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Accounting conservatism and corporate governance

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Abstract

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.

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Notes

  1. Following Beaver and Ryan (2005), we refer to this news-dependent conservatism as conditional. Other authors label it as ex post conservatism, income statement conservatism, or earnings conservatism. Unconditional or news-independent conservatism—also labeled ex ante or balance-sheet conservatism—in turn, refers to the persistent understatement of shareholders’ equity that results from historic cost accounting and underrecognition of certain intangible assets due to the accounting rules (Feltham and Ohlson 1995). In the paper, we only focus on conditional conservatism as it plays a clear role in the contracting and monitoring functions of corporate governance. However, it is difficult to see how contracting is affected by conservatism in the form of an unconditional accounting bias of known magnitude. Rational agents would simply invert the bias. If the bias is unknown, it can only reduce contracting efficiency (Ball and Shivakumar 2005).

  2. Watts (2003b) argues that tax and regulation also contribute to conservatism; however, the empirical evidence thus far offers more limited evidence on the contribution of these factors to conservatism.

  3. Our use of the expression strong (weak) governance is purely descriptive. It is not intended to mean that strong governance is better than weak governance.

  4. For example, internal governance mechanisms such as independent boards of directors and audit committees have been shown to constrain aggressive practices, limiting the incidence of income-increasing earnings management (Beasley 1996; Klein 2002; Peasnell et al. 2005). Similarly, recent research shows that independent audit committees hire better quality auditors (Abbot et al. 2003) that, in turn, impose more conservative accounting choices (Basu et al. 2001; Chung et al. 2003).

  5. Literature on this field provides mounting evidence that efficient corporate governance results in lower agency costs and that internal and external governance structures are associated to firm performance. For example, Cremers and Nair (2005) show that firms with strong external and internal governance generate abnormal returns of 10% to 15%. Core et al. (1999) find that less effective boards of directors—characterized by the CEO holding the chairman position; larger size; directors appointed by the CEO; and the presence of gray outside directors, old directors, and busy directors—are correlated with higher levels of CEO compensation after controlling for economic determinants of compensation; moreover, they find that predicted excess compensation, based on the governance structure of the firm, is negatively correlated with stock returns 1, 3, and 5 years ahead.

  6. Gompers et al. (2003) examine 24 provisions: anti-greenmail, blank-check preferred stock, business combination laws, bylaw and charter amendment limitations, classified board, compensation plans with change in control provisions, director-indemnification contracts, control share cash-out laws, cumulative voting requirements, director’s duties, fair-price requirements, golden parachutes, director indemnification, limitations on director liability, pension parachutes, poison pills, secret ballots, executive severance agreements, silver parachutes, special meeting requirements, supermajority requirements, unequal voting rights, and limitations on action by written consent.

  7. Like Bertrand and Mullainathan (2001), we use unit weights to construct Totgov following the recommendations of Grice and Harris (1998), who find that unit-weighted composites exhibit better psychometric properties than alternative weighting schemes.

  8. Prior studies (Givoly et al. 2007; Callen et al. 2006) express their distrust of inferences drawn from the Basu (1997) model if used in a time-series (firm-specific) approach. We use a cross-sectional approach.

  9. Ryan (2006, Footnote 2) states that “two well-known empirical results together imply the biases identified by Dietrich et al. are likely to be fairly small and so biases in returns-based measures of asymmetric timeliness are likely to be correspondingly small. First, the low R2s observed in contemporaneous returns-earnings regressions suggest that the extent to which earnings causes returns is tiny compared to the extent to which both variables are determined by other, more primitive information. Second, a large literature, only some of which employs the reverse regressions of earnings on returns used to estimate asymmetric timeliness, exists that shows returns typically reflect information on a timelier basis than earnings.”

  10. Basu uses the annual stock rate of return measured from 9 months before fiscal year end t to 3 months after fiscal year-end t. However, most subsequent studies use the fiscal year. Measuring returns 3 months after fiscal year-end is aimed at giving time to the market to incorporate information in contemporaneous earnings. Using fiscal year returns avoids returns being distorted by new information (different from earnings) coming to the market. Our results are not affected by this choice.

  11. The inclusion of additional control variables such as the incidence of losses and earnings variability (Francis et al. 2004) does not change the inferences. Neither does including as a proxy for growth opportunities, the book-to-market value of assets ratio. We exclude this last variable because it also captures a certain degree of conservatism.

  12. We are grateful to an anonymous referee for this insight.

  13. Managers may also manipulate the timing and level of cash flows (e.g., Roychowdhury 2006; Bushee 1998; Bartov 1993), however, due to its low flexibility and high visibility, this is expected to be a residual form of earnings management (Peasnell et al. 2000).

  14. Our data covers the period 1992 through 2003. The IRRC data is only available for 1990, 1993, 1995, 1998, 2000, and 2002. Gompers et al. (2003) report that for the majority of firms there is little time-series variation in the index. Taking advantage of this fact, like Cremers and Nair (2005), we align the index values available for 1990 with firm data for 1992, the index values for 1993 with firm data for 1993 and 1994, the index values for 1995 with firm data for 1995, 1996, and 1997, the index values for 1998 with firm data for 1998 and 1999, the index values for 2000 with firm data for 2000 and 2001, and the index values for 2002 with firm data for 2002 and 2003.

