The Role of Conservatism in Financial Reporting

3890 Words May 20th, 2011 16 Pages
The Role of Conservatism in Financial Reporting

Table of Contents

Introduction 3 Applications of Conservatism in Accounting 4 Advantages associated with Conservatism 7 Disadvantages associated with Conservatism 11 Recommendations and conclusions 14 References 17

Introduction
This report investigates the application of conservatism in accounting and its role in financial reporting. We also examine and compare the advantages and disadvantages associated with conservatism and provide our opinion about conservatism. Conservatism may be a controversial accounting measurement principle but it has a long history and its use is far-reaching. Conservatism by definition is that all probable losses or expenditures will be recognized as they
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It is easy to recognize that information asymmetry exists in contracting due to the principal-agent nature of the relationship between a lender and a borrower, as well as between shareholders and managers of the firm. In both cases the agent has more information about the firm than does the principal.
In accordance with the bonus plan hypothesis of positive accounting theory, managers will have a tendency to overstate the net value of assets and debt-holders are aware this. Watts also mentions that the agents have limited liability in contracts because the cost of their actions can be well over their individual wealth; therefore the principal may never recover the losses incurred (Watts, 2002). Conservatism allows the principals to use “lower bounds measures” to monitor the agents by applying restrictions such as debt covenants and impede behaviour that could lower the value of net assets or the loan, thus increasing the firm’s risk (Watts, 2002). In contracting, conservatism is used to offset some of the information asymmetry in an attempt to reduce agency costs and overall risk of debt-holders. Contracts also tend to exclude non-verifiable assets such as intangibles, making the net value of assets conservative.
Shareholder’s litigation – Many academics identify shareholder litigation as another cause for the continued use of conservatism in accounting. The reason is that litigation produces asymmetric payoffs because “overstating

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