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MSc Accountancy & Control

Accountancy

Faculty of Economic and Business, University of Amsterdam

Master Thesis:

The effect of board characteristics and board strengths on accounting

conservatism before and during the financial crisis

Name: Yuner Pan Net word count: 15.778 Student number: 10191658 Supervisor: G. Georgakopoulos Final date: 22 June 2015

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Statement of Originality

This document is written by Yuner Pan, who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

Abstract

In this research I extented the research of Ahmed and Duellman (2007) with updated data from recent years, and with a focus on the period before and during the financial crisis. This research will also contribute to a societal point of view by providing information to investors and other stakeholders about the importance of conservatism as an efficient governance mechanism to mitigate information risk and control for agency problems. Using two different measures of accounting conservatism, which are the market-based measure and the accrual-based measure, I find a negative relationship between the board characteristics (the percentage of inside directors and the additional directorships) and market-based conservatism. This relationship is weaker for the period during the financial crisis as compared to the period before the crisis. Furthermore, I document that the negative relationship between CEO and chairman duality and accrual-based conservatism is weaker associated during the financial crisis than before crisis. The results are consistent with the expectation that the financial crisis can be considered as an important element that leads to failures and weaknesses in corporate governance mechanisms. The board becomes less effective due to the failure of communicating information from the management to the board during the financial crisis. The managers might hide information with regard to aggressive reporting and risk taking (Kirkpatrick, 2009). This evidence also indicates the substitutive relationship between the strength of the board and conservatism: weaker corporate governance mechanisms will demand for more conservative accounting (Ahmed & Duellman, 2007; LaFond & Roychowdhury, 2007; LaFond & Watts, 2006, 2008). The results hold after controlling for inside directors’ ownership, leverage, firm size, sales growth, sales opportunities, profitability and litigation risks, as well as for unobservable firm characteristics that are stable over time by using fixed effects regressions.

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2 Table of Contents 1. Introduction ... 3 1.1 Background information ... 3 1.2 Research question ... 4 1.3 Motivation ... 6

2. Literature review and hypothesis development... 7

2.1 Accounting conservatism ... 7

2.2 Explanations of conservatism ... 8

2.3 Prior studies ... 9

2.4 The agency theory and agency problems ... 10

2.5 Corporate governance and board characteristics ... 12

2.6 The link between board characteristics and accounting conservatism ... 14

2.7 Hypothesis development ... 16

2.7.1 Financial crisis and accounting conservatism ... 16

2.7.2 Complementary relationship between board strengths and conservatism ... 17

2.7.3 Substitutive relationship between board strengths and conservatism ... 18

3. Research methodology ... 21

3.1 Research method ... 21

3.2 Research measurements and variables ... 21

3.2.1 Measures for board characteristics and board strengths... 21

3.2.2 Measures for accounting conservatism ... 24

3.2.3 Control variables ... 26

3.3 The empirical model ... 29

4. Results ... 30

4.1 Description of selected sample ... 30

4.2 Descriptive statistics ... 32

4.3 Market-based conservatism and board characteristics ... 39

4.4 Accrual-based conservatism and board characteristics ... 44

4.5 Sensitivity analysis ... 49

5. Conclusion ... 50

6. Limitations ... 51

7. References ... 51

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1. Introduction

1.1 Background information

Many accountants believe that conservatism is an appropriate approach to make accounting decisions, because managers, investors and accountants prefer possible errors in measurement in the direction of understatement rather than overstatement of net income and net assets. The reason for existence of conservatism is that business and economic activities operate constantly in uncertainties (FASB, 1980).

Accounting conservatism exists when there is difference between the verification for recognition of profits and losses. This means that firms are conservative in their accounting practices, when they recognize losses more quickly than profits (Watts, 2003a). Basu (1997, p. 4) has a similar definition of conservatism: ‘accountants have the tendency to require a higher degree of verification for recognizing good news than bad news in financial statements.’ The most valued benefit of conservatism is that it serves the needs of the creditors, because the understatement due to conservatism protects these external users and this has been seen as desirable for many years (Hellman, 2008).

Conservatism has been the most noticeable feature of accounting information for centuries and this topic is still widely discussed in the accounting world. Despite the major benefit of conservatism for the creditors, there has been a lot of criticism regarding to conservatism. Hendriksen (1982) states that conservatism is a threat to the relevance of accounting data, because it is a poor method to measure the uncertainty in valuation and in income. The reason is that conservatism allows the systematically and constantly understating of assets and overstating liabilities, recognizing revenues too late and expenditures too early (Hellman, 2008). However, recent research about conservatism shows a significant increase of accounting conservatism in the last few decades (Givoly & Hayn, 2000).

Corporate governance mechanisms play an important role in the implementation of accounting conservatism. Corporate governance encompasses all the provisions and mechanisms that guarantee that the assets of a company are managed efficiently and in the interest of the capital providers. Corporate governance mechanisms also mitigate the inappropriate dispossession of resources by managers or any other party to the company (Ahmed & Duellman, 2007; García Lara, García Osma & Penalva, 2007).

