Measure Of Conservatism Research Articles

The impact of conservatism on management earnings forecasts

We investigate the empirical relation between a firm's accounting conservatism and management's issuance of quantitative earnings forecasts. Using three measures of conservatism from prior literature, along with two aggregate measures, we find a negative association between conservatism and the frequency, specificity, and timeliness of management forecasts. The results are robust to estimating the regression in changes, using firm fixed-effects, and using a two-stage instrumental variables approach. Overall, these results suggest that accounting conservatism acts as a substitute for management forecasts by decreasing information asymmetry in the market and reducing potential litigation through the timely reporting of bad news.

The Choice of Joint-Auditors and Earnings Quality: Evidence from French Listed Companies

In France, every listed company is legally required to hire two auditors performing together the audit. Joint-auditing, initially instituted to allow a dual control, provides a unique and rich setting to study the consequences of the choice of auditors. It is generally assumed that audit market is segmented into at least two categories, large (Big 4) and small (non-Big 4) auditors, and that large audit firms are perceived to provide higher quality audits. Consistently to these assumptions, we hypothesize that financial reporting by companies audited by two Big 4 audit firms is of higher quality than companies audited by one Big 4 and one non-Big 4 or by two non-Big 4. Quality is operationalized using Basu's (1997) measure of conservatism, an important attribute of reporting quality. We test our hypothesis on a sample of 177 French listed companies on 31 December 2003. We regress earnings on stock returns and type of auditors. The result provides evidence that, contrary to our hypothesis, the presence of two Big 4 is associated with lower reporting quality. This surprising result can be explained by the fact that the interaction between two Big 4 audit firms is likely to be less productive in terms of corporate governance than the interaction between a Big 4 and a non-Big 4. When two Big 4 audit firms, applying comparable methodologies and incurring comparable reputation risk, work together, they would be more likely to rely on each other and, consequently, would have fewer incentives to provide maximum effort.

Earnings Restatements and Subsequent Accounting Conservatism*

In this paper we examine the effect of earnings overstatement disclosures on subsequent earnings conservatism. We hypothesize that after overstatement disclosures, overstating firms undertake a more conservative financial reporting strategy to restore credibility of their financial reporting with the market. We find that overstating firms report more conservatively after restatements than before restatements; and after restatement disclosures, overstating firms report more conservatively than their non-restating peer firms do. These results are consistent with the notions that externally, investors demand greater conservatism from firms that previously reported aggressively, and internally, managers in overstating firms have incentives to adopt more conservative financial reporting to restore their own reputations for credibility. Our results are robust when we use different methods to calculate conservatism measures and when we use an overall restatement sample that includes firms that previously understated earnings.

Changes in Discretionary Financial Reporting Behavior Following the Sarbanes-Oxley Act

We examine the effect of the Sarbanes-Oxley Act (SOX) on the extent of aggressive/conservative reporting behavior of public companies. SOX imposes considerably greater potential penalties on CEO/CFOs who engage in financial wrongdoing; therefore, risk averse managers are likely to report lower earnings by reducing discretionary accruals following SOX. Our results, based on a matched sample of dual-listed Canadian firms and their domestically-listed counterparts, indicate that (1) firms subject to SOX are more conservative in financial reporting in the post-SOX period as evidenced by lower signed discretionary accruals, the differential earnings persistence conditional conservatism measure, and the Penman and Zhang (2002) unconditional conservatism measure, and (2) the impact of SOX on firms' conservative reporting through discretionary accruals in the post-SOX period is not homogeneous; it is more pronounced for firms that were aggressive in the pre-SOX period.

Do firms become more conservative after financial restatements?

