No full-text available
To read the full-text of this research,
you can request a copy directly from the authors.
Effects of corporate financial distress on peer firms: do intra-industry non-distressed firms become more conditionally conservative?
Abstract
We study whether public announcements (through delisting warnings) of financial distress of some firms in an industry affect the conditional accounting conservatism of intra-industry non-distressed firms. We hypothesize that the lenders of non-distressed firms perceive higher riskiness and demand for stricter debt covenants and more efficient monitoring of debt contracts when some firms show signals of financial distress in that industry. Intra-industry non-distressed firms increase their levels of conditional conservatism to meet the lenders’ demands for stricter monitoring of debt contracts and to reduce debt costs. Using the delisting warning data from the Chinese stock exchanges, we find that financial distress announcements lead to increases in conditional conservatism of non-distressed firms in that industry. We provide new evidence for the spillover effects of financial distress within an industry and the usefulness of conditional conservatism in debt contracts.
... Boubakri et al. (2013) argue that a potent government might control SOEs to make prudent investment decisions to maintain social benefits and employment prospects in the context of privatization. Concentrated ownership benefits firms by mitigating FD, as large shareholders (blockholders) have incentives to curb managerial actions, such as excessive risk-taking (Miglani et al., 2015) but ownership concentration magnifies the risk of Vietnamese companies (Tran & Le, 2020). Firms with CEO ownership have a lower FD probability (Brédart, 2013). ...
... Financial distress has garnered significant attention in recent theoretical and empirical literature across various countries (Kazemian et al., 2017). This state could result in higher borrowing costs and more stringent debt covenants (Sun et al., 2022) due to heightened risk perceptions among lenders and investors, raising the likelihood of bankruptcy or restructuring (Senbet & Wang, 2012) and deteriorating firm performance (Molina and Preve, 2009). ...
... Such behavior could lead to suboptimal decision-making, reduced firm value, and an increased FD likelihood . Tran & Le (2020) show that concentrated ownership enlarges Vietnamese companies' risk. Based on these arguments, we propose that: ...
This study examines the relationship between stock return volatility (SRV) and financial distress (FD) and the moderating roles of ownership structure, managerial (CEO) ability, and financial constraints in this nexus. Using a panel sample of Vietnamese-listed companies from 2010-2020, we find that firms experiencing high SRV encounter more FD. Our finding is robust to alternative measures of both SRV and FD variables. Large-cap and low-leverage firms bear less FD risk owing to excessive stock return volatility than small-cap and high-leverage companies. Additional analyses reveal that the presence of state ownership mitigates FD likelihood while the presence of institutional and concentrated ownership exacerbates FD probability when heightened SRV. Further, an adverse impact of SRV on the firm's stability is more pronounced in companies with strong CEO power and less financial constraints. This research provides deep insights for corporate executives and policy-makers on the relationship between SRV and FD. Furthermore, it underscores the necessity of managing stock return volatility to ensure the stability of listed firms in emerging markets.
... Accounting conservatism is one of the accounting principles commonly used in accounting practice. A systematic review of accounting conservatism can help us understand this principle more deeply (Zhang et al. 2019;Sharma and Kaur 2021;Sun et al. 2022;Tambolo and Cevolani 2023). One example of a systematic review that can be conducted is to study the effect of accounting conservatism on the quality of financial information. ...
Purpose: The purpose of this study is to analyze the influence of accounting conservatism, profitability, growth opportunities, and default risk on the earnings responsiveness coefficient of mining sector companies listed on the Indonesia Stock Exchange during the period of 2020-2022. Design/Methodology/Approach: This study utilizes a quantitative research design with purposive sampling technique to select a sample of 60 mining sector companies listed on the Indonesia Stock Exchange during the period of 2020-2022. The data collected from the financial reports of the selected companies is analyzed using classical assumption tests and multiple regression analysis. Findings: The results of this study indicate that accounting conservatism has a significant positive effect on the earnings responsiveness coefficient of mining sector companies listed on the Indonesia Stock Exchange during the period of 2020-2022. However, profitability and default risk variables do not have a significant effect on the earnings responsiveness coefficient. On the other hand, growth opportunities have a significant negative effect on the earnings responsiveness coefficient. Practical Implications: The findings of this study can be useful for practitioners in making managerial decisions, especially in enhancing the earnings responsiveness of mining sector companies listed on the Indonesia Stock Exchange. Practitioners can utilize accounting conservatism as a tool to improve earnings responsiveness. Additionally, this study provides insights for regulators in determining policies related to the earnings responsiveness coefficient. Regulators can consider growth opportunities in their decision-making processes. Originality/Value: This study contributes to the accounting literature by revealing the influence of different factors on the earnings responsiveness coefficient of mining sector companies in Indonesia. The results of this study can also serve as a basis for further research on other factors that influence the earnings responsiveness coefficient of companies in other sectors. Paper Type: Empirical Research.
... For Scope 1, corporate debt-paying ability is more important. Highly indebted corporations struggle with onerous debt responsibilities, which limit the implementation of management strategies to reduce carbon emissions (Sun et al. 2022). Thus, we argue that the higher corporate debt-paying ability, the more focus is on carbon emission reduction activities. ...
Corporate carbon performance is a key driver of achieving corporate sustainability. The identification of factors that influence corporate carbon emissions is fundamental to promoting carbon performance. Based on the carbon disclosure project (CDP) database, we integrate the least absolute shrinkage and selection operator (LASSO) regression model and the fixed effects model to identify the determinants of carbon emissions. Furthermore, we rank determining factors according to their importance. We find that Capx enters the models under all carbon contexts. For Scope 1 and Scope 2, financial-level factors play a greater role. For Scope 3, corporate internal incentive policies and emission reduction behaviors are important. Different from absolute carbon emissions, for relative carbon emissions, the financial-level factors’ debt-paying ability is a vital reference indicator for the impact of corporate carbon emissions.
