Are Timeliness and Conservatism Due to Debt or Equity Markets? An International Test of Contracting and Value Relevance Theories of Accounting - PDF

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Are Timeliness and Conservatism Due to Debt or Equity Markets? An International Test of Contracting and Value Relevance Theories of Accounting by Ray Ball*, Ashok Robin** and Gil Sadka*** *Graduate School
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Are Timeliness and Conservatism Due to Debt or Equity Markets? An International Test of Contracting and Value Relevance Theories of Accounting by Ray Ball*, Ashok Robin** and Gil Sadka*** *Graduate School of Business University of Chicago 5807 S. Woodlawn Ave Chicago, IL Tel. (773) ** College of Business Rochester Institute of Technology Rochester NY ***Columbia Business School Columbia University 3022 Broadway New York, NY First version: 15 September 2004 This version: 7 April 2006 Acknowledgments We gratefully acknowledge the comments of Sudipta Basu, Robert Bushman, Peter Easton, Christian Leuz and Jerry Zimmerman, the referee, conference participants at the JAR/LBS London Conference and the 16 th Annual Conference on Financial Economics and Accounting, and workshop participants at the Burton Workshop at Columbia University, University of Amsterdam, University of Chicago and University of Minnesota. We are grateful for financial support from the University of Chicago, Graduate School of Business. Abstract We provide a simple test of costly contracting and value relevance theories of accounting, using data on the importance of debt and equity markets in 22 countries. Contracting theory predicts that timely loss recognition (contemporaneous incorporation of economic losses in accounting income) increases in the importance of a country s debt markets, but timely gain recognition does not. The value relevance view, that equity markets provide the sole criterion for financial reporting, predicts a positive relation between equity market size and timeliness in both gain and loss recognition. In these international data, it is debt markets not equity markets that explain important financial reporting properties. Conditional conservatism, in the Basu (1997) sense of asymmetrically timelier loss recognition, seems due to debt market demand. Equity markets do not appear to influence any aspect of financial reporting timeliness. 2 Are Timeliness and Conservatism Due to Debt or Equity Markets? An International Test of Contracting and Value Relevance Theories of Accounting 1. Introduction An influential body of accounting literature views the primary or exclusive function of public financial reporting as informing share markets. In its strictest form, this view implies that financial reporting rules and practice are (or, for some, should be) determined entirely by the demands of the equity market for new information. Shareholders are interested in information about both gains and losses, so this view implies that the relation between earnings and stock returns is (or should be) symmetric. Shareholders are interested in timely information, so this view also implies that the relation between earnings and stock returns is (or should be) contemporaneous, not lagged. A commonly-espoused metric of financial reporting informativeness to investors therefore is the linear R 2 between earnings and contemporaneous returns (Lev 1989). This body of literature is widely known as the value relevance school of thought. 1 An alternative influential view is that the primary function of public financial reporting is to increase the efficiency with which various parties, notably creditors and managers, contract with the firm. An implication of this view is that financial reporting practice is shaped by the demands originating from the use of financial statement 1 The notion of earnings timeliness was introduced by Ball and Brown (1968), who concluded (p. 176): the annual income report does not rate highly as a timely medium. Nevertheless, subsequent literature emphasized the informativeness of earnings. This led to a focus on event-day price responses to earnings announcements, which (while statistically significant in large samples) are a minor component of the variance of annual and longer-horizon stock returns. Lev (1989) reiterated the low timeliness of earnings, expressing in terms of the R 2 between earning and contemporaneous returns, and called for research to improve the quality of financial information (section 8). Holthausen and Watts (2001) provide a recent review of the value relevance literature. 