Firm's Uncertainty and Accounting Conservatism

Abstract

Conservatism is ”a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in a business situation are adequately considered (FASB, 1980).” Intuitively, a firm's uncertainty is associated with conservatism. In this paper we investigate the association between a firm's risk and conservatism, by specifically examining whether adopting conservative accounting reduces a firm's uncertainty. We suggest that a high level of conservatism adopted by a firm does not effectively reduce the firm's risk in the following period. Furthermore, we investigate whether over (under) conservatism results in less (more) conservatism in the following period. We obtain strong evidence indicating that conservatism might converge to a long-term mean. Our collective evidence is consistent with the suggestion that the changes in the level of a firm's conservatism adjust with the changes in the firm's uncertainty. An increase in the changes of a firm's uncertainty results in a decrease in the changes of the conservatism level adopted by the firm in the following period. On the other hand, a decrease in the changes of a firm's uncertainty leads to an increase in the changes of the conservatism level adopted by the firm in the following period.