Conservatism as a Defining Principle for Accounting
STEPHEN PENMAN*
Columbia Business School,
COLUMBIA UNIVERSITY

ABSTRACTThe removal of “conservatism” as a qualitative characteristic from the Conceptual
Framework of the IFRS has met with considerable resistance. This paper argues thatconservatism has a role in accounting, but not as a qualitative characteristic. Rather, it
serves as a defining principle for how accounting is to be done. It is thus central toresolving “recognition” and “measurement” issues in the Conceptual Framework, issues
that determine what actually goes into the balance sheet and income statement but
issues on which the Framework is particularly weak. As a “prudent reaction to
uncertainty,” conservatism supplies the investor with information about the payoffs toinvestments, particularly the uncertainty involved in those investments.
JEL Classification: M41
Key Words: Accounting Policy; Conservative Accounting

1. Introduction
The International Accounting Standards Board (IASB) and the Financial AccountingStandards Board (FASB) in the United States have oscillated in embracing accounting“conservatism” in their conceptual frameworks. The idea appears in the original FASB Concepts
Statement No.2, as a “qualitative characteristic” but not as such in the current exposure draft of
the IASB’s Conceptual Framework or the FASB’s most recent Concept Statement.1 However,*Corresponding Author. Address 3022 Broadway, New York, NY 10027, USA. Telephone +1-212-854-9151 E-mailshp38@columbia.edu.
1
See FASB (1980) for Concepts Statement No. 2 and IASB (2015) for the current Exposure Draft for the IASB
Conceptual Framework. The current FASB Concept Statement No. 8 (FASB, 2010) is that Board’s latest attempt at
a conceptual framework.
Received October 31, 2016; available online December 21, 2016 (Advance publications by J-STAGE)
DOI: 10.11640/tjar.6.2016.03

Copyright©2016 Research Institute for Economics & Business Administration – Kobe University.

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the demotion of conservatism in conceptual thinking is not without controversy.
This paper argues that accounting conservatism serves investors well and supports theargument with empirical evidence. Indeed, the paper identifies conservatism as a defining
principle for how accounting is actually executed to convey information to investors.
The objection to including conservatism in the Conceptual Framework appears to be basedon the notion that conservatism implies bias, and bias is undesirable. Conservatism is replacedwith “neutrality,” a seeming more pleasing attribute. This paper shows that conservative
accounting indeed implies bias, but (constrained) bias is a desirable feature of accounting
information. With that bias, conservatism is not just one of many desirable qualitative features ofaccounting, but rather a core principle that can drive quantification in accounting. In identifying
conservatism as a qualitative characteristic—worse, by dropping it altogether—the Boards’
Framework understates its importance. Rather, it is a key for resolving “recognition” and“measurement” issues in the Conceptual Framework (hereafter, CF).
Recognition and Measurement principles are at the heart of accounting—they determine
what actually goes into the financial statements and at what amounts. Yet it is at this point that
the CF is weakest. The CF attempts to resolve the issues by requiring the accounting to satisfy
stated definitions of assets and liabilities while maintaining prescribed qualitative characteristics
like “relevance,” “faithful representation,” and “comparability.” This approach fails to produce
clear, concrete guidance for standard setting or practical accounting.
I hope to show that this impasse is for two reasons. First, qualitative characteristics are notdefinitive enough to resolve recognition and measurement issues. More cutting-edge principles
are required. Second, asset and liability definitions fail to come to grips with the information thatinvestors need; these legalistic definitions are far from their mind when they invest. The
incorporation of conservatism, not as a mere qualitative characteristic but as defining principle forreporting to those investors, breaks the impasse.
Accounting standard setting is a design project. Financial statements are for users—thecustomers, one might say—so the accounting mission is to design a product that satisfies thecustomers’ demand. The CF is clear about this customer focus and who the customer is: thestated objective of financial reporting in the CF is to report to investors about the “amount,
timing, and uncertainty” of future cash flows and on the stewardship of management to thoseinvestors. This paper endorses that objective with the implication that the CF is to be judged by
how it satisfies this objective. The focus is on the first part of the objective, providing information
about future cash flows. That, of course, is of prime concern to investors (and the analysts who
support them) who wish to understand the value of investments (that is determined in valuation
theory by expectations about the amount, timing, and uncertainty of future cash flows). Thisfocus is without any prejudice to the stewardship objective. There is a considerable literature thatinvestigates conservative accounting for stewardship reporting and more generally for contractingwith agency issues and asymmetric information.2 This paper complements that analysis with analternative way of thinking about the issue—a way of thinking that does not necessarily involve
agency issues.
2

See Kwon, Newman, and Suh (2001), Göx and Wagenhoffer (2009), Gigler et. al. (2009), Zhang (2008), andWittenberg-Moerman (2008), for example. Mora and Walker (2015) and Barker and McGeachin (2015) evaluate
accounting policy in light of these papers. Ewert and Wagenhofer (2012, Chapter 4) reviews the research in thisarea).

