The Economic Determinants of Self-imposed Accounting
Conservatism*
Xinrong Qiang
Ph.D. Candidate in Accounting
Department of Accounting and Law
School of Management
State University of New York at Buffalo
Buffalo, NY 14260-4000
[email protected]
(716) 645-3330
Second Draft: January 2003
*
This paper is a part of my dissertation in progress with defended proposal in April 2002 and expected
completion in May 2003.
The Economic Determinants of Self-imposed Accounting
Conservatism
ABSTRACT
Evidence of conservative accounting in the pre-standard setting era suggests that
the observed accounting conservatism could be self-imposed by firms, in addition to
being mandated by accounting standards. This study investigates three related issues: 1)
do firms choose to be conservative in financial reporting? If so, 2) what factors affect a
firm’s choice of conservatism level; and 3) why do we observe self-imposed
conservatism with the ample evidence of optimistic financial reporting, as provided by
earnings management literature?
Using unique conservatism measures developed in this study, I find that 16% of
sample firms’total conservatism is self-imposed. Within a comprehensive framework
based on information and contracting theories, I find that firms’choices of conservatism
level are affected by their litigation costs, auditor liability, board structure, debt
ownership, and political costs. It should be noted that all of the above determinants of
long-term accounting discretion are income-decreasing factors. While income-increasing
factors, such as equity issue and incentive compensation, are found to affect short-term
discretion only. Jointly, the above findings suggest that firms choose to be conservative
in the long run (bias) but may manage earnings up in the short run (noise).
JEL Classification Code: M41; C23; D21
Key Words: Accounting Discretion; Conservatism; Bias; Earnings Management; Noise;
Information; Contracting
Data Availability: Data are obtainable from publicly available sources.
1. INTRODUCTION
This study investigates the existence and determinants of self-imposed accounting
conservatism by firms. In this study, accounting conservatism is defined as a downward
bias of reported earnings. Intertemporally, the bias can be represented by the cumulative
deviation of reported earnings from economic earnings over multiple years.
Previous empirical studies provide evidence on the existence of conservative
accounting both in the U.S. (Basu, 1997) and throughout the world (Ball et al., 2000).
Studies also find evidence that accounting conservatism existed in the pre-standard
setting era (Holthausen and Watts, 2001) and that the degree of conservatism in the U.S.
has increased over time (Basu, 1997; Givoly and Hayn, 2000). However, it is unclear to
what extent the observed accounting conservatism is mandated by accounting standards,
driven by industry factors, or self-imposed by firms.
The evidence of conservative accounting even in the pre-standard setting era
suggests the observed conservatism could be self-imposed by firms, in addition to being
mandated by accounting standards. To test whether there exists self-imposed accounting
conservatism, I develop a unique set of conservatism measures at the market, industry,
and firm levels. At the firm level, conservatism is measured by the accumulation of
earnings discretion over time, where earnings discretion in each year is measured by
aggregating the abnormal portion of each earnings component in that year. I find that, on
average, 16% of the total conservatism of a sample firm is self-imposed by the firm. The
results also show an increasing trend of self-imposed accounting conservatism over the
period 1988-99.
With this evidence on the existence of self-imposed accounting conservatism, the
study further investigates factors that affect a firm’s choice of conservatism level. A
1
firm’s choice of conservatism level, like any other accounting discretion, is a result of
conflicting forces driven by the multiple roles of accounting information.
A
comprehensive framework, therefore, is constructed to jointly take into account such
forces. The advantage of using such a framework is that it allows the incremental effect
of each hypothesized incentive to be properly identified after controlling for the effects of
other incentives. Based on information and contracting theories, the factors within the
framework include: (a) cost of capital reduction, (b) litigation cost reduction, (c) barrierto-entry enhancement, (d) management bonus maximization, (e) avoidance of debt
contract violations, and (f) political cost reduction. Since, by definition, conservatism is
a matter of long-term accounting discretion, factors within the framework are
hypothesized as determinants of self-imposed conservatism only if they are expected to
have long-term effects.
For a sample of 596 firms, I find that litigation costs, auditor liability, board
structure, debt ownership, and political costs affect the choice of conservatism level. The
fact that each of these determinants asymmetrically leads to downward bias of reported
financial results explains the observed self-imposed conservatism.
However, the earnings management literature documents that managers tend to
overstate earnings to increase their bonus (Healy, 1985; Holthausen, et al., 1995), to
reduce renegotiation costs of debt covenants (Defond and Jiambalvo, 1994; Healy and
Palepu, 1990; Sweeney, 1994), and to inflate stock price at equity issue (Rangan, 1998;
Teoh, et al., 1998a, b) and stock swaps (Erickson and Wang, 1999).
This seems
contradictory to both the existence and increasing trend of self-imposed conservatism.
Further investigation of the short-term effects of these factors within the overall
framework shows that, consistent with the earnings management literature, firms with
2
more equity issues and larger weight on incentive compensation tend to temporarily
overstate earnings. However, as indicated before, such opportunistic reporting behaviors
do not persist in the long run, suggesting that the long-term costs of such opportunistic
behaviors outweight the short-term benefits. Overall, the comparison between the longterm and short-term effects of the economic determinants of accounting discretion sheds
light on the seemingly contradictory co-existence of accounting conservatism and
income-increasing earnings management.
This study contributes to the accounting literature in several ways. First, this
study investigates the accounting conservatism self-imposed by firms, which has not been
studied in the prior literature. Second, the information- and contracting-based framework
constructed in this study can be applied to future studies of accounting discretion other
than self-imposed accounting conservatism. Third, the conservatism measures developed
in this study can be used in future studies. The measures have the following advantages:
1) the measures, being independent of market data, are less noisy; 2) the measures,
considering conservatism in various earnings components, are more complete; and 3) the
measures, decomposing a firm’s conservatism into portions at market, industry, and firm
levels, broaden the potential field of future studies.
The findings of this study may improve our understanding of the effectiveness
and persistence of conflicting forces behind conservative accounting practices. Policy
makers may take into account the existing forces when setting the level of standardimposed accounting conservatism. For example, if market forces, such as shareholders’
litigation and corporate governance mechanisms, are effective and persistent in protecting
investors against managers’ opportunistic behavior, less stringent or more creditororientated requirements on conservatism could be optimal considering the trade-off
3
between relevance and reliability.
The remainder of the paper is organized as follows. Background is introduced in
section 2. Hypotheses are developed in section 3. Measures and empirical tests are
designed in section 4. Empirical results are presented in section 5. Conclusions are
summarized in section 6.
2. BACKGROUND
Prior studies provide preliminary evidence of the individual effect of several
proposed determinants of accounting conservatism, including auditor liability (Basu,
1997), ownership structure and corporate governance (Ball et al., 2000), conflicts over
dividend policy (Ahemd et al., 2002), and reputation risks (Lubberink and Huijgen, 2001).
Watts (1993) and Holthausen and Watts (2001) propose that firms are conservative in
order to reduce litigation and contracting costs.
The degree of self-imposed accounting conservatism, like any other accounting
discretion, is a result of conflicting forces driven by the multiple roles of accounting
information. However, none of the above studies hypothesizes and tests the determinants
of conservatism within a framework of such conflicting forces. The advantage of using
such a framework is that it allows the incremental effect of each hypothesized incentive
to be properly identified after controlling for the effects of other incentives.
An important issue that has not been addressed in the prior literature is the
relation between conservative accounting and earnings management. For example, what
is the difference between income-decreasing earnings management and accounting
conservatism and why do we observe both accounting conservatism and incomeincreasing earnings management? Certain types of earnings management may have
temporary effects on reported accounting numbers. Examples could be inflating earnings
4
to maximize compensation or to reduce cost of capital at equity issue. Such effects are
likely to reverse in the short run.
These types of earnings management add noise to
reported earnings but do not cause the mean of reported earnings to deviate from that of
economic earnings. On the other hand, accounting conservatism is by definition a longterm financial reporting strategy that biases the mean of reported earnings. Therefore,
incentives of earnings management could lead to accounting conservatism when they
persist in the long run. For example, large firms under persistent threat of antitrust
charges may be conservative in the long run. In summary, a factor has no effect on a
firm’s choice of conservatism level if it only temporarily affects a firm’s accounting
discretion. Only factors that have long-term effects are determinants of self-impose
accounting conservatism.
3. HYPOTHESES
3.1. Information-based considerations
Cost of capital
Allowing untruthful disclosures, information theory predicts that firms tend to
withhold unfavorable information opportunistically to inflate stock price (Verrecchia,
2001; Newman and Sansing, 1993; Gigler, 1994; Evans and Sridhar, 1999). Empirical
studies also find that opportunistic managers tend to increase disclosure of good news
(Lang and Lundholm, 2000) and to overstate earnings (Teoh, Welch and Wong, 1998a, b;
Rangan 1998) for the purpose of inflating stock price at the time of equity issue.