  15. For parsimony, we only report the results that use the modified Jones model of Dechow et al. (1995) to estimate discretionary accruals. The results are not affected by the choice of accruals estimation method.

  16. Fama and MacBeth (1973) regressions should be interpreted with caution. Basu (1999) gives a number of reasons against the use of mean annual regressions, related mainly to the parameters not being stationary.

  17. Our estimate of discretionary accruals is based on the modified Jones model. This model only controls for two simple relations: between accruals and sales and accruals and property, plant, and equipment. This model would rarely capture other possible drivers of conservatism such as special items (restructuring charges and other one-time items). Managers also may use special items to affect conservatism. To assess this possibility, we augment earnings and the discretionary accruals estimate by adding the special items (Compustat item #17) deflated by beginning-of-the-period market value of equity. Then, we repeat the tests in Panel A of Table 2. Untabulated results indicate that the inferences still hold.

  18. We also repeated this test including an industry × year interaction term and obtained the same inferences.

  19. Notice that our proxies for conservatism—Basu’s (1997) earnings asymmetric timeliness, Ball and Shivakumar’s (2005) accruals asymmetric timeliness, and Givoly and Hayn’s (2000) average accruals—are different from the measure for the relevance of accounting numbers used by Bushman et al. Their measure captures earnings symmetric timeliness, which is closer to what the literature refers to as relevance.

  20. In these tests we are unable to use the Heckman procedure as described in Sect. 3.3. The reason is that here we are partitioning the sample into strong and weak governance firms, and the probit regression that models governance choice cannot be applied to each partition separately. Nevertheless, all previous evidence indicates that the results are not biased by not taking into account the endogeneity of governance choice.

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Acknowledgements

We appreciate the helpful comments and suggestions from Carol Marquardt, Antonio Dávila, Miguel Ferreira, Joachim Gassen, Christian Leuz, Flora Muino, Ivana Raonic, William Rees, Stefan Reichelstein (the editor), Phillip Stocken, Martin Walker, two anonymous reviewers, and seminar participants at the AAA 2006 Annual Meeting, EAA 2005 Annual Meeting, ACCID 2005 Annual Conference, University of Alicante, University of Valencia, IESE Business School, ISCTE Business School, London Business School, The University of Manchester, and University of Navarra (Pamplona). We acknowledge financial contribution from the Spanish Ministry of Science and Technology (SEJ2005-08644-C02-01/ECON). Juan Manuel García Lara also thanks the financial contribution from SECJ2004-09176-C02-02/ECO.

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Authors and Affiliations

  1. Department of Business Administration, Universidad Carlos III de Madrid, Calle Madrid 126, 28903, Getafe, Madrid, Spain

    Juan Manuel García Lara

  2. Department of Accounting, Universidad Autónoma de Madrid, Fco. Tomás y Valiente 5, Madrid, 28049, Spain

    Beatriz García Osma

  3. IESE Business School, University of Navarra, Av. Pearson 21, Barcelona, 08034, Spain

    Fernando Penalva

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  1. Juan Manuel García Lara
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  2. Beatriz García Osma
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  3. Fernando Penalva
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Correspondence to Fernando Penalva.

Appendices

Appendix 1

1.1 Determinants of governance choice

We use the two-step Heckman (1979) procedure to take into account the endogenous nature of governance. In the first stage, governance choice is modeled using a probit model. In particular, we regress a dummy variable that indicates whether the firm has selected either to have strong or weak governance on a set of determinants. We define strong (weak) governance as having values of Totgov below (above) the median of this variable. In the second stage, we estimate Eqs. 1–9 including as an additional control variable the inverse Mills ratio computed from the parameters of the first stage. The determinants of governance are taken from previous literature:

  1. (a)

    Size. Larger firms are more complex and place higher demands on governance structures. Demsetz and Lehn (1985) find that size is significantly associated with ownership concentration. We measure size as the three-year average of the natural logarithm of the market value of equity, measured at the end of the fiscal year, and predict a positive association with the quality of governance.

  2. (b)

    Growth opportunities. Previous research documents that growth opportunities explain the cross-sectional differences in governance configurations. Following Smith and Watts (1992), our (inverse) proxy for growth is the three-year average of the annual book-to-market value of assets ratio, measured at the end of the fiscal year. The market value of assets is defined as the market value of equity plus the book value of liabilities.

  3. (c)

    Firm age. Previous research hypothesizes that the age of the firm is related to the governance structure. Following Bushman et al. (2004), our proxy is the natural logarithm of the firm’s age at the end of the fiscal year, measured as the number of years the firm has been public.