We utilize a unique setting associated with the mandatory closure of the government‐to‐business revolving door to examine whether and how an exogenous rise in firm‐level political uncertainty affects the mispricing of earnings. The tension that underlies our study stems from two opposing effects. To the extent that such uncertainty can trigger opinion divergence (rational attention) among investors, it is expected to delay (accelerate) price discovery and increase (decrease) security mispricing. Our identification strategy draws on the difference‐in‐differences analysis associated with the Chinese regulation in 2013 that mandated the resignation of corporate independent directors with a government background. Consistent with the dominance of the opinion divergence effect, we observe that these involuntary resignations unintentionally increase delays in share price responses following earnings announcements. These findings are more evident among firms that enjoy more benefits from independent directors with a government background. Further analyses confirm that these involuntary resignations trigger more opinion divergence rather than rational attention among investors by showing significant increases in analyst forecast diversity but no changes in analyst coverage following such resignations. We provide novel evidence that market information efficiency could deteriorate as an unintended consequence of the escalation of firm‐level political uncertainty.
This study defines financially distressed enterprises based on stock delisting risk warnings and uses the annual data of A-share listed companies on the Shanghai and Shenzhen stock exchanges from 2008 to 2021 to examine the impact and mechanism of financial distress on the capital expenditures of non-distressed enterprises in the same city. The results indicate that if financially distressed enterprises exist within a city, the capital expenditure of non-distressed enterprises within the same city will subsequently decrease. The conclusions hold after multiple robustness and endogeneity tests. Mechanism tests show that financially distressed enterprises reduce the operating performance and cash flow of non-distressed enterprises in the same city through business performance contagion, thereby reducing their intrinsic motivation for capital expenditure. However, financial distress enhances creditors’ credit risk perceptions of non-distressed enterprises in the same city through signal transmission effects, prompting creditors to tighten credit contracts or directly intervene in corporate capital expenditure decisions, thus suppressing corporate capital expenditure. Heterogeneity tests indicate that the smaller the asset size of non-distressed enterprises, the larger the scale of financially distressed enterprises relative to non-distressed enterprises in the same city, or the more severe the agency problem of non-distressed enterprises or degree of financial distress, the more significant the negative externality of financial distress on the capital expenditures of local enterprises. The economic consequences test shows that the reduction effect of financial distress on the capital expenditure of non-distressed enterprises in the same city ultimately improves their capital expenditure efficiency.
This study empirically tests the effect of stock risk warning of listed companies on the risk of stock price crash of non-warning companies in the same industry and its mechanism in the Chinese A-share listed companies from 2008 to 2021 as samples. The research results show that the risk warning information has a capital market governance effect on peer companies, that is, the new risk warning information in an industry will alleviate the risk of stock price crash of peer companies. This conclusion remains robust after a series of robustness and endogeneity tests. The mediating mechanism test shows that the idiosyncratic information content of the stock price mediates the process of risk warning information affecting the risk of stock price crash of peer companies. The heterogeneity test shows that the governance effect of risk warning information on the risk of stock price crash of peer companies is more significant when the problem of company agency is more serious, the competitive market position is lower, or the differences in opinion among investors are smaller. This study provides empirical evidence for the necessity of the existence of the risk warning system. Additionally, it provides a reference for the capital market risk supervision of similar transition economies such as China.
We examine the impact of conditional conservatism on earnings management. Our findings support the view that conditional conservatism reduces accruals-based earnings management but also triggers a trade-off between accruals and real earnings management. In our main tests we use the passage of SFAS 121 as a plausibly exogenous regulatory change that increased the level of conditional conservatism but did not materially affect earnings management. We find that, after the regulation, treated firms reduce accruals-based earnings management and increase real earnings management, and are less likely to be marginal or habitual beaters of earnings benchmarks. Given the crucial role of earnings for firm valuation and analysis, and that conditionally conservative accounting choices are observable, our results should be of wide interest for investment professionals.
We study non‐officer directors’ influence on the accounting conservatism of U.S. public firms. Between 1986 and 2002, all 50 U.S. states enacted laws that limited non‐officer directors’ litigation risk without changing officer directors’ litigation risk. We find that conditional conservatism decreased after the staggered enactments of the laws, which we attribute to less non‐officer‐director monitoring of financial reporting in affected firms. Conservatism fell less when shareholder or debtholder power was high, consistent with major stakeholders moderating the influence of non‐officer directors. We verify that our results stem from reductions in the asymmetric timeliness of accruals and, specifically, its current assets components. We also show that affected firms switched away from Big N auditors more often, which reduced these firms’ commitment to conservative financial reports.
This article is protected by copyright. All rights reserved
We provide empirical evidence of the effect of managerial risk incentives on financial reporting conservatism. We hypothesize that firms use greater accounting conservatism as a means of addressing increased firm risk arising from excessive managerial risk incentives provided by option compensation. Consistent with this hypothesis, we find a positive association between excessive managerial risk incentives and accounting conservatism measured as asymmetric timeliness of loss recognition. By contrast, we find no impact by normal (anticipated) risk-taking on accounting conservatism. Further analysis shows that the association between excessive managerial risk incentives and accounting conservatism is more pronounced when firms face more severe debtholder–shareholder conflicts. We also find that while cost of debt financing is positively associated with both anticipated and excessive risk incentives, the relationship with the latter is weakened by timelier loss recognition, suggesting firms with heightened risk incentives could economically benefit from using more conservative accounting.