However, managers’ private information should eventually be revealed to the
public. In the long run, it is costly for managers to frequently inflate earnings at equity
issues because investors will learn from the past and therefore assess lower value (higher
cost of capital) for the subsequent issues if managers lied before. Therefore, a firm’s
5
long-term reporting strategy regarding to equity issues depends on the expected net
benefits (current benefits net of future costs) of inflating earnings. For firms with more
highly concentrated ownership, there are less free-ridings of small investors and therefore
lower costs for investors to detect lies. From a long run perspective (an equilibrium
process), lower the investors’costs to detect lies, higher the firms’probability of being
detected and therefore higher the expected future costs (lower expected net benefits) of
inflating earnings. Therefore I predict that the degree of equity ownership concentration,
reducing the expected net benefits of managers’inflation of earnings at equity issue,
increases the degree of conservatism.
H1a: Firms with more highly concentrated ownership of equity choose more
conservative accounting strategies, ceteris paribus.
Similar to the case of reducing cost of equity capital, firms may have incentives to
inflate the value of debt by overstating earnings at the time of debt issue and potential
creditors may demand conservative accounting to counteract managers’opportunistic
behavior at debt issue.
In addition, creditors may demand conservative accounting
information because: 1) creditors are asymmetrically affected by gains and losses (Watts
and Zimmerman 1986); and 2) creditors and stockholders have conflicts over dividend,
financing, and investment policies (Jensen and Meckling, 1976; Begley, 1994) hence
stockholders tend to transfer wealth from creditors.1 As argued in the case of equity issue,
1
Shareholders can transfer wealth from creditors through overpayment of dividends, financing of new debt,
and transfers, acquisition, or disposal of assets. To control these conflicts, restrictions on dividend
payment, capital structure and asset changes are typically included in debt covenants (Leftwich, 1983).
Accounting numbers in both income statement and balance sheet are used in such debt covenants (Kalay,
1982; Begley, 1994), Conservative accounting that understates earnings and asset and overstates liabilities
makes the restrictions become tight more quickly. It reduces the probability that shareholders would
transfer wealth from creditors. Therefore creditors prefer conservative accounting that reports lower
earnings and assets and higher liabilities.
6
I expect that the managers’intention to inflate earnings at debt issue, if it exits, will be
dominated by the effect of creditors’demand for conservative information in the long run.
Therefore I predict that highly concentrated ownership of debt, as a force to counteract
managers’ intention to inflate earnings at debt issue and shareholders’ intention to
transfer wealth after debt issue, increases the degree of conservatism.
H1b: Firms with more highly concentrated ownership of debt choose more
conservative accounting strategies, ceteris paribus.
Litigation costs
There exists asymmetric litigation probability and settlement amount between bad
and good news. Theoretical research of disclosure has modeled litigation costs as an
incentive to disclose news that is sufficiently bad (Trueman, 1997; Evans and Sridhar,
1999). Empirical evidence shows that overstatement of earnings or assets is far more
likely to generate a lawsuit than understatement (Kellogg, 1984). The expected litigation
costs, which are a function of lawsuit probability, settlement amount and legal fees, are
asymmetric for bad news (overstatement) and good news (understatement) as well.
Empirical studies in the disclosure literature find that asymmetric expected litigation
costs create incentives for managers to disclose bad news earlier (Skinner, 1994; Kasznik
and Lev, 1995; Skinner 1997). Therefore I expect that managers of firms with higher ex
ante expected litigation costs have stronger incentives to use conservative accounting to
reduce the expected litigation costs of the firms.
H2a: Firms with greater expected litigation costs choose more conservative
accounting strategies, ceteris paribus.
7
The asymmetry exists not only for litigations against firms but also for those
against auditors. Kellogg (1979) finds that buyers’lawsuits against auditors outnumber
sellers’lawsuits by a ratio of 13 to 1. To reduce their own expected litigation costs,
auditors tend to push clients to be conservative. Auditors can accomplish this by being
less willing to accommodate aggressive accounting of clients, by increasing their auditing
fees, or even by terminating relations with risky clients.2 To avoid auditing fee increases
or costs of an unfavorable auditor’s opinion and auditor change, firms tend to be
conservative. For risky clients, such conservative accounting information may not reduce
the probability of lawsuits. However, it could serve as evidence in legal processes to
reduce settlement amounts, and therefore to reduce the overall expected litigation costs
for auditors. Therefore I expect managers of firms with an auditor who may experience
higher ex ante expected litigation costs to choose more conservative accounting.
H2b: Firms with auditors bearing greater expected litigation costs choose more
conservative accounting strategies, ceteris paribus.
Proprietary costs
The theory of proprietary costs argues that firms have an incentive to withhold
good news or to understate earnings 3 to deter the entry of potential competitors.
Considering incentives from the product market only, Vives (1984) and Gal-Or (1985,
1986) predict that incumbent firms with unfavorable information tend to disclose such
2
Pratt and Stice (1994) suggest that client characteristics such as risk, size, growth and financial condition
significantly affect auditors’expected litigation costs and auditing fee. Krishnan and Krishnan (1997) finds
that auditors are more likely to resign from jobs that have a higher probability of resulting in litigation.
3
Information possessed by firms includes proprietary information, which would adversely affect future
cash flows of disclosing firm if disclosed, and non-proprietary information, which does not directly affect
firm cash flows. However, the cutoff point is somewhat ambiguous (Hao, 1999). For example, higher
reported profits may change prior belief about product market condition and hence attract new entry.
Therefore simply understating earnings could be helpful to deter entry of potential competitors.
8
information to deter entry. Other theoretical studies on incentives of voluntary disclosure
include deterring entry as an incentive to disclose unfavorable news (Darrough and
Stoughton 1990; Wagenhofer 1990; Newman and Sansing, 1992). Empirically, Harris
(1998) finds that firms in less competitive industries tend to disclose less detailed
segment information to protect their abnormal earnings. I predict firms in industries with
higher ex ante probability of potential entry to be more conservative in order to reduce
proprietary costs associated with the entry of potential competitors.
H3: Firms facing greater probability of potential entry choose more conservative
accounting, ceteris paribus.
3.2. Contracting-based considerations
Bonus hypothesis
Due to costs of renegotiation of compensation contracts and costs of monitoring,
managers’bonuses tend to fix on earnings. The bonus hypothesis predicts that managers
with accounting-based compensation plan tend to overstate earnings.4 Empirical studies
find consistent results (Healy, 1985; etc.). However, managers’private information will
eventually be revealed to the board. Managers’long-run reporting discretion for bonus
maximization depends on the expected net benefits, which include both current benefit
and future costs. Stronger board monitoring counteracts managers’inflation of earnings
by increasing the both the probability and penalty of detecting opportunistic reporting.
As a result, the expected net benefits of inflating earnings are lower for firms with
stronger corporate governance. Therefore I predict that strong corporate governance, as a
force to counteract managers’ intention to be optimistic for the purpose of bonus
4
This prediction applies only when earnings fall between lower bound and upper bound. However, when
earnings are higher than upper bound or lower than lower bound, managers have incentive to understate
earnings to maximize future bonus (Healy, 1985; Holthausen et al., 1995).
9
maximization, increases the degree of conservatism.
H4:
Firms with stronger corporate governance choose more conservative
accounting strategies, ceteris paribus.
Debt covenant hypothesis
Due to costs of renegotiation of debt contracts, debt covenants tend to fix on
accounting numbers.
The debt covenant hypothesis predicts that managers tend to
overstate earnings and assets to reduce the renegotiation costs of debt contracts when a
firm is close to breaching its debt covenants. Empirical evidence shows that violating
firms have more aggressive abnormal accruals (Sweeney, 1994) and change to more
aggressive accounting policies (Defond and Jiambalvo, 1994). Unlike existing investors,
existing creditors have no mechanism to counteract firms’inflation of earnings. Instead,
creditors may be protected by conservative accounting standards. As to self-imposed
accounting conservatism, I expect that managers of firms with higher ex ante risks of
breaching debt covenant tend to be less conservative.
H5: Firms closer to breaching debt covenants choose less conservative accounting
strategies, ceteris paribus.
Political cost hypothesis
Due to monitoring and compliance costs of making and enforcing rules,
regulation decisions tend to fix on accounting numbers. The political cost hypothesis
predicts that managers tend to understate earnings to reduce potential political costs.
Firms with large profits are more likely to attract regulators’ attention. Therefore
reporting larger profits tends to increase the probability of being regulated or charged of
10
monopoly (Cahan, 1992). Large profits also can be used as evidence against firms in an
antitrust action (Han and Wang, 1998), deregulation (Key, 1997), and policy relief (Jones,
1991). Therefore reporting larger profits tends to increase political costs or forgo
potential benefits of deregulation and policy relief. Therefore I expect firms with greater
expected political costs tend to be more conservative.
H6:
Firms with greater expected political costs choose more conservative
accounting strategies, ceteris paribus.
4. RESEARCH DESIGN
4.1. Measures of conservatism
Market-based measures use price or returns to proxy for unbiased financial
information (intrinsic value or economic income, respectively). 5
The major concern is
the validity of market value (stock returns) as a proxy for intrinsic value (economic
income) due to noise in market data. Accounting-based measures directly use accounting
information to estimate bias of net assets or earnings.6 Accounting-based measures used
in prior studies, however, only reflect specific accounting conservatism.7
Conservatism measures at firm level
Givoly and Hayn (2000) define conservatism as a selection criterion among
5
Such measures are market-to-book (Stober, 1996), market-to-book unexplained by lagged returns and time
(Beaver and Ryan, 2000; Ahemed et al. 2002), the excess of the association of stock price movements with
earnings signals in ‘bad news’periods over their association with earnings signals in ‘good news’periods
(Basu, 1997; Ball et al. 2000; Pope and Walker, 1999; Holthausen and Watts, 2001).