The board of directors plays a central role of these corporate governance of the large companies and is one of the important corporate governance mechanisms (Fama & Jensen, 1983), because the board is the center of the decision-making and the control system (García

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4 Lara et al., 2007). Watts (1977, 2003a, 2003b, 2006) claims that accounting conservatism becomes a part of an efficient contracting technique that reduces deadweight losses that arise from agency problems. The reason is that the board of directors requires verifiable and reliable information to monitor the managers and conservatism will facilitate in decreasing deadweight losses. Deadweight losses result from deficiency caused by an inefficient allocation of resources and this will reduce equity and firm values (Jensen & Meckling, 1976; Watts & Zimmerman, 1986). Therefore it is interesting and useful to investigate the relationship between accounting conservatism and the board directors’ characteristics.

1.2 Research question

As already argued, researchers have doubts concerning conservatism (Hendriksen, 1982). This doubt also concerns the accounting standard setters: International Accounting Standards Board (IASB) and Financial Accounting standards Board (FASB), they argue that conservatism damages the qualities of financial reporting information (IASB, 2006a). The IASB and FASB want to focus more on future-oriented financial reporting and improve the relevance of financial reporting. The focus on conservatism is contradicted with the accounting standard setters, because the need for conservatism is often linked to reliable reporting with a focus of past events. Also according to the FASB (1980), conservatism is incongruent with some other qualitative characteristic, such as neutrality, comparability, consistency and representational faithfulness.

Despite these critiques conservatism does have benefits. The use of conservative accounting treatment in contracts with different parties will decrease information asymmetry and moral hazard problems, which arise from agency conflicts (García Lara et al., 2007). The board of directors is a corporate governance mechanism. One important duty of the board of directors is to monitor the managers and evaluate their activities within the company (Beekes, Pope & Young, 2004; Fama & Jensen, 1983; García Lara et al., 2007). Accordingly, an adequate and effective governance will lead to better monitoring and supervising of management, because conservative accounting can mitigate agency costs and reduce litigation risk for directors, auditors and managers. Therefore it is expected that an adequate corporate governance mechanism will prefer conservative accounting treatment and information due to accelerating the recognition of bad news. Thus, accounting conservatism functions as early warning signal to the board of directors, by providing timely investigation into the reasons for bad news (García Lara et al., 2009).

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5 Many prior researches about the relationship between the board characteristics and accounting conservatism were conducted under regular market conditions. However, it is also interesting to investigate the financial reporting quality and corporate governance performance during the financial crisis, because corporate governance plays an important role in increasing firm performance and value. The corporate governance mechanism could be affected by financial exogenous shocks (Aldamen et al., 2012). In light this research question that arises is: To what extent do the board characteristics and board strengths affect the

accounting conservatism before and during the financial crisis?

To examine this research question I will use different proxies for accounting conservatism, which are the market-based and the accrual-based measures (Ahmed and Duellman, 2007). Besides, I will use five different board characteristics that proxy for their board strengths, which refers to their independence and their monitoring expertise and incentives. The five characteristics are the percentage of inside directors, CEO and chairman duality, board size, shares held by outside directors and additional directorships (Ahmed and Duellman, 2007). The analysis in this study controls for inside directors’ ownership, leverage, firm size, sales growth, sales opportunities, profitability and litigation risks, as well as for unobservable firm characteristics that are stable over time by using fixed effects regressions.

I find a negative relationship between the board characteristics (the percentage of inside directors and the additional directorships) and market-based conservatism. This relationship is weaker for the period during the financial crisis as compared to the period before the crisis. Furthermore, I document that the negative relationship between CEO and chairman duality and accrual-based conservatism is weaker associated during the financial crisis than before crisis. The results are consistent with the expectation that the financial crisis can be considered as an important element that leads to failures and weaknesses in corporate governance mechanisms. The board becomes less effective due to the failure of communicating information from the management to the board during the financial crisis. The managers might hide information with regard to aggressive reporting and risk taking (Kirkpatrick, 2009). This evidence also indicates the substitutive relationship between the strength of the board and conservatism: weaker corporate governance mechanisms will demand for more conservative accounting (Ahmed & Duellman, 2007; LaFond & Roychowdhury, 2007; LaFond & Watts, 2006, 2008).

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1.3 Motivation

The main motivation of this research proposal is driven by the fact that the ISAB and the FASB both wanted to abandon the concept of conservatism in 2008. However, according to Watts (2003a) for a successful elimination of the concept of conservatism, they first need to understand the existence and use of conservatism. If the accounting regulators do not take the effort to understand this, they will fail to eliminate the concept of conservatism and this results in unintended consequences.