In this article, we attempt to distinguish between the properties of moderator and mediator variables at a number of levels. First, we seek to make theorists and researchers aware of the importance of not using the terms moderator and mediator interchangeably by carefully elaborating, both conceptually and strategically, the many ways in which moderators and mediators differ. We then go beyond this largely pedagogical function and delineate the conceptual and strategic implications of making use of such distinctions with regard to a wide range of phenomena, including control and stress, attitudes, and personality traits. We also provide a specific compendium of analytic procedures appropriate for making the most effective use of the moderator and mediator distinction, both separately and in terms of a broader causal system that includes both moderators and mediators. (46 ref) (PsycINFO Database Record (c) 2012 APA, all rights reserved)
Financial distress prediction (FDP) takes important role in corporate financial risk management. Most of former researches in this field tried to construct effective static FDP (SFDP) models that are difficult to be embedded into enterprise information systems, because they are based on horizontal data-sets collected outside the modelling enterprise by defining the financial distress as the absolute conditions such as bankruptcy or insolvency. This paper attempts to propose an approach for dynamic evaluation and prediction of financial distress based on the entropy-based weighting (EBW), the support vector machine (SVM) and an enterprise’s vertical sliding time window (VSTW). The dynamic FDP (DFDP) method is named EBW-VSTW-SVM, which keeps updating the FDP model dynamically with time goes on and only needs the historic financial data of the modelling enterprise itself and thus is easier to be embedded into enterprise information systems. The DFDP method of EBW-VSTW-SVM consists of four steps, namely evaluation of vertical relative financial distress (VRFD) based on EBW, construction of training data-set for DFDP modelling according to VSTW, training of DFDP model based on SVM and DFDP for the future time point. We carry out case studies for two listed pharmaceutical companies and experimental analysis for some other companies to simulate the sliding of enterprise vertical time window. The results indicated that the proposed approach was feasible and efficient to help managers improve corporate financial management.
Conservatism, through the timelier recognition of losses in the income statement, is expected to increase firm investment efficiency through three main channels: (1) by decreasing the adverse effect of information asymmetries between outside equity holders and managers, facilitating the monitoring of managerial investment decisions; (2) by increasing managerial incentives to abandon poorly performing projects earlier and to undertake fewer negative net present-value investments; and (3) by facilitating the access to external financing at lower cost. Using a large US sample for the period 1990-2007 we find a negative association between conservatism and measures of over- and under- investment, and a positive association between conservatism and future profitability. This is consistent with firms reporting more conservative numbers investing more efficiently and in more profitable projects. Our results add to a growing stream of literature suggesting that eliminating conservatism from accounting regulatory frameworks may lead to undesirable economic consequences.
This paper addresses the relationship between stock markets and credit default swaps (CDS) markets. In particular, I aim to gauge if the co-movement between stock prices and sovereign CDS spreads increases with the deterioration of the credit quality of sovereign debt. The analysis of correlations, Granger causality, cointegration, and the results of an error-correction model represented in a state space form show a close link between these markets, but do not evidence that the co-movement increases in periods of financial distress. I also analyze the transmission of volatility between the two markets. The results do not support the hypothesis that volatility propagation surges during financial distress periods. On the contrary, for some cases, the data suggests that the lead-lag relationships between the two markets volatility are stronger during stable periods.
Contagion usually refers to the spillover of the effects of shocks from one or more firms to other firms. Most studies of contagion limit their analysis to how shock affect firms in the same industry, or "intra-industry" contagion. The purpose of this paper is to explore and document the likely magnitude of "inter-industry" contagion. In their comprehensive study of intra-industry contagion using many individual industries Lang and Stulz (1992) argue that if contagion is not simply an informational effect it will impose a social cost on our economic system. If this is true for intra-industry contagion, then the same argument must hold for inter-industry contagion as well. We focus on inter-industry contagion effects in this paper because the vast majority of the extant literature about contagion has neglected its important potential cost to shareholders. Most of the studies on contagion attempts to differentiate between a "pure" contagion effect and a signaling or information-based contagion effect. An example of a pure contagion effect would be the negative effects of a bank failure spilling over to other banks regardless of the cause of the bank failure. And, an example of a signaling contagion effect would be if a bank failure is caused by problems whose revelation is correlated across banks, and the correlated banks are impacted negatively. We conduct our investigation of contagion by examining three separate announcements involving adverse information about commercial real estate portfolios. The first announcement is by a large commercial bank (the Bank of New England), the second announcement consists of a series of events--from several large banking organizations and a regulatory agency (the Office of the Comptroller of the Currency), and the third announcement is by a large life insurance company (Travelers). There are two reasons we chose these particular events. First, the events seemed to be very unusual and very significant indicators of future (and present) financial distress. Second, the events shared a common theme of financial distress caused by problems with commercial real estate portfolios. We first establish that the commercial bank announcements negatively impact the equity values of life insurance companies (and vice versa). Next, we demonstrate that the bank regulatory agency announcement negatively impacts the equity values of life insurance companies as well as commercial banks. We then explicitly test if the shareholder wealth effects are linked to a set of specific firm characteristics. Consistent with previous contagion studies, our results provide strong evidence of "intra-industry" contagion related wealth effects. We also find that these contagion effects, to a significant degree, can be explained by firm specific variables. This implies that the intra-industry spillover effects associated with our three events are not of the totally "pure" contagion variety, but have an informational component as well. We also find very strong evidence of significant "inter-industry" contagion-based shareholder wealth effects. Again, these contagion-based wealth effects do not appear to be purely contagion-based. Wealth effects can also be explained by such factors as geographic proximity, asset composition, liability composition, leverage, size, and regulatory expectations.
The paper examines the power and reliability of the differential timeliness measure (DT) developed by (Basu (1997) to gauge reporting conservatism. We identify certain characteristics of the information environment unrelated to conservatism that affect the DT measure and find that the measure is sensitive to the degree of uniformity in the content of the news during the examined period, the types of events occurring in the period, and the firm's disclosure policies. Our tests, based on both actual and simulated data, indicate that assessing the extent of reporting conservatism requires the recognition of, and control for, these characteristics. We also find that the difference in the timeliness of bad versus good news is likely to be more pronounced than previously reported. Further, we provide additional evidence on the negative association between the DT measure and alternative aspects of conservatism, suggesting that the exclusive reliance on any single measure for assessing the overall conservatism of a reporting regime (firms, countries or time periods) is likely to lead to incorrect inferences.