Penman: Conservatism as a Defining Principle for Accounting

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The paper begins by defining the concept of conservatism I have in mind. It then discusses
the role of “qualitative characteristics” for resolving accounting issues and the omission ofconservatism from those qualitative characteristics. The paper then shows how conservatism canbe a defining principle to guide accrual accounting and the development of accounting standards
for reporting to investors, and brings theory and empirical evidence to the issue.

2. Defining Conservative Accounting
A number of definitions of conservatism can be found in the literature, with a distinction
often drawn between “unconditional conservatism” and “conditional conservatism.” 3 For
purposes of this paper the definition in Concepts Statement No. 2 is embraced: conservatism is “aprudent reaction to uncertainty.” In other words, conservative accounting is accounting that deals
with uncertainty. 4 It in no way excludes the concepts of unconditional and conditional
conservatism—indeed, it identifies them as a reaction to uncertainty (as will be seen). It is thisoriginal definition of conservatism that is implicitly rejected in subsequent conceptual framework
documents.
Given the stated objective of financial reporting to provide information about the “amount,
timing, and uncertainty” of future cash flows (emphasis added), it is curious why conservatism isabandoned in the current drafts of the CF. Perhaps the elevation of “prudence” is meant tosubstitute, for it is now prudence that is tied directly to uncertainty: “prudence is the exercise of
caution when making judgments under conditions of uncertainty” (IASB, 2015, paragraph 2.18).
But something is lost in doing so. First, in the paragraph that contains this quote, prudence isinvoked as supporting neutrality, and conservatism is deemed to be in conflict with neutrality.5
Second, the original definition of conservatism refers to a “prudent reaction,” so is moredemanding that a reactive accounting be developed—accounting that responds to uncertainty.
The original definition is quite explicit: if accounting is to inform about uncertainty—as theobjectives of financial reporting state—it is defined as conservative accounting.
Of course, all this wordsmithing is frustrating and perhaps unnecessary, and my parsing of
the words might be seen as word-play. However, if accounting is to inform about uncertainty, as
required by the CF objectives, we require an accounting that is a “prudent reaction to uncertainty.”
Let’s call that accounting “conservative accounting” as Concepts Statement No. 2 indeed does.

2.1 Conservative Accounting and Bias
In the 2015 IASB draft of the CF, neutrality, “supported by the exercise of prudence,” is3

The former refers to the expensing of investments that are particularly risky (such as R&D) or carrying booked assets
on the balance sheet at low amounts (with accelerated depreciation, for example). The latter refers to further writedown of assets conditional upon the receipt of new information that indicates outcomes are likely to be lower than
expected. Feltham and Ohlson (1995) and Zhang (2000) are the standard references for unconditional conservatism
while those for conditional conservatism are Basu (1997) and Watts (2003a, 2003b).
4
A distinction is often drawn between “risk” and “uncertainty.” No such distinction is drawn in this paper; uncertainty
is taken to mean the absence of a certain outcome. The term, “risk” will sometimes be used, merely because it fits agiven context.
5
The FASB (2010) Concepts Statement No. 8, an amendment of Concepts Statement No. 2, excludes both “prudence”
and “conservatism” because “including either would be inconsistent with neutrality” (paragraph BC3.27) and “anadmonition to be prudent is likely to lead to bias” (paragraph BC3.28).

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substituted for conservatism. The reason (it is said) is that conservatism implies bias and bias is
intolerable in financial reporting. This seems to make sense. However conservative accounting,appropriately applied, means necessary bias.
Consider the accounting for receivables. A receivable is booked now (time zero) for cash to
be received one period later (time 1). No-arbitrage valuation theory says that the value of thatcash is the expected cash discounted for risk (at a discount rate, r):Value of receivable0 

Expected cash1
1 r

Under IFRS, accounts receivable are indeed discounted (via an allowance for bad debts) for
the “probability of non-receipt of cash.” An accountant, wishing to be unbiased, might apply thediscount such that the receivable (net of the allowance) is equal to an unbiased estimate of the
expected cash flow from the receivable. That supplies information about the amount of expectedcash flows. However, the valuation formula says that the appropriate number is not the expectedcash flow but a number that includes a discount to the expected cash flow for risk: the expectedcash flow is biased downwards to reflect that discount.
Thus, accounting that reports on the “amount, timing, and uncertainty” of expected cash
flows includes that discount as a “prudent reaction to uncertainty” about the amount of future
cash flows. That requires a (conservative) bias in the net receivable below the expected amount ofcash flows. Investors are then notified that expected outcomes are uncertain. Valuation theory
also says that, with this discount, expected returns should equal the no-arbitrage return for therisk borne. With the (net) book value for the receivable at the discounted value,

Expected Cash 1
1  rBook Value of Receivable(from the equation above). That is, expected earnings to be reported next period is not zero but
positive such that the expected book rate-of-return on the receivable is equal to the discount rate:
the accounting yields expected earnings that are the reward for the risk borne in holding thereceivable. That contrasts with zero expected earnings if the book value of the receivable is(unbiasedly) set to equal expected cash flows.
One might argue that the receivable example is trivial because the timing of the cash receipt
is usually in the immediate future, so there is little remaining uncertainty. However, theaccounting applies in the same way to a 30-year mortgage loan which has to be discounted forpossible credit losses. And, even with receivables, the amount of the discount typically depends
on the risk in holding the receivable, with a higher discount (allowance for credit losses) required
for a high-risk receivable. Indeed, if the receipt of cash is highly uncertain, no receivable isrecognized as all. That is conservative accounting in the extreme—accounting that takes a (large)
discount to expected cash flows when uncertainty is high.
Again, one must not get hung up on terminology, and the CF framework documents arecorrect in dismissing (gratuitous) bias that is unrelated to the economics of the business. But
business involves risk and the discount for risk in conservative accounting reflects the economicsof the business.