From a scientific point of view this study contributes to the prior literature about conservatism, because in this study I outline the existence of the different definitions of conservatism. Furthermore, I discuss ‘why’ and ‘how’ conservatism has been used in the past and I give special attention to the analysis of the relationship between board characteristics and conservatism. Moreover, I will improve the research of Ahmed and Duellman (2007) to contribute the scientific point of view with updated data from the recent years and with a special focus on the financial crisis period and the period after the financial crisis. In their research the authors eliminate the financial and insurance sectors in their sample and the data period dates from 1999 until 2000, however in this study I do incorporate these industries as another contribution.

This research will also contribute from a societal point of view by providing information to investors and other stakeholders about the importance of conservatism as an efficient corporate governance mechanism to mitigate information risk and control for agency problems. Additionally, the corporate governance mechanism, and in particular the board of director characteristics, will affect a firm’s performance and value in general and therefore addressed in this research.

The remainder of this research is organized as follows. The second section consists of a literature review which will end with the hypothesis development. In the third section the proxies for the dependent, the independent and the control variables are described. Also the empirical model of this research is described. In the section 4 the data sample and the results are discussed and followed by a sensitivity analysis. Finally, in the last section the conclusion is presented.

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2. Literature review and hypothesis development

In this section previous papers and theory will be discussed in order to be able to develop the hypothesis of this study. Firstly, the concept of accounting conservatism will be explained. Secondly, the different explanations for the existence of conservatism will be discussed in further detail. Thirdly, the relevant prior studies about the topics will be discussed. Fourthly, the agency theory and agency problems will be explained. Fifthly, corporate governance mechanisms with special attention on board characteristics and introduction of SOX will be shortly discussed. Sixthly, the link between board characteristics and accounting conservatism will be explained. Finally, the hypothesis will be developed after clarifying the effect of financial crisis on conservatism and two perspective relationships between board characteristics and conservatism.

2.1 Accounting conservatism

Researchers have introduced a lot of different definitions of conservative accounting (Penman & Zhang, 2002). The traditional definition is: ‘anticipate no profits but anticipate all losses’ (Bliss, 1924). This expression became too extreme in the modern accounting world (Watts, 2003b), therefore Basu (1997) came up with a modern interpretation. Basu (1997, p. 4) states: ‘I interpret conservatism as capturing accountants’ tendency to require a higher degree of verification for recognizing good news than bad news in financial statements.’

His interpretation of conservatism means that earnings reflect bad news faster than good news. Thus, managers recognize unrealized losses earlier than unrealized gains, which lead to an asymmetry in the timeliness and persistence of earnings. Therefore, he (Basu, 1997) predicts that earnings are timelier and more sensitive in reflecting publicly available ‘bad news’ than ‘good news’. With ‘bad news’ he means the negative unexpected annual stock returns as proxy and ‘good news’ the positive unexpected annual stock returns (Basu, 1997).

Another interpretation of conservatism is based on Feltham and Ohlson (1995) in the accounting-based valuation literature. They characterize conservative accounting as ‘biased’ accounting. They argue that conservative accounting occurs when the market value equals or exceeds the book value of an asset. In their paper they indicate that ‘unbiased’ accounting results in full capitalization of an initial investment in an operating assets. On the other hand, ‘biased’ (conservative) accounting only captures a small fraction of that investment and expenses the rest of that initial investment. Thus, conservative accounting results in relatively lower earnings in the early periods and offsetting earnings in later periods.

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8 Both Basu (1997) and Feltham and Ohlson (1995) were predecessors for a lot researchers (Ball, Kothari & Robin, 2000; Ball & Shivakumar, 2005; Dechow, Hutton & Sloan, 1999; Francis, Hasan & Wu, 2013; Givoly & Hayn, 2000; LaFond & Roychowdhury, 2007) and played a role in the development of a more general definition of conservatism.

2.2 Explanations of conservatism

The concept of conservatism has an influential meaning for the accounting practices for centuries. Early in the 15th century, the trading partnership showed that accounting in Europe was conservative (Penndorf, 1930). The existence and influence of conservatism can be explained by the costly contracts between parties and is explained extensively in the following sections (Watts, 2003a).

Contracting explanations

In the business and economic world there is always uncertainty regarding future profits. Managers, on the other hand, possess valuable private information about the firm operations and the assets. If the compensation of the managers is linked with the reported earnings, then the managers have incentives to influence the reported earnings with their private information. The contracted parties e.g., the debtholders and creditors, want to prevent this unwanted behavior of the managers by demanding conservatism (Watts & Zimmerman, 1986). This is why the debtholders and creditors attach more value to timely information regarding to ‘bad news’, because the option value of their claims are more important than an increase in firm value (Smith & Warner, 1979).

In other words, conservatism plays an ex ante efficient role in contracting between other parties and the management. If accounting was not regulated, then the contracted party will voluntarily choose for conservatism to protect themselves (Basu, 1997). The research of Watts (2003a) focusses mainly on three different types of contracts that appear to be efficient to use conservatism:

 Conservatism and debt contracts: conservatism decreases the possibility that management will abnegate positive net present value (NPV) projects, and that they will overstate earnings and assets.

