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 implications for accounting regulators. Part II summarizes the empirical evidence on conservatism, its consistency with alternative explanations, and opportunities for future research. The evidence is consistent with conservatism's 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 litigation, taxation, and accounting regulation. The evidence in Part II suggests the contracting 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 of the evidence on conservatism, but cannot be the prime explanation. The explanations and evidence have important implications for accounting regulators. FASB attempts to ban conservatism in order to achieve “neutrality of information” without understanding the reasons conservatism existed and prospered for so long are likely to fail and produce unintended consequences. Successful elimination of conservatism will change managerial behavior and impose significant costs on investors and the economy in general. Similarly, researchers and regulators who propose the inclusion of capitalized unverifiable future cash flows in financial reports should consider the costs generated by their proposal's effect on managerial behavior.

No abstract

We estimate a firm-year measure of accounting conservatism, examine its empirical properties as a metric, and illustrate applications by testing new hypotheses that shed further light on the nature and effects of conservatism. The results are consistent with the measure, C_Score, capturing variation in conservatism and also predicting asymmetric earnings timeliness at horizons of up to three years ahead. Cross-sectional hypothesis tests suggest firms with longer investment cycles, higher idiosyncratic uncertainty and higher information asymmetry have higher accounting conservatism. Event studies suggest increased conservatism is a response to increases in information asymmetry and idiosyncratic uncertainty.Both authors are at the Sloan School of Management,

A simple model of earnings, cash flows and accruals is developed by assuming a random walk sales process, variable and fixed costs, accounts receivable and payable, and inventory and applying the accounting process. The model implies earnings better predicts future operating cash flows than does current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross correlations of each firm's series. The implications and predictions are tested on a 1337 firm sample over The relation between earnings and cash flows . IntroductionEarnings occupy a central position in accounting. It is accounting's summary measure of a firm's performance. Despite theoretical models that value cash flows, accounting earnings is widely used in share valuation and to measure performance in management and debt contracts.Various explanations have been advanced to explain the prominence of accounting earnings and the reasons for its usage. An example is that earnings reflects cash flow forecasts (e.g., Beaver, 1989, p. 98;and Dechow, 1994) and has a higher correlation with value than current does cash flow (e.g., Watts, 1977;and Dechow, 1994). In this paperwe discuss the use of accounting earnings in contracts, reasons for its prominence and the implications for inclusion of cash flow forecasts in earnings. One prediction that emerges is that earnings' inclusion of those forecasts causes earnings to be a better forecast of (and so a better proxy for) future cash flows than current cash flows. This can help explain why earnings is often used instead of operating cash flows in valuation models and performance measures.Based on the discussion of contracting's implications for earnings calculation, we model operating cash flows and the formal accounting process by which forecasted future operating cash flows are incorporated in earnings. The modeling enables us to generate specific integrated predictions for: i) the relative abilities of earnings and operating cash flows to predict future operating cash flows; and ii) firms' time series properties of operating cash flows, accruals and earnings. We also predict cross-sectional variation in the relative forecast-abilities and correlations. The predictions are tested both in-and out of-sample and are generally consistent with the evidence.Dechow (1994) shows working capital accruals offset negative serial correlation in cash flow changes to produce first differences in earnings that are approximately serially uncorrelated.' She also shows that in offsetting serial correlation accruals increase earnings' association with firm value. One of this paper's contributions is to explain the negative serial correlation in operating cash flow changes in particular and the time series properties of earnings, operating cash flows and accruals in general. A second contribution is to explicitly model how the accounting process offsets the negative correlation in operating cash flow changes to produce earnings changes that are less serially...

In this paper we critically evaluate the standard-setting inferences that can be drawn from value relevance research studies that are motivated by standard setting. Our evaluation concentrates on the theories of accounting, standard setting and valuation that underlie those inferences. Unless those underlying theories are descriptive of accounting, standard setting and valuation, the value-relevance literature's reported associations between accounting numbers and common equity valuations have limited implications or inferences for standard setting; they are mere associations. We argue that the underlying theories are not descriptive and hence drawing standard-setting inferences is difficult. AbstractWe evaluate the literature that, for standard-setting purposes, assesses the usefulness of accounting numbers on their stock market value association. For several reasons we conclude the literature provides little insight for standard setting. First, the association criterion has no theory of accounting or standard setting supporting it. Standard setters' descriptions of their objectives and accounting practice are both inconsistent with the criterion. Important forces shaping accounting standards and practice are ignored. Second, many tests in the literature rely on valuation models that omit important factors and many studies do not provide links between valuation model inputs and accounting numbers. Finally, there are a variety of significant econometric issues in the studies.