We use antitakeover laws passed by several states in the mid-1980s and early 1990s as an exogenous increase in agency conflicts, and examine how these laws affect the demand for asymmetric timeliness of loss recognition (ATLR). Consistent with the debt-based contracting demand for ATLR, we find an increase in ATLR after the assuage of antitakeover laws for firms with high contracting pressures. These increases are incremental to those found in control firms that face similar pressures but whose states did not pass antitakeover laws. We do not find comparable changes in ATLR for firms with higher agency costs of equity. In contrast to the observed increases in ATLR, we find no change in the short-window information content of earnings announcements. Overall, our results suggest that higher agency conflicts result in a heightened demand for ATLR in financial statements but not for more forward-looking new information. Further, these demands seem to emanate from debtholders and not from equityholders.
This study examines the effect of banking competition on borrowing firms’ conditional accounting conservatism (i.e., asymmetric timely loss recognition). The context of the study is the staggered passage of the Interstate Banking and Branching Efficiency Act (IBBEA), the deregulation that permits banks to establish branches across state lines and increases bank competition. I find that firms report less conservatively after the passage of the IBBEA in their headquarter states. The effect on conditional conservatism is stronger for firms in states with a greater increase in competition among banks, firms that are more likely to borrow from in-state banks, firms with greater financial constraint, and firms subject to less external monitoring. Additional tests confirm that the decline in conditional conservatism is observed only after the adoption of IBBEA and lasts for two years. The findings indicate that banks tend to “lowball” borrowers when competition arises by relaxing their demand for conservative reporting. Overall, this study highlights the unintended impacts of banking competition on borrowing firms’ financial reporting.
Basu's [1997] measurement of conditional conservatism as the asymmetric timeliness of earnings underlies hundreds of studies. However, many subsequent studies cast doubt on the extent to which Basu's measure captures conditional conservatism versus statistical biases or alternative constructs (collectively, “biases”), thereby questioning the validity of the inferences that empirical researchers draw from analyses using the measure. We modify Basu's measure in four simple ways to remove these biases. Our key modification is the inclusion of interactive controls for return variance, a volatility proxy that captures Patatoukas and Thomas’ [2011] return variance effect and various sources of economic optionality and adjustment costs. This inclusion captures volatility‐related effects on both the level of earnings and the sensitivity of earnings to returns, and it allows the magnitudes of these effects to vary with the sign of returns. We conduct validation analyses using placebo dependent variables, synthetic returns, and non‐conditionally conservative earnings components that show our modified Basu measure is largely free of known biases. We further show that our measure is associated with contracting and other economic variables as predicted by theory. Our findings suggest that researchers can rely on our modified Basu measure to identify the determinants and effects of conditional conservatism.
This article is protected by copyright. All rights reserved
Binary financial distress prediction (FDP), which categorizes corporate financial status into the two classes of distress and nondistress, cannot provide enough support for effective financial risk management. This paper focuses on research on multiclass FDP based on the support vector machine (SVM) integrated with the decomposition and fusion methods. Corporate financial status is subdivided into four states: financial soundness, financial pseudosoundness, moderate financial distress and serious financial distress. Three multiclass FDP models are built by integrating the SVM with three decomposition and fusion methods, i.e., one-versus-one (OVO), one-versus-rest (OVR), and error-correcting output coding (ECOC), and they are, respectively called OVO-SVM, OVR-SVM and ECOC-SVM. Empirical research based on data from Chinese listed companies shows that OVO-SVM overall outperforms OVR-SVM and ECOC-SVM and is preferred for multiclass FDP. In addition, all three models trained on the original highly class-imbalanced training dataset cannot obtain satisfying performance, and the data level preprocessing mechanisms that make class distributions balanced in the training dataset can greatly improve their multiclass FDP performance. Compared with multivariate discriminant analysis (MDA) and multinomial logit (MNLogit), OVO-SVM has significantly higher accuracy for financial pseudosoundness and moderate financial distress and lower accuracy for financial soundness and serious financial distress, resulting in no significant difference among their overall multiclass FDP performance. However, OVO-SVM is still more competitive than MDA and MNLogit in that financial pseudosoundness and moderate financial distress are much more difficult to predict by human expertise than the other two financial states.
This study examines how conditional accounting conservatism varies after debt contracts are executed (ex-post conditional conservatism) depending on the closeness to violations of debt covenants, the costs of covenant violations, and bank monitoring. I hypothesise that borrowers with lower debt-covenant slack have an incentive to avoid covenant violations and will have lower ex-post conditional conservatism levels than those with higher slack. I find that borrowers with both lower and higher slack increase their ex-post conditional conservatism, but that the magnitude of this increase in conservatism is positively associated with the level of covenant slack. Further, this positive relationship between the ex-post change in conditional conservatism and the debt-covenant slack is more pronounced when the costs of the debt-covenant breach are greater, and is less pronounced when lenders have stronger incentives to monitor borrowers. This study provides evidence that the ex-post change in conditional conservatism is affected by the costs of a covenant breach and bank monitoring.
This paper surveys both the theoretical and the empirical archival literature on conservatism when accounting information is used for debt contracting. The theoretical literature shows mixed results whether conservative accounting is desirable, which depends on the underlying agency problem, the information available, and the contracting space. The empirical literature takes a more holistic view in measuring the degree of conservatism. It studies a broad array of possible effects of conservatism in debt financing, but also beyond. The results overwhelmingly support the view that conservatism plays a useful role in debt contracting, although there are also some mixed results. We describe key results and empirical designs, and we provide suggestions for future research.