 Conservatism and executive compensation contracts: conservatism decreases the possibility that management will overstate net assets and cumulative earnings to increase the net assets of the firm, which is a proxy for their bonuses. However, the management should focus on the positive NPV of the projects for future profit.

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9  Conservatism and firm governance: conservatism provides signals for the examination of negative NPV projects on time and therefore to provide suitable action if it is necessary. Thus, conservatism protects the shareholders’ option to practice their property rights.

Litigation explanation

Both Beaver (1993) and Watts (1993) note that litigation under Securities Acts encourages conservatism. The reason therefore is that litigation and lawsuits occur more frequently when the net assets and income are overstated then these are understated.

Income tax explanation

The relationship between income tax and conservatism is that taxable income is closely linked with the reported earnings and therefore the accounting treatment has great influence for calculating of these earnings (Watts and Zimmerman, 1979).

Regulatory explanation

As already argued in the earlier sections, regulating bodies also have incentives for the preparers of companies’ reported financial statements to act conservative. Watts (2003a) notes that losses from overstated assets and income are more outstanding than losses from understated assets and income. This is often usable as argument in the political process. Moreover, these are also the incentives that encourage regulators and standard setters to be conservative.

2.3 Prior studies

There are a number of existing studies that examine the link between board characteristics and financial reporting quality1. Recently, there are several research studies (García Lara et al. 2007, 2009; LaFond & Roychowdhury, 2008) that focus on the relationship between corporate governance mechanisms and accounting conservatism. It is important to pay attention to prior studies, because these studies magnify the extent of understanding of the topics of this study.

1Beasley (1996) made an empirical analysis of the relation between the board of directors’ composition and financial statement fraud. His results indicate that firms whose experience the financial statement fraud have lower proportion of outside board member relatively to the non-financial statement fraud firms. Both Dechow, Sloan and Sweetney (1996) and Faber (2005) support the results of Beasley (1996), which is that the percentage of outside directors is negatively related to the probability of financial statement fraud.

Other researchers (Klein, 2002; Xie, Davision & DaDalt, 2003) examine the link between the board characteristics and earnings management. Klein (2002) finds strong results that firms that changed their board from majority to minority of outside board members have a less independent board and these firms experience an increased level of earnings management. Moreover, the results of Xie et al. (2003) indicate that the existence of earnings management is less likely when the firms’ boards have more independent outside directors and directors with corporate experiences.

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10 García Lara et al. (2007, 2009) and LaFond and Roychowdhury (2008) use accounting conservatism as the measure of financial reporting quality, which is an enriched contribution in the accounting researches. García Lara et al. (2007) find that firms with lower chief executive officer (CEO) influence over the functioning of the board of directors show a higher level of accounting conservatism. Moreover, firms with stronger corporate governance experience a higher degree of accounting conservatism. The governance level incorporate both internal and external characteristics (García Lara et al., 2009). Internal governance control mechanisms include shareholder and debtholder monitoring, board monitoring, corporate by laws and rules, and the internal managerial labor market. External mechanisms refers to the market for corporate control, the external managerial labor market, competition in the product market, and national legal and judicial systems that protect investors’ rights (Bushman & Smith, 2001).

Additionally, managerial ownership is also a part of corporate governance mechanism. Separation of ownership and control will increase agency problems between managers and shareholders. The shareholders will increase their demand for accounting conservatism to address this problem. The results of LaFond and Roychowdhury (2008) are consistent with their hypothesis, which is when the managerial ownership declines, the agency problems become worse and the demand of accounting conservatism will increase. Thus, the authors find that the asymmetric timeliness of earnings declines with the increase of managerial ownership.

2.4 The agency theory and agency problems

As in previous subsections already discussed, conservatism plays an ex ante efficient role in contracting between other parties and the management. This social and economic interactions between these parties arise from the agency relationship. An agency relationship exists when the agent, acts for, on behalf of, or as representative for the principal, in a particular domain of decision-making. Moreover, the existence of this agency relationship is described from the agency theory (Eisenhardt, 1989).

This agency relationship mainly involves two parties: the principal and the agent. The principal is someone who has ultimate authority and the agent is anyone acting on behalf of the principal (Baiman, 1990). Agency theory is concerned with resolving two potential problems that can exist from agency relationship. The first problems is the agency problem and the second problem is the related to risk sharing (Eisenhardt, 1989).

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11 The agency problem, which arises when the desires or goals of the principal and the agent are not aligned with each other. Also the supervision of the principal over the agent is difficult or costly, which leads to the fact that the principal cannot verify the actual behavior of the agent. On the other hand, the risk sharing problem arises when the principal and the agent have different preferences toward risk. This means that the principal prefers different actions when it comes to risk bearing, because too many risks might harm his or her capital. However, the agent can act differently due to different risk preferences, because it is not his/her capital (Eisenhardt, 1989).

