Accounting Conservatism And Corporate Governance
Corporate governance has been increasingly important after the fall of Enron and Arthur Anderson in U.S and a lot of corporate failures in other countries. Academics, business practitioners and the general public are getting more aware of the role that corporate governance plays in firm performance and in the survival of firms in the long-term. Jensen(1993) states that internal governance mechanisms are insufficient to achieve appropriate governance without the presence of the market for corporate control. Recent research indicates that external governance reinforces internal governance and vice versa (Cremers and Nair, 2005).
Corporate governance generally refers to the external rules and regulations and internal system  that are designed to minimize the agency problem and is "the system by which companies are directed and controlled" ( Cadbury Committee, 1992, p. 15). Prior studies in corporate governance have predominantly focused on US companies, while those related to Asian countries are rather few ( Kiel and Nicholson, 2003). But because Hong Kong companies do not have the same corporate governance structure as US and Western companies, the empirical findings for US companies may not apply to Hong Kong and other Asian companies. (Lam and Lee, 2008)
Accounting conservatism means a branch of accounting that requires a high degree of verification before making a legal claim to any profit. Accounting conservatism will recognize all probable losses as they are discovered and most expenditure as they are incurred. Revenue will be deferred until it is verified. Having strict revenue-recognition criteria is one of the most common forms of accounting conservatism.
According to ‘Evidence on the Role of Accounting Conservatism in Corporate Governance’ by Anwer S. Ahmed & Scott Duellman, Conservatism is potentially useful in corporate governance in several ways. First, it helps prevent excess payments to managers (Watts, 2003). Second, it provides managers with incentives to avoid taking on negative NPV projects (Ball, 2001; Ball and Shivakumar, 2005). Third, it increases the likelihood that managers will abandon or shut down negative NPV projects because it generates timely signals that can trigger further investigation by the board (Ball, 2001; Watts, 2003). These potential benefits of conservatism in governance suggest a positive relation between the strength of governance and conservatism. Given the evidence in Bushman et al. (2004), who find a reverse relation between governance structures and the timeliness of earnings, we try to illuminate whether the direction of causality flows from governance to conservatism or vice versa.
2.1 Problems statement
We would like to investigate specifically in the existence of the positive relationship among corporate governance and accounting conservatism. That is stronger corporate governance will exhibit a higher degree of accounting conservatism. In this paper, governance level is assessed by calculating the ratio of the independent directors in the board while the level of accounting conservatism is determined by the non-discretionary accruals in prediction periods by using the Jones Model (1991).
We are going to prove that the s stronger corporate governance will exhibit a higher degree of accounting conservatism. We will also show that good governed firms do not use abnormal accruals opportunistically.
2.2 Literature Review
Corporate governance and accounting conservatism have been rapidly developed for over a long period of time. There are different views in the empirical literature linking corporate governance to accounting conservatism. Some suggested that they are positively related (Juan Manuel Garcı´a Lara, Beatriz Garcı´a Osma & Fernando Penalva 2007). Their argument is that firms with stronger corporate governance will exhibit a higher degree of accounting conservatism, and using a large sample of U.S. firms for the period 1992 through 2003, they posit that corporate governance provisions play an important role in the implementation of accounting conservatism.
There are many determinants of governance according to the previous literature: firm size (Demsetz and Lehn 1985); growth opportunities (Smith and Watts 1992); firm age (Bushman et al. 2004); free cash flow (Jensen 1986; Lang et al. 1991); idiosyncratic risk (Demsetz and Lehn 1985); leverage (Cremers and Nair 2005); industry concentration and geographic concentration (Bushman et al. 2004); CEO tenure (Hermalin 2005); firm performance (Hermalin and Weisbach 1988; Demsetz and Lehn 1985); auditor size (Basu et al. 2001); regulated industry (Demsetz and Lehn 1985; Bushman et al. 2004); high-tech industry (Chandra et al. 2004).
In their journal, they measure conservatism using three proxies as they wish to ensure the robustness of their results. The first one is market-based, and the other two are accruals-based. In addition, they also take into account the endogenous nature of corporate governance and the fact that governance and conservatism may be simultaneously determined. On the other hand, they study whether these differences in the timeliness of earnings to bad news across governance structures are driven by differences across firms in their use of accruals.
However, there are other parties that suggested they are negatively related (Wuchun Chi, Chiawen Liu & Taychang Wang 2007). By using the firm-year specific C-Score developed by Khan and Watts (2007), they indicate that firms with weaker governance structures tend toward being more conservative.