We examine whether firms' earnings exhibit higher degrees of conservatism after restating their financial statements. Conservatism is defined as more timely recognition of gains than losses in earnings (Basu, 1997). Using a sample of restatements derived from the Government Accountability Office (GAO) database and four alternative measures of earnings conservatism, we find that overall the restating firms' earnings exhibit greater conservatism during the two years following restatements. This increase is more pronounced for firms that self-prompt their restatements than firms that are prompted to restate by external parties such as auditors or the Securities and Exchange Commission (SEC). We also find weak evidence suggesting that the post-restatement increase in conservatism is more pronounced after the Sarbanes-Oxley Act (SOX) enactment in 2002.

The Benefits of Conservative Accounting to Shareholders: Evidence from the Financial Crisis

Using the recent financial crisis as a natural quasi-experiment, we test whether and to what extent conservative accounting affects shareholder value. We find that there is significantly positive and economically meaningful relation between conservatism and firm stock performance during the current crisis. The result holds for alternative measures of conservatism and is validated in a series of robustness checks. We further find that the relation between conservatism and firm value is more pronounced for firms with weaker corporate governance or higher information asymmetry. Overall, our paper complements LaFond and Watts (2008) by providing empirical evidence to their argument that conservatism is an efficient governance mechanism to mitigate information risk and control for agency problems, and that shareholders benefit from it. JEL Classification: M41; M48; G01 Keywords: Accounting conservatism, Shareholder value, Financial crisis

Decomposing group differences of latent means of ordered categorical variables within a genetic factor model.

A genetic factor model is introduced for decomposition of group differences of the means of phenotypic behavior as well as individual differences when the research variables under consideration are ordered categorical. The model employs the general Genetic Factor Model proposed by Neale and Cardon (Methodology for genetic studies of twins and families, 1992) and, more specifically, the extension proposed by Dolan et al. (Behav Genet 22: 319-335, 1992) which enables decomposition of group differences of the means associated with genetic and environmental factors. Using a latent response variable (LRV) formulation (Muthén and Asparouhov, Latent variable analysis with categorical outcomes: multiple-group and growth modeling in Mplus. Mplus web notes: No. 4, Version 5, 2002), proportional differences of response categories between groups are modeled within the genetic factor model in terms of the distributional differences of latent response variables assumed to underlie the observed ordered categorical variables. Use of the proposed model is illustrated using a measure of conservatism in the data collected from the Australian Twin Registry.

Estimating and validating a firm‐year‐specific measure of conservatism: Australian evidence

AbstractWe provide new evidence on the asymmetric timeliness with which economic gains and losses are recognized in Australian financial reporting (i.e. conservatism), as well as some of the factors associated with variation in conservatism. We first derive, and then estimate and subsequently validate, a firm‐year‐specific measure of conservatism (C_Score) in the manner suggested by Khan and Watts (2007). Our results indicate that conservatism is a pervasive feature of the Australian financial reporting environment. Conservatism is positively associated with stock return volatility, investment cycle length and prior period conservatism, and it is negatively associated with firm age, firm size and leverage. The results are an encouraging start for research into the causes and consequences of conservatism in Australian financial reporting.

The Impact of Default Risk on the Basu Measure of Accounting Conservatism

In this paper, we analytically and empirically examine the impact of default risk on the Basu (1997) measure of accounting conservatism. Using the classic Merton (1974) call-option model of equity, we show that the Basu asymmetric timeliness coefficient is biased upward by the existence of the default risk in a firm, and that bias tends to increase with the level of default risk. Furthermore, we propose a new measure of conservatism, the Default-Adjusted-Basu (“DAB”) measure, by modifying the original Basu measure. The DAB measure is likely more robust to the influences of default risk than is the original Basu measure. Our empirical evidence is consistent with our theoretical arguments with regards to both the impact of default risk on original Basu measure and the advantage of our DAB measure of conservatism.

