...IN PRESS Journal of Accounting and Economics 45 (2008) 27–54 www.elsevier.com/locate/jae The contracting benefits of accounting conservatism to lenders and borrowers$ Jieying Zhangà Leventhal School of Accounting, University of Southern California, Los Angeles, CA 90089, USA Received 1 March 2004; received in revised form 17 May 2007; accepted 8 June 2007 Available online 19 July 2007 Abstract This paper examines the ex post and ex ante benefits of accounting conservatism to lenders and borrowers in the debt contracting process. I expect conservatism to benefit lenders ex post through the timely signaling of default risk, as manifested by accelerated covenant violations, and to benefit borrowers ex ante through lower initial interest rates. Consistent with these predictions, I find that more conservative borrowers are more likely to violate debt covenants following a negative price shock, and that lenders offer lower interest rates to more conservative borrowers. r 2007 Elsevier B.V. All rights reserved. JEL classification: M41; G32 Keywords: Conservatism; Debt contracting; Covenant violation; Spread 1. Introduction While positive accounting theory suggests that accounting conservatism enhances efficiency in the debt contracting process (Watts and Zimmerman, 1986; Watts, 2003a, b), there is little empirical evidence on the debt contracting benefits of conservatism. In this paper, I provide evidence on the ex post and ex ante benefits of conservatism to lenders and borrowers...
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...Arien Hazell 412002254 Watts (2003) Conservatism in Accounting Part I: Explanations and Implications Paper Review ACCT 3040 Advanced Accounting Theory and Practice Mr Terry Harris Conservatism is one of the fundamental principles of accounting and its application in financial accounting has recently become a highly controversial issue involving a variety of views as there is a desire for financial accounting information to be neutral. Conservatism has lasted in the accounting practice for many years and has become more popular over the past 30 years. In addition, Basu (1997) and Sterling (1970) made statements that lead us to believe that conservatism’s influence on accounting practice has been long and significant. Sterling (1970) argued that conservatism is the most influential principle of valuation in accounting agreeing with Basu (1997) who argued that it has influenced the accounting practice for at least 500 years. Professor Ross L Watts wrote two papers on the conservatism in financial accounting. Paper I sought to examine alternative explanations for conservatism in accounting and their implications for accounting regulators while Paper II is aimed at looking at the empirical evidence on conservatism, its consistency with alternative explanations and opportunities for future research. The paper under review is Paper I and the objectives of this paper are to discuss the explanations for conservatism and draw implications for regulation and standard setting...
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...Corporate Governance and Accounting Conservatism in China* Donglin Xiaa and Song Zhub,** b School of Economics and Management, Tsinghua University, China School of Economics and Business Administration, Beijing Normal University, China a Abstract A principal-agent relationship exists among creditors, shareholders and management, and information asymmetry among them leads to asymmetric loss functions, which induces conservative accounting. This paper investigates the determinants of accounting conservatism using accrual-based measures and data from 2001 to 2006 in China. We find that a higher degree of leverage, lower level of control of ultimate shareholders and lower level of management ownership lead to more conservative financial reporting. We also find that political concerns and pressures among state-owned enterprises are greater than those among non-state owned enterprises, which leads to more conservative financial reporting among the former. However, a decrease in such concerns leads to a decrease in accounting conservatism. Overall, we find that among the determinants of conservatism in China, debt is the most important, followed by ownership, and that board has little influence. JEL classification: G30; M41 Keywords: Information asymmetry; Agency problem; Accounting conservatism; Political concerns; Corporate governance * We thank George Yang from Chinese University of Hong Kong and participants at CJAR Summer Research Workshop for helpful comments....