6
Such measures are level and rate of cumulative non-operating accruals (Givoley and Hayn, 2000),
estimated hidden reserve of R&D, advertisement, and inventory (Penman and Zhang, 2002; Cheng, 2001),
and summary score of income-decreasing accounting choices (Zimijewski and Hagerman, 1981).
7
Non-operating accruals measure ignores conservatism from operating accruals. Hidden reserve measure
only considers a few aspects of conservatism and is not appropriate for studying incentives of self-imposed
conservatism. Accounting choice measure does not include conservatism in estimation (e.g. bad debt
expense), real decision (e.g. R&D investment), and non-operating losses (e.g. impairment of assets).
11
accounting principles that leads to the minimization of cumulative reported earnings.8
This definition suggests the use of cumulative earnings discretion as a conservatism
measure. First, I estimate each abnormal earnings component, such as abnormal current
and long-term operating accruals, non-operating accruals, and operating cash flows (e.g.
R&D). Abnormal current accruals (ACAjt) are the error term from a cross-sectional
regression of current accruals (CAjt) on change of sales (SALEjt) and long-term growth
(LTGjt) for firm j in year t within the firm’s industry i (2-digit SIC).9
CA
AT
jt
= α1it ×
jt − 1
1
AT
∆SALE
+ α 2it ×
jt − 1
AT
jt
jt − 1
+ α 3it × LTG jt + ε jt ∀j ∈ i
(1)
Abnormal depreciations and amortizations (ADPjt) are the error term from a crosssectional regression of depreciation and amortization expenses (DPjt) on Property, Plant
and Equipment (PPEjt) for firm j in year t within the firm’s industry (2-digit SIC).10
DP
AT
jt
jt − 1
= β1it ×
1
AT
jt − 1
PPE
+ β 2 it ×
AT
jt
+ δ jt ∀j ∈ i
(2)
jt − 1
Abnormal non-operating accruals (ANAjt) are estimated by subtracting industry
mean of non-operating accruals (INAit) from firm’s non-operating accruals (NAjt).11
Abnormal R&D (ARDjt) is based on the error term from a cross-sectional
regression of R&D (RDjt) on sales (SALEjt), lag R&D expenses (RDjt-1), fund available
8
Based on the notion that ‘conservatism is essentially an issue of the timing and sequencing of revenues
and expenses relative to the associated cash flows’, they measure conservatism by comparing time-series
properties (sum, skewness, variability, etc.) of earnings versus cash flows. More specifically, they
measures are cumulative accruals (relative cumulative magnitude of earnings versus cash flows), relative
skewness of earnings versus cash flows, relative variability of earnings versus cash flows.
9
I add future growth to current abnormal accruals model used by Rangan (1998) because McNichols (2000)
provides evidence that firms expecting future growth tend to increase working capital.
10
This model can be viewed as a part of Jones (1991) model. I estimate it separately to obtain separate
estimation of abnormal depreciation and amortization.
11
In the literature, there is no suggested economic determinant of non-operating accruals and its
components (e.g. special items, discontinued operation, and extraordinary items). Also, most of them are
nonrecurring and infrequent in nature. Therefore, I simply subtract industry mean to estimate firm-specific
part. All firm-specific variables are deflated by lagged assets.
12
before R&D (OCFjt + RDjt) and long-term growth (LTGjt) within industry (2 digit SIC).12
RD
AT
jt
= γ 1it ×
jt − 1
SALE
1
AT
+ γ 2it ×
jt − 1
AT
jt
RD
+ γ 3it ×
jt − 1
AT
jt − 1
jt − 1
OCF
+ γ 4it ×
jt
AT
+ RD
jt
+ γ 5it × LTG jt + υ jt ∀j ∈ i
jt − 1
(3)
The error term is adjusted for R&D amortizations of current and previous R&D
investments by applying industrial amortization rate in Lev and Sougiannis (1996).
t
∑
δ
υ AT
i , t − τ jτ
jτ − 1
τ = max(1, t − M )
i
−
AT
jt − 1
(4)
Where:
is amortization rate of R&D for industry i in the nth year after a R&D
δ
i, n
investment (Lev and Sougiannis, 1996).
Mi is total number of years that an R&D investment brings earnings for industry i.
is error term in regression (3) in year τ for firm j.
υ
jτ
Second, I aggregate the above four abnormal earnings components to obtain an
overall measure of earnings discretion (CSVjt).
CSV jt = ACA jt + ADPjt + ANA jt + ARD jt
(5)
Last, I accumulate the measure of earnings discretion over time to obtain a
measure of conservatism (CUMCSVjt).13 I also use the percentage rankings of CSVjt and
CUMCSVjt within industry and market as alternative measures in this study.
CUMCSV jt =
t
∑ CSV × AT
jτ
jτ − 1
τ =1
AT
(6)
jt − 1
12
This model follows model developed by Berger (1993). Determinants used in his model are suggested in
industrial organization literature. I exclude industry mean R&D and GNP from original model because I
run cross-sectional regression within industry. The effects are captured by intercept.
13
CSVjτ is, by construction, deflated by the beginning total assets of year τ. To calculate the cumulative
earnings discretion, I first multiply the current year’s deflator back and then deflate the cumulative value by
the beginning assets of the last year of the whole sample period. The purpose is to reduce any possible bias
introduced by a deflator, which is likely to increase over time.
13
Conservatism measures at industry and market level
Intercepts from industry regressions capture market- and industry-wide abnormal
earnings components. Intercepts from market regressions capture market-wide abnormal
earnings components. The differences between industry intercepts and market intercepts
therefore capture industry-wide abnormal earnings components. My overall industryspecific measure of abnormal earnings (CSVit) is the aggregation of those differential
intercepts. Also, I adjust for R&D amortizations at both industry and market level by
applying amortization rates as in Lev and Sougiannis (1996).
CSVit = (αˆ1it − αˆ1t ) + ( βˆ1it − βˆ1t ) + ( INAit − MNAt ) + ((γˆ1it − IRDAMTit ) − (γˆ1t − MRDAMTt ))
(7)
Where:
αˆ1it
,
βˆ1it
, and
γˆ
1it
are intercepts from regression (1), (2), and (3) respectively.
INAit
is industry mean of non-operating accruals.
αˆ1t
βˆ
1t
,
, and
respectively.
γˆ1t
are intercepts from market level regression of (1), (2), and (3)
MNAt is
market mean of non-operating accruals.
t
IRDAMTit =
∑
τ = max(1, t − M )
i
δ
γˆ
i , t − τ 1iτ
is R&D amortization at industry level.
t
MRDAMTt =
∑
τ = max(1, t − 5)
δ
γˆ
t − τ 1τ
is R&D amortization at market level.
Intercepts from market regressions capture market-wide abnormal earnings
components. The overall market-wide abnormal earnings (CSVt) are the aggregation of
those market intercepts.
CSVt = αˆ1t + βˆ1t + MNAt + (γˆ1t − MRDAMTt )
14
(8)
4.2. Empirical tests
Long run test
In my long run test, the dependent variable used in the cross-sectional regression
is one of the conservatism measures as described in section 4.1. I include all factors
within the framework of accounting discretion as independent variables to make the long
run test comparable to the short run test. Significant coefficient of a factor in the long run
test suggests that the factor has long-term effects on firms’discretion (aggressive or
conservative).
Conservati sm j = a + a Equity Issue j + a Equity Ownership j + a Debt Issue j + a Debt Ownership j
0 1
2
3
4
(-)
(-)
+ a Litigation Costs j + a Auditor Li ability j + a Potential Entry j
5
6
7
(-)
(-)
(-)
+ a Incentive Compensati on j + a Corporate Governance j
8
9
(-)
+ a
Debt Coven ants j + a Political Costs i + e j
10
11
(-)
( + )
Conservatism
j
(9)
is one of the three firm-specific conservatism measures
(cumulative earnings discretion for firm j over a 12-year sample period and its rank
within market and industry). Larger value indicates more aggressive (less conservative).
Equity Issue j is the proceeds from common stock issues plus stock swaps minus
stock repurchases for firm j over the sample period, deflated by market value of equity.
Larger amount of net equity issue represents greater need for equity capital.
Equity Ownership
j
is a composite proxy variable for firm j’s mean equity
ownership concentration over the sample period.
The variable is generated from
principal component analysis of three ownership variables (percentage institution
ownership, percentage block holder ownership, and average percentage shareholding of
15
investors). A larger value represents more highly concentrated equity ownership hence
stronger counter force against the manager’s intention to inflate earnings at equity issue.
Hypothesis H1a predicts the sign of α2 to be negative (more conservative).
Debt Issue j is the proceeds from debt issues for firm j over the sample period,
deflated by market value of equity. Larger amount of debt issue represents firms’greater
need for debt capital.
Debt Ownership j is the mean weight of private debt in total debt of firm j over the
sample period. A larger value represents more highly concentrated debt ownership hence
stronger counter force against manager’s intention to inflate earnings at debt issue.
