Macroeconomic effects of aggregate accounting conservatism: A cross‐country analysis

• DOI: http://doi.org/10.1111/jifm.12093
• Author: Chuong Do,Sandeep Nabar
• Date: 01 February 2019
• Published date: 01 February 2019

J Int Financ Manage Account. 2019;30:83–107.

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INTRODUCTION

In this study, we examine whether conditional and unconditional conservatism, aggregated at the

country level, are associated with national economic growth. Basu (1997, p. 7) defines conditional

conservatism as “accountants’ tendency to require a higher degree of verification to recognize

Received: 18 December 2017

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Revised: 6 November 2018

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Accepted: 7 November 2018

DOI: 10.1111/jifm.12093

ORIGINAL ARTICLE

Macroeconomic effects of aggregate accounting

conservatism: A cross- country analysis

Chuong Do

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Sandeep Nabar

© 2018 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

We thank Professor Sidney Gray (editor), two anonymous reviewers, Don Herrmann, Matthew Bjornsen, Martin Kim, Yue

Qiu, Jose Miranda-Lopez, and workshop participants at Oklahoma State University, the 2017 AAA International Section Mid-

Year Meeting, and the 2017 AAA Southwest Annual Meeting for helpful comments.

Spears School of Business,Oklahoma State

University, Stillwater, Oklahoma

Correspondence

Sandeep Nabar, Spears School of Business,

Oklahoma State University, Stillwater, OK.

Email: sandeep.nabar@okstate.edu

Abstract

This paper examines whether aggregate conditional and

unconditional conservatism are associated with economic

growth. Prior studies find that conditional conservatism

improves contracting efficiency, but that unconditional

conservatism has either a neutral or detrimental impact on

contracting. We therefore conjecture that country- level

conditional conservatism increases the efficiency of re-

source allocation in an economy, whereas country- level

unconditional conservatism is not similarly beneficial.

Using a cross- country sample, we construct country- level

estimates of conditional and unconditional conservatism.

We find that conditional conservatism is associated with

higher level of growth in Gross Domestic Product and

Gross Domestic Product per Capita. By contrast, uncondi-

tional conservatism shows no or negative association. Our

study contributes to the ongoing debate on the desirability

of accounting conservatism and also extends the literature

on the macroeconomic effects of aggregate financial re-

porting attributes.

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DO anD naBaR

good news as gains than to recognize bad news as losses.” Ball and Shivakumar (2005, p. 89) de-

fine unconditional conservatism as “an accounting bias towards reporting of low book values of

stockholder equity.” We hypothesize that conditional conservatism is positively associated with

economic growth, but that unconditional conservatism does not have any significant association

with economic growth.

We expect that conditional conservatism improves economic growth by facilitating the efficient

distribution of resources within the economy. LaFond and Watts (2008) argue that an important pur-

pose of conditional conservatism is to mitigate the information asymmetry between firm insiders

and outsiders. Managers have personal incentives to exaggerate firm performance, but conditional

conservatism acts as a control mechanism by requiring greater verification for gains relative to losses.

Conditional conservatism thus curbs wealth transfers from capital providers to managers and also

motivates managers to instead focus their efforts on value- enhancing activities. Several studies con-

clude that conditional conservatism is beneficial for both equity investors (e.g., García Lara, García

Osma, & Penalva, 2011; Shuto & Takada, 2010) and debtholders (Ball, Robin, & Sadka, 2008; Guay,

2008; Zhang, 2008). An additional benefit of conditional conservatism is that the timely recognition

of losses also accelerates corrective actions when projects fail. Decision- making can be more quickly

transferred to lenders and other capital providers preventing significant loss of value. Thus, condi-

tional conservatism acts as both a preventive and remedial mechanism. We posit t hat conditional

conservatism therefore improves resource allocation within the economy by increasing the likelihood

that scarce resources are allocated to profitable projects.

While the literature on conservatism has generally regarded conditional conservatism as beneficial,

the merits of unconditional conservatism are less clear. Unconditional conservatism is a downward

bias in accounting profits and book values induced by predetermined accounting procedures (e.g.,

Beaver & Ryan, 2005). According to Ball and Shivakumar (2005, p. 90), “an unconditional bias of

unknown magnitude introduces randomness in decisions based on financial information and can only

reduce contracting efficiency.” In a similar vein, Ball, Robin et al. (2008) argue that contracting effects

of unconditional conservatism are likely unfavorable, or at best, neutral. Moreover, unconditional con-

servatism, unlike conditional conservatism, does not provide new information to stakeholders (Ball &

Shivakumar, 2005; Basu, 2005). Unconditional conservatism may deter managers from undertaking

marginally profitable investments. If resources are misallocated or squandered by managers, uncondi-

tional conservatism does not help accelerate the triggering of covenants and the transfer of decision-

making power. Therefore, we expect that unconditional conservatism does not help improve resource

allocation in an economy.

To estimate conditional conservatism, we construct a country- year measure using Basu’s (1997)

model for 26 countries from 1988 to 2014. One issue with Basu’s model at the country level is the

noise associated with returns resulting from different levels of market efficiency across countries. To

address this concern, we obtain an alternative measure of conditional conservatism using a modified

version of Basu’s model which does not use returns. In this second model, conditional conservatism

is measured as the differential persistence of negative and positive earnings changes. We also con-

struct a country- year measure of unconditional conservatism for 23 countries.1 Following Beaver and

Ryan (2000), we obtain this measure by regressing the market- to- book ratio on contemporaneous, and

3 years of lagged, stock returns. The intercept in this regression represents an estimate of unconditional

conservatism for that country- year. As with conditional conservatism, we also provide an alternative

measure of unconditional conservatism. Specifically, following Givoly and Hayn (2000), we calcu-

late unconditional conservatism at the firm level as non- operating accruals deflated by lagged assets,

averaged over 3 years. The median of all firms in a country- year is the measure for that country- year.