To mitigate these problems a most efficient contract must be developed, because it is essential to govern the contractual arrangement between the agent and the principal (Ross, 1973). The optimal contract is determined on the behavior and the outcome between the principal and the agent. According to Baiman (1990) there is the notion that individuals (agents) act in their own interest, thus due to self-interest, the agent may not behave in alignment with the principal as agreed. In the literature there are two aspects of the agency problem results of contracting with the agent (Eisenhardt, 1989).

The first contracting problem is moral hazard, which refers to the lack of effort of the agent. Since the effort of the agent is not observable by the principal, the agent might shirk by not putting forth on the agreed-upon effort. The second contracting problem is adverse selection, which refers to the misrepresented ability by the agent. This means that the agent can claim that he or she has a certain required skills or abilities during the hiring process. This problem arises because the principal cannot verify the skills and abilities of agent at time of hiring and it is too costly for the principal to verify the agent constantly, while he or she is working (Eisenhardt, 1989).

The principal has two options to address these contracting problems due to unobservable behavior of the agent. The first option is to detect the agent’s behavior by investing in the information systems, such as severe reporting procedures, independent board of directors and additional layers of management. By investing in these mechanisms the principal will get more information (Eisenhardt, 1989). The reason why principal has less information than the agent is caused by the information asymmetry. Information asymmetry is an information gap between the principal and the agent. Because the agent acts and handles on the behalf of the principal, which means that the agent has direct information from the source. This information asymmetry is in favor of the agent (Jensen & Meckling, 1976). The other option is to focus on the outcomes of the agent’s behavior when setting up the contract.

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12 Because an outcome- based contract will motivate the agent to perform in the alignment of the principal’s (risk) preferences (Eisenhardt, 1989).

Fama and Jensen (1983) argue that the board of directors is one relevant information system for monitoring executive behaviors of the agent. In the perspective of the agency relationship, boards can be used as monitoring mechanism for shareholder (principal) interests. The board provide enriched information when the behaviors of the top executives are better known, thus reducing the information asymmetry. When boards also provide more useful information, top executives are more likely to behave consistent with the interest of the principal.

2.5 Corporate governance and board characteristics

Various researchers (Eisenhardt, 1989; Fama & Jensen, 1983, Jensen & Meckling, 1976) pay attention to the corporate governance and especially the role of board of directors, because both are issues of fundamental importance in the economics. Understanding of the role of boards and their characteristics is essential for the understanding of corporate behavior and corporate activities (Adams, Hermalin & Weisbach, 2010).

The need for corporate governance originates from the separation between the ownership of the company (principal) and its management (agent) and when the executives act in their own interest by taking actions that benefit themselves. In other words, corporate governance is essential to solve the agency problem and to lower agency costs. Agency costs arise from agency problem and are paid by the principal (Larcker & Tayan, 2011).

Larcker and Tayan (2011, p. 8) define corporate governance as follows: ‘a collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders’. Additionally, a corporate governance of a large company should at least have a board of directors to provide oversight for the management and an external auditor to express an opinion on the reliability and truthfulness of financial statements.

Boards have two main responsibilities, which are providing advisory and oversight functions. These two responsibilities are linked in many ways, but they have fundamentally different focuses. Advisory responsibility means that the board consults with management regarding the operational and strategic direction of the firm. Therefore, board members must have the needed skills expertise to offer necessary advices. Also, the board members have to focus on decisions that balance risk and reward.

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13 Oversight responsibilities are related to monitoring management and ensure that management is acting in the interest of the shareholders. Moreover, boards need to oversee legal and regulatory compliance, including the audit process, reporting requirements for listed firms and industry-specific regulations. Often to fulfill these duties, a board depends on the advices of legal counsel and other external paid professionals, such as external auditors, investment bankers and tax advisors. Board members who are considered as effective members have to be capable to complete both advisory and oversight responsibilities (Larcker & Tayan, 2011).

The differences of the responsibilities between the management and the board of directors must be kept in mind. Directors only provide advices on the strategies of the firm, but they do not develop these strategies. Moreover, directors only ensure the integrity of the financial statements but do not prepare the statements. In other words, the board functions not as an extension of management, but as representatives of the shareholders (Larcker & Tayan, 2011).

The characteristics of the board of directors are commonly described in terms of its structural attributes: its size, professional and demographic information characterizing the serving directors on the board, their independence from the management, numbers of committees and directors compensation (Larcker & Tayan, 2011). Moreover, in an operational perspective, the information richness of the boards can also be measured in terms of board characteristics, such as frequency of the board meetings in a year, number of board subcommittees, and tenure of the board members, number of the board members representing specific ownership groups and number of board members with specialized experience (Eisenhardt, 1989).

Additionally, an one-tier board is the common board structure for listed companies in the United States (U.S.). This means that the board consists of both executive and non-executive directors and they are both functional at the same organizational level (Maassen, 1999, p. 14 -16). In this study the observations of data sample are taken from financial information of the U.S. publicly listed companies (S&P502) and therefore it is essential to outline the detailed requirements governance standards in the U.S. (Larcker & Tayan, 2011, p. 36):

The listed company’s board is required to have a majority of independent directors.