Hypothesis H1b predicts the sign of α4 to be negative (more conservative).
Litigation Costs
j
is a composite proxy variable for firm j’s average ex ante
expected litigation costs over the sample period. The variable is obtained from principal
component analysis of three market risk factors (equity beta, cumulative returns, and
share turnover).14 A larger value represents higher ex ante expected litigation costs of
firms. H2a predicts the sign of α5 to be negative (more conservative).
Auditor liability j is the percentage of years during the sample period that firm j’s
auditor is one of the Big-Six. Big-Six auditing firms have ‘deep pockets’and therefore
14
This approach follows Johnson et al. (2001). Equity beta is the coefficient from a regression
r jd − r fd = ßjt (rmd − r fd ) + e jd d = 1 to dayst , where r jd is daily return of firm j at day d. rmd is daily return
of equal-weighted market index at day d.
r fd
is daily risk-free rate.
days t
is the number of trading days in
year t. The regression is run by each firm-year to estimate beta for each firm-year. Cumulative return is
days
t
∑
1
r
jd
− 1 for
each firm-year. Share turnover is 1 − ( 1 − Turn jt )
days
t
, where Turn jt is average daily trading
volume divided by number of shares outstanding. Firm level variables are the average of firm-year variable
over the sample period.
16
are more likely to be sued.15 The more frequently a firm hires a Big-Six auditor, the
greater the expected litigation costs of the firm’s auditor hence the stronger the auditor’s
pressure on the firm to be conservative. Hypothesis H2b predicts the sign of α6 to be
negative (more conservative).
Potential Entry j is the speed of profit adjustment for firm j during the sample
period.16 A larger value represents slower speed of profit adjustment (or, alternatively,
more persistent abnormal profitability) hence higher ex ante probability of potential entry
of rival firms. Hypothesis H3 predicts the sign of α7 to be negative (more conservative).
Incentive Compensation j is the mean implied weight on incentive pay in firm j’s
compensation over the sample period. 17 Larger weight on incentive pay suggests a
stronger incentive for managers to overstate earnings.
Corporate Governance j is a composite proxy variable for the mean strength of
firm j’s corporate governance over the sample period. The variable is generated from
principal component analysis of four corporate governance variables (board size,
percentage outsiders’shareholding, block holder on board, CEO on board). Prior studies
15
Jones and Raghunandan (1998) show that during a period of increasing auditors’litigation risks, Big-Six
auditing firms are more likely to reduce risky clients than small audit firms. Therefore Big-Six auditing
firms are more sensitive to the change of litigation environment.
16
The speed of profit adjustment is coefficient ߈2 j from time-series regression for each firm (Harris, 1998):
X jt = ß0 j + ß1 j N jt −1 X jt −1 + ß2 j P jt −1 X jt −1 + e jt
.
X jt = ROA jt − ROAit
, ROAit is industry mean ROA . N jt equals
to 1 if X jt is less than or equal zero and 0 otherwise. P jt equals to 1 if X jt is greater than zero and 0
otherwise.
17
The implicit weight of incentive pay in total compensation for firm j in year t is
γˆ ROA
1j
jt
COMP
jt
, where γˆ1 j is
estimate from time-series regression for each firm: COMPjt = γ 0 j + γ 1 j ROA jt + γ 2 j NMgrjt + ν jt . COMPjt is
total compensation averaged across firms’top managers’in year t. ROA jt is return on assets of year t.
NMgr jt
is number of top managers included in calculation of average total compensation. It is included as a
control variable because including more managers drives the average down. Since earnings are associated
with stock price, γˆ1 j also captures the effect of stock-based compensation as well as those from bonus.
Larger γˆ1 j implies higher implicit weight on earnings.
17
(Dechow et al., 1996; Klein, 2002; etc.) show that the above variables affect quality of
financial reporting. A larger value represents more monitoring from the board hence
stronger counter force against the manager’s intention to inflate earnings to maximize
compensation. Hypothesis H4 predicts the sign of α9 to be negative (more conservative).
Debt Covenants j is the average leverage (long-term debt/assets) for firm j during
the sample period. Leverage is a proxy variable for the closeness to breaching debt
covenants. Higher leverage represents higher ex ante probability of breaching debt
covenants hence a stronger incentive to inflate earnings (and book value). Hypothesis H5
predicts the sign of α10 to be positive (less conservative).
Political Costs j is the percentage of years during the sample period that firm j’s
market share within its industry is more than a cutoff percentage (5, 10 or 15%, etc.). It
is a proxy variable for firms’political visibility. Larger percentage indicates that a firm is
more visible to regulators hence has higher ex ante expected political costs. Hypothesis
H6 predicts the sign of α11 to be negative (more conservative).
Short run test
The short run test is conducted at the firm-year level on equation (9). The
dependent variable used in the regression is one of the earnings discretion measures as
described in section 4.1 (earnings discretion for firm j in year t and its rank within market
and industry). Independent variables are also firm-year level (see notes in table 6 for
detail).
A significant coefficient of a factor in the short run test indicates that the factor
has a short-term effect on firms’ accounting discretion (to overstate or understate
earnings). According to evidence from the earnings management literature, some factors
18
not significant in the long run test may be significant in the short run test (e.g. equity
issue). Factors expected to be significant in the long run test do not have to be significant
in short run test because some determinants of firms’long-term accounting discretion
may not be effective in the short run.
5. EMPIRICAL RESULTS
5.1. Sample selection and data
The original sample consists of all COMPUSTAT 2001 industry and research
firms with the necessary data to estimate measures of conservatism for at least one year
in the period of 1988-99. 18
This sample is used to estimate abnormal earnings
components. The full sample consists of 4,745 firms (25,445 firm-years) with measures
of earnings discretion in at least one year in the sample period. The constant sample
consists of 596 firms (7,152 firm-years) with measures of earnings discretion in every
year in the sample period. The full and constant samples are used to examine the
existence and intertemporal trend of self-imposed conservatism. The constant sample is
used to test the determinants of self-imposed conservatism. Table 1 presents sample
compositions (Panel A) and descriptive statistics (panel B) for both the full and constant
samples.19
Data needed to construct conservatism measures are obtained from the
COMPUSTAT database. Data of equity issues, stock swaps, stock repurchases, and debt
issues are obtained from the SECURITY DATA CORPORATION (SDC) database. Data
needed to construct proxy variables for equity ownership, corporate governance, and
18
Following the earnings management literature, financial institutions and utility firms are excluded
because the predicting models of accruals for such firms are different from those of firms in ordinary
industries.
19
Due to the requirement of consecutive data over 12 years, constant sample firms tend to be more
concentrated in traditional industries, larger in size, more profitable, and of lower R&D investments and
market-to-book ratio, indicating potential survivorship bias in tests of determinants.
19
incentive compensation are obtained from the COMPACT DISCLOSURE-SEC and
EXECUCOMP databases. Data needed to construct proxy variables for litigation costs
are obtained from the DAILY CRSP database. Data needed for other proxy variables
used in the long run and short run tests are obtained from the COMPUSTAT.
5.2. Validity of conservatism measures
I first test the validity of the conservatism measures developed in this study.
Results in Panel A and B of Table 2 suggest that the conservatism measures used in this
study are stable. 20 In Panel C, cross-correlations among components of conservatism
measures indicate that those components are correlated over the long run.21 Correlations
in Panel D indicate that, generally, measures developed in this study are consistent with
those used in prior studies.22
5.3. Existence and intertemporal trend of self-imposed accounting conservatism
Table 3 and Figure 1 show the existence and increasing trend of self-imposed
conservatism for both the full and constant samples.
The mean self-imposed
conservatism is –0.184 for the full sample (Panel A) and –0.052 for the constant sample
(Panel B). Results show that the degree of self-imposed conservatism has increased over
the period 1988-99 for both samples. Detailed information on components suggests that
20
Panel A shows that the volatility of percentage conservatism ranking of sample firms is around 15%
while that of earnings discretion is around 23%. Panel B shows that, from sub-period 1988-93 to 1994-99,
42-55% of constant sample firms stay in the same ranking quartile and less than 2-15% firms change two or
three quartiles from the first sub-period to the second one.
21
The negative correlation between abnormal current accruals and non-operating accruals suggests than
firms may transfer earnings across the operating line in short run. The positive correlation between
cumulative abnormal depreciation expenses and current accruals suggests firm’s reporting strategy within
operating accruals is consistent in long run. Cumulative abnormal R&D expense is negatively correlated
with all three accrual components. It suggests that firm use less discretion on operating cash flows when
discretion on accruals are available because discretion on cash flows is more costly than that on accruals.
22
The correlation between my measures and Basu (1997)’s measure is insignificant. The reason could be
that I use time-series regression for each firm instead of cross-sectional ones as used in prior studies The
former has much fewer observations in each regression than the latter therefore could be less efficient.
20
self-imposed conservatism is carried out mostly through reporting lower current and
long-term operating accruals.
Table 4 and Figure 2 compare the degree of self-imposed conservatism with that
of industry and market level.