This paper analyzes whether the financial distress of a firm affects the investment decisions of non-distressed competitors. On average, firms in distress impose indirect costs to non-distressed competitors by increasing costs of credit in the industry and hence restricting credit access and investment. These average negative effects continue to hold in the absence of industry downturns and are temporary. However, negative effects are mitigated for firms with stronger balance sheets or in concentrated markets, suggesting that firms with strong balance sheets prey on their weaker rivals to improve their market position.
Purpose
This paper aims to examine the impact of culture on accounting conservatism during transition to international standards.
Design/methodology/approach
The sample used in this analysis consists of 15 countries of the European Union that have adopted International financial reporting standards (IFRS) pursuing Regulation N° 1606/2002. The study covers the 2000-2010 period. Two conservatism measures are used, the Basu (1997) measure to account for conditional conservatism and the accruals measure to account for unconditional conservatism. To test the impact of culture, the six dimensions of Hofstede (1980, 2010) are used.
Findings
The results of the analysis show that variation of conditional conservatism is influenced by the six cultural dimensions. However, unconditional conservatism is only affected by power distance.
Originality/value
The results of the study are interesting and provide a better understanding of the adoption of IFRS worldwide. The role of culture in explaining accounting practices after adopting a single set of accounting standards is particularly highlighted.
Using the collapse of the junk bond market in the early 1990s as an exogenous shock to external capital, I document, in both difference-in-differences and triple difference designs, that speculative-grade firms that recognize economic losses in a timely manner experience a smaller reduction in investment following the collapse. The effect is more pronounced for speculative-grade firms with a low level of asset liquidation value. Using the excess bond premium as a proxy for fluctuations in the supply of capital, I also extend the generalizability of my findings to a broader sample of 84,421 firm-years over the 1972-2011 period.
This paper studies the influence of network centrality of independent directors on accounting conservatism. Using A-share list companies from 2007–2012 as the sample, we find that: (1) the higher the network centrality of independent directors, the lower the accounting conservatism; (2) considering the different environment in which the companies operate, network centrality of independent directors only has a significant influence on accounting conservatism in regions with a poor financial development environment and a poor legal environment; (3) considering the different environment within the companies, the network centrality of independent directors only has a significant influence on accounting conservatism in companies without bank connections. The findings of this paper enrich the studies of determinants of accounting conservatism from the perspective of association with characteristics of independent directors, and show the substitution effect of an institutional environment and other networks to the function of network centrality of independent directors.
Firms grow in a competitive environment and competition can be a source of corporate growth. In an increasingly global market, companies face increased competition. As such, it is natural that all firms face some degree of risk due to competition. While firms compete for market share, they also imitate competitors in order to minimize risk that accompanies competition. This research attempts to demonstrate the effects of inter-firm competition on investment decisions. Using idiosyncratic equity returns as the instrument variable, this paper uses a two-stage least squares regression, as well as an ordinary least squares (OLS), to identify the influence of peer firms` investment decisions on a firm`s own investment strategy. The results confirm that firms show stronger imitative behavior with more intense competition. Also, firms with higher debt ratios show higher peer group influence. This imitative factor provides clues to measure the risk-averseness in investment decisions.
This study investigates the effect of peer firms on firm investment strategies. We test the peer group effect hypothesis along differing levels of financially constrained firms as well as differing degrees of industry competition. Using idiosyncratic equity returns as the instrument variable, we use 2-stage least squares regression to identify the influence of peer firms’ investment decisions on a firm’s own investment policies. Our analyses empirically confirm that there is a peer group effect in making firm investment decisions. More financially constrained firms show greater dependency on peers’ investment decisions. Tests of peer sensitivity to the increase in industrial competition, however, displayed a U-shaped quadratic curve, which shows that firms have the lowest peer group effect in medium-competition markets. We claim that imitative behavior in investment is presumably weak in the mid-competition market because firms are yet to be distinguished in this market.
Using a financial reporting and valuation model, we investigate the construct validity of Basu's (1997) asymmetric timeliness (AT) regression coefficient as a measure of conditional conservatism in corporate financial reporting. We predict that the AT coefficient will be positive even in the absence of conditional conservatism, and it will vary with non-accounting factors even if the degree of conditional conservatism is held constant. Our empirical analysis shows that AT coefficient estimates vary in directions predicted by our theory. Specifically, we find that AT coefficient estimates increase with expected returns and asymmetry in the distribution of returns, and decrease with cash flow persistence. Importantly, we identify the spread between the variances of bad news and good news accruals as an alternative measure of conditional conservatism that is free of the effects confounding the AT coefficient. Consistent with a key implication of conditional conservatism, we find that the variance of bad news accruals is significantly higher than the variance of good news accruals primarily due to conditionally conservative accruals related to inventory write-downs, long-term asset write-downs, and goodwill impairments. A series of placebo tests provides additional support for the construct validity of our alternative measure of conditional conservatism.
Data Availability: Data are publicly available from the sources indicated in the text.
This study examines whether there is an industry contagion effect for negative market reactions to internal control material weakness (ICMW) disclosures. From a sample of companies experiencing market share price declines to disclosures of ICMW over the years 2005–2014, results indicate that peer industry companies also experience market share price declines. We also find that the decline in share prices is related to accounting quality in that peer industry companies with higher accrual, relative to cash flow, components of earnings have larger negative market reaction compared to companies with lower accrual components of earnings. Our study contributes to the literature streams examining accounting information transfer and internal control quality.
Data availability: Data are publicly available from sources identified in the paper.