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14  Nonexecutive directors must meet independently from executive directors on a

scheduled basis.

The compensation committee of the board must consist entirely of independent directors.

The audit committee must have a minimum of three members, all of whom are “financially literate” and at least one of whom is a “financial expert.”

The company must have an internal audit function.

The CEO must certify annually that the company is in compliance with NYSE requirements.

One of the most important event of legislation in connection with the U.S. governance is the Sarbanes–Oxley Act (SOX) of 2002. The introduction of SOX was a reaction to scandals and failures of major companies, such as Enron and WorldCom, to improve corporate governance and to diminish conflicts of interests between various stakeholders of the companies (Larcker & Tayan, 2011). The main objective of SOX is “to restore public confidence in the integrity of financial reporting by encouraging firms to provide accounting information that more closely reflects the underlying business performance.” (Taylor & Xu, 2010, p. 129).

To achieve this objective, SOX also requires firms to improve their corporate governance by requiring that listed companies have to designate an independent director as the ‘lead director’ of the board for each meeting (Larcker & Tayan, 2011). Also the Securities and Exchange Commission (SEC) wants to enhance the objective of SOX by adopting additional disclosure requirements to reduce corporate governance issues. For example, all listed firms have to disclose information about the choice why to have the CEO as the chairman of the board, the board size, the board meeting attendance of the members, the diversity of the board, the nominees for positions on the board and the rotation of board members. All these additional requirements are helpful for investors to increase their ability to make informed voting and investment decisions (SEC, 2009).

2.6 The link between board characteristics and accounting conservatism

Conflicts of interest in a company can be explained as an agency problem, because managers have effective control of the company’s assets, but they do not have a significant equity stake in these company that they control (Jensen & Meckling, 1976). As already pointed out, to mitigate these problems a most efficient contract must be developed, but these conflicts cannot be resolved completely through contracts. The reason for this is that it is too costly and impossible to write and enforce such contracts (Hart, 1995). Fama and Jensen (1983)

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15 state that an organization is actually a nexus of contracts, which consists of written and unwritten contracts among owners of factors of production and customers. The contract structure combines internal rules with the available technologies and external legal constraints. That is why it is too complex and impossible to provide a complete perfect contract (Fama & Jensen, 1983; Hart, 1995).

Consequently, in a world of incomplete contracts, an alternative solution such as corporate governance mechanisms are necessary to mitigate these conflicts of the firms. The costs and benefits of each governance mechanism (such as board of directors, institutional shareholders, managerial ownership and labor) are different. An organization needs to compose an optimal combination of governance mechanisms that maximize the firm value. Moreover, these corporate governance mechanisms vary systematically across firms, because the costs and benefits differ with firm characteristics such as the investment opportunity set, leverage and the relative importance of external financing (Agrawal & Knoeber, 1996; Watts, 2006).

It is difficult to provide an empirical study for all governance mechanisms, since each firm and industry is characterized by different market constellations. Therefore in this study the emphasis is on the relation between the board of director characteristics and accounting conservatism for two reasons. The first reason is that Fama and Jensen (1983, p. 311) argue that boards are ‘the common apex of the decision control systems of organizations in which decision agents do not bear a major share of the wealth effects to their decisions’. The board of an organization ratifies and monitors top managers’ decisions, because it is efficient to separate the initiation and the implementation of decisions. The directors of a board possess powers such as hiring and firing the managers, determining managers’ compensation and approve key decisions such as acceptance or rejecting of major investment projects. Additionally, directors give advices to the managers on proposed strategies and advices about hiring outside professional expertise (Grinstein & Tolkowsky, 2004; Larcker & Tayan, 2011). The second reason is the fact that the board of directors needs reliable and verifiable information to monitor and to advice managers effectively. The accounting and financial reporting system constitutes an essential source of these reliable and verifiable information, which is useful to supervise and evaluate managers as well as their decisions and strategies (Bushman & Smith, 2001; Watts & Zimmerman, 1986). Moreover, recall that the concept of conservatism has an influential meaning for the accounting practices for centuries. This concept is an important characteristic of a firm’s accounting system that helps the board of directors to reduce deadweight losses and to correct other sources of information by

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16 enhancing the firm and equity values (Watts, 2003a, 2006). Deadweight losses exist from deficiency caused by an inefficient allocation of resources and this will reduce equity and firm values (Jensen & Meckling, 1976; Watts & Zimmerman, 1986). That is why it is interesting to study the connection and relation between board characteristics and accounting conservatism.

2.7 Hypothesis development

In order to measure the power of the boards, the term ‘board strengths’ is introduced in this research, which focusses on the independence and the monitoring incentives of the board of directors. In this subsection, first the effect of financial crisis on conservatism will be discussed. Thereafter, the complementary and substitutive relationship between board strengths and accounting conservatism will be discussed. At the end the hypothesis will be presented.