For the full sample, on average, the self-imposed
conservatism is 16% of a firm’s overall conservatism. 48% and 37% are specific to
firm’s industry and overall market environment, respectively. For the constant sample,
7% of a firm’s overall conservatism is self-imposed. 37% and 56% are at industry and
market level, respectively.23
5.4. Economic determinants of self-impose conservatism
In Table 5, Panel A presents descriptive statistics of dependent and independent
variables used in the long run regression and Panel B shows the correlations between
those independent variables.
significantly correlated. 24
Some of the hypothesized determinant variables are
However, none of the independent variables are highly
correlated, indicating that the results would not be distorted by multicolinearity
problems.25
Panel C of Table 5 presents the major results.
Overall, the hypothesized
determinant variables can explain 15% of sample firms’ self-imposed accounting
conservatism. Consistent with hypothesis H1b, H2a, H2b, H4, and H6, the estimated
coefficients of debt ownership, litigation costs, auditor liability, corporate governance,
23
Compare with full sample, less percentage of total conservatism is self-imposed by firms in constant
sample. Similarly, less percentage of total conservatism of firms in constant sample is driven by industryspecific factors. This is consistent with that firms in constant sample are more concentrated in traditional
industries and have less R&D investment and lower market-to book ratio.
24
It suggests the importance to include all of them in order to test the incremental effect of each individual
hypothesized determinant. Otherwise the significant effect of one determinant variable found by a study
could be simply driven by other omitted correlated determinant variables.
25
The correlation between Equity Ownership and Litigation Cost is relatively high (0.62). Comparison
between results of univariate (not reported) and multivariate regressions or dropping a suspicious variable
from original multivariate regression shows that coefficients are not distorted. Similar comparisons are
made for other pairs of variables with correlation higher than 0.3. No distortion is found.
21
and political costs are all significantly negative.
The significant results on litigation costs and auditor liability suggest that, in the
long run, shareholders’law suits against managers or auditors are an effective way to
deter mangers’opportunistic behavior. Similarly, the significant results on corporate
governance and debt ownership suggest that board and private debt holders also serve as
effective deterrents. On the other hand, the insignificant result on equity ownership
suggests that institutional equity owners are not as effective as boards at deterring
managers’opportunistic reporting behavior. This may be due to myopic institutional
owners who hold firms’stocks only for trading purposes. The significant result on
political costs suggests that the regulation process is not flexible even in the long run,
providing firms with the incentives to choose conservative accounting to avoid potential
unfavorable regulations such as antitrust actions.
The insignificant coefficients on equity and debt issue suggest either that firms
don’t inflate earnings at security issue or that firms’opportunistic behavior cannot be
sustained in the long run.
Similar explanations could apply to the insignificant
coefficients for potential entry, incentive compensation, and debt covenants. Therefore
further results from the short run test could be helpful.
Panel C of Table 6 presents the short run results.
Overall, the determinant
variables can explain 2% to 3% of sample firms’ short-term accounting discretion.
Unlike the insignificant effects shown in the long run test, equity issue and incentive
compensation have significantly positive effects on firms’reported earnings, suggesting
that managers tend to overstate earnings at equity issue and for compensation
maximization.
Also, the coefficient on potential entry is significantly negative,
suggesting that incumbent firms with a higher ex ante probability of entry tend to
22
understate earnings to deter potential entry of rival firms. Significant effects of equity
issue, potential entry, and incentive compensation only in the short run but not in the long
run are consistent with that capital and product markets and contracting process are
efficient in the long run, respectively. Except for debt ownership, all other factors that
have a long run effect are effective in the short run as well, suggesting that shareholders’
law suits and board monitoring are also effective mechanisms to deter short-term
optimistic financial reporting.
However, regression results in Table 5 and 6 show that coefficients of debt issue
and debt covenants are consistently insignificant. The insignificant results for debt issue
could be driven by profitability not being a major concern when potential creditors make
their lending decision. Empirically, unlike that of equity issue, there is no evidence that
firms inflate earnings at debt issue in prior studies. Similarly, empirical evidence on
firms’incentives to overstate earnings in order to avoid violating debt covenants is not as
strong as that of compensation maximization.26
Comparison between results of Table 5 and Table 6 shows that all factors that
lead to overstatement of earnings only exist in the short run and all factors with long run
effect lead to understatement of cumulative earnings (book value). The findings could
serve as an explanation for why we observe both optimistic financial reporting (shortterm effects), as indicated by the earnings management literature, and accounting
conservatism (long-term effects), as suggested by the conservative accounting literature.
26
For example, Healy and Palepu (1990) find that, instead of overstating earnings, firms close to violating
debt covenants tend to cut dividends. Evidence from subsequent studies ((Defond and Jiambalvo, 1994;
Sweeney, 1994) are for ex post violating (unsuccessful) firms, not firms with ex ante risks of violating debt
covenants.
23
6. CONCLUSIONS AND REMANING WORK TO BE DONE
6.1. Conclusions
First, this study provides evidence on the existence and increasing trend of selfimposed accounting conservatism. Second, results of this study show that firms’optimal
level of self-imposed accounting conservatism is a result of conflicting forces including
potential shareholders’litigation against firms and their auditors, monitoring from board
and private debt owners, and the threat of unfavorable regulations. Finally, comparison
between determinants of long-term and short-term accounting discretions show that
income-increasing incentives, such as inflating stock price at equity issue and
maximizing compensation, temporarily affect firms accounting discretion but not in the
long run. All determinants of long-term accounting discretion are income-decreasing
factors.
The findings provide an explanation for the co-existence of seemingly
contradictory accounting discretions, conservatism and income-increasing earnings
management.
6.2. Remaining work to be done
First, several additional tests on self-imposed accounting conservatism need to be
done: 1) use a larger constant sample by shortening the sample period to widen the
externality; 2) use a simultaneous equation system to test the effect of hypothesized
determinants because many of them are not exogenous in the long run; 3) use logistic
regression to test company events that drive structural change of firms’self-imposed
conservatism.
Second, tests at the industry level need to be done because the results show that
37-48% of firms’total accounting conservatism is driven by industry factors. Industry
level tests are: 1) a cross-industry test on the effect of industry-specific factors including
24
industry litigation and competition environments, controlling the differences in standardimposed accounting conservatism (e.g. expensing R&D) across industries; 2) structural
change test at industry level. Results (not reported) show that some industries (SIC4, 7,
and 8) have an increasing trend of accounting conservatism while others do not. Logistic
regressions are to be conducted at 2-digit SIC level.
Time table for completion
Work to be done
1. Additional cross-sectional tests at firm level
1) Larger constant sample
2) Simultaneous equation system
2. Structural change tests at firm level
3. Cross-sectional tests at industry level
4. Structural change tests at industry level
5. Dissertation Writing
6. Dissertation Defense
Expected
Completion Date
02/15/2003
02/28/2003
03/15/2003
03/31/2003
04/31/2003
05/31/2003
25
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28
Table 1 Sample
Panel A Sample composition
SIC
Industry Description
Full Sample
1　2　3　4　5　7　8　9　Mining and Construction
Manufacturing
Manufacturing
Transportation and Communication
Wholesale and Retail Trade
Services
Services
Public Administration
Total
Number Percentage
35
0.7%
852
18.0%
2515
53.0%
92
1.9%
85
1.8%
982
20.7%
134
2.8%
50
1.1%
4745
Constant /
Full
Constant Sample
100%
Number Percentage Percentage
4
0.7%
11%
117
19.6%
14%
422
70.8%
17%
5
0.8%
5%
3
0.5%
4%
39
6.5%
4%
4
0.7%
3%
2
0.3%
4%
596
100%
Panel B Sample descriptive statistics
Sample　Statistics　Net
Income
Current Depreciation
NonAccruals
operating
Accruals
R&D
Sales
Total
Assets
Market to
book
Mean
Median
N=25,445
Std
-0.058
0.035
0.371
-0.003
-0.003
0.134
0.053
0.047
0.034
0.003
0.008
0.089
0.129
0.071
0.180
1.246
1.169
0.772
1,690
55
9,274
5.89
2.35
73.03
Constant Mean
Median
N=7,152
Std
0.047
0.060
0.135
-0.001
0.000
0.090
0.052
0.048
0.025
0.007
0.007
0.064
0.079
0.055
0.082
1.317
1.245
0.572
3,318
160
14,673
2.99
2.00
6.31
Full
29
Table 2 Validity of the conservatism measures in this study
Panel A Volatility of ranking measures for the constant sample
Volatility of
CSV ranking
within market
(σ)　0.23
0.07
0.41
0.06
Mean
Std Dev
Maximum
Minimum
Volatility of
CSV ranking
within industry
(σ) 0.23
0.07
0.41
0.07
Volatility of
CUMCSV rankings
within market
(σ)　0.16
0.07
0.42
0.00
Volatility of
CUMCSV ranking
within industry
(σ)　0.15
0.08
0.38
0.02
CSV is earnings discretion in year t. CUMCSV is cumulative earnings discretion from 1988 to year t.
Panel B Frequencies of structural change of conservatism for the constant sample
Average CSV
ranking
within market Change of
quartile
-3
-2
-1
0
1
2
3
Average CSV
ranking
within industry　1%
19%
55%
24%
1%
2%
20%
55%
23%
1%
Cumulative CSV
ranking
within market 2%
6%
22%
46%
19%
5%
1%
Cumulative CSV
ranking
within industry　2%
8%
20%
42%
23%
5%
1%
Reported numbers are the percentage of total sample firms that change their ranking quartile from the sub-period 1988-92
to 1993-99. Average CSV and cumulative CSV differ in whether deflate earnings discretion by beginning asset of year t or
that of the last year in a sub-period.