Penman: Conservatism as a Defining Principle for Accounting

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3. Qualitative Characteristics and Operating Principles
These points might suggest that conservatism should be reinstated as a “qualitative
characteristic” in the CF. But is that the place for it?

3.1 Qualitative Characteristics as Defining Principles
The IASB proposed CF lists a number of qualitative characteristics that accounting data are
required to exhibit. Premier among them are relevance and faithful representation coupled with the“enhancing” characteristics of comparability, verifiability, timeliness, and understandability. Should
conservatism join the list to be effective?
There is little doubt that these qualitative characteristics are virtuous. Embracing them forfinancial reporting is not only noble but necessary. However, these qualities are not specificenough to resolve recognition and measurement; they have no cutting edge. Who would argue
that accounting should not be relevant, faithfully representative, etc.? If we all accept that
accounting should be relevant, does that tell us whether fair value accounting or historical costaccounting should be implemented? Both are surely relevant and one might be more relevant
than the other, but we need something more to discriminate between them or to inform us underwhat circumstance one measurement approach dominates the other—and I cannot see the otherqualitative characteristics resolving the issue. To the point, it is fair to say that, while the CF
offers historical cost and current value on the menu of alternative measurements, it provides little
guidance for choosing between them despite the presence of the umbrella of qualitative
characteristics.
In short, qualitative characteristics are not operating principles to define how the accounting
is to be done. They are broad, admirable qualities that apply to information generally, notcharacteristics that define accounting information in particular.
The CF is a proposed constitution for standard setting, so there are parallels in otherconstitutions, whether it be for a country, a society, or a club. In the constitution of the UnitedStates, for example, there is an admirable preface that upholds the ideal of freedom (“theBlessings of Liberty”) among others. However, the constitution only gets a cutting edge with theamendments, the Bill of Rights. So, the first amendment says the state cannot interfere with thefreedom of religion, the freedom of speech, the freedom of the press, and the freedom toassemble peaceably. These operating principles give the constitution a cutting edge such that a
court (like an accounting standard setter) has a firm basis to resolve individual cases. These aresurely additional nuances that have to be dealt with in specific court cases—as there will be instandard setting for specific issues—but specific-enough guidance is there.

3.2 Conservatism as a Defining Principle
These thoughts suggest that reinstating conservatism as a qualitative characteristic is not
likely to be effective. However, the active tone in defining conservatism as a “prudent reaction to
uncertainty” suggests that it could take on a role as an operating principle for determining how
accounting should be done—a principle for recognition and measurement. Could this be thecase?
3.2.1 A Lesson from an Accounting Principles Course
I well remember the first accounting course I took as an undergraduate. The professor began
the class by demonstrating the accounting for a tennis club. He called it Cash Accounting,6

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delivering a statement of cash receipts and disbursements and a balance sheet consisting only of
cash. He then said that, for a business, we use a different type of accounting, called Accrual
Accounting. This delivers an income statement rather than a cash-flow statement and a balance
sheet with many more items than cash.
He characterized accrual accounting as follows: total cash flows over the life of a businessequal total (accrual) earnings, but accrual accounting recognizes earnings in different periods thanthe cash flows. He then asked: what is the principle for recognizing earnings in each period? The
answer: under uncertainty, earnings are not recognized until there is resolution of uncertainty.
That is, under uncertainty, accountants defer the recognition of earnings until the uncertainty has
been resolved. That “realization” point is typically when the firm has a confirmed customer andother uncertainties, such as the firm’s performance, are also resolved. This is a defining principlethat generates the income statement. And, as earnings add to the balance sheet via the closing
entry, it is also defining principle for adding value to balance sheet. Stated differently, theprinciple says: do not add to the balance sheet until there is resolution of uncertainty.
For the investor receiving accounting reports, a price-to-book ratio (P/B) thus represents the
expectation of future earnings in the market price (P) that have not yet been recognized by theaccountant in the book value (B). A price-earnings ratio (P/E) compares the expectation of future
earnings in the market price (P) to earnings that are currently recognized (E). A high P/E
forecasts significantly more future earnings than the earnings the accountant is currently
recognizing. But, the accounting underlying the earnings measurement, tied as it is to uncertainty
resolution, conveys something else to the investor: the expected earnings are at risk of not being
realized.
This defining principle for the recognition of earnings is a “prudent reaction to uncertainty.”
Concept Statement No. 2 calls that conservative accounting. Conservative accounting is not aqualitative characteristic, but a defining principle for how the accounting is done in the presenceof uncertainty. Again, terminology is not important. If the words “conservative accounting” haveother associations in some minds, an alternative label might be entertained. But the point is torecognize that investors require accounting for the uncertainty of future cash flows.
Characterized as an operating principle rather than a qualitative characteristic, conservative
accounting now has a cutting edge: it discriminates between current value accounting andhistorical cost accounting. The value-in-use version of current value accounting measurement in
the CF operates under a different principle for handling uncertainty: anticipate all future cash
flows with a discount for risk (as in a discounted cash flow present-value calculation). That is very
different from waiting until the firm wins a customer and cash flows are “highly probable.” So thedifference in handling uncertainty is made stark. Under conservative accounting, risk is revealed
ex ante by not booking anticipations of the future and the balance sheet evolves only as the risk isresolved. Under current value accounting, risk is imbedded in the balance sheet, to be revealed
only ex post, as earnings are shocked by the failure of value booked to the balance sheet to berealized. Which accounting serves the investor—the customer—best?
It is unfortunate that “historical cost accounting” has taken on that name, making it appear
stuck in the past, backward-looking (it is said). The driver is not historical cost, but an
accounting for uncertainty: carry inventory (and the assets that produce inventory) at cost on thebalance sheet until there is a resolution of uncertainty. At that point and only at that point, writeup the balance sheet by substituting inventory (at cost) for accounts receivable (at market), withthe difference going to gross margin in the income statement. That is actually forward-looking