1 information in contracting (Watts and Zimmerman, 1986). This body of literature is widely known as the costly contracting school of thought. Debt and equity markets differ in both the extent and nature of the demands for timely financial reporting they create. We emphasize two fundamental differences. One important difference between debt and equity lies in the distinction between financial reporting and non-financial disclosure. Debt markets are more likely to demand timely financial reporting because debt contracts are written in terms of reported variables such as interest coverage in the income statement and balance sheet leverage. While both debt and equity prices obviously respond to information that is not captured in the financial statements, albeit in different ways, debt differs from equity in that many of the rights of lenders to protect themselves against opportunism by borrowers are couched only in terms of financial statement variables. Consequently, recognition (incorporation of gains and losses in earnings and hence onto balance sheets) is more important for debt than mere disclosure of those gains and losses. Shareholders, on the other hand, are comparatively indifferent between receiving information about economic gains and losses via the financial statements or via non-financial disclosure, so long as they receive it in a timely fashion. Paradoxically, this difference largely unrecognized in the literature implies that the correlation between financial statement variables and equity returns is potentially more important to debt markets than to equity markets. A related difference between debt and equity demands for financial reporting arises from portfolio diversification. For diversified equity investors, the individual-firm R 2 between earnings and returns, as popularized by (Lev 1989), is not necessarily of interest. More relevant is the R 2 at the portfolio level (Ball and Brown 1969, p. 316), 2 which normally is substantially larger. In contrast, debt contracts are written in terms of individual firms financial statement variables. This difference only reinforces the above paradox, that the timeliness with which financial statements incorporate the information in equity prices is more important to the debt market than to the equity market. A second difference between debt and equity is that the value of debt claims on average is less sensitive to increases in firm value than to decreases. The contractual rights of lenders to restrict dividends, borrowing and new investment are limited to adverse situations: that is, to firms that have incurred economic losses. Gains are less likely to trigger lenders contractual rights. An implication of this asymmetry is that debt markets are more likely to demand timely recognition of losses than gains. This in turn implies that the correlation between financial statement variables and equity returns is more important to debt markets when returns are negative than when they are positive. Asymmetric correlation was first observed by Basu (1997). We refer to the asymmetry as conditional conservatism (Ball and Shivakumar, 2005; Beaver and Ryan, 2005). At least as early as Gilman (1939, page 232), there is recognition in the literature that the demand for accounting conservatism originates at least in part in debt markets. More recently, Jensen and Meckling (1976, page 338) and Watts (1977) propose that financial reporting exists to reduce agency costs of both debt and equity. Working in this tradition, Watts and Zimmerman (1986) and Watts (1993, 2003a, 2003b) have renewed interest in the role of debt contracting in explaining conservatism, and the comprehensive survey by Holthausen and Watts (2001) concludes that debt indeed is the most likely explanation. This literature predates Basu (1997), and has not clearly distinguished conservatism in its conditional and unconditional senses. We formulate the contracting 3 role of debt as the hypothesis that conditional conservatism, defined as timelier financial statement recognition of economic losses than gains, exists in large part to facilitate efficient contracting in debt markets. Despite the centrality of timeliness and conservatism to financial reporting, to the best of our knowledge there has been no direct investigation of what economic factors determine them. We offer a simple test that utilizes international data. At the individual country level, using Basu (1997) piecewise linear regressions of earnings on returns, we estimate several fundamental financial reporting properties: gain recognition timeliness, loss recognition timeliness, the asymmetry between them (conditional conservatism), and overall financial recognition timeliness (gains and losses included). We also estimate unconditional conservatism from the regression intercepts (an earnings-based measure of unconditional conservatism that controls for conditional conservatism) and from book-tomarket ratios (a balance-sheet-based measure of unconditional conservatism). We then regress these financial reporting properties on measures of the depths of countries debt markets and equity markets, using data from La Porta et al. (1997, 1998). 