Panel C Cross-correlations between the component conservatism measures for the constant sample
Earnings discretion
(7,152 firm-years)
Conservatism
(596 firms)
ACA　ADP　ARD　ANA　ACA　1
-0.02
-0.08**
-0.24**
-0.02
1
-0.03**
0.00
-0.07**
0.01
1
-0.01
-0.31**
0.04**
0.05**
1
CUMACA 1
ADP　ARD　ANA　CUMACA CUMADP CUMARD CUMANA
CUMADP 0.05
CUMARD -0.10**
CUMANA -0.42**
0.15**
1
-0.09**
0.09**
-0.15**
-0.13**
1
-0.07*
-0.02
0.12**
-0.13**
1
ACA is abnormal current accruals estimated from equation (1). ADP is abnormal long-term operating accruals
(depreciation expense) estimated from equation (2). ANA is abnormal non-operating accruals estimated by subtracting
industry mean. ARD is abnormal operating cash flows (R&D expense) estimated from equation (3).
CUMACA, CUMADP, CUMARD, and CUMANA are cumulative ACA, ADP, ARD, and ANA from 1988 to 99,
respectively.
Pearson correlations are reported in upper triangle and Spearman correlations are reported in lower triangle. ‘*’indicates
significant at 0.1 level. ‘**’indicates significant at 0.05 level.
30
Table 2 Validity of conservatism measures in this study (continued)
Panel D Correlations with measures used in prior studies for the constant sample (596 firms)
CUMCSV1　Rank of CUMCSV1 Rank of CUMCSV1
within industry　within market　-0.10**
-0.13**
0.54**
0.52**
-0.10**
-0.14**
-0.46**
-0.38**
-0.03
-0.02
-0.05
-0.05
-0.03
-0.02
Market-to-book ratio2　Cumulative non-operating accruals3 Hidden reserve4　Conservative Accounting Choices5　β 2 using raw return6　β 2 using excess return6　β 2 using size-adjusted excess return6　-0.08**
0.57**
-0.20**
-0.34**
-0.04
-0.05
-0.03
1
CUMCSV is the conservatism measure developed in this study as described in section 4.1.
Market-to-book ratio is market-to-book ratio for firm j at the fiscal end of sample period.
3
Cumulative non-operating accruals is sum of NA jt over 1988-99 deflated by beginning total asset of 1999, where
2
NA jt = ( NI jt − OCF jt − DPjt − CA jt ) . NI
is net income (loss).
OCF
jt
is operating cash flow. DP is zero minus depreciations
jt
jt
& amortizations. CA jt is current accruals for firm j in year t.
4
Hidden reserve for firm j at the end of year t is
INVRSV
RDRSV
jt
jt
deflated by beginning total asset, where
INVRSV jt + RDRSV jt + ADVRSV jt
is LIFO reserve reported in footnotes for LIFO firm j in fiscal year t. Its value is zero for non-LIFO firms.
is R&D expense reserve.
in fiscal year t and δ
i, n
after R&D investment.
RDRSV
jt
=
t −1
∑
− RD
τ = 0
j, t − τ
τ


 1 − ∑ δ  , where
i, n

 n=0
RD
jt
is zero minus R&D expenses for firm j
is Lev and Sougiannis (1996) estimated amortization rate of R&D for industry i in the nth year
ADVRSV
jt
zero minus advertising expense and
τ


 1 − ∑ λ  , Where ADV is
jt
n
τ =0
 n=0 
is ad hoc amortization rate of advertising investment in the nth year after a R&D
is advertizing expense reserve.
λ
n
investment. Following Penman and Zhang (1999a, b), I assume λ
1
ADVRSV
= 2/3
and
jt
λ
=
2
t −1
∑
− ADV
= 1/ 3
j, t − τ 
for all industries.
5
Conservative accounting choices are the summary score for income-decreasing accounting method choices
( DF jt + ACCL jt + LIFO jt ), where DF equals to 1 if deferral method is used for investment tax credit and 0 otherwise. ACCL
jt
jt
equals to 1 if accelerate method is used for depreciation and 0 otherwise.
LIFO
jt
equals to 1 if LIFO method is used for
inventory and 0 otherwise. For computer (SIC 8040, 8050-52) and electronics (SIC 8053, 8070-90) industries, FIFO is
more conservative because deflation of inventory over time. Therefore, for those industries, LIFO equals to 1 if FIFO
jt
method is used for inventory and 0 otherwise.
β2 is from time-series regression X jt / Pjt−1 = α 0 j + α1 j × DR jt + β 0 j × R jt + β 2 j × DR jt × R jt + δ jt for each firm. X is
jt
6
earnings per share for firm j in fiscal year t. R
jt
is cumulative monthly returns on firm j from month –9 to +3 relative to
year end of fiscal year t. DR is a dummy variable that equals to 1 if R
jt
jt
< 0 and 0 otherwise.
Pearson correlations are reported. ‘**’indicates significant at 0.05 level. ‘*’indicates significant at 0.10 level.
31
Table 3 Self-imposed accounting conservatism and its components
Panel A Full sample
Year　Number
of firms　Earnings Discretion
Conservatism
(Cumulative Earnings Discretion)
Total　Abnormal Abnormal Abnormal Abnormal Total　Abnormal Abnormal Abnormal Abnormal
current long-term
nonoperating
current long-term
nonoperating
accruals　operating operating cash flows　accruals　operating operating cash flows　accruals　accruals　accruals　accruals　1988　1989　1990　1991　1992　1993　1994　1995　1996　1997　1998　1999　1,748
1,639
1,667
1,714
1,866
2,038
2,124
2,310
2,615
2,672
2,573
2,479
Overall　25,4452
-0.007
-0.001
-0.020
-0.018
-0.018
-0.020
-0.027
-0.012
-0.012
-0.022
-0.031
0.001
-0.014
-0.006
-0.020
-0.011
-0.007
-0.002
-0.010
0.009
-0.005
-0.005
-0.002
0.007
-0.010
-0.012
-0.010
-0.010
-0.011
-0.012
-0.014
-0.024
-0.015
-0.011
-0.011
-0.017
0.020
0.020
0.013
0.005
0.000
-0.007
-0.001
0.004
-0.001
-0.004
-0.009
0.004
-0.003
-0.002
-0.004
-0.002
0.001
0.002
-0.002
0.000
0.010
-0.002
-0.008
0.008
-0.0161 -0.0051 -0.0131
0.0021
0.0001 -0.007
-0.007
-0.027
-0.045
-0.063
-0.083
-0.110
-0.121
-0.133
-0.155
-0.186
-0.184
-0.014
-0.020
-0.040
-0.051
-0.058
-0.060
-0.070
-0.061
-0.066
-0.071
-0.073
-0.067
-0.010
-0.023
-0.033
-0.042
-0.053
-0.066
-0.079
-0.103
-0.119
-0.129
-0.141
-0.158
0.020
0.040
0.053
0.058
0.058
0.051
0.050
0.053
0.052
0.048
0.039
0.043
-0.003
-0.004
-0.008
-0.010
-0.009
-0.007
-0.010
-0.010
0.000
-0.002
-0.010
-0.002
Panel B Constant sample
Year　Number
of firms　Earnings Discretion
Conservatism
(Cumulative Earnings Discretion)
Total　Abnormal Abnormal Abnormal Abnormal Total　Abnormal Abnormal Abnormal Abnormal
current long-term
nonoperating
current long-term
nonoperating
accruals　operating operating cash flows　accruals　operating operating cash flows　accruals　accruals　accruals　accruals　1988　1989　1990　1991　1992　1993　1994　1995　1996　1997　1998　1999　Overall　1
2
596
596
596
596
596
596
596
596
596
596
596
596
0.005
0.010
-0.014
-0.008
-0.007
-0.013
-0.005
0.000
0.012
-0.006
-0.004
0.009
-0.006
-0.008
-0.005
-0.005
-0.005
-0.006
-0.006
-0.014
-0.005
-0.002
-0.001
-0.002
0.026
0.024
0.016
0.011
-0.001
-0.006
0.003
0.008
0.005
0.003
-0.007
0.002
-0.003
-0.001
0.001
0.001
0.007
0.006
0.007
0.005
0.011
-0.001
0.000
0.007
71522 -0.0021 -0.0071 -0.0061
0.0071
0.0031 Mean of overall sample
Total of overall sample
32
-0.011
-0.005
-0.025
-0.015
-0.008
-0.008
-0.009
0.002
0.001
-0.006
0.005
0.001
0.005
0.013
-0.005
-0.018
-0.026
-0.040
-0.051
-0.052
-0.037
-0.041
-0.047
-0.052
-0.011
-0.017
-0.043
-0.056
-0.061
-0.065
-0.074
-0.068
-0.065
-0.068
-0.061
-0.062
-0.006
-0.014
-0.017
-0.021
-0.025
-0.030
-0.035
-0.048
-0.045
-0.040
-0.038
-0.039
0.026
0.045
0.055
0.057
0.048
0.036
0.032
0.034
0.034
0.032
0.019
0.011
-0.003
-0.002
0.001
0.003
0.012
0.019
0.026
0.030
0.040
0.036
0.034
0.039
Figure 1 Self-imposed accounting conservatism and its components
A. Full sample
0.200
0.150
0.100
0.050
CSV
ACA
0.000
ADP
ANA
ARD
-0.050
-0.100
-0.150
-0.200
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
YEAR
B. Constant sample
0.200
0.150
0.100
0.050
CSV
ACA
0.000
ADP
ANA
ARD
-0.050
-0.100
-0.150
-0.200
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
YEAR
CSV is earnings discretion, the sum of abnormal earnings components. ACA is abnormal current accruals estimated from
equation (1). ADP is abnormal long-term operating accruals (depreciation expenses) estimated from equation (2). ANA is
abnormal non-operating accruals estimated by subtracting industry mean. ARD is abnormal operating cash flows (R&D
expenses) estimated from equation (3). Figures plot the cumulative values of the above variables.
