Asymmetric Timeliness Research Articles

The Confounding Effect of Cost Stickiness in Conservatism Research

Sales decreases affect earnings more than sales increases because of cost stickiness. We hypothesize that this correlated omitted variable constitutes a confounding effect in standard asymmetric timeliness models. Adding sales change direction to the Basu (1997) and Ball et al. (2013b) models decreases measured conservatism significantly and has a large impact on the relative ranking of industry-level conservatism estimates and on inferences about drivers of conservatism. Future empirical research on conditional conservatism should control for the potential confounding effect of sticky costs.

Mandatory Audit Firm Rotation and Audit Quality

In a setting where mandatory audit firm rotation has been effective for more than 20 years (i.e. Italy), we analyse changes in audit quality during the auditor engagement period. In our research setting, auditors are appointed for a three-year period and their term can be renewed twice up to a maximum of nine years. Since the auditor has incentives to be re-appointed at the end of the first and the second three-year periods, we expect audit quality to be lower in the first two three-year periods compared to the third (i.e. the last) term. Assuming that a better audit quality is associated with a higher level of accounting conservatism, and using abnormal working capital accruals as a proxy for the latter, we find that the auditor becomes more conservative in the last three-year period, i.e. the one preceding the mandatory rotation. These results are confirmed using Basu's [1997. The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics, 24(1), 3–37] timely loss recognition model. In an additional analysis, we use earnings response coefficients as a proxy for investor perception of audit quality, and we observe results consistent with an increase in audit quality perception in the last engagement period.

Is UK Financial Reporting Becoming Less Prudent?

This paper seeks to discover whether as a result of the removal of prudence as a concept within the revised 2010 Conceptual Framework, the accounts of companies in the FTSE100 in the UK have displayed any trends to be more or less conservative/prudent. The research design uses the two most popular measures of accounting conservatism (prudence) used in literature, Market-to-Book ratio and the Basu Asymmetric Timeliness model (Basu 1997) and compares the period prior to the change in the 2010 Conceptual Framework with the same measures post the change. The study finds that using both measures of conservatism, the levels of conservatism have fallen since the removal of prudence from the Conceptual Framework. This paper has implications for the users of financial statements and standard setters as the lower levels of prudence or accounting conservatism are associated with higher levels of risk (litigation) and costs (agency costs) which can affect stock valuations.

Innovation efficiency and asymmetric timeliness of earnings: Evidence from an emerging market

This study investigates the impact of intellectual capital output on the asymmetric income timeliness of firms in Taiwan, which is an emerging economy with a high concentration of research and development (R&D)-intensive firms but poor investor protection. The higher growth opportunities and increased risk faced by R&D firms make them more vulnerable to shareholder litigation. Specifically, I examine whether companies that are less efficient at transforming new ideas or techniques into granted patents are more timely in their recognition of losses and less timely in their recognition of gains in response to higher expected litigation costs. Indeed, I observe a negative relationship between innovation efficiency and asymmetric income timeliness and this is more evident among highly R&D-intensive firms. In a parallel analysis, I also find that the observed greater earnings conservatism of low-innovation-efficient firms is more evident following the introduction of the Securities and Futures Investor Protection Act in the year 2003, when a class action litigation mechanism was established. Together, these findings highlight the role of accounting conservatism in mitigating the potential litigation risk faced by high-tech industries.

The Relationship between Board Skills and Conservatism: Malaysian Evidence

This study seeks to examine the influence of board skill, multiple directorships (BSHIP), and tenure of independent directors on accounting conservatism, as measured by asymmetric timeliness and accrual-based conservatism (CONACCR). Fixed-effect regression models were constructed on a sample of 2016 firm-year observations for asymmetric timeliness model and 2033 firm-year observations for CONACCR model, which covered from 2001 to 2007. The findings show that the degree of financial expertise on the board is positively associated with the recognition of bad news which is relative to good news into earnings. BSHIP appears to have no effect on conservatism. Independent directors who have longer tenure in the board of the firms are slower in recognizing bad news which is relative to good news into earnings. The study provides empirical evidence on the effectiveness of the board of directors, which will be an interest to the practitioner or regulators in reviewing the corporate governance regulations.

Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism

ABSTRACTA substantial literature investigates conditional conservatism, defined as asymmetric accounting recognition of economic shocks (“news”), and how it depends on various market, political, and institutional variables. Studies typically assume the Basu [1997] asymmetric timeliness coefficient (the incremental slope on negative returns in a piecewise‐linear regression of accounting income on stock returns) is a valid conditional conservatism measure. We analyze the measure's validity, in the context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firm's operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which “unbooked” information (such as revised expectations about rents and growth options) is independent of other information, and discuss the conditions under which a proxy for this characteristic is the market‐to‐book ratio. We also conclude that much criticism of the Basu regression misconstrues researchers’ objectives.

Litigation Cost, Market-to-Book, and Asymmetric Timeliness of Earnings

Recent studies have questioned the validity of the Basu asymmetric timeliness of earnings (AT) as the proxy for accounting conservatism. An important basis for the criticism is the negative association observed between AT and market-to-book ratio (MB), another proxy for conservatism. Drawing upon prior research, we hypothesize and find that the negative relationship is stronger in a more litigious environment, indicating that low MB is a proxy for elevated expected litigation cost. Therefore the negative association reflects the rational response of managers and auditors in applying greater conservatism to mitigate expected litigation cost that increases as MB dips below a threshold. The negative association is not a valid basis for questioning the validity of the Basu model. This study demonstrates that MB is a proxy for risk, contributing to the debate on whether book-to-market ratio is a proxy for risk or the product of mispricing in the finance literature.

Foreign Private Issuers' Application of IFRS Around the Elimination of the 20-F Reconciliation Requirement

This study examines how the elimination of the 20-F reconciliation requirement affects the quality of accounting data prepared by cross-listed firms that report under IFRS as promulgated by the IASB (hereafter CL IFRS firms). Using IFRS-adopting firms that are not cross-listed in the U.S. (hereafter NCL IFRS firms) as the control sample, we find that CL IFRS firms experience a decrease in the magnitude of accounting discretion, a change in the asymmetric timeliness of earnings, and an improvement in the value relevance of reported earnings between the pre- and the post-elimination periods. These results suggest that the SEC's previous reconciliation requirement may have an unintended negative effect on CL IFRS firms' incentives in the application of IFRS. Comparing accounting quality under IFRS and U.S. GAAP in the post-elimination period, our additional analysis shows that the quality of accounting data prepared using IFRS by CL IFRS firms is comparable to that prepared using U.S. GAAP by U.S. firms, except that IFRS-based numbers exhibit less earnings asymmetry than U.S. GAAP-based numbers.

Political Uncertainty and Accounting Conservatism: Evidence from the U.S. Presidential Election Cycle

We hypothesize that political uncertainty leads to higher agency costs between managers and shareholders resulting in an increased demand for accounting conservatism. Exploiting the exogenous variation in political uncertainty induced by the U.S. gubernatorial election cycle, we find that the asymmetric timeliness of news recognition increases with political uncertainty. Our political uncertainty hypothesis operates through three economic channels, namely, political power of the incumbent, industrial exposure to politics, and the alignment of managerial and investor incentives. Accordingly, we find that the political uncertainty effect is more pronounced when the governor has control of legislature and when patronage is weaker, when a firm belongs to an industry that is more exposed to politics, when managers are better disciplined by governance mechanisms and when their reputations are more tied to the firm.

Conservatism and the Information Content of Earnings

This study finds that higher asymmetric timeliness is associated with slower resolution of investor disagreement and uncertainty at earnings announcements. These findings indicate that a potential cost of asymmetric timeliness is less transparent earnings, which impedes equityholders’ ability to discern the valuation implications of earnings when they are announced. We also find that during the earnings announcement period after the initial price reaction to the announcement, firms with higher levels of asymmetric timeliness have positive stock returns and higher levels of stock purchases by insiders.

More on Estimating Conditional Conservatism

Basu (1997) proposes a measure of financial reporting conservatism based on asymmetry in the conditional earnings/returns relation. Patatoukas and Thomas (2011) show upward bias in this measure, because a placebo — lagged earnings — also exhibits similar asymmetry. Ball, Kothari, and Nikolaev (2013a) and Collins, Hribar, and Tian (2014) propose alternative explanations for the bias and offer revised measures to overcome the bias. We find, however, that both revised measures remain substantially upward biased. In particular, a placebo based on lagged share price mimics time-series and cross-sectional variation observed for the revised measures. More generally, we find biases in the asymmetric timeliness specification because earnings, accruals, and other measures of performance are often related to second and higher moments of the distribution of returns. In addition to suggesting the asymmetric timeliness specification be used with caution, our study illustrates the useful role placebos can play in archival studies.

Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism

A substantial literature investigates conditional conservatism, defined as asymmetric accounting recognition of economic shocks (“news”), and how it depends on various market, political and institutional variables. Studies typically assume the Basu (1997) asymmetric timeliness coefficient (the incremental slope on negative returns in a piecewise-linear regression of accounting income on stock returns) is a valid conditional conservatism measure. We analyze the measure’s validity, in the context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firm’s operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which “unbooked” information (such as revised expectations about rents and growth options) is independent of other information, and discuss the conditions under which a proxy for this characteristic is the market-to-book ratio. We also conclude that much criticism of the Basu regression misconstrues researchers’ objectives.

Aggressive Financial Reporting and Corporate Fraud

This study documents new evidence on the relationship between firms financial reporting behavior and engagement in corporate fraud. Using a matched sample of 184 companies over an eight-year period from 2003 to 2010, we empirically examine whether firms that practice aggressive financial reporting are more likely to be involved in corporate fraud. We determine aggressive financial reporting by (1) conducting a time-series test of timely loss recognition and (2) using asymmetric timeliness of earnings models. Our results show that firms with fraudulent financial statements employ aggressive financial reporting during the two years prior to the occurrence of fraud. Specifically, we found that firms engaged in fraud have significantly less timely loss recognition and lower asymmetric timeliness of earnings compared to firms not engaged in fraud. The result is robust even after including various controls. We conclude that aggressive reporting provides an early sign of the potential for corporate fraud, and thus contributes towards efforts to deter fraud.

Assessment of Earnings Conservatism in Government-Linked Companies

We examine the level of earnings conservatism in government-linked companies, where significant ownership and control lies in the hands of federal or state government. We assess conservative practice using the asymmetric timeliness of earnings model introduced by Basu (1997). The sample in this study includes 234 government-linked companies and 1122 widely held companies listed on Bursa Malaysia over the period 2005 to 2010. Our results show that, in contrast to widely held companies, government-linked companies are not conservative when preparing their financial statements. Further analysis that divides government-linked companies into companies under federal government control and those under state government control shows that the conservatism level between the two groups varies. Unlike federal-government-controlled companies, state-controlled companies recognised bad news in a more timely way than they recognised good news. Our findings are in line with the claims that managers in government-linked companies practice agressive financial reporting due to weak governance, a high incentive to maximize compensation and greater agency problems. Conservative reporting found in state-controlled companies suggests that managers in these companies might have a lower incentive to inflate earnings because their opportunity for better job prospects is limited to the state level.

On Estimating Conditional Conservatism

ABSTRACTThe concept of conditional conservatism (asymmetric earnings timeliness) has provided new insight into financial reporting and stimulated considerable research since Basu (1997). Patatoukas and Thomas (2011) report bias in firm-level cross-sectional asymmetry estimates that they attribute to scale effects. We do not agree with their advice that researchers should avoid conditional conservatism estimates and inferences from research based on such estimates. Our theoretical and empirical analyses suggest the explanation is a correlated omitted variables problem that can be addressed in a straightforward fashion, including fixed-effects regression. Correlation between the expected components of earnings and returns biases estimates of how earnings incorporate the information contained in returns. Further, the correlation varies with returns, biasing asymmetric timeliness estimates. When firm-specific effects are taken into account, estimates do not exhibit the bias, are statistically and economically significant, are consistent with priors, and behave as a predictable function of book-to-market, size, and leverage.Data Availability: Data are publicly available from sources identified in the article.