In the Chinese stock market, firms experiencing financial distress have been imposed on a Special Treatment (ST) cap by the China Securities Regulatory Commission. Using a sample of 441 ST firms tracked from 1998 to 2011, this paper employs a Cox proportional hazards model to predict turnaround probability for a distressed firm to remove the ST cap. The predictor variables incorporate (1) accounting-driven ratios, (2) market-driven variables, and (3) information on ownership structure and restructuring status throughout the process. In contrast to previous distress studies, this paper finds that market variables do not add predictive power to the model when combined with accounting variables. Also, incorporating the time effect, the results show that the survivor function for an ST firm's survival is negatively related to the duration, and that the Cox hazards model outperforms the logit model in the out-of-sample forecast.
This paper examines the effect of accounting conservatism on firm-level investment during the 2007–2008 global financial crisis. Using a differences-in-differences design, we find that firms with less conservative financial reporting experienced a sharper decline in investment activity following the onset of the crisis compared to firms with more conservative financial reporting. This relationship was stronger for firms that were financially constrained, faced greater external financing needs, or had higher information asymmetry. We also find that more conservative firms experienced lower declines in both debt-raising activity and stock performance. The evidence suggests that accounting conservatism reduces underinvestment in the presence of information frictions.
Propensity score matching (PSM) has become a popular technique for estimating average treatment effects (ATEs) in accounting research. In this study, we discuss the usefulness and limitations of PSM relative to more traditional multiple regression (MR) analysis. We discuss several PSM design choices and review the use of PSM in 86 articles in leading accounting journals from 2008–2014. We document a significant increase in the use of PSM from zero studies in 2008 to 26 studies in 2014. However, studies often oversell the capabilities of PSM, fail to disclose important design choices, and/or implement PSM in a theoretically inconsistent manner. We then empirically illustrate complications associated with PSM in three accounting research settings. We first demonstrate that when the treatment is not binary, PSM tends to confine analyses to a subsample of observations where the effect size is likely to be smallest. We also show that seemingly innocuous design choices greatly influence sample composition and estimates of the ATE. We conclude with suggestions for future research considering the use of matching methods.
Data Availability: All data used are available from sources cited in the text.
Sales decreases affect earnings more than sales increases because of cost stickiness. We hypothesize that this correlated omitted variable constitutes a confounding effect in standard asymmetric timeliness models. Controlling for a piecewise linear effect of sales changes in these models decreases the measured asymmetric timeliness significantly and changes inferences about the average level of conservatism and the extent of cross-sectional variation in conservatism. Validation tests confirm that the asymmetry for sales changes is consistent with sticky costs and is distinct from conditional conservatism. Future empirical research on conditional conservatism should recognize the potential confounding effect of sticky costs.
This study examines the relation between performance covenants in private debt contracting and conservative accounting under adverse selection. We find that under severe adverse selection (i.e., high information asymmetry), accounting conservatism and performance covenants act as complements to signal that the borrower is unlikely to appropriate wealth from the lender. No such relation obtains in a low information asymmetry regime. We further show that in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants generally enjoy lower interest rate spreads than borrowers with low levels of conservatism and loose performance covenants. Consistent with our signaling theory, in the high information asymmetry regime, borrowers with high levels of conservatism and tight performance covenants are less likely to make abnormal payouts to shareholders. Our empirical results are robust to alternative measures of conservatism and covenant restrictiveness.This article is protected by copyright. All rights reserved.
This paper is the first in a two-part series on conservatism in accounting. Part I examines alternative explanations for conservatism in accounting and their implications for accounting regulators. Part II summarizes the empirical evidence on conservatism, its consistency with alternative explanations, and opportunities for future research. The evidence is consistent with conservatism's existence and, in varying degrees, the various explanations. Conservatism is defined as the differential verifiability required for recognition of profits versus losses. Its extreme form is the traditional conservatism adage: "anticipate no profit, but anticipate all losses." Despite criticism, conservatism has survived in accounting for many centuries and appears to have increased in the last 30 years. The alternative explanations for conservatism are contracting, shareholder litigation, taxation, and accounting regulation. The evidence in Part II suggests the contracting and shareholder litigation explanations are most important. Evidence on the effects of taxation and regulation is weaker, but consistent with those explanations playing a role. Earnings management could produce some of the evidence on conservatism, but cannot be the prime explanation. The explanations and evidence have important implications for accounting regulators. FASB attempts to ban conservatism in order to achieve "neutrality of information" without understanding the reasons conservatism existed and prospered for so long are likely to fail and produce unintended consequences. Successful elimination of conservatism will change managerial behavior and impose significant costs on investors and the economy in general. Similarly, researchers and regulators who propose the inclusion of capitalized unverifiable future cash flows in financial reports should consider the costs generated by their proposal's effect on managerial behavior.
Spreads on new and renegotiated corporate loans are significantly higher when the loan originates (or is renegotiated) in the two years surrounding bankruptcy filings by industry rivals. This industry-specific contagion is particularly severe in the middle of industry bankruptcy waves. Furthermore, this contagion in loan spreads is mitigated in concentrated industries, consistent with the hypothesis and evidence in Lang and Stulz (1992) that bankruptcy filings in concentrated industries can have positive consequences for rivals (increased market share and/or power). There is also some evidence that contagion affects non-spread terms in loan contracts.
Basu (1997) proposes a measure of financial reporting conservatism based on asymmetry in the conditional earnings/returns relation. Patatoukas and Thomas (2011) show upward bias in this measure, because a placebo—lagged earnings—also exhibits similar asymmetry. Ball, Kothari, and Nikolaev (2013a) and Collins, Hribar, and Tian (2014) propose alternative explanations for the bias and offer revised measures to overcome the bias. However, we find that both revised measures remain substantially upward-biased. In particular, a placebo based on lagged share price mimics time-series and cross-sectional variation observed for the revised measures. More generally, we find biases in the asymmetric timeliness specification because earnings, accruals, and other measures of performance are often related to second and higher moments of the distribution of returns. In addition to suggesting that the asymmetric timeliness specification be used with caution, our study illustrates the useful role placebos can play in archival studies.
Data Availability: Data are available from the sources identified in the text.