2 We interpret market depth as a measure of the strength of the demand for a particular financial reporting property that arises from debt and equity investors respectively. The motivation for this simple test is as follows. Timely financial reporting is not in unlimited supply: it is a costly economic activity. Timeliness requires accounting accruals based on revisions of expected future cash flows (Ball and Shivakumar 2006), and accruals incur incremental accounting and auditing costs relative to simply recording 2 We use the term debt broadly, to include both short and long term obligations. Specifically, we intend it to include trade credit, which we would expect to induce a demand for timely loss recognition in relation to working capital accounts in particular (such as inventory and receivables write-downs, and loss accruals). Regretfully, the debt data available to us do not include trade credit. The market size variables are scaled by countries Gross National Products. 4 realized cash outcomes. For example, implementation of an asset impairment standard such as SFAS No. 144 involves costly verification of downward revisions in expectations of future cash flows. Verification of upward revisions likewise is a costly activity. Reviewing inventory on a regular basis to check for wastage, obsolescence, theft, damage and other losses consumes accounting and audit verification resources. Regular review of receivables, provisions and accruals generally involves costly accounting and auditing. Thus, like all economic activities, timely financial reporting has a supply schedule. On the demand side of the financial reporting market, other things equal the countries with smaller debt and equity markets generate less demand for timely gain and loss recognition than those with larger markets. Because timely recognition is a costly economic activity, other things equal we would expect the smaller markets to exhibit less of it and the larger markets to exhibit more of it. This simple logic underlies our tests, in which countries financial reporting properties are regressed on their debt and equity markets sizes, to estimate where the ultimate demand for financial reporting resides. The regressions control for countries legal system origins (English, French, German or Scandinavian). Ball, Kothari and Robin (2000) report that legal origin is related to financial reporting timeliness and conditional conservatism, and view it as a proxy for the degree of political influence on financial reporting (versus debt and equity market influences). The regressions also control for three legal-system variables reported in La Porta et al. (1997, 1998): Rule of Law, Corruption and Creditors Rights. Bushman and Piotroski (2006) report that legal-system variables also are related to financial reporting timeliness and conditional conservatism. 5 In our sample of 22 countries, we find an economically and statistically significant positive relation between timely loss recognition measures and debt market size. In contrast, the relation between timely loss recognition and equity market size is negative and in most tests is statistically insignificant. Further, we find no relation between timeliness of gain recognition and either debt or equity market size. Nor is there an evident relation between equity market size and overall earnings timeliness, as measured by the R 2 in a Basu (1997) piecewise linear regression of earnings on fiscalyear returns. Finally, both book-to-market ratios and earnings-sheet-based measures of unconditional conservatism are not significantly related to either debt or equity market size. All results are robust with respect to a variety of controls. We interpret the debt market relation with loss recognition and the absence of an equivalent relation with gain recognition as confirmation of the debt contracting hypothesis (which predicts such an asymmetry). On the other hand, we interpret the lack of a consistent relation between the size of equity markets and both timely gain and timely loss recognition, as well as overall timely gain and loss recognition (measured by the piecewise linear earnings-returns R 2 ), as a rejection of the value relevance hypothesis. The conclusion that important financial reporting properties are associated internationally with debt markets more than equity markets has substantial implications for accounting research and practice. For researchers, the result that conservatism (in the conditional form of asymmetrically timely loss recognition) is a function of debt market demand is inconsistent with any theory or model in which the sole (or predominant) criterion for financial reporting is the linear (Pearson) correlation between book value and any notion of underlying market or true value. That is, the conclusion is inconsistent 6 with the basic premise of the value relevance school of accounting thought, but consistent with the costly contracting school. 3 The evidence is relevant to students of international accounting and economic differences. The Basu (1997) asymmetry in U.S. loss recognition timeliness is substantially more pronounced in companies listed in common law countries than in companies listed elsewhere (Ball, Kothari and Robin, 2000; Ball, Robin and Wu, 2000; 2003). Our evidence suggests that this result is due more to differences between common law and other countries in the depth of their debt markets, than to differences in the depth of their equity markets. For practitioners, the result that conditional conservatism arises primarily from legitimate demand from debt markets suggests that the long-standing ambivalence of standard-setters to conservatism in financial reporting could be misplaced, and perhaps based in part on a confusion between conditional and unconditional conservatism (Ball and Shivakumar, 2005), or alternatively on the misconception that the demand for financial reporting originates primarily or exclusively in the equity market. 