2.7.1 Financial crisis and accounting conservatism

The financial crisis in 2007 in the U.S. is still a new topic for the academic researchers and therefore there are not many empirical researches been done about the relationship between accounting conservatism and corporate governance mechanisms in that period (Francis et al., 2013; Persakis & Iatridis, 2015). However, there are several recently published researches that investigate the accounting conservatism in different financial crises, namely, the Asian financial crisis in 1997 (Gul, Srinidhi & Shieh, 2002; Herrmann, Pornupatham & Vichitsarawong, 2010; Vichitsarawong, Eng & Meek, 2010).

Reinhart and Rogoff (2008) argue that each financial crisis is indeed different from another, but they also share notable similarities, such as in inflated asset prices, in debt accumulation, in growth patterns and in current account deficits. The 2007 U.S. sub-prime crisis was mainly caused due to falling U.S. housing prices, which led to higher default levels of particularly among less credit-worthy borrowers. The impact of these defaults on the financial sector has been more intensified due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, these new complex vehicles also made the instruments extremely non-transparent and illiquid when house prices were falling (Reinhart and Rogoff, 2008). Furthermore, Francis, LaFond, Olsson and Schipper (2004) state that both conservatism and timeliness can be considered as indicators of ‘transparency’.

Vichitsarawong et al. (2010) examine conservatism and timeliness of earnings in the period surrounding the Asian financial crisis in 1997 in four different Asian countries, which are Hong Kong, Malaysia, Singapore and Thailand. The accounting standards in these four

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17 investigated countries are under the influence by common law accounting standards (e.g. the U.S and the United Kingdom). Researchers (Kodres & Pritsker, 1998; Kaminsky & Schmukler, 1999) argue that firms facing the crisis were under pressure to provide more positive information to investors in order to decrease the negative impact of the crisis. Concerns arose from this point view, which is that management tented to provide more aggressive in reporting with more good news (gains) than usual and delay recognition of bad news (losses), because investors would react faster to bad news than good news. Vichitsarawong et al. (2010) find that accounting conservatism in the Asian financial crisis period is lower than under normal economic conditions. Moreover, conservatism increased after the crisis period and the degree of improvement is greater than in the pre-crisis period.

Both Gul et al. (2002) and Herrmann et al. (2008) investigate the level of conservatism surrounding the Asian financial crisis period and they support the evidence of Vichitsarawong et al. (2010). Herrmann et al. (2008) compare level of conservatism of the clients of Big 4 and non-Big 4 audit firms in Thailand. Their results indicate a significant increase of conservatism clients of both Big 4 and non-Big 4 after the financial crisis. However, the clients of the Big 4 auditors are more conservative during the crisis relatively to the clients of the non-Big 4 audit firms. Furthermore, Gul et al. (2002) show a decrease of conservatism during de financial downturn in Hong Kong. Their results also show that the decreased accounting conservatism is associated with the higher audit effort and therefore it leads to higher audit fees.

2.7.2 Complementary relationship between board strengths and conservatism

The complementary perspective refers to the fact that adequate governance results in better monitoring of management. The expectation behind this perspective is that efficient corporate governance mechanisms will favor the implementation of accounting conservatism (Chi, Liu & Wang, 2009). According to Watts, (1977, 2003a, 2006) strong boards will demand greater conservatism, because conservative accounting can help directors to decrease agency costs, which arise from asymmetric information, asymmetric payoff functions and limited liabilities between managers and other parties of the company. Arguments that support the fact that accounting conservatism facilitates corporate governance are discussed hereafter.

Watts (2003a) mentions that conservatism decreases managers’ ability and their incentives to overstate earnings and net assets by requiring higher verification standards for gain recognition than loss recognition. In this way the managers’ ability to hide information on expected losses is reduced. Therefore, conservatism prevents overcompensation of

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18 managers, which is costly to restore ex post (after the contracts are agreed between managers and owner) because of managers’ limited liability, responsibility and tenure.

Another argument is mentioned by both Ball (2001) and Watts (2003a), which is that conservatism provides a monitoring role of firms’ investment policies. By requiring more timely recognition of expected losses, conservatism helps in identifying negative NPV investment projects or poorly performing investments. By identifying these negative NPV projects on time, the board of directors can provide a signal to investigate both the project and the managers. This also limits deadweight losses from poor investment decisions and thus increases firm and equity values. Deadweight losses result from deficiency caused by an inefficient allocation of resources and this will reduce equity and firm values (Jensen & Meckling, 1976; Watts & Zimmerman, 1986).

Recently, García Lara et al. (2009) find evidence that supports the fact that firms with strong governance use discretionary accruals to inform investors of bad news in a timelier manner. The authors point out that corporate governance provision plays an important role in the implementation of accounting conservatism. Moreover, in their research they control for endogenous nature of corporate governance and the fact that governance mechanism and conservatism may be simultaneously determined.

