Estimation and empirical properties of a firm-year measure of accounting conservatism

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Abstract

We estimate a firm-year measure of accounting conservatism, examine its empirical properties as a metric, and illustrate applications by testing new hypotheses that shed further light on the nature and effects of conservatism. The results are consistent with the measure, C_Score, capturing variation in conservatism and also predicting asymmetric earnings timeliness at horizons of up to 3 years ahead. Cross-sectional hypothesis tests suggest firms with longer investment cycles, higher idiosyncratic uncertainty and higher information asymmetry have higher accounting conservatism. Event studies suggest increased conservatism is a response to increases in information asymmetry and idiosyncratic uncertainty.

Introduction

Accounting conservatism is the asymmetric verification threshold for gains versus losses: the verification threshold for gains is higher (Basu, 1997). This differential verification requirement results in asymmetric earnings timeliness with respect to gains versus losses, conservatism flow, that builds up a cumulative understatement of net assets, conservatism stock (Watts, 2003a). Conservatism has been an enduring qualitative characteristic of financial reporting for at least five centuries (Basu, 1997), and has been the subject of much academic research.1

Empirical research on conservatism requires a metric or scale that can characterize both cross-sectional and time-series variation in conservatism. A number of measures of conservatism have been proposed (see Watts, 2003b, for a summary), with the Basu (1997) flow measure being the most widely used (Ryan, 2006). The Basu measure is estimated either for an industry-year using a cross-section of firms in the industry or for a firm using a time-series of firm-years. Both estimation methods have limitations. The industry-year measure obscures cross-sectional variation in the conservatism of individual firm financial reports by assuming all firms in the industry are homogeneous. The individual firm measure obscures the timing of changes in the conservatism of individual firm financial reports by assuming the firm's operating characteristics are stationary. Many changes affecting a firm's financial reporting conservatism are likely both time- and firm-specific. An example is a change in the information asymmetry between investors and the firm's managers caused by a firm-specific reduction in growth opportunities (LaFond and Watts, 2008).

Not surprisingly, researchers have expressed a demand for a firm-level measure of conservatism that can reflect the timing of conservatism changes and the variation of conservatism across firms within an industry. These expressions are both explicit (e.g., Ryan, 2006, p. 3),2 and implicit (by researchers proposing such measures, e.g., Callen et al., 2008). Despite the demand, there is as yet no well-articulated firm-year conservatism flow measure. This paper's objective is to meet that demand. In the paper we:

  • (i)

    estimate a firm-year conservatism measure;

  • (ii)

    provide evidence consistent with the measure reflecting conservatism in a timely fashion; and

  • (iii)

    illustrate the measure's application by testing previously untested conservatism hypotheses.

Estimation. Estimation of our firm-year measure, C_Score, is based on the Basu (1997) asymmetric earnings timeliness notion implied by accounting conservatism (e.g., Basu, 1997; Watts, 2003a; Roychowdhury and Watts, 2007). There is a large literature providing empirical evidence on both asymmetric earnings timeliness’ existence (for a summary see Watts, 2003b), and its cross-sectional and inter-temporal variation as predicted by the theory of conservatism in Watts (2003a). Given this evidence, we assume asymmetric earnings timeliness represents a flow measure of accounting conservatism, and generate a firm-year measure of conservatism.

We estimate annual cross-sectional Basu (1997) regressions, specifying the asymmetric earnings timeliness coefficient (or Basu coefficient) as a linear function of firm-specific characteristics. These characteristics—size, market-to-book and leverage—are chosen because conservatism varies with them, both theoretically and empirically (e.g., LaFond and Watts, 2008). We limit the estimation to these three independent variables for reasons of parsimony. Using fewer variables in estimation makes more firm-years and hence larger samples available to researchers.3 The firm-year conservatism measure, C_Score, is calculated by substituting the firm's size, market-to-book and leverage into the estimation regression for that year. Section 2 provides details.

Empirical Properties. To assess C_Score's effectiveness in measuring conservatism, we examine whether its empirical properties are consistent with the accounting conservatism predictions that are empirically confirmed in the literature. We also examine whether C_Score can predict firms’ future asymmetric earnings timeliness. In particular:

  • (i)

    Distributions of return on assets (ROA) and non-operating accruals (NOAcc). Basu (1995), Givoly and Hayn (2000) and Watts (2003b) provide predictions for how the first, second and third moments of these distributions vary with accounting conservatism. Consistent with these predictions and with C_Score measuring conservatism, we find mean ROA is decreasing in C_Score deciles, while NOAcc variability is increasing in C_Score deciles. However, the other moments of these variables are not correlated with C_Score.

  • (ii)

    Accounting conservatism's variation with the firm's probability of litigation and with information asymmetry among the firm's investors. Accounting conservatism is expected to increase with the firm's likelihood of litigation (Beaver, 1993; Watts, 1993, Watts, 2003a; Basu, 1997; Holthausen and Watts, 2001) and with information asymmetry among investors in the firm (Watts, 2003a, p. 209; LaFond and Watts, 2008). Variation of conservatism with legal liability across time and firms has been empirically demonstrated in several papers, including among others, Ball et al. (2000), Holthausen and Watts (2001) and Ryan and Zarowin (2003). LaFond and Watts (2008) present evidence that conservatism varies across firms and across time with information asymmetry. We find firm characteristics such as the probability of litigation and information asymmetry among investors are positively associated with C_Score.