4 Further, the result that debt markets but not equity markets are associated with important properties of public financial reporting brings into question the fundamental concept of general purpose external financial reporting, that it is directed toward the common interest of various potential users. 5 Finally, the result that unconditional conservatism is unrelated to debt market importance is inconsistent with the notion that low book values are justifiable for creditor protection, as argued in Ball (2004) and Ball and Shivakumar (2005). This has long been viewed as the dominant rationale for continental European 3 The two schools of thought are debated in Holthausen and Watts (2001) and Barth et al. (2001). 4 AICPA (1970, para. 35); FASB (1980, paras ). 5 FASB (1978, para. 30). 7 conservatism, particularly in Germany (Schneider, 1995; European Federation of Accountants, 1997; Haller, 1998; Nobes, 1998), but it does not make compelling economic sense and is inconsistent with our results. We recognize that our research design is simple, and far from perfect. As in most cross-sectional international studies, correlated omitted variables are a concern. The sample is small (we have usable data for only twenty two countries), and we have only proxies for the dependent and independent variables. Nevertheless, we are able to explain approximately half of the cross-country variation in estimated loss recognition timeliness and obtain statistically significant results for the debt market proxy. The research design does not rely on subjective scoring of countries formal accounting standards to estimate conservatism, because standards are not implemented uniformly internationally. Following Ball, Kothari and Robin (2000, pp. 4-5), the research utilizes observable properties of the financial statements that firms in different countries actually report. Section two of the paper develops the debt hypothesis, that asymmetrically timely loss recognition (conditional conservatism) primarily satisfies debt market demand, and contrasts it with the equity hypothesis. Section three describes the sample, data, estimation procedures, and across-country regressions used to test the hypotheses. Section four outlines the results. Section five discusses issues of causation and correlated omitted variables in this research design, and section six presents brief conclusions. 2. Hypotheses: Timely Financial Reporting Primarily Satisfies Debt or Equity Market Demand This section describes timeliness of gain and loss recognition as an accounting choice variable. It then contrasts conditional conservatism (asymmetrically timely loss 8 recognition relative to gain recognition), with unconditional conservatism (reporting low earnings and book values, independent of economic income). Finally, it develops the predictions of the debt and equity hypotheses concerning conservatism. 2.1 Timeliness: An Important Accounting Choice Economic gains and losses can be thought of as increases and decreases respectively in the present values of expected future cash flows. There is comparatively little timing discretion over the recording of actual cash flows, because there is little ambiguity concerning when they eventuate (in accounting parlance, when they are realized ). In contrast, there is considerable accounting discretion over when revisions in expectations are incorporated in the financial statements (in accounting parlance, there is discretion when they are recognized ). By definition, timely gain or loss recognition incorporates present value revisions in reported income around the time those revisions occur. This likely requires costly accounting accruals based on revisions of expected future cash flows (Ball and Shivakumar 2006), because the gains or losses are not fully realized at that point in time (i.e., they are not yet fully reflected in actual cash flows). Examples of loss accruals are write-downs in accounts receivable due to downward revisions in expected future cash collections, write-downs in inventory (due to loss, damage, obsolescence, declines in market price, or other decreases in expected future cash flows arising from the inventory), booked decreases in values of marketable securities and fair values of derivatives, foreign currency losses, provisions for environmental liabilities, provisions for litigation settlements, loss provisions, restructuring charges, and asset impairment charges. Examples of gain accruals are booked increases in values of marketable 9 securities and fair values of derivatives, foreign currency gains, and long-term asset revaluations. A lower-co
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