Conservatism (AutoRecovered)

Financial Accounting
Assignment’s topic: conservatism
Submitted to prof: Mohamed El Banan
Submission date: 6/3/2024
Submitted by: Martina Nabil Saad

Conservatism
Definition of conservatism
Accounting conservatism is a major principle in accounting and an important feature of

financial reporting quality that requires cautions and high degree of verification.
Accounting conservatism could be defined as a prudent reaction recognition of good and

bad news about entities’ earnings, In Basu’s view, conservatism is the use of higher
degrees of reliability to identify and record profits and good news, as opposed to using
lower degrees of reliability to identify and record losses and bad news (Basu, 1997).
It represents a firm’s policy on asymmetric, timely recognition of economic losses

relative to economic gains (Basu, 1997; Khalifa et al., 2018; Zhang, 2020)
So, all probable losses are recognized but gains can only be registered when they are fully
realized and this is actually support what is said by (FASB, 1980) “conservatism dictates
the use of an estimate that is less optimistic”
Types of Conservatism
1- Conditional conservatism occurs when negative economic news is recognized in

accounting earnings in a timelier manner than positive economic news. In other words,
conditional conservatism is characterized by the asymmetric recognition of positive and
negative economic news. Examples of conditional conservatism include the asymmetric
treatment of loss and gain contingencies and accounting for inventory using the lower-of-
cost-or-market convention.
2- Unconditional conservatism occurs through the consistent under-recognition of

accounting net assets. Unlike conditional conservatism, unconditional conservatism does
not depend on news events. Examples of unconditional conservatism include
immediately expensing research and development expenditures and accelerated
depreciation.
The pros and cons of accounting conservatism
the literature and empirical evidence are divided regarding the pros and cons of
accounting conservatism. Looking at the positive side, conservative accounting can act as
a governance mechanism preventing managers from taking on projects with negative net
present value investments (Ahmed and Duellman, 2011; Kravet, 2014).
It can also reduce agency costs (Zaher et al., 2020), cost of equity capital (Khalifa and
Othman, 2015) or managers’ myopic behavior (Hejranijamil et al., 2020). Additionally,
stricter verification of good news can constrain earnings management practices (Lara et
al., 2020). Therefore, accounting conservatism could provide assurance to investors and
creditors regarding increased performance quality and a lower probability of future
litigation costs.
On the other hand, there is a significant body of academic and professional studies stating
that accounting conservatism is harmful in presenting reliable accounting information,
leading to its exclusion as a desirable qualitative accounting practice [FASB], 2010)
Lara et al. (2014) argued that conservatism increases the delay in verifying good news,
which may result in financial statements inhibiting higher information asymmetry
regarding the positive prospects of the financial statements. Furthermore, additional
research has documented that accounting conservatism, by motivating managers to be
risk- averse, could encourage them to reject corporate decisions that have risky positive
net present values in mergers and acquisitions (Kravet, 2014;Roychowdury, 2010).
According to (Anagnostopoulou and Tsekrekos, 2017; Francis et al., 2005; Wang, 2013;
Kousenidis et al., 2014; Hui et al., 2009; Hsieh et al., 2018; Hejranijamil et al., 2020),
accounting conservatism should reflect all risks in the business information, and thus,
financial reports should be prepared with caution when businesses are faced with higher
uncertainty so we should examine whether different types of uncertainty may have
different effects on the extent of accounting conservatism.
In doing so, we classify uncertainty into two categories: probabilistic uncertainty (risk)
and nonprobabilistic uncertainty (ambiguity) (Hsieh et al., 2018). Probabilistic
uncertainty refers to a condition in which outcomes can be forecasted and predicted
(Heinsalu, 2012).
Nonprobabilistic uncertainty, also known as ambiguity, refers to a situation in which the
probability of events is unknown, and the environmental outcomes are difficult to predict,
with firms lacking adequate data for determining output (Hsieh et al., 2018; Heinsalu,
2012).
this study examines two different dimensions of uncertainty – risk and ambiguity – and
suggests that they have opposite effects on accounting conservatism. In a risky
environment, conservative accounting practices offer decision-makers greater benefits,
such as increasing innovation and enhancing performance indicators when firms report
accounting numbers (Laux and Ray, 2020) or preventing overly optimistic management
behavior with financial statements (Solichah and Fachrurrozie, 2019). Thus, our study
examines the positive effect of risk on accounting conservatism. On the other hand,
prospect theory provides theoretical justification for the negative effects of ambiguity and
accounting conservatism. The theory states that decision-makers may opt for risk-taking
activities when faced with potential loss. Contrariwise, decision-makers may JFRA prefer
risk-averse decisions when firms face situations with potential higher gain. Applied to the
study setting, where higher ambiguity may indicate a greater loss (unfavorable
environment), firms may respond to this unfavorableness with more risk-taking
behaviors, resulting in less conservative accounting practices.
References
Basu, S. (1997). The conservatism principle and the asymmetric timeliness of

earnings1. Journal of accounting and economics, 24(1), 3-37.
Daryaei, A. A., Fattahi, Y., & Aldbs, A. (2024). The puzzling association between
accounting conservatism and corporate social responsibility. Asian Journal of Accounting
Research, 9(1), 35-46.
Fuad, F., Rohman, A., Yuyetta, E. N. A., & Zulaikha, Z. (2023). How risk and ambiguity
affect accounting conservatism. Journal of Financial Reporting and Accounting.
Ghazalat, A., & AlHallaq, S. (2024). Predicting and assessing bankruptcy risk: the role of
accounting conservatism and business strategies. Journal of Financial Reporting and
Accounting.
Ruch, G. W., & Taylor, G. (2015). Accounting conservatism: A review of the

literature. Journal of Accounting Literature, 34(1), 17-38.

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Financial Accounting

Assignment’s topic: conservatism

Submitted to prof: Mohamed El Banan

Submission date: 6/3/2024

Submitted by: Martina Nabil Saad

Accounting conservatism is a major principle in accounting and an important feature of

Accounting conservatism could be defined as a prudent reaction recognition of good and

It represents a firm’s policy on asymmetric, timely recognition of economic losses

1- Conditional conservatism occurs when negative economic news is recognized in

2- Unconditional conservatism occurs through the consistent under-recognition of

Basu, S. (1997). The conservatism principle and the asymmetric timeliness of

Ruch, G. W., & Taylor, G. (2015). Accounting conservatism: A review of the

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