Accounting Theory: Conservatism

3053 Words Oct 7th, 2011 13 Pages
Introduction

Conservatism has an undeniably significant influence in accounting field and has been practiced by most businesses for centuries until now. Basu (1997) found that as early as 15th century, conservative accounting had been practiced in trading partnerships in the Europe. Besides, it is also discovered that the theory of lower-of-cost-or-market-principle had been discussed long ago (Basu, 1997).

Conservatism or prudence does not have its exact definition but there are heaps of interpretations made by researchers which contribute to a better understanding of this accounting principle. Givoly and Hayn (2002) illustrate that conservatism is a practice of caution in recognizing and measuring income and assets.
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An improper and unethical accounting practice which may ignore conservatism is the main reason that led to these failures. Chi et al. (2009) admit and conclude that companies with weaker governance are more conservative.

The study of conservatism is also motivated by the desire to certify the level of reliability of information from companies’ financial reporting. With reliable information, well-informed decisions can be made by the users without any remorse. Barth et al. (2001, p. 94) suggest that “conservatism can be a by-product of applying the FASB’s reliability criterion”.

Additionally, it is crucial to know whether the different application of conservatism results in varying quality of financial information by companies. Applying consistent and appropriate accounting principles will eventually reduce quality concern by users of financial statements.

Hence, it is undeniable that accounting conservatism is one of the most important elements in financial reports. The subsequent contents of this research essay will be about motivations that encourage firms to adopt conservative financial reporting practices, critical analysis and descriptions about the empirical method employed by researchers in determining and measuring conservatism, a discussion about the association between conservative financial reporting and information quality and finally, a conclusion.

Motivations for firms to adopt conservative financial

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