Penman: Conservatism as a Defining Principle for Accounting

7(to an uncertain future). Again, one should not get hung-up on language, but perhaps thisaccounting should be called “prudent accounting for uncertainty” rather than “historical costaccounting.” Or, perhaps, “conservative accounting.”
3.2.2 The Application of Conservative Accounting in Practice
My Accounting Principles professor continued by showing how the principle is applied.
First, a revenue recognition principle: recognize revenue only when there is a customer
against which there is a legal claim, the major economic activity is accomplished, and receipt ofcash is reasonably certain. Even then, discount the receivable for the probability that cash may
not be received—a prudent reaction to uncertainty. The new IFRS 15 on revenue recognition
uses somewhat different formal criteria but the focus is still on resolution (satisfaction) of acontact with the receipt of cash “highly probable.”
Second, to complete the earnings (profit) calculation, match expenses to revenues. The
accountant then reports a net figure of how the firm adds to shareholders’ equity from tradingwith customers—a value-added number which is a basis for predicting (net) cash flows fromfuture revenues from customers.6
It is on this second point that, in retrospect, I see that professor was wrong, at least in
describing how accounting is currently practiced. Matching requires that any expenditure thatgenerates future revenues be capitalized in the balance sheet and then depreciated or amortized tobe matched against those revenues as they are recognized. However, accounting does not do that.
Expenditure on research for new products is expensed to the income statement, as withadvertising and promotion to build brands that will (hopefully) yield future revenues. That is
mismatching: expenses to produce future revenues are matched against current revenues, andfuture revenues are subsequently reported without the matched (amortized) expenses. The
mismatching is not confined to research and advertising: currently, firms expense expenditures tobuild supply chains and product distribution networks, employee training and development costs,
software development, start-up costs, merger costs, and more. Indeed, it is estimated that asignificant portion of selling, distribution, and administrative (SG&A) expense in the income
statement is actually investments. This expensing of investment falls into the category of socalled “unconditional conservatism.” The exercise of “conditional conservatism” also means
mismatching: impairments due to revisions in expectations of future revenues are expensed
against current revenues.
I refer to my early education because it draws out principles underlying current accounting
practice. I expect it resonates with others whose accounting courses focused on accounting
principles rather than the teaching of IFRS rules. As broadly characterized as conservative
accounting, current practice becomes a benchmark for evaluating the critical question: Is
accounting, as practiced, an appropriate accounting for uncertainty? If not, what would an
appropriate accounting look like?
3.2.3 A Tension
At first glance, it would appear that GAAP and IFRS accounting fails. The theory of thefirm characterizes business activities as making investments and producing earnings from thoseinvestments. Thus, one should not confuse investment with the return on investment. Stated
6

The accounting just described is that in the seminal accounting theory paper of Paton and Littleton (1940).

