conservatism: Concepts and Modeling” Sudipta Basu Algebraically model, simulate and graph the effects of various factors on the nonlinear earnings-return relation induced by conditional conservatism. 2005 5 The Timeliness of Income Recognition by European Companies: An analysis of Institutional and Market Complexity Ivana Raonic, Stuart McLeay, Ioannis Asimakopoulos Analyze of the asymmetric timeliness of income recognition of good and bad news in the earnings of 366 European firms between 1987 and 1999 2004 6 Discussion of The Timeliness of Income Recognition by European Companies: An analysis of Institutional and Market Complexity Bill Rees 2004 7 Asymmetric timeliness of accounting conservatism J. R. Dietrich, K. A. Muller III, E. J. Riedl Research on the relationship between earnings and stock returns to examine whether “bad” news is incorporated into earnings on a more timely basis than “good” news. 2007 8 International Differences in the Timeliness, Conservatism, and Classification of Earnings Peter F. Pope , Martin Walker Analyze of the differences in the timeliness of income recognition between the U.S. and U.K. GAAP financial reporting regimes 1999 9 Econometrics of the Basu Asymmteric Timeliness Coefficient and The Accounting Conservatism. (Working Paper) Ray Ball, S. P. Kothari, Valeri Nikolaev Analysis of the econometrics of the Basu asymmetric timeliness coefficient. The analysis addresses the conceptual and econometric challenges to the measure raised in the recent literature. First Draft : May 2006, Current version April 2009

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