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...1. Introduction Accounting practices have been argued to reflect information quality of the firm in the market. Recently, there has been renewed interest in the relation between information asymmetry and conservative financial reporting practices. Many theorists have critiqued this aspect of information asymmetry, which has garnered significant interest in the accounting arena in the world today. This paper is set out to analyze the literature on conservative financial reporting, dissecting Akerlof’s article surrounding information asymmetry. Following this, possible motivations by firms to undertake these accounting measures will be meted out, coupled with an examination of the empirical evidence in reflection of the measurement of conservatism, with a final conclusion pertaining the relationship of information quality and financial reporting choices being ascertained. 2. Conservative Financial Reporting Conservatism is the differential verifiability required for the recognition of accounting gains versus losses that generates an understatement of net assets. (Basu, 1997) There has been evidence strongly suggesting that U.S companies had used conservative financial reporting practices since the last five decades. (Watts, 2003) It is argued that conservatism of financial reporting arises because of information asymmetry between firm managers and shareholders. While information asymmetry refers to a situation where one party has more or superior information compared to another...
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...1.0 Introduction Conservatism is arguably one of the most prominent and prolonged characteristics in accounting practices (Basu, 1997). Over the centuries, many researchers have accomplished in-depth reports and thoughtful analysis regarding different focuses on conservatism. Literatures related are abundant and fruitful. In next section, this paper will firstly give a brief review on a number of related literatures. Follows that, some of the most significant motivations to adopt conservatism such as contracting demand, litigation pressure, agency problem, tax implication, regulation concern and political economy will be discussed in section three. For the purpose of construction, regression analysis, as the most commonly used research technique, are also analyzed in section four of this paper, which also includes a summary of the requirements in sample selection process. Meanwhile, another crucial aim of this paper is to introduce the empirical evidence of a positive relationship between information quality and conditional conservatism. In section five, this paper intends to explain the empirical findings of Iatridis (2011) that a high quality accounting information discloser will apply conditional conservatism but restrict unconditional conservatism. 2.0 Literature Review Researchers commonly characterize accounting conservatism as “asymmetric timeliness in recognition of accounting gains versus losses and systematic understatement of net assets” (Chi...
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...Armon Vakili BUS A455 – Applied-Professional and Empirical Research in Accounting and Auditing February 27, 2013 Accounting Research Workshop Paper “Asymmetric Timely Loss Recognition, Private Debt Markets, and Underinvestment: Evidence from the Collapse of the Junk Bond Market” Jaewoo Kim, University of Iowa Jaewoo Kim’s research dissertation is encompassed entirely by the concept of “accounting conservatism”. The report stems from prior research and empirical evidence that concludes accounting conservatism has an inverse relationship with a firm’s tendency to overinvest. It’s also conceptualized based on previous reports that examine the role accounting conservatism plays with the inclusion of specific characteristics of debt contracts (such as covenants, provisions, etc.). This reports seeks to move away from the relationship conservatism has with overinvestment and beyond the relationship it has with pre-existing debt contracts. More specifically, this report’s primary research questions asks “Does accounting conservatism have an effect on a firm’s ability to acquire debt from private markets when other access to debt is constrained?” Kim seeks to examine whether a firm’s accounting conservatism can be used as a tool to access new avenues of capital debt when that firm’s previous debt financing has been constrained. This is an interesting study because it can produce important information that might be crucial for firms that are troubled with constrained access...
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...Chapter 4 – International Accounting Culture Culture is a broad concept that would be expected to impact on legal system, tax system, the way businesses are formed and financed and so on. In recent decades, it has also been used to try to explain international differences in accounting systems. Violet(1983) argued that accounting is a ‘socio-technological activity’ that involved interaction between both human and non-human resources. Violet claims that accounting cannot be considered culture-free. Hofstede(1980) has defined culture as ‘the collective programming of the mind which distinguishes the members of one human group from another.’ Gray argues that the value systems of accountants will be derived and related to societal values, Cultural dimension of • Individualism, • Power Distance, • Uncertainty Avoidance and • Masculinity The values of accounting subculture will in turn, it is believed, impact on the development of the respective accounting systems at the national level. Therefore, at this point we can perhaps start to question whether accounting system can be developed in a “one-size-fits-all perspective – an approach which in some respects, the IASC appears to have adopted. Individualism versus Collectivism Individualism stands for a preference for a loosely knit social framework in society wherein individuals are supposed to take care of themselves and their immediate families only. Collectivism stands for a preference for a tightly...