This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that the adjusted numbers (earnings) better measure firm performance. However, accruals require assumptions and estimates of future cash flows. We argue that the quality of accruals and earnings is decreasing in the magnitude of estimation error in accruals. We derive an empirical measure of accrual quality as the residuals from firm-specific regressions of changes in working capital on past, present, and future operating cash flows. We document that observable firm characteristics can be used as instruments for accrual quality (e.g., volatility of accruals and volatility of earnings). Finally, we show that our measure of accrual quality is positively related to earnings persistence.
This study investigates whether agency costs of free cash flow (FCF) are associated with conditional conservatism. Prior research documents that conditional conservatism improves ex ante efficient investment decisions and facilitates ex post monitoring of managers’ investment decisions. As conditional conservatism can provide protection from possible managerial expropriation, the demand for conditional conservatism should increase with the agency costs of FCF. Using excess cash as a proxy for the agency costs of FCF, I provide evidence that firms with higher agency costs of FCF incorporate losses in a timelier manner relative to gains compared to their counterparts. Additionally, the association between excess cash and conditional conservatism predictably varies with the presence of alternative monitoring mechanisms that mitigate FCF problems, such as debt or dividend payouts or repurchases. Further investigation suggests that greater conservatism is associated with a lower likelihood of overinvestment among firms bearing high agency costs of FCF, demonstrating the ability of conservatism to reduce agency costs of FCF.
We find, like [Lang, L.H.P., Stulz, R.M., 1992. Contagion and competitive intra-industry effects of bankruptcy announcements: An empirical analysis, Journal of Financial Economics, 32(1), 45-60], that large firm bankruptcies generate a dominant contagion effect. A value-weighted portfolio of competitors' stocks experiences a significant loss of 0.56% in the three days centered around the Chapter 11 announcement. This represents an average loss of $3.32 for all the competitors combined for every dollar lost by the bankrupt firm. In addition, we find that small firm bankruptcies also generate a dominant contagion effect among smaller sized competitors; an equally-weighted portfolio of all competitors has a significant 0.12% drop. In a new approach to separate the contagion and competitive effects, we compare the stock price reactions of competitors who themselves subsequently file for bankruptcy in the next three years (candidates for contagion effect) with those who do not do so (candidates for competitive effect). As expected, candidates for contagion effect experience a significant, negative three-day stock price reaction of -4.68%. However, contrary to expectations, candidates for competitive effect also have a significant, negative return (-0.49%), suggesting that the competitive effect is weak at best since it is dominated by the contagion effect even in this sample. Other procedures to identify candidates for competitive effect generally yield similar findings. Finally, we analyze competitors' stock price reactions based on selected characteristics (e.g., industry concentration, and leverage), with similar results as before. One explanation for the failure to detect a competitive effect is that the impact may already have been incorporated in stock prices prior to the filing for Chapter 11. Consistent with this explanation, we find significant positive stock price reactions by competitor stocks for the hundred days prior to the bankruptcy announcement.
Dividend payments are generally costly to shareholders. One principal reason for such payments is that they force managers to raise funds in the external capital markets to finance new projects, which presumably reduces their incentives to engage in empire-building activities. We posit that, because accounting conservatism can also mitigate managers’ incentives to engage in value-destroying projects, it could reduce the need for dividend payments and the associated costs. Accordingly, we find that dividend payments decrease with accounting conservatism. This effect holds even after we control for the underlying accounting factors that directly affect dividends, or limit the sample to firms that have no debt covenants pertaining to dividend payouts, indicating that the reason for the conservatism effect transcends the standard debt covenant restriction argument. More importantly, consistent with the agency cost explanation, the evidence also indicates that the conservatism effect increases with potential agency conflicts between managers and shareholders.
Accounting conservatism can serve as a mechanism to balance the interests of managers and shareholders and to reduce the effects of information asymmetry. Much of the research examining conservatism has been conducted in Anglo-American settings, in which ownership is typically widely dispersed. In Asian countries, such as China, ownership structure tends to be more concentrated, and state owners are more prevalent. In this paper, we examine the relationships between ownership structure and conservatism in China. Three ownership structure issues are examined: the influence of the largest shareholder, whether the largest shareholder is the government, and the power and governmental status of minority shareholders. For companies with a large shareholder, management may serve the interests of this largest shareholder to the exclusion of the interests of minority shareholders, who generally prefer more conservative reporting. Consistent with this idea, we find that conservatism is negatively associated with the percentage of shares held by the largest shareholder, and that this effect is particularly significant when the ownership percentage exceeds 30%. We do not find that state ownership influences the relationship between the largest shareholder's ownership and accounting conservatism. However, we do find that privately controlled companies in which the state owns a minority interest are more conservative than those without material state minority ownership.
We examine the relation between the cost of equity capital and seven attributes of earnings: accrual quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism. We characterize the first four attributes as accounting-based because they are typically measured using accounting information only. We characterize the last three attributes as market-based because proxies for these constructs are typically based on relations between market data and accounting data. Based on theoretical models predicting a positive association between information quality and cost of equity, we test for and find that firms with the least favorable values of each attribute, considered individually, generally experience larger costs of equity than firms with the most favorable values. The largest cost of equity effects are observed for the accounting-based attributes, in particular, accrual quality. These findings are robust to controls for innate determinants of the earnings attributes (firm size, cash flow and sales volatility, incidence of loss, operating cycle, intangibles use/intensity, and capital intensity), as well as to alternative proxies for the cost of equity capital.