33
Table 4 Comparison of conservatism (CUMCSV) at the firm, industry, and market level
Year　1988　1989　1990　1991　1992　1993　1994　1995　1996　1997　1998　1999　Full Sample
Constant Sample
ＣＵＭＣＳＶ　ＣＵＭＣＳＶ ＣＵＭＣＳＶ ＣＵＭＣＳＶ Number ＣＵＭＣＳＶ　ＣＵＭＣＳＶ ＣＵＭＣＳＶ ＣＵＭＣＳＶ Number
Firm Industry Market of firms　Total
Firm Industry Market of firms　Total
Level
Level Level　Level
Level
Level　-1.181
-0.007
-0.007
-0.027
-0.045
-0.063
-0.083
-0.110
-0.121
-0.133
-0.155
-0.186
-0.184
0.065
-0.004
-0.003
0.036
0.092
0.020
0.075
-0.010
-0.065
-0.153
-0.332
-0.564
-0.014
0.018
-0.069
-0.143
-0.197
-0.268
-0.451
-0.427
-0.439
-0.423
-0.378
-0.433
100%
16%
48%
37%
1748
1639
1667
1714
1866
2038
2124
2310
2615
2672
2573
2479
-0.766
0.005
0.013
-0.005
-0.018
-0.026
-0.040
-0.051
-0.052
-0.037
-0.041
-0.047
-0.052
0.048
-0.012
-0.013
0.011
0.054
0.031
0.119
0.080
0.076
-0.007
-0.135
-0.282
-0.014
0.018
-0.069
-0.143
-0.197
-0.268
-0.451
-0.427
-0.439
-0.423
-0.378
-0.433
100%
7%
37%
56%
CUMCSV is the conservatism measure developed in this study as described in section 4.1.
34
596
596
596
596
596
596
596
596
596
596
596
596
Figure 2 Comparison of conservatism at the firm, industry, and market level
A. Full sample
0.600
0.400
0.200
CSVM
0.000
CSVI
CSV
-0.200
-0.400
-0.600
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
YEAR
B. Constant Sample
0.600
0.400
0.200
CSVM
0.000
CSVI
CSV
-0.200
-0.400
-0.600
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
YEAR
CSV is earnings discretion at firm level (self-imposed). CSVI is abnormal earnings at industry level (industry-driven).
CSVM is abnormal earnings at market level (market-driven). Figures plot the cumulative values of the above variables.
35
Table 5 Determinants of long-term accounting discretion (conservatism) for the constant sample
Panel A Descriptive statistics of dependent and independent variables
Dependent Variables
cumcsv1 cumcsv cumcsv Equity
market industry
Issue2
ranking ranking Equity
Debt
Ownership3 Issue4
Debt
Ownership5
Independent Variables
Litigation Auditor
Potential Incentive
Corporate
Debt
Political
Costs6
Liability7
Entry8
Compensation9 Governance10 Covenants11 Costs12
Mean
-0.027 0.502
0.519
-0.005
0.002
0.173
0.406
-0.007
0.928
0.691
0.189
-0.012
0.128
0.034
Median
-0.005 0.494
0.518
-0.004
-0.001
0.000
0.340
-0.041
1.000
0.757
0.005
-0.159
0.114
0.000
0.293 0.283
0.285
0.030
0.141
0.377
0.327
0.598
0.228
0.296
0.327
0.463
0.096
0.170
Std
Panel B Correlations between independent variables
Equity Equity
Debt
Issue2 Ownership3 Issue4
Independent Variables
Debt
Litigation Auditor
Potential Incentive
Corporate
Debt
Political
Ownership5 Costs6
Liability7
Entry8
Compensation9 Governance10 Covenants11 Costs12
Equity Issue
1
0.02
Equity Ownership
-0.15** 1
Debt Issue
-0.07
0.08*
-0.02
0.12**
-0.13**
0.09*
-0.04
-0.03
0.24** -0.17**
0.62**
0.22**
-0.10**
0.24**
-0.52**
-0.05
0.07
-0.15** 0.46**
1
0.12**
0.14**
-0.02
0.04
-0.33**
0.37**
0.24**
Debt Ownership
0.06
-0.28** 1
-0.05
0.00
0.07
-0.08*
0.21**
-0.22**
-0.11**
Litigation Costs
0.10** 0.61**
0.29** -0.07
1
0.23**
-0.10**
0.04
-0.27**
-0.11**
0.04
Auditor Liability
-0.05
0.25**
0.23** -0.02
0.22**
1
-0.03
0.06
-0.22**
0.11**
0.05
Potential Entry
0.06
-0.10**
-0.08*
0.06
-0.06
-0.03
1
0.09**
0.03
0.02
0.05
Incentive Compensation
-0.27** 0.24**
0.17** -0.06
0.06
0.04
0.09**
1
-0.11**
-0.03
0.09**
Corporate Governance
0.15** -0.55**
-0.56** 0.23**
-0.28**
-0.26**
0.07
-0.16**
1
-0.18**
-0.20**
Debt Covenants
-0.02
0.01
0.41** -0.23**
-0.07
0.13**
-0.01
0.02
-0.26**
1
0.11**
Political Costs
-0.05
0.11**
0.30** -0.15**
0.10**
0.05
0.05
0.12**
-0.26**
0.13**
1
-0.18**
-0.02
-0.22**
Pearson and Spearman correlations are reported in upper and lower triangle, respectively.
36
Panel C Coefficient estimates and t-statistics (the long run test at the firm level)
Dependent Adj R2
Variable &
# of firms
Intercept　Equity Equity
Debt
Issue2 Ownership3 Issue4
(−)
Debt
Ownership5
Independent Variables
Litigation Auditor
Potential Incentive
Corporate
Debt
Political
Costs6
Liability7
Entry8
Compensation9 Governance10 Covenants11 Costs12
(−)
(−)
(−)
(−)
(−)
(+)
(−)
1
cumcsv
cumcsv
market
ranking
cumcsv
industry
ranking
15%
0.095
0.403
0.039
-0.028
-0.102
-0.166
-0.081
-0.005
0.049
-0.059
0.043
-0.113
455
1.76*
1.07
0.33
-0.83
-2.81**
-6.85**
-1.66*
-0.14
1.37
-1.99**
0.33
-1.77*
15%
0.681
0.462
-0.039
-0.025
-0.085
-0.166
-0.128
-0.033
0.054
-0.060
-0.006
-0.226
-0.30
-0.66
-2.14**
-6.17**
-2.28**
-0.78
1.36
-1.81*
-0.04
-3.02**
-0.015
-0.005
-0.095
-0.169
-0.149
-0.058
0.051
-0.071
-0.098
-0.173
-0.11
-0.12
-2.40**
-6.30**
-2.68**
-1.37
1.28
-2.14**
-0.68
-2.19**
458
15%
457
10.79** 1.12
0.746
0.192
12.14** 0.46
1
cumcsv (cumulative earnings discretion) is a measure of long-term accounting discretion (conservatism) over 1988-99 for each firm in constant sample.
Equity Issue is the proceeds from common stock issue plus stock swap and minus stock repurchase during the sample period, deflated by market value of equity.
3
Equity Ownership is generated from principal components analysis of three ownership variables (percentage institution ownership, percentage block holder ownership,
and average percentage shareholding of investors). The eigenvector is (0.65, -0.47, and 0.58).
4
Debt Issue is the proceeds from debt issue during the sample period, deflated by market value of equity.
5
Debt Ownership is the average percentage private debt in total debt across the sample period.
6
Litigation Costs is obtained from principal component analysis of 3 market risk factors (equity beta, cumulative returns, and share turnover). The eigenvector is (0.67,
0.27, and 0.68). Equity beta is the slop coefficient from a regression r jd − r fd = ßjt (rmd − r fd ) + e jd d = 1 to dayst , where r jd is daily return of firm j at day d. rmd is
2
daily return of equal-weighted market index at day d.
r fd
is daily risk-free rate.
estimate beta for each firm-year. Cumulative return is ∑ r
jd
− 1 for
days t
is the number of trading days in year t. The regression is run by each firm-year to
each firm-year. Share turnover is 1 − ( 1 − Turn jt )**dayt , where Turn jt is average daily trading volume
divided by number of shares outstanding. Firm level variables are the average of firm-year variable over sample period.