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...THEORY OF ACCOUNTS ACCOUNTING CONCEPTS 1. Which of the following statements is/are true? I. Accounting is a service activity intended to fulfill a useful function in society II. Accounting involves the art of recording, classifying and summarizing transaction and events, and interpreting the results thereof. III. Accounting is an art but not a science IV. Accounting provides quantitative financial information intended to be useful in making economic decisions a. I, II, III, IV c. I, II, IV b. I, II, III d. II, III, IV 2. The branch of accounting concerned with the presentation of financial information primarily for use of third person outside of business enterprise. a. Financial Accounting c. Government Accounting b. Management Accounting d. All of the above 3. Accounting is an art because a. of the existence of a body knowledge governing accounting practice b. of accounting theory c. the necessity of applying creative skill and ability d. None of the above 4. Financial accounting is the branch of accounting that focuses on a. special purpose reports of financial position and results of operations b. financial statements c. the various need of statement users d. general purpose reports of financial position and results of operations 5. General-purpose information is a. not intended to satisfy the specialized needs of individual users. b. intended to satisfy the specialized needs of individual users c. not intended to satisfy the common...
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...Positive accounting is the branch of academic research in accounting that seeks to explain and predict actual accounting practices. This contrasts with normative accounting, that seeks to derive and prescribe "optimal" accounting standards. The branch of academic research in accounting that seeks to explain and predict actual accounting practices. Positive accounting can be associated with the contractual view of the firm.[1][2] The firm is viewed as “a nexus of contracts” and accounting one tool to facilitate the formation and performance of contracts. Under this view, accounting practices evolve to mitigate contracting costs by establishing ex ante agreement among varying parties. For example, positive accounting postulates that conservatism in accounting –in this sense defined conditionally as requiring lower (higher) standards of verifiability to recognize losses (gains)– has origins in contract markets, including managerial compensation contracts and lender debt contracts. As an example, absent conservatism, managerial compensation agreements may reward managers based on current reports that later evidence indicate were unwarranted. The contractual view of positive accounting puts it in tension with value relevance studies in accounting: the latter contend that accounting’s primary role is to value the firm, and thus practices like conservatism are sub-optimal.[3] The value relevance school emphasizes the usefulness of accounting information to equity investors in contrast...
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...THE ACCOUNTING REVIEW Vol. 79. No. 4 2004 pp. 967-1010 Costs of Equity and Earnings Attributes Jennifer Francis Duke University Ryan LaFond University of Wisconsin Per M. Olsson Duke University Katherine Schipper Financial Accounting Standards Board ABSTRACT: 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 vi/ell as to alternative proxies for the cost of equity capital. W I. INTRODUCTION e...
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...Chapter 2 Financial Reporting and Analysis REVIEW Financial statements are the most visible products of a company’s financial reporting process. The financial reporting process is governed by accounting rules and standards, managerial incentives, and enforcement and monitoring mechanisms. It is important for a user of financial information to understand the financial reporting environment along with the accounting information presented in financial statements. In this chapter, the concepts underlying financial reporting are discussed with special emphasis on accounting rules. Next the purpose of financial reporting is discussed – its objectives and how these objectives determine both the quality of the accounting information and the principles that underlie the accounting rules. The relevance of accounting information for business analysis and valuation is also discussed and limitations of accounting information are identified. Last, accrual accounting is discussed including the strengths and limitation of accruals, and the implications of accruals for financial statement analysis. OUTLINE | | |Financial Reporting Environment | |Statutory Financial Reports ...