Goodwill accounting and asymmetric timeliness of earnings

PurposeThe purpose of this paper is to investigate how fair value reporting and increased managerial discretion under the new goodwill accounting affect the asymmetric timeliness of earnings;, i.e. accounting conservatism.Design/methodology/approachVarious empirical models are applied to a sample of 11,034 firms. To capture a cross‐sectional variation in asymmetric timeliness of earnings, Kahn and Watts' C_Score is adopted.FindingsIt is found that financial reporting for firms with purchased goodwill has become more conservative after the enactment of the new standard. However, once an increase in conservatism that is not attributable to new goodwill accounting is controlled for, it is found that accounting earnings for firms with purchased goodwill become less conservative.Research limitations/implicationsThe results should be interpreted with caution, because the effect of concurrent events other than the adoption of SFAS 142 on reported earnings is not perfectly controlled.Practical implicationsThe results of this paper support Watts' assertion that new goodwill accounting impairs accounting earnings' ability to reflect the economic earnings in a timely manner, but these results should be interpreted with caution, as the main objective of goodwill accounting is not to improve accounting conservatism.Originality/valueThis paper makes a timely contribution to the debate of fair value accounting by focusing on the impact of SFAS 142 on the asymmetric timeliness of earnings. By employing all available firms with purchased goodwill balances rather than relying on firms that report impairment losses, our research design better captures the impact of SFAS 142 on financial reporting.

Effects of Nonlinearity and Multi-Period Lags on Basu (1997) Measure

This paper examines impacts of nonlinearity and multi-period lags on Basu (1997) measure. First, we predict and find that earnings responses increase with absolute magnitudes of news; therefore, asymmetric timeliness is more pronounced when news of large absolute magnitudes occur. Next, we examine lagged earnings responses to good and bad news and hypothesize that differences between them persist and turn negative as lag increases. Concepts to compare extents of conservatism when considering nonlinearity and lags are also provided. Our empirical results suggest that nonlinearity in earnings responses and multi-period earnings responses should be considered to compare conservatism more validly.

Cross Sectional Variation in Cash Flow Asymmetric Timeliness and Its Effect on the Earnings-Based Measure of Conditional Conservatism

Earnings asymmetric timeliness in recognizing losses versus gains is the most commonly used measure of conditional accounting conservatism. However, this measure captures both accrual asymmetric timeliness and operating cash flow (CFO) asymmetric timeliness. Because cash flow asymmetry is not related to differential verification thresholds in recognizing gains versus losses, we argue that it adds noise or bias to tests of conservatism. Importantly, we show that CFO asymmetry varies cross-sectionally with variables associated with firms’ life-cycle stage -- size, age, growth, and capital expenditures. We attribute this result to the differential weight that the market places on assets in place versus growth options in good news versus bad news environments during various stages of a firm’s life cycle. Using three empirical settings, we show that CFO asymmetric timeliness confounds results in studies where the sample is over-represented by early life-cycle stage firms or the partitioning variable deemed to give rise to conservative reporting is correlated with the firms’ life-cycle stage. Going forward, we recommend that researchers either use an accrual-based asymmetric timeliness measure or control for firm characteristics associated with life-cycle stage when testing for conditional conservatism.

Agency-based demand for conservatism: evidence from state adoption of antitakeover laws

We use antitakeover laws passed by several states in the mid-1980s and early 1990s as an exogenous increase in agency conflicts and examine how these laws affect the demand for asymmetric timeliness of loss recognition (ATLR). Consistent with the debt-based contracting demand for ATLR, we find an increase in ATLR after the passage of antitakeover laws for firms with high contracting pressures. These increases are incremental to those found in control firms that face similar pressures but whose states did not pass antitakeover laws. We do not find comparable changes in ATLR for firms with higher agency costs of equity. In contrast to the observed increases in ATLR, we find no change in the short-window information content of earnings announcements. Overall, our results suggest that higher agency conflicts result in a heightened demand for ATLR in financial statements but not for more forward-looking new information. Further, these demands seem to emanate from debtholders and not from equityholders.

Goodwill Accounting and Asymmetric Timeliness of Earnings

This paper investigates how fair value reporting and increased managerial discretion under the new goodwill accounting affect the asymmetric timeliness of earnings; i.e., accounting conservatism. We adopt Kahn and Watts’ (2009) C_Score, a firm-year measure of Basu (1997) conservatism, to capture a cross-sectional variation in asymmetric timeliness of earnings. We find that financial reporting for firms with purchased goodwill has become more conservative after the enactment of the new standard. However, once we control for an increase in conservatism that is not attributable to new goodwill accounting, we find that accounting earnings for firms with purchased goodwill become less conservative. Our results support Watts’ (2003a) assertion that new goodwill accounting impairs accounting earnings’ ability to reflect the economic earnings in a timely manner, but these results should be interpreted with caution, as the main objective of goodwill accounting is not to improve accounting conservatism.