CONSERVATISM IN ACCOUNTING ZHENG Ying Sun-Yat Sen University

Overview  Definition and Measurement of Accounting Conservatism  Determinants of Accounting Conservatism  Economic Consequences of Accounting Conservatism

Definition and Measurement of Accounting Conservatism  Definition:  the accountant’s tendency to require a higher degree of verification to recognize good news as gains than bad news as losses  Classification:  Conditional : ex-post or news-dependent, Lower of cost or market value  Unconditional: an ex ante policy, lower book values of assets (higher book value of liability) in the early period of an asset or liability life. High rate of amortization  Measurement  Basu (1997): reverse earning-return relationship  Ball and Shivakumar (2005): accrual based  Khan and Watts (2009): firm level

Measuring Conservatism  Reverse Earning/ return relationship – 1375 citation

Basu (1997)

Measuring Conservatism  Accrual based model – 582 citation;

Ball and Shivakumar (2005):

Measuring Conservatism  Firm level conservatism-C-score-69 citation

Khan and Watts (2009):

Determinants of Accounting Conservatism— Theoretical  Contracting Efficiency  Litigation Cost  Accounting Regulation  Tax

Exp1:Contracting  Part of efficient technology employed in the organization of the firm and its contracts with various parties  Conservatism accounting is a means of addressing moral hazard caused by parties to the firm having asymmetric information, asymmetric payoffs, limited horizons, and limited liability.  Managers’ opportunistic behavior?  Payoff - compensation?  Risk-shifting/ asset substitution  Debt contracts  Increase firm value---efficiency?

Contracting  Demand side for timeliness information: contract users  For managers  Verifiability---mark to market?  Timeliness information cannot be easily verified sometimes  For contract enforcement  Asymmetric verifiability  Asymmetric payoff for specific parties  Debt contract-tangible assets  Compensation contract-limited tenure and limited liability  Corporate governance—hiding loss project

Determinants of Accounting Conservatism— Empirical  Dependent: Accounting conservatism  Independent: Determinants  Control: Size, Leverage, BMR  Country-level (investor protection and financial markets)  Ball et al. (2000)  Ball et al. (2003)  Bushman and Piotroski (2006)  Ball et al. (2008)  Industry-level (product market competition)  Dahliwahl et al. (2009)  Haw et al. (2009)  Firm-level  Information asymmetry: Lafond and Roychowdhury (2008)  Corporate governance: Ahmed, A., and S. Duellman (2007)  Qiang (2007)

Economic Consequences of Accounting Conservatism  Main role of conservatism:  Contracting efficiency  Governance role  Incentive to disclose + Economic consequences  Capital market consequence Market value Cost of equity Cost of debt  Non-market consequences Litigation Turnover Compensation Real activities, like investment

Economic Consequences of Accounting Conservatism – Cost of Debt  Accounting conservatism and cost of debt:  Zhang (2008): spreads on private debt and measures of conservatism  Moerman (2008): the timely loss recognition reduces the bid-ask spread in the secondary loan market  Bauwhede and Gent (2008)  Ball, Bushman and Vasvari (2008): in the syndicated loan markets + lenders reduce interest rates when borrowers are relatively more conservative

Economic Consequences of Accounting Conservatism – Governance Role  Conservatism and investment efficiency  Bushman et al. (2007): cross country investment efficiency  Francis and Martin (2010): acquisition-investment decision  Lara et al. (2010, SSRN): over-investment and under-investment

Main Points  Hypothesis link between conservatism and investment efficiency  Moral hazard: mangers have incentives to delay exercising the abandonment option on unsuccessful project because of personnel cost  Ex-ante knowledge of conservatism to improve future project selection  Adverse selection: information role to facilitate financing

FRANCIS AND MARTIN (2010)  Research question: conservatism and firm’s acquisition investment, more profitable  Bidder’s announcement return and changes in prost acquisition operation performance  Busu (1997) model to estimate conservatism  Sample: SDC US Mergers and Acquisitions database  Period:

FRANCIS AND MARTIN (2010)  H1. A bidder’s expected acquisition profitability (measured as a bidder’s 3 day CAR around an acquisition announcement date) is positively associated with the bidder’s timeliness of loss recognition.

FRANCIS AND MARTIN (2010)

Lara et al. (2011)  Research question: conservatism and investment efficiency, both under-investment and over- investment  Investment efficiency: residual from investment-q model following Biddle et al(2009)  Conservatism: C-score  Sample: U.S. sample  Period:

Lara et al. (2011)