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...professional body representing Chartered Accountants in Australia. Our reach extends to more than 53,000 of today and tomorrow’s business leaders, representing some 43,000 Chartered Accountants and 10,000 of Australia’s best accounting graduates who are currently enrolled in our world-class post-graduate program. Our members work in diverse roles across commerce and industry, academia, government, and public practice throughout Australia and in 107 countries around the world. We aim to lead the profession by delivering visionary thought leadership projects, setting the benchmark for the highest ethical, professional and educational standards and enhancing and promoting the Chartered Accountant brand. We also represent the interests of members to government, industry, academia and the general public by actively engaging our membership and local and international bodies on public policy, government legislation and regulatory issues. The Institute can leverage advantages for its members as a founding member of the Global Accounting Alliance (GAA), an international accounting coalition formed by the world’s premier accounting bodies. The GAA has a membership of 700,000 and promotes quality professional services to share information and collaborate on international accounting issues. Established in 1928, the Institute is constituted by Royal Charter. For further information about the Institute, visit charteredaccountants.com.au Foreword The use of extensions to traditional financial reporting...
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...CHAPTER 2 Generally Accepted Accounting Principles Introduction Need of Accounting Principles Generally Accepted Accounting Principles Characteristics of Accounting Principles Objectivity Application Reliability Feasibility Understandability Accounting Concepts Separate Entity Concept Money Measurement Concept Dual Aspect Concept Going Concern Concept Cost Concept Period Accounting Period Concept Periodic Matching of Costs and Revenues Concept Realisation Concept Accounting Conventions Conservatism Consistency Materiality Full Disclosure Your Check Your Understanding Descriptive Questions Interview Questions Accounting for Managers 24 2.1 INTRODUCTION Accounting is the language of business. When we speak in any language, our intention is our ideas are to be understood by others. Language can be understood only when words used by us convey the same meaning to the listener. Both the speaker and listener should mean the same for the words used. Equally, every language has grammar of its own. When we write or speak, we follow the principles of grammar. Similar is the case with accounting. Most of the activities, be it official, social or personal, are guided by a set of certain rules or conventions. Some of the conventions are as follows: ♦ In India, we always drive on the left hand side of the road. ♦ Overtaking the vehicle, either two-wheeler or four-wheeler, is to be made on the right side, alone. ♦ As a citizen of India...
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... * useful to present to potential investors and creditors and other users in making rational investment, credit, and other financial decisions * helpful to present to potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts * about economic resources, the claims to those resources, and the changes in them * helpful for making financial decisions * helpful in making long-term decisions * helpful in improving the performance of the business * useful in maintaining records Basic concepts To achieve basic objectives and implement fundamental qualities GAAP has four basic assumptions, four basic principles, and four basic constraints. Assumptions * Accounting Entity: assumes that the business is separate from its owners or other businesses. Revenue and expense should be kept separate from personal expenses. * Going Concern: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. Only when liquidation is certain this assumption is not applicable. The business will continue to exist in the unforeseeable future. * Monetary Unit principle: assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation. * The Time-period principle implies that the economic activities of an enterprise can be divided...
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...PROFESSIONALISM | Regulation environment:1. accounting is regulated by private-sector body(FASB), but government underpins the authority of its standards. 2. no legal requirement for the publication of FS3. each state has its own corporate statutes and not rigorously enforced. Reports rendered to local agencies are often unavailable to the public4. only listed companies have compulsory requrirements for FR at the federal level as specified by the SEC. | | | | Regulation environment:1. Dutch accounting presents several interesting paradoxes. The Dutch have relatively permissive statutory accounting and financial reporting requirements but very high professional practice stds. The Netherlands is a code law country, yet accounting is oriented toward fair presentation.2. Accounting and tax separate3. Dutch Civil Code includes 1970 Act of Annual Accounts. True and fair view required. | | STATUTORY CONTROL | | Regulatory environment:1. traditional society with strong cultural and religious roots.2. interdependence in personal and corporate relationships. (Low individualism)3. companies hold equity interest in each other, and often jointly own other firms. Eg. Keiretsu.4. Banks are often part of these industrial groups, there is a high degree of debt finance. Therefore, corporate managers must primary answer to banks and other financial institutions rather than shareholders.5. a strong bureaucratic control over business affairs and accounting. 6. Business culture a mixture of domestic...
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