With the enforcement of the removal system for "distress firms" in China's securities market in 2001, the development of the bankruptcy process for firms in China did create huge impacts to the community. Therefore, identification of potential business failures and offering early warnings for the impending financial crises became very important to analysts, practitioners and regulators. There are very distinct differences in the nature of the firms, the accounting procedures, the quality or trustworthiness of financial documents, and corporate governance between the firms in China and in the western world. Therefore, it may not be practical to directly apply the models or methodologies that developed in the western world to support the identification of such potential distress. In our research, we developed a model called Z China Score to support the identification of potential distress firms. We applied the model to China's securities market for distress diagnosis. The study achieved a 98.8 percent accuracy in classifying distress firms for the original samples and 94 percent accuracy for holdout samples. The early validation test showed that the discriminant-ratio model constructed provided an early warning capacity up to four years prior to financial distress.
Despite the conceptual appeal and popularity of the differential timeliness (DT) measure of conditional conservatism proposed in Basu (1997), Dietrich et al. (2007) and Givoly et al. (2007) have identified considerable biases associated with that measure. We renew their call to avoid using the DT measure because it is affected unexpectedly by two empirical regularities—namely, scale is negatively related to (1) deflated mean earnings and (2) variance of stock returns. Even though these regularities are unrelated to conditional conservatism, their joint effect is substantial and pervasive. More importantly, prior findings regarding time-series and cross-sectional variation in differential timeliness are confounded by corresponding variation in these regularities.
Data Availability: Data are publicly available from sources identified in the article.
Using both a market-based and an accrual-based measure of conservatism, we find that firms facing more severe conflicts over dividend policy tend to use more conservative accounting. Furthermore, we document that accounting conservatism is associated with a lower cost of debt after controlling for other determinants of firms' debt costs. Our collective evidence is consistent with the notion that accounting conservatism plays an important role in mitigating bondholder-shareholder conflicts over dividend policy, and in reducing firms' debt costs.
We predict and find that accounting restatements that adversely affect shareholder wealth at the restating firm also induce share price declines among non-restating firms in the same industry. These share price declines are unrelated to changes in analysts' earnings forecasts, but instead seem to reflect investors' accounting quality concerns. Peer firms with high industry-adjusted accruals experience a more pronounced share price decline than do low accrual firms. This accounting contagion effect is concentrated among revenue restatements by relatively large firms in the industry. We also find that investors impose a larger penalty on the stock prices of peer firms with high earnings and high accruals when peer and restating firms use the same external auditor. Our results are consistent with the notion that some accounting restatements cause investors to reassess the financial statement information previously released by non-restating firms.
We examine whether Basu’s (1997) differential timeliness metric and the related C-Score metric are effective in detecting predictable differences in conservatism surrounding corrections of overstated earnings. Cross-sectional and time-series analyses, employing 2,132 firms making restatements during 1999–2005, suggest Basu-based metrics capture variation in conservatism. Further, we find that increases in conservatism following restatements are contingent on improvements in corporate governance. Collectively, these results provide evidence of the usefulness of the Basu-based metrics in the restatement setting.
This paper is Part II in a two-part series on conservatism in accounting. Part I examined alternative explanations for conservatism in accounting and their implications for accounting regulators (SEC and FASB). Part II summarizes the empirical evidence on the existence of conservatism, conservatism's increase over time, and conservatism's alternative explanations. It also discusses opportunities for future research on conservatism.
The empirical literature uses a variety of conservatism measures in time-series and cross-sectional tests of contracting, shareholder litigation, taxation, and accounting regulation explanations for conservatism. The tests' results suggest the importance of all four explanations. Two non-conservatism explanations—earnings management and the abandonment option—cannot individually or jointly explain the observed systematic understatement of net assets that is the hallmark of conservatism.
Researchers should note that accounting's effects on managerial behavior play a central role in the evolution of both accounting and financial reporting. Assessing the relevance of an accounting method to financial statement users' decisions requires assessing managers' abilities to use that method to manipulate accounting numbers and commit fraud. The evidence on conservatism suggests asymmetric verifiability is critical to constraining manipulation and fraud.
We show that corporate financial policies are highly interdependent; firms make financing decisions in large part by responding to the financing decisions of their peers, as opposed to changes in firm-specific characteristics. On average, a one standard deviation change in peer firms' leverage ratios is associated with an 11% change in own firm leverage ratios --- a marginal effect that is significantly larger than that of any other observable determinant and one that is driven by interdependencies among debt and equity issuance decisions. Consistent with information-based theories of learning and reputation, we find that smaller, more financially constrained firms with lower paid and less experienced CEOs are more likely to mimic their peers. Additionally, we quantify the externalities engendered by these peer effects, which can amplify the impact of changes in exogenous determinants on leverage by almost 70%.
This paper provides guidance for empiricists interested in measuring conditional conservatism and in interpreting associations of those measures with variables of interest. I begin by discussing the nature and importance of conditional conservatism and surveying the literature identifying conditional conservatism. I then describe and comment on the various limitations of asymmetric timeliness identified in the literature. Despite these limitations, I argue that asymmetric timeliness is the most direct implication of conditional conservatism, and that alternative measures that have been proposed need not capture any type of conservatism. Finally, I provide four specific suggestions for estimating asymmetric timeliness and for interpreting it as a measure of conditional conservatism.
We examine the association between borrower (firm) and lender (bank) state ownership and accounting conservatism for a sample of Chinese firms. We hypothesize that state-owned enterprises (SOEs) adopt less conservative accounting than non-state-owned enterprises (NSOEs) because lenders are less concerned with downside risk for SOEs than for NSOEs. We also hypothesize a negative relation between conservatism and the fraction of total loans a firm borrows from state-owned banks (SBs) because SBs have weaker demand for assurance of sufficient net assets to cover loan repayments than non-state-owned banks (NSBs). We find support for both hypotheses. Further analyses reveal that: (1) firms that borrow from commercial SBs exhibit more conservative accounting than firms that borrow from policy SBs and (2) firms adopt more conservative accounting as they get more loans from banks with foreign ownership or exclusively foreign banks. However, the results of these additional analyses are to some extent sensitive to alternative measures of accounting conservatism.