8The Japanese Accounting Review, 6 (2016), 1-16

differently, separate capital from income, stocks from flows. Accounting is a stocks-and-flows
system, so should obey this dictum. A practice that expenses investment against income fails to
do so, creating the confusion and making the bottom-line earnings a difficult number tointerpret: earnings is no longer the flow from capital investment.
To the point, the many calls to capitalize research expenditures, brand building expenses,
and other “intangible” assets are driven by a desire to report a better return-on-investment
measure—one that has the investments in the denominator and a numerator that is notcontaminated by expensed investments.
At second glance, the expensing of investment appears to be a reaction to uncertainty.
Inventory and property, plant, and equipment (PPE) are booked to the balance sheet. They
pertain to products that can be sold or facilities to produce products that can be sold. However,for expenditures on research where typically there is not a yet product (let alone a customer), theexpenditure is expensed. The distinction between the two treatments is a difference in theuncertainty about future revenues. Indeed, in requiring immediate expensing of Research andDevelopment under FASB Statement No. 2, the U.S. Board focused on the “uncertainty of
future benefits.” In IAS 38, the IASB applied the criterion of “probable future economic benefits”
to distinguish between Research (which is expensed) and Development (which is capitalized andamortized). IAS 12 recognizes deferred tax assets only if it is probable that taxable profits will be
realized in the future. While not codified, the uncertainty-of-future-benefits criterion seems toapply to advertising and promotion (will the promotion campaign be successful?) and other socalled intangible assets. There is a reluctance, in practice, to booking assets to the balance sheet if
there is a relatively low probability of an outcome. Even inventory and PPE that are booked tothe balance sheet are written down on (down-ward) revisions of that probability. Thisconservative accounting connects to uncertainty.
Like revenue recognition, the expensing of investment under uncertainty defers earnings to
the future: current earnings are lower due to the expensing but future earnings are expected to behigher (now without amortization of investment cost against revenues from the investments).
However, the connection to uncertainty means that these deferred earnings are at risk: they may
not be realized. Just like the accounts receivable example earlier in the paper, the accounting thus
imbeds the economics of uncertainty: higher risk requires a higher expected return—and higher
risk means higher expected earnings.
There clearly is a tension between mixing stocks and flows and recognizing uncertainty ininvesting activities. This is the sharp edge to be resolved in a conceptual framework. There ismuch at issue. On the one hand, there are calls by many to capitalize “intangible assets” and toreport a book rate-of-return that resembles an economic rate of return. On the other hand, there
are those who resist putting assets with low probability of payoff on the balance sheet—“water inthe balance sheet” (they say) that is likely to evaporate when outcomes are not realized, yielding
an income statement dominated by impairments.

4. Conservative Accounting and the Investor: Theory and EvidenceWith the focus of the CF on investors, any resolution in the CF must accord with valuation
theory and be also consistent with the empirical evidence on how investors process accounting
information. We thus raise the following questions:Penman: Conservatism as a Defining Principle for Accounting

9 Is the connection of conservative accounting to risk consistent with no-arbitrage
valuation theory in finance?
 Is conservative accounting consistent with accounting-based valuation that isderived from that theory?
 Does the empirical evidence indicate that investors associate conservative
accounting with risk?

4.1 Conservative Accounting and No-Arbitrage Valuation Theory
No-arbitrage valuation theory depicts investors as giving up future consumption (to invest)
in anticipation of the return of cash to buy consumption in the future. However, that cash is in
the future and at risk, so investors require a discount to the amount of expected cash flows forboth the timing and uncertainty of future cash flows, and set (no-arbitrage) prices accordingly.
The discount for the timing is given by the risk-free rate and that for uncertainty by a risk
premium over the risk-free rate.
Accordingly, when buying a share of a firm at a no-arbitrage price, investors expect to earn
the expected return that includes a risk premium over the risk free rate. However, when they sell
the share and invest the cash proceeds in the risk-free asset―they realize the return―the risk is
reduced, and so is the expected return (now equal to the risk-free rate). The risk from theinvestment is resolved, the investor is released from risk.
Buying a share of a firm is buying the expected earnings of a firm and the risk the investor
bears is the risk of those earnings not being realized. Correspondingly, when the firm realizes
those expected earnings into cash or a near-cash asset on shareholders’ behalf, the investors’ risk
and expected return are correspondingly reduced. But, until realization, earnings are still at risk ofbeing realized and the investor requires a higher return for that risk. Conservative accounting, by
waiting until risk is resolved, reflects the investor’s risk.
Put another way, an investor can release from the risk in expected earnings by selling thestock and investing in the risk-free asset. But when the firm realizes those expected earnings into
cash or a near-cash asset on shareholders’ behalf, the investor’s risk and expected return are
similarly reduced. On a consolidated basis, the firm’s accounts are part of the shareholders’accounts, so it makes no difference if the shareholder “realizes” or the firm “realizes” on theshareholder’s behalf― the shareholders (the 100 percent owners) have the claim to the same cash.
A no-arbitrage condition so dictates (frictions aside). Cash payout has no effect on cum-dividend
value under Miller and Modigliani (1961) (M&M) no-arbitrage assumptions, so cash held in thefirm has the same value as cash on personal account.7
However, there is no necessary connection of conservative accounting to priced risk. Noarbitrage asset pricing theory casts risk as that which cannot be diversified away. Thus only
systematic risk is priced, and a firm’s risk is determined by a beta sensitivity to that risk.
Conservative accounting might just involve diversifiable risk, so is of no consequences to investors.

7

If dividends are paid out of accumulated earnings, recognizing earnings only on the resolution of uncertainty would
seem to constrain dividends. However, while total recognized earnings over the life of the firm determine total cash
to be paid out to investors, the timing of their recognition does not constrain periodic dividends under M&M
assumptions. Those assumptions involve perfect capital markets so investors can generate cash for consumption at
any time by liquidating their investment or by borrowing. Thus there is no need to tie dividends to earnings.

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This has yet to be worked out.8 That said, the no-arbitrage argument above implicitly refers topriced risk. The realization principle can be cast in terms of asset pricing: earnings are recognizedwhen a firm can book a zero-beta asset, cash or a near-cash (discounted) receivable. Realization isupon release from beta risk.