They also point out that conservatism in accounting and governance mechanisms are substitutes in alleviating agency problem and information asymmetry. As Khan and Watts’s (2007, page 14) point out that, “Younger firms… are unlikely to have evolved better governance mechanisms to mitigate agency problems with creditors and shareholder. This suggests that younger firms will be (required to be) more conservative.” LaFond and Roychowdhury (2008) further find that conservatism declines with managerial ownership. They explain that lower managerial ownership results in more severe agency problem, thereby increasing the demand for accounting conservatism.
Furthermore, LaFond and Watts (2008) provide evidence that conservatism is positively associated with the degree of information asymmetry. In other words, different governance structures may represent different information environments. If conservative accounting is vehicle to reduce uncertainty and information asymmetry, it is expected that a less solid governance structure will result in a higher “contracting” demand for conservative accounting. Their empirical evidence is consistent with the assertion that conservative accounting and firm’s other governance mechanisms are substitutes, which supports the contracting explanation.
2.3 Objectives of the study
There has long been research about the relationship between corporate governance and accounting conservatism. However, there have little been done in the context of Hong Kong and there is no previous in depth research on the association between accounting conservatism and governance. Only the work by Beekes et al. (2004) for the UK is in a similar line. As a result, we would like to analyze the relationship between them by looking at the HK cases.
2.4 Statement of hypotheses
Our main hypothesis is that governance and conservatism are positively associated because governance structures demand conservatism to achieve the desired monitoring and control benefits. The level of governance can be seen through finding the ratio of independent directors while the level of accounting conservatism is determined by the non-discretionary accruals in prediction periods by using the Jones Model (1991).
As mentioned above, this article examines the influence of board structure, namely the size of the board of directors and the board independency, may have on the degree of the accounting conservatism. So we decided to select some samples from the Hong Kong listed companies to have a further study of this relationship in Hong Kong.
The way we select our samples is using the method of random sampling. First, we listed out all the listed companies in Hong Kong. Then, we rearranged the companies in alphabetical order and choose the first one for every ten of the companies. And the companies that have been selected are listed below: (117 companies selected)
COME SURE GROUP
AUPU GROUP HLDG
DH WULING AUTO
C ZENITH CHEM
CATHAY PAC AIR
CH GRAND FOREST
GLORIOUS PPT H
CHI O SHIPBLDG
CHINA GAS HOLD
HK HEALTH CHECK
HON KWOK LAND
CHINESE EST H
JIAHUA STORES H
SUN EAST TECH
JOHNSON ELEC H
KAI YUAN HLDGS
TAI CHEUNG HOLD
KECK SENG INV
LE SAUNDA HOLD
VAN SHUNG CHONG
MEI AH ENTER
WAH HA REALTY
WING ON CO
NGAI HING HONG
SHUN HO RES
PICO FAR EAST
SINO PROSPER SG
RISING DEV HOLD
The accounting and market data required is collected from the firms’ financial reports year ended 2006 which is the sampling period and other financial information databases, such as Hong Kong Stock Exchange. As during that year it did not affected by the financial downturn, the result will be more reliable under this normal financial status. All financial data is in Hong Kong currency and per share.
A multivariate regression analysis is formulated to study the relationship between board structure and firm performance. It is consisted of some dependent, independent variables about such firm’s attributes as described below.
In this study, the relationship that governance and conservatism are positively associated is the dependent variable which is measured by ratio of independent directors in the board and the total accruals.
The ratio of independent directors in the board and the total accruals are the independent variables influencing the dependent variable with the effect of coefficients. The ratio of independent directors in the board is used to assess the level governance in a firm which is calculated by having the number of independent directors divided by the total number of directors in the board. By utilizing the Jones Model (1991), we will use changes in revenues from period t-1 to t and period t gross plant, property, and equipment of a firm to predict total accruals. (Jones, 1991, p. 211)
The Jones model uses changes in revenues (Compustat data item #12) from period t-1 to t and period t gross plant, property, and equipment (Compustat item # 7) to predict total accruals, as follows (Jones, 1991, p. 211).
TAit-1 = ai1TAit-1+ b1iREVitTAit-1+ b2iPPEitTAit-1+ eit …(9)
Equation (9) is fitted over an estimation period for each firm i, to provide the three parameter estimates (ai, b1i, and b2i). These estimates are then used to forecast non-discretionary accruals in prediction periods, using values of the explanatory variables from those periods. Also, since the relation is estimated separately for each firm, only firms with sufficient years of non-missing data in the estimation period (10 years) are included in the sample. By using the above model, we can find out the accruals of the listed companies. After that, by comparing the ratio of the independent director, we hope to prove the relationship between governance and conservatism are positively associated.
4. Time Schedule
Firms’ data collected
Data analyzed and conclusion delivered
End of March
Voluntary submission of draft report to supervisor
Amendment of the draft report
End of April
Submission of final report
Preparation of oral presentation
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