In summary, the above listed arguments indicate that accounting conservatism is a useful tool for directors, especially outside directors in fulfilling their role of ratifying and monitoring key decisions. Because stronger boards are more likely to be competent at efficient contracting and they have a better understanding of the benefits of conservatism they are more likely to demand more conservative accounting. Contrary, boards dominated by insiders or boards with weak monitoring incentives are less likely to provide managers with greater opportunity to use conservative accounting.

2.7.3 Substitutive relationship between board strengths and conservatism

The substitutive perspective, on the other hand, believes that conservative accounting is a vehicle to reduce uncertainties and information asymmetry. The expectation behind this perspective is that a less solid corporate governance mechanism will lead to a higher demand for conservative accounting, because the agency problem is more serious in these firms (Chi et al., 2009).

Khan and Watts (2007, p. 14) argue that ‘Younger firms are unlikely to have evolved better governance mechanisms to mitigate agency problems with creditors and shareholders’. Their argument is based on the following reasons. Younger firms tend to have

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19 a higher proportion of growth options relative to installed capital and younger firms will also have higher information asymmetry both between managers and investors and between managers and lenders (Khan and Watts, 2009). Since conservatism has an efficient contracting role for decreasing agency costs generated by those information asymmetries (Ball, 2001; Watts, 2003a), Khan and Watts (2009) expect the older the firm, the less conservative the accounting.

Furthermore, information asymmetries will increase with the firm’s investment cycle length and with its firm-specific uncertainty. The uncertainty enhances information asymmetries, and will lead to 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 (Khan and Watts, 2009).

LaFond and Roychowhury (2008) find a decrease of conservatism measured by the asymmetric timeliness of earnings with managerial ownership. They explain their result as follows, when managerial ownership declines, the severity of the agency problems will enhance and therefore also an increased demand for accounting conservatism. Since the agency problems especially arise from greater separation between ownership and control. Thus, the managers only have limited liability with respect to other stakeholders of the organization. To reduce the agency problems, managerial ownership provides more liabilities to the managers and they will bear more risks related to the firm’s performance.

Francis et al. (2013) examine the level of accounting conservatism during the U.S. financial crisis of 2007. They investigate whether accounting conservatism affects shareholder value. Francis et al. (2013) find strong evidence that there is a positive relation between conservatism and stock returns during the financial crisis. Also they support the argument of prior empirical evidences (Ahmed & Duellman, 2007; LaFond & Roychowdhury, 2007; LaFond & Watts, 2006, 2008) that conservative accounting is an efficient governance mechanism to mitigate information risk and control for agency problems.

Overall, the substitutive perspective suggests that a weaker board with a majority of insiders will result in a higher demand of conservative accounting. Contrary, strong boards dominated by outsiders or boards with stronger monitoring incentives are less likely to demand the use of conservative accounting.

Both the complementary and the substitutive relationship between board strengths and conservatism imply the fact that conservatism is an efficient governance mechanism to mitigate information risk and control for agency problems. Therefore, the expectation of this

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20 study will be consistent with results of the previous studies (Ahmed & Duellman,2007; LaFond & Roychowdhury, 2007; LaFond & Watts, 2008) and I hypothesize the following:

H1a: The strength of board governance will be more negatively associated with accounting

conservatism before the financial crisis.

H1b: The strength of board governance will be less negatively associated with accounting

conservatism during the financial crisis.

The strength of board will be less associated with accounting conservatism during the financial crisis. The reason for this is that the researchers (Kodres & Pritsker, 1998; Kaminsky & Schmukler, 1999) argue that firms facing the crisis were under pressure to provide more positive information to investors in order to decrease the negative impact of the crisis. In other words, the management (agent) has the tendency to be more aggressive in reporting, e.g. to report more good news (gains) than usual and delay recognition of bad news (losses), because investors would react faster to bad news than to good news. Besides aggressive reporting by management, they also favor extensive risk taking (Kirkpatrick, 2009).

According to Kirkpatrick (2009) the financial crisis can be considered as an important element that leads to failures and weaknesses in corporate governance mechanisms, which causes harms to their purpose to safeguard against excessive risk taking in companies. Moreover, the results of Erkens, Hung and Matos (2009) suggest that corporate governance had an important impact on companies’ performance during the crisis through their risk taking and financing policies. Kirkpatrick (2009) argues that the oversight and advisory responsibilities of the board, will be less effective during financial crisis than under normal conditions, because the board functions ineffectively. The board becomes less effective due to the failure of communicating information from the management to the board during the financial crisis. The managers might hide information with regard to aggressive reporting and risk taking, which enhance information asymmetry (Kirkpatrick, 2009). Furthermore, consistent with Vichitsarawong et al. (2010), they find that accounting conservatism in the Asian financial crisis is lower than under normal economic conditions. That is why I expect the hypothesis above.

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3. Research methodology

This section presents three aspects of the research. First the research method will be clarified. Second, the research measurements of both dependent and independent variables and thereafter the seven control variables which compose the empirical models will be discussed. Third, the empirical models will be explained.

3.1 Research method

I will use an empirical archival research method with the obtained data from different databases and the