4.2 Conservative Accounting in Accounting-based Valuation
Research has developed valuation based on accrual accounting numbers rather than expectedcash flows. Starting with the no-arbitrage dividend discount formula for equity valuation andsubstituting earnings and book values for dividends, dt, via the clean-surplus accounting relation,a no-arbitrage price is given by
dt
Earnings t  rt Book Value t 1
 Book Value 0  Rtt 1 Rtt 1

P0  

where rt is the discount rate for risk in period and R t is (one plus the) discount rate in the term
structure from 0 to t. (Values subscripted t > 0 are expected values.) The numerator, Earningst –rtBook Valuet-1 is so-called residual income, and the model is referred to as the residual income
model.
While this model brings in accounting numbers, it is based only on a substitution via theclean-surplus relation, and mere substitution puts little on the table: the utility of the valuation
depends on how earnings and book values are recognized and measured. To the point, theformula permits any type of (clean-surplus) accounting up to the last period when the firm
liquidates, even random numbers for earnings and dividends. That is because it only enforces areconciliation of earnings and book values to dividends in the last period: earnings must be
measured such that the liquidating dividend equals book value (and thus the book value goes tozero on the payout of the dividend). With the valuation based on an infinite summation (with noliquidation for a going concern), this is problematic.
This point is typically not recognized when the model is applied in practical valuation: thevaluation is only as good as the accounting involved and the model does not specify that
accounting. The research task is to specify the appropriate accounting, and the standard-setting
task is to promulgate the appropriate accounting for valuation.9 When applied in practicalvaluation, analysts use IFRS or GAAP accounting. Is that appropriate? Or, to the point of thispaper, is conservative accounting appropriate?
There are two features of the model that would suggest so.
First, current book value in the formula is not discounted for risk in the formula.
Conservative accounting yields such a book value. Assets that are particularly risky are notbooked to the balance sheet and assets that are booked are impaired if there are indications thatcarrying value will not be realized. Further, earnings are added to the balance sheet only on the
resolution of uncertainty. That is a low-risk balance sheet, one that is unlikely to hold negative
surprises for the investor in the future; value in the balance sheet is not likely to reverse. That is abalance sheet that does not have to be discounted.
89Penman and Zhang (2016b) explore a model where conservative accounting connects to priced riskThis point is expanded upon in Penman (2015, 2016).

Penman: Conservatism as a Defining Principle for Accounting

11

Second, the formula separates the low-risk book value from earnings that are still at risk andthus have to be discounted. Further, the timing of the expected earnings over future periods isbased on their expected realization and that expectation (for period t) is matched with a timevarying discount rate, Rt, that varies with the risk that the expected earnings will not be realized.
Thus, not only is a discount rate implied by the uncertainty of earnings realization, but also aterm structure that reflects the expected timing of and uncertainty about the realizations. Thus,
for a firm where expected earnings are expected to be realized in the short term from carried
inventory, the discount rate might be relatively low, while earnings expected in the long-term fora start-up biotech research program might be strongly discounted for risk.
These observations provoke a tantalizing conjecture: Conservative accounting can provide
information about the discount rate that an investor applies to expectations. Much needs to bedone to pin down that conjecture, including connecting conservative accounting to(undiversifiable) priced risk. While the modeling is not as yet forthcoming, the empiricalevidence does indicate that conservative accounting connects to priced risk.

4.3 Conservative Accounting and Empirical Evidence
As observed, conservative accounting (by expensing some investments) confuses stocks withflows, capital and income. Thus a return on investment measure based on book values does notindicate the economic rate of return.
However, the book rate of return takes on a different interpretation under conservative
accounting, that of conveying risk and expected return. This section provides evidence, and that
evidence indicates that conservative accounting connects to priced risk in the market.
Conservative accounting is applied to the operating activities of a firm (not the financing
activities) and so affects the book rate of return for the operating activities, the Return on Net
Operating Assets (RNOA) (the operating income from the business relative to the net operating
assets on the balance sheet).10 The effect of conservative accounting on RNOA is deterministic
and well known.11 Given (operating) earnings in the numerator, the omission of investments inthe denominator yields an RNOA higher than the economic rate of return on average. However,with growing investments subject to expensing under conservative accounting, earnings (in the
numerator) is reduced to yield a lower RNOA,
Tables 1 – 3 are adapted from Penman and Zhang (2016). Table 1 reports the association of
RNOA (calculated under U.S. GAAP) with forward stock returns. Each year, 1963-2013, listed
U.S. firms (other than financials where the accounting works differently) are ranked on their
RNOA and formed into 10 (decile) portfolios. The stock returns over the subsequent year arethen calculated and the mean of these returns from each year for each portfolio is reported in thetable. These means are an estimate of the expected returns associated with different levels of
RNOA and thus, if risk is priced efficiently in the market (on average), they are an estimate of
the reward for bearing risk. It is clear from Table 1 that RNOA bears no relation to these returns:
RNOA does not indicate risk and the expected return.
Table 2 is constructed in the same way as Table 1, but now from a measure, ΔC, which
captures how conservative accounting affects the numerator of RNOA, with a higher ΔC
10RNOA is sometimes referred to as Return on Invested Capital (ROIC). RNOA is the unlevered return, in contrast
to the levered return on equity (ROE) which includes the effect of financing leverage.
11
See Feltham and Ohlson (1995) and Zhang (2000), for example.