  • (iii)

    Prediction of future asymmetric timeliness. Givoly et al. (2007) and Ryan (2006) observe that firm level asymmetric timeliness estimates are not very stationary over time despite theory (e.g., Watts, 2003a) suggesting they would be stationary absent significant changes in the firm's characteristics. Since estimation of C_Score allows for changes in firm characteristics, we examine C_Score's ability to predict asymmetric earnings timeliness changes. The full sample results suggest C_Score discriminates between firms with varying degrees of asymmetric earnings timeliness up to 3 years ahead. This result also holds for a sample of firms with only positive returns in the estimation period. Since Basu conservatism measures cannot be estimated for firms that only have positive returns, this result implies C_Score can be used to increase sample size in future conservatism studies.

Hypothesis Tests. In the Empirical Properties section we examine whether C_Score can replicate the existing conservatism literature's empirical results. We also use C_Score to empirically test previously untested predictions and to conduct traditional event studies. The latter would not be possible absent a firm-year conservatism measure.

  • (i)

    Previously untested cross-sectional predictions. We hypothesize that conservatism is decreasing in firm age and increasing in investment cycle length and firm-specific uncertainty. Younger firms tend to have a higher proportion of growth options relative to installed capital, and higher information asymmetry both between managers and investors and between managers and lenders. Since conservatism is an efficient governance and contracting mechanism for reducing agency costs generated by those information asymmetries (Watts, 1993, Watts, 2003a; Ball, 2001; Holthausen and Watts, 2001), we expect the older the firm, the less conservative the accounting.4 Information asymmetries are also expected to increase with the firm's investment cycle length and with its firm-specific uncertainty. The former captures investment uncertainty, which is a subset of the latter (total uncertainty). The uncertainty exacerbates information asymmetries, and the resulting moral hazard and adverse selection problems. This suggests the longer the investment cycle and the greater the firm-specific uncertainty, the more conservative the firm's accounting.

    Our empirical results are generally consistent with these cross-sectional hypotheses.

  • (ii)

    Event Studies. LaFond and Watts (2008) predict that increases in information asymmetry between parties to the firm lead increases in conservatism, rather than conservatism leading information asymmetry.5 Our event study results are consistent with this argument. We also conduct event studies of conservatism changes around significant increases in the probability of litigation and stock return volatility and find that C_Score increases significantly in response to large changes in stock return volatility.

We contribute to the literature in a number of ways. First, we fill a gap in the literature by developing a simple methodology for estimating a firm-year measure of conservatism, and by providing evidence on its empirical properties as a metric. Second, we test new hypotheses about conservatism's variation with a firm's age, investment-cycle and idiosyncratic volatility. Third, we are the first to provide event study evidence on the increase in conservatism in response to significant increases in the probability of litigation, information asymmetry and idiosyncratic uncertainty.6

The rest of this paper proceeds as follows. Section 2 describes the estimation method. Section 3 describes the sample. Section 4 discusses the empirical properties of C_Score. Section 5 discusses the hypothesis tests. Section 6 presents further discussion and tests, and Section 7 concludes. The appendix presents variable definitions.

Section snippets

A firm-year measure of conservatism

In this section, we first provide the theoretical motivation for the variables used to generate the C_Score: the market-to-book ratio, firm size and firm leverage. Then we describe how these variables are used in the Basu model to estimate a firm-year conservatism measure.

Sample

We extract data from the intersection of CRSP and Compustat for the years 1962–2005. All data definitions are presented in the appendix. We delete firm years with missing data for any of the variables used in estimation, and firm years with negative total assets or book value of equity. Annual returns are obtained by cumulating monthly returns starting from the fourth month after the firm's fiscal year end (Hayn, 1995; Basu, 1997).

We delete firm years with price per share less than $1, and

Estimation results

Table 3 shows the coefficients from estimation of the regression in Eq. (4). We estimate the regressions annually to allow the coefficients to vary annually, and report the mean coefficients over the 43 years in Table 3. The t-statistics are based on the standard error of the 43 coefficients (Fama and Macbeth, 1973). We calculate the C_Score for a firm-year as given in Eq. (3), using the parameter estimates for each year, and calculate the G_Score as given in Eq. (2).

Table 3 shows the relation

Hypothesis tests

To illustrate applications of the C_Score we develop and test new hypotheses to shed further light on the nature of conservatism. The hypotheses are classified as cross-sectional and event-time hypotheses.

Alternative explanation

An alternative explanation for some of our results is that C_Score may simply be capturing systematic risk as opposed to conservatism because C_Score is negatively correlated with ROA and positively correlated with the probability of litigation and return volatility. This argument suggests (i) systematic risk should be positively correlated with C_Score, and (ii) ranking firm-years into deciles of systematic risk should yield similar correlations in sign, magnitude and significance.

We use the

Conclusion

We estimate a firm-year measure of financial reporting conservatism, C_Score, provide evidence on its empirical properties as a metric and its predictive ability for future asymmetric timeliness, and illustrate its applications by developing and testing new hypotheses.

Results suggest the C_Score predicts flow conservatism (the Basu asymmetric timeliness coefficient) at horizons of up to 3 years ahead. This predictive ability holds even for samples of firms with positive returns in the year the

Acknowledgement

We thank Thomas Lys and Jerry Zimmerman (Editors), Sugata Roychowdhury, an anonymous referee and seminar participants at the MIT Sloan School for comments.

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