Accounting conservatism of cross-listing firms in the pre- and post-Sarbanes Oxley periods

Abstract This study investigates the level of accounting conservatism of a sample of cross-listed firms, American Depository Receipts (ADRs), during the pre- and post-Sarbanes Oxley (SOX) periods. After examining two proxies for accounting conservatism, Basu's [Basu, S. (1997). The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics 24(1), 3–37.] conservatism measure and abnormal accruals, we find that the SOX-exposed Levels II and III ADRs become more conservative during the post-SOX period while the SOX-unexposed Level I ADRs have no increase in the level of accounting conservatism. Further, we investigate whether such an increase in accounting conservatism is associated with different levels of shareholder protection in ADRs' home countries, and find that only Levels II and III ADRs from code law (weak shareholder protection) countries become more conservative and Levels II and III ADRs from common law (strong shareholder protection) countries have no change in accounting conservatism. These results suggest that SOX-exposed cross-listing firms from weak shareholder protection countries are most greatly influenced by the stringent requirements in SOX, and hence respond by increasing conservatism in their financial reporting.

Asymmetry in Cash Flows and Accounting Conservatism

In this paper, I present evidence that the asymmetry in cash flows biases standard measures of conditional conservatism. First, the magnitude of the asymmetric timeliness coefficient decreases substantially (by 28–58%) when the dependent variable is accruals in the Basu (1997) model. Second, the results show that both accruals and cash flows are less persistent for firms with negative returns. This result suggests that the Basu (1997) asymmetric earnings change specification cannot distinguish whether the lower persistence of earnings is due to accounting conservatism or a result of real activities. Third, I show that extant non-price proxies for economic loss are very poor at identifying the sign of economic income. Finally, I replicate a recent study and demonstrate that inferences change when using accruals as the dependent variable and after controlling for variables that are the determinants of nondiscretionary accruals.

Conservatism Measures that Remove the Effects of Asset Composition

Recent studies show that regression-based estimates of accounting conservatism reflect both differences in the asymmetric recognition of bad news and differences in asset composition. In particular, a firm’s market value and returns reflect both assets-in-place and expected future rents, while book values tend to reflect only assets-in-place. We propose two tests that remove the effect of asset composition on cross-sectional comparisons of accounting conservatism. First, a test based on a ratio of regression coefficients allows for valid cross-sectional comparisons of conservatism relative to overall news recognition. Second, in some cases, researchers can separately identify and make cross-sectional comparisons of the fraction of good news recognized and the fraction of bad news recognized. The estimates in this second scenario use a regression of earnings on returns interacted with a book-to-market ratio. We validate our model by deriving and testing several predictions based on it.

Proposed Standards for Acute Exposure to Low Enrichment Uranium for Compliance with 10 CFR 70.61

Title 10, Code of Federal Regulations Part 70, puts forth requirements for licensure of special nuclear material including specific risk criteria for acute intakes based on biological effects. Standards for acute oral and inhalation intakes of soluble low enrichment are proposed for the three levels of biological effects given in the regulations. These levels were developed largely from available human data and have a large measure of conservatism. The proposed threshold for life endangerment was 500 mg for acute inhalation intakes and 2,500 mg for acute ingestion intakes. Acute intakes of 1,400 mg for ingestion and 100 mg for inhalation are proposed as thresholds for irreversible or serious long lasting health effects. For minor transient health effects, the proposed levels are 410 and 30 mg, respectively, for acute ingestion and inhalation intakes. For acute intakes below these levels, no demonstrable toxicological effects are anticipated.

Does auditor tenure influence the reporting of conservative earnings?

In this study, we examine the relation between auditor tenure and the reporting of conservative earnings. Using several measures of conservatism, we document a positive association between the conservatism in reported earnings and the length of the auditor–client relationship. We further document an increase in conservatism between short and medium tenure that does not deteriorate over long tenure. Collectively, the results imply lower conservatism for short auditor tenure, which suggests that mandating auditor rotation may have an adverse affect on the conservatism in reported earnings.