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The Japanese Accounting Review, 6 (2016), 1-16

indicating earnings reduced more by the conservative accounting—by the deferral of earnings to
the future via revenue deferrals and the expensing of investments. It is clear that this measureranks returns over the ΔC portfolios: more conservative accounting indicates higher risk and thus
higher returns as a reward for that risk. So, while there is little theoretical modeling connecting
conservative accounting to priced risk, that appears to be so empirically.
Table 3 has the same RNOA portfolios as in Table1, but now with RNOA ranked withineach RNOA portfolio into three portfolios based on the degree of the application of conservative
accounting, ΔC. It is clear that, while RNOA does not indicate expected returns (in Table 1),
distinguishing the extent to which RNOA is affected by conservative accounting does: if thenumerator earnings are depressed by conservative accounting (high ΔC), that indicates risk and ahigher expected return. And that is so for all levels of RNOA, though the effect is particularly
strong for low RNOA where the effect of conservative accounting on RNOA is the strongest.
In sum, these findings report that conservative accounting appears to capture priced risk.
Further, they bring a different interpretation to the book rate of return. Rather than a measure of
the economic rate of return, RNOA affected by conservative accounting conveys risk andexpected return. The investor is warned: a low RNOA due to conservative accounting indicates arisky investment. (Think of a start-up expensing research and development with the productoutcome uncertain). The investor is also warned not to interpret the book rate of return as “real”(economic) profitability. The mixing of capital and income takes this away to convey information
about risk instead.
It follows that, were accountants to remove conservative accounting, information about risk
would be lost. That might be a worthwhile tradeoff if the result were an economic measure of
profitability. However, is that a realistic alternative for the accountant? It would require
identifying the elements of transactions with customers and suppliers that are investments fromthose which are periodic revenues and expenses. How much of a price reduction for a customer isan investment to attract the customer in the future? How much of a salesperson’s salary is fordeveloping long-term relationships for future revenues? How much of current wages and bonuses
are for services currently provided versus incentives to remain loyal in the future? Will researchexpenditure really yield expected benefits? Even if an expenditure is identified as an investment to
go on the balance sheet, the accountant is left with the thorny issue of an appropriate
amortization rate which affects both the numerator of RNOA and the carrying value of theinvestment in the balance sheet going forward. Is an economic rate of return that crisplyidentifies capital and income within the realm of accounting determination? These are very
difficult accounting issues (perhaps beyond resolution). An appropriate response might then be:when uncertain about these points, be conservative and expense immediately.

5. Conservative Accounting and the Conceptual Framework
The current draft of the IASB Conceptual Framework actually attempts to confront thesequestions. It does so via a so-called “balance-sheet approach” to recognition and measurement.
Assets and liabilities are recognized in the balance sheet if they satisfy specified definitions.
Earnings then fall out as the change in net assets, a byproduct of balance sheet measurement. The
definition of an asset requires future expected economic benefits and that is a necessary condition
for an investment. Does this principle rule out conservative accounting?

ΔC Portfolios

18.3

19.1

1.1

3

20.0

5.5

4

18.3

8.2

5

18.4

10.5
17.3

13.2
17.9

16.7

8

15.2

22.6

9

16.4

38.8

HIGH

-1.0

92.7

HIGH-LOW

14.2

LOW

15.9

2
15.4

3
17.0

4
15.3

5
17.0

18.0

ΔC Decile Portfolios
6
7
18.5

8

20.5

9

22.3

HIGH

The flags, ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

8.1***

HIGH-LOWLOW
MEDIUM
HIGH
HIGH-LOW
14.1
17.0
22.8
8.7***

2
17.2
18.4
21.4
4.2***

3
19.5
17.8
23.1
3.6**

4

5
15.6
17.6
21.5
5.9***

Source: Adapted from Penman and Zhang (2016).

11.1
8.9
22.6
11.5***

LOW

17.2
17.6
20.3
3.1**

16.8
16.2
19.2
2.4*

16.7
17.6
19.0
2.3

RNOA Decile Portfolios
6
7
8

9
12.1
15.8
18.4
6.3***

The flags, ***, **, and * indicate significance at the 1%, 5%, and 10% levels, respectively.