  4. (d)

    Free cash flow. High free cash flow poses a problem for firms with low growth opportunities, since managers may invest the excess cash in negative net present value projects or engage in empire-building acquisitions. Jensen (1986) suggests that governance structures can mitigate this agency problem. Following Lang et al. (1991), our proxy to capture this determinant is the three-year average of [(operating cash flow minus preferred and common dividends)/total assets] if the book-to-market ratio is greater than or equal to one, and zero otherwise. Firms with book-to-market ratios greater than one are expected to have low growth opportunities. The free cash flow problem demands better governance, therefore we expect to find a positive association between Free cash flow and the quality of governance.

  5. (e)

    Idiosyncratic risk. Demsetz and Lehn (1985) suggest that the amount of noise in the firm’s operating environment is expected to increase the costs of direct monitoring, which in turn increases the demands on governance structures. These costs are expected to increase at a decreasing rate with the difficulty in monitoring. Hence, we use the logarithmic transformation of the firm’s idiosyncratic risk. Idiosyncratic risk is defined as the natural logarithm of the standard deviation of the residual return from a 36-month market model regression of the firm’s monthly returns on the returns to the CRSP value-weighted market portfolio, imposing a minimum of 12 observations. We predict a positive association between Idiosyncratic risk and the quality of governance.

  6. (f)

    Leverage. Cremers and Nair (2005) find that internal and external governance mechanisms are stronger complements in firms with low leverage, because higher debt reduces the probability of a takeover as the target is less attractive to the prospective acquirer. This fact reduces the governance usefulness of anti-takeover mechanisms. Our proxy for leverage is the ratio of short and long-term debt to total common shareholders, equity.

  7. (g)

    Industry concentration and geographic concentration. Bushman et al. (2004) argue that organizational complexity increases with industry and geographic diversification. These authors hypothesize and find that the complexity associated with diversification causes costly governance responses because the inherent additional managerial difficulties generated by more complex firms place higher demands on the governance structures. To control for the level of diversification, we employ the same proxies used by Bushman et al. (2004). Industry concentration is defined as the three-year average of the sum of the squares of (firm sales in each industry segment/total firm sales). Geographic concentration is defined as the three-year average of the sum of squares of (firm sales in each geographic segment/total firm sales). Higher values of these two proxies indicate more industry/geographic concentration. These two proxies are inverse measures of diversification; therefore, we expect to find a negative association with the quality of governance.

  8. (h)

    CEO tenure. Hermalin (2005) develops a model in which a trend towards more board diligence leads to shorter CEO tenures. Bushman et al. (2004) find that the number of years the CEO has been a director is positively associated with the presence of more inside directors in the board. Hermalin and Weisbach (1988) find that board independence declines over the course of the CEO’s tenure. We hypothesize that the number of years the CEO has been in office, CEO tenure, is another determinant of governance as longer tenures increase the likelihood of having more insiders in the board. We predict a negative association between CEO tenure and governance.

  9. (i)

    Performance. Previous research documents the association between certain governance attributes and past firm performance. Hermalin and Weisbach (1988) find that the likelihood of independent directors being added to the board increases following poor firm performance. Similar to Demsetz and Lehn (1985), to control for past firm performance we use the three-year stock return measured as the continuously compounded monthly CRSP return over 36 months, ending at fiscal year-end.

  10. (j)

    Regulation. The additional monitoring provided by regulators may systematically affect the governance characteristics of firms operating in regulated environments. Following Demsetz and Lehn (1985) and Bushman et al. (2004), we include an indicator variable that takes the value of one if the firm is a utility and zero otherwise. We do not control for financial firms because our sample excludes these firms.

  11. (k)

    High-tech industry. We also include an indicator variable if the firm is in a high-tech industry (Chandra et al. 2004).

  12. (l)

    Quality of the auditor. The quality of the auditor may be associated with the quality of governance (Basu et al. 2001). We define an indicator variable, Big-5, that takes on the value of one if the auditor of the firm is a Big Five auditor and zero otherwise.

The table below contains the results of the estimation of the first-stage probit regression of a Heckman (1979) model. The sample consists of 9,152 firm-year observations (1,611 firms) for the years 1992 through 2003. The reported z-statistics are based on standard errors which are robust to both heteroscedasticity and within-group serial correlation. The two-sided thresholds of the z-statistics for significance at the 0.10, 0.05, and 0.01 confidence levels are 1.64, 1.96, and 2.61, respectively.

  Heckman procedure: first-stage probit regression
Full size table

As a sensitivity check, we also included additional variables to control for past accounting performance. In particular, we estimated specifications that included current and past return on assets, or a variable to reflect the incidence of negative earnings realizations in the past, calculated as the proportion of losses over the prior ten years. None of the inferences reported in the tables in the paper is affected by the inclusion of these variables.

Appendix 2

  Heckman estimation of the asymmetric timeliness across governance structures when the dependent variable is a proxy for discretionary accruals
Full size table

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García Lara, J.M., García Osma, B. & Penalva, F. Accounting conservatism and corporate governance. Rev Account Stud 14, 161–201 (2009). https://doi.org/10.1007/s11142-007-9060-1

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