Auditor liability is the percentage of years during the sample period that the firm’s auditor is one of the Big-Six.
8
Potential Entry is the speed of profit adjustment of a firm during the sample period. The speed of profit adjustment is coefficient
7
firm:
X jt = ß0 j + ß1 j N jt −1 X jt −1 + ß2 j P jt −1 X jt −1 + e jt .
X jt = ROA jt − ROAit
ß̂2j from
time-series regression for each
, ROAit is industry mean ROA . N jt equals to 1 if X jt is less than or equal zero and 0 otherwise.
P jt equals to 1 if X jt is greater than zero and 0 otherwise.
9
Incentive Compensation is the average percentage of implicit incentive pays in total compensation of firm’s top managers across the sample period. The implicit
weight of incentive pay in total compensation for firm j in year t is γˆ1 j ROAjt /COMPjt , where γˆ1 j is estimate from time-series regression for each firm:
COMPjt = γ 0 j + γ 1 j ROA jt + γ 2 j NMgrjt + ν jt
. COMPjt is total compensation averaged across firms’top managers’in year t. ROA jt is return on assets of year t. NMgrjt
is number of top managers included in calculation of average total compensation.
Corporate Governance is generated from principal components analysis of four corporate governance variables (board size, percentage outsiders’shareholding, block
holder on board, CEO on board). The eigenvector is (-0.43, 0.51, 0.66, -0.32).
11
Debt Covenants is the average leverage (long-term debt/assets) during the sample period.
12
Political Costs is the percentage of years that a firm’s market share within its industry is more than 5% during the sample period.
‘*’indicates significant at 0.1 level. ‘**’indicates significant at 0.05 level.
10
37
Table 6 Determinants of short-term accounting discretion for the constant sample
Panel A Descriptive statistics of dependent and independent variables
Dependent Variables
cumcsv1 cumcsv cumcsv Equity
market industry
Issue2
ranking ranking Equity
Debt
Ownership3 Issue4
Debt
Ownership5
Independent Variables
Litigation Auditor
Potential Incentive
Corporate
Debt
Political
Costs6
Liability7
Entry8
Compensation9 Governance10 Covenants11 Costs12
Mean
0.000
0.524
0.526
-0.006
0.014
0.017
0.372
-0.011
0.936
0.696
0.205
-0.071
0.151
0.052
Median
0.003
0.527
0.533
0.000
0.022
0.000
0.172
-0.060
1.000
0.759
0.017
-0.278
0.133
0.000
Std
0.073
0.225
0.236
0.074
0.158
0.074
0.398
0.693
0.245
0.372
0.380
0.544
0.118
0.221
Panel B Correlations between independent variables
Equity Equity
Debt
Issue2 Ownership3 Issue4
Independent Variables
Debt
Litigation Auditor
Potential Incentive
Corporate
Debt
Political
Ownership5 Costs6
Liability7
Entry8
Compensation9 Governance10 Covenants11 Costs12
Equity Issue
1
0.00
Equity Ownership
-0.07** 1
Debt Issue
0.01
0.09**
-0.01
-0.01
-0.05**
0.01
-0.03*
0.00
0.11** -0.15**
0.48**
0.19**
-0.07**
0.20**
-0.47**
-0.11**
0.07**
-0.05** 0.24**
1
0.03**
0.06**
-0.01**
0.01
-0.15**
0.21**
0.12**
Debt Ownership
0.02
-0.11** 1
-0.06**
0.03
0.02
-0.07**
0.14**
-0.15**
-0.06**
Litigation Costs
0.05** 0.49**
0.11** -0.07**
1
0.11**
-0.08**
0.07**
-0.20**
-0.11**
0.06**
Auditor Liability
-0.02
0.18**
0.10** 0.04**
0.12**
1
0.03
0.06**
-0.22**
0.07**
0.05**
Potential Entry
0.00
-0.09**
0.00
0.01
-0.09**
0.03*
1
0.07**
0.03*
0.02
0.03**
Incentive Compensation
-0.08** 0.19**
0.10** -0.01
0.11**
0.06**
0.12**
1
-0.09**
-0.09**
0.07**
Corporate Governance
0.07** -0.48**
-0.36** 0.12**
-0.22**
-0.21**
0.04**
-0.16**
1
-0.06**
-0.17**
Debt Covenants
0.04** -0.08**
0.22** -0.15**
-0.08**
0.07**
-0.02
-0.05**
-0.12**
1
0.05**
Political Costs
0.01
0.27** -0.03
0.09**
0.05**
0.04**
0.08**
-0.25**
0.08**
1
-0.12**
0.07**
0.01
-0.07**
Pearson and Spearman correlations are reported in upper and lower triangle, respectively.
38
Panel C Coefficient estimates and t-statistics (the short run test at the firm-year level)
2
Dependent Adj R
Intercept　Equity
Variable # of firmIssue2
Equity
Debt
Ownership3 Issue4
Debt
Ownership5
Independent Variables
Corporate
Debt
Political
Litigation Auditor
Potential Incentive
Costs6
Liability7
Entry8
Compensation9 Governance10 Covenants11 Costs12
-0.023
-0.020
0.001
-0.005
-0.017
-0.007
0.020
-0.006
-0.005
-0.014
years　csv1
csv
market
ranking
csv
industry
ranking
2%
0.018
3310
3.18** 2.12** -2.20**
-1.14
0.18
-2.18**
-3.09**
-2.13**
5.81**
-2.16**
-0.41
-2.47**
3%
0.621
-0.037
-0.001
-0.021
-0.093
-0.023
0.058
-0.022
-0.014
-0.058
-0.52
-0.10
-3.28**
-5.41**
-2.02**
5.47**
-2.52**
-0.40
-3.11**
0.029
-0.007
-0.029
-0.094
-0.048
0.053
-0.027
-0.034
-0.040
0.41
-0.66
-4.26**
-5.34**
-3.81**
4.79**
-2.94**
-0.91
-2.06**
3301
3%
3307
0.036
0.192
-0.050
33.04** 2.61** -1.54
0.643
0.117
-0.019
32.95** 2.10** -0.55
1
csv (earnings discretion) is a measure of short-term accounting discretion in each year during 1988-99 and for each firm in a constant sample of 596 firms.
Equity Issue is the proceeds from common stock issue plus stock swap and minus stock repurchase during the sample year, deflated by market value of equity.
3
Equity Ownership is generated from principal components analysis of three ownership variables (percentage institution ownership, percentage block holder ownership,
and average percentage shareholding of investors). The eigenvector is (0.65, -0.47, and 0.58).
4
Debt Issue is the proceeds from debt issue during the sample year, deflated by market value of equity.
5
Debt Ownership is the percentage private debt in total debt at the end of sample year.
6
Litigation Costs is obtained from principal component analysis of 3 market risk factors (equity beta, cumulative returns, and share turnover). The eigenvector is (0.67,
0.27, and 0.68). Equity beta is the slop coefficient from a regression r jd − r fd = ßjt (rmd − r fd ) + e jd d = 1 to dayst , where r jd is daily return of firm j at day d. rmd is
2
daily return of equal-weighted market index at day d.
r fd
is daily risk-free rate.
estimate beta for each firm-year. Cumulative return is ∑ r
jd
− 1 for
days t
is the number of trading days in year t. The regression is run by each firm-year to
each firm-year. Share turnover is 1 − ( 1 − Turn jt )**dayt , where Turn jt is average daily trading volume
divided by number of shares outstanding.
Auditor liability equals to 1 if firm’s auditor is one of the Big-Six in the sample year and 0 otherwise.
8
Potential Entry is the speed of profit adjustment of a firm during the sample period (1988-99). The speed of profit adjustment is coefficient
7
regression for each firm:
X jt = ß0 j + ß1 j N jt −1 X jt −1 + ß2 j P jt −1 X jt −1 + e jt .
X jt = ROA jt − ROAit
ß̂2j from
time-series
, ROAit is industry mean ROA . N jt equals to 1 if X jt is less than or equal
zero and 0 otherwise. P jt equals to 1 if X jt is greater than zero and 0 otherwise.
Incentive Compensation is the percentage of implicit incentive pay in total compensation of firm’s top managers in the sample year. The implicit weight of incentive
pay in total compensation for firm j in year t is γˆ1 j ROAjt /COMPjt , where γˆ1 j is estimate from time-series regression for each firm:
9
COMPjt = γ 0 j + γ 1 j ROA jt + γ 2 j NMgrjt + ν jt
. COMPjt is total compensation averaged across firms’top managers’in year t. ROA jt is return on assets of year t. NMgrjt
is number of top managers included in calculation of average total compensation.
Corporate Governance is generated from principal components analysis of four corporate governance variables (board size, percentage outsiders’shareholding, block
holder on board, CEO on board). The eigenvector is (-0.43, 0.51, 0.66, -0.32).
11
Debt Covenants is the average leverage (long-term debt/assets) at the end of the sample year.
12
Political Costs equals to 1 if a firm’s market share within its industry is more than 5% during the sample year and 0 otherwise.
‘*’indicates significant at 0.1 level. ‘**’indicates significant at 0.05 level.
10
39