14.6
15.1
17.6
2.9**

HIGH

TABLE 3: MEAN ANNUAL RETURNS FOR PORTFOLIOS FORMED BY RANKING ON ΔC-SCORE WITHIN EACH RNOA DECILE,
IN PERCENT

Return17.4

Return-9.7

2

TABLE 2. MEAN ANNUAL RETURNS FOR PORTFOLIOS FORMED BY RANKING ON ΔC-SCORE, IN PERCENT

-53.9

RNOA

LOW

RNOA Decile Portfolios
6
7

TABLE 1. MEAN ANNUAL RETURNS FOR PORTFOLIOS FORMED BY RANKING ON RNOA, IN PERCENT

Penman: Conservatism as a Defining Principle for Accounting
13

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The Japanese Accounting Review, 6 (2016), 1-16

5.1 Conservatism is Actually in the Conceptual Framework
While removing conservatism from the CF as a qualitative characteristic, it turns out that it
becomes an operating principle when the Framework comes to recognition. While theexpectation of future benefits is a necessary condition to recognize an asset in the CF, it is not
sufficient. Barker (2015) points out that the definition of an asset in the CF also imposes otherconditions: the economic resource must be “controlled by the entity as a result of past events”(paragraph 4.5). Thus, anticipated cash flow from future customers cannot be recognized—they
are not controlled by the entity as a result of a past event. That is a revenue recognition rule,albeit via a criterion for recognizing the associated asset (typically the receivable) in the balance
sheet. Conservative revenue recognition is in the Framework.
As an application, IFRS 15, the new revenue recognition standard takes this balance-sheet
approach by focusing on the satisfaction of contractual rights and obligations. But it is clear that
requires the accountant to wait to recognize revenue until this uncertainty is resolved and, in thewords of the standard, receipt of cash is “highly probable.” As to measurement, both the CF andIFRS 15 rule out the anticipation of cash flows from future customers in a current value
calculation. So, they require historical cost or, in our rewording of “historical cost accounting,”
accounting that is a “prudent reaction to uncertainty.” Revenue recognition under the CF
effectively takes a (big) discount for uncertainty: while the market price of a stock may anticipate
future customers, the principle discounts that price for the risk that the customers may notmaterialize. That yields a book value less than market price, with the addition to book value only
booked when and if the customers materialize. The if implies uncertainty.
While the IASB CF implicitly requires revenue recognition based on resolution of
uncertainty, the draft Conceptual Framework of the Accounting Standards Board of Japan (readin English) is much more explicit. It proposes a “release from risk” concept for recognizing
earnings and a separation of such earnings from those that (under fair value accounting) do notsatisfy this criterion.12

5.2 The Application of Conservatism in the Conceptual Framework is Incomplete
Deferred revenue recognition is only one arm of conservative accounting. The other is theaccounting for expenditures, that is, the designation of expenditures as an asset or an expense. As
said, this is crucial to distinguishing capital from income and, at first appearance, the CF appears
to state necessary conditions: an economic benefit over which the entity has control and which is
the result of past events. Expenditures are past events and typically yield control, so it would seemto come down to the issue of whether there are expected economic benefits. Does this supply thenecessary and sufficient conditions? Are the conditions sufficient to separate capital from income
to yield an economic rate of return?
To sharpen the question: Does the CF require booking an asset with expected future benefits
but very low probability of success? Would that not result in very doubtful assets being booked tothe balance sheet, assets where the best prediction for the future would be an impairment because
the investment does not pay off? Would not investors see this as “water in the balance shee?.” Is
this an asset that represents security for creditors to lend against? Would not the income
statement be swamped with impairments of low-probability investments that did not work out?

12

On this, see van Mourik and Katsuo (2015) and Saito and Fukui (2016).

Penman: Conservatism as a Defining Principle for Accounting

15

What would be the meaning of “earnings?”
While the CF definition of an asset has the necessary condition of expected future benefits,
it does not deal with the uncertainty around that expectation. It is inconceivable that a qualitative
characteristic can provide the solution—most expenditures are “relevant,” “verifiable,”“understandable,” etc. Further criteria have to be supplied to distinguish risky investments that go
onto the balance sheet and those that don’t.
The impasse can be broken in one of two ways. Either design an accounting that clearly
separates capital from income or develop principles that establish a threshold for when net assets
go on the balance sheet. The former is quite problematical; indeed, the separation of capital fromincome may be a principle that does not work under uncertainty. The second is more realistic,
indeed Barker and Penman (2016) propose a solution based on a refined matching concept under
uncertainty, and others may be available. The separation of “research” from “development” in IAS
38 tackles the issue, though one might look for a more concrete criterion than “probable” toestablish the uncertainty threshold.

6. Conclusion
The removal of “conservatism” as a qualitative characteristic from the Conceptual
Framework has met with considerable resistance. This paper argues that conservatism has a rolein accounting, but not as a qualitative characteristic. Rather, it serves as a defining principle for
how accounting is to be done. As a prudent reaction to uncertainty, conservatism supplies theinvestor with information about the payoffs to investments, particularly the uncertainty involvedin those investments.
Indeed, while seemingly demoted as a qualitative characteristic, conservatism is actually inthe current draft of the Conceptual Framework in its implied revenue recognition criteria.
However, the CF framework is incomplete: it does not deal with question of booking or
expensing expenditures on uncertain investments.
One might dismiss these points by claiming that accounting is not about dealing withuncertainty. That is a tough position to support given that (1) investing is all about handling
uncertainty, (2) the CF objectives explicitly cast accounting as providing information about “theamount, timing, and uncertainty” of future cash flows, and (3) there is no role for accounting
under certainty: it is uncertainty that is the rationale for accrual accounting.
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