Litigation Risk, Price to Book and Conservatism in Financial Reporting

Prior literature has documented negative cross sectional associations between beginning of year price to book ratios (PBR) and the asymmetric timeliness (AT) of earnings, a measure of conservatism in financial reporting. We hypothesize and find that expected litigation costs are positively associated with gamma, a symbol denoting minus one times the association between PBR and AT. To test the hypothesis, we compare gamma before and after the 1995 Private Securities Litigation Reform Act, which exogenously reduces expected litigation costs. We find that gamma decreases significantly following the Act. Our results are robust to different measures of low PBR and different sample construction methods. The results imply that lower PBR proxies for higher expected litigation costs.

Conservatism of earnings reported under International Accounting Standards: A comparative study

ABSTRACTIn this study we analyse whether the use of IASB standards affects the conservatism of earnings of the firms that adopt them. We compare the conservatism of firms by groups of firms/countries using or not IAS. Our results show that 1) Earnings conservatism is, as pointed out in prior research, more pronounced in common-law-based developed economies; 2) The voluntary use of IASB standards in Europe (prior to 2005) has significantly increased the measures of earnings conservatism in adopting firms, and 3) The use of IAS fails to improve the relevance and reliability of accounting information in emerging/developing countries, where enforcement and investor protection is low.

Estimating and Validating a Firm-Year Specific Measure of Conservatism: Australian Evidence

We provide new evidence on the asymmetric timeliness with which economic gains and losses are recognized in Australian financial reporting (i.e. conservatism), as well as some of the factors associated with variation in conservatism. We first derive, and then estimate and subsequently validate, a firm-year-specific measure of conservatism (C_Score) in the manner suggested by Khan and Watts (2007). Our results indicate that conservatism is a pervasive feature of the Australian financial reporting environment. Conservatism is positively associated with stock return volatility, investment cycle length and prior period conservatism, and it is negatively associated with firm age, firm size and leverage. The results are an encouraging start for research into the causes and consequences of conservatism in Australian financial reporting.

Anti-Intellectualism and Political Ideology in a Sample of Undergraduate and Graduate Students

To estimate correlations for scores on a student anti-intellectualism scale with scores on a measure of political conservatism, 235 students were given a survey containing a student anti-intellectualism scale, a political conservatism scale, and a demographics questionnaire identifying the participants' sex, college classification, ethnicity, political party affiliation, and self-described political ideology. The political conservatism scale contained two factors, Religiosity and Economic Conservatism, both of which were scored separately in addition to an overall Conservatism score. Students' Anti-intellectualism scores were correlated with Political Conservatism scores (r = .37, p < .01), with Religiosity scores (r = .42, p < .01), and with Economic Conservatism scores (r = .17, p < .05). An analysis of variance indicated a significant difference in students' Anti-intellectualism scores based on college classification (F4,233 = 2.27, p < .04). Specifically, freshman had significantly higher scores than graduate students.

Accounting conservatism and corporate governance

We predict that firms with stronger corporate governance will exhibit a higher degree of accounting conservatism. Governance level is assessed using a composite measure that incorporates several internal and external characteristics. Consistent with our prediction, strong governance firms show significantly higher levels of conditional accounting conservatism. Our tests take into account the endogenous nature of corporate governance, and the results are robust to the use of several measures of conservatism (market-based and nonmarket-based). Our evidence is consistent with the direction of causality flowing from governance to conservatism, and not vice versa, indicating that governance and conservatism are not substitutes. Finally, we study the impact of earnings discretion on the sensitivity of earnings to bad news across governance structures. We find that, on average, strong-governance firms appear to use discretionary accruals to inform investors about bad news in a timelier manner.

Conservatism as motivated avoidance of affect: Need for affect scales predict conservatism measures

We propose that individual differences in the motivation to avoid emotions are related to political conservatism. We argue that because conservatism is concerned with managing uncertainty and emphasizes ego-control, conservative ideologies match with the motivational concerns of those individuals who find emotions to be uncertainty-enhancing and dysfunctional. In a group of 267 participants, positive associations were found between emotion avoidance and right-wing authoritarianism, social dominance orientation, and support for conservative policies. Negative associations were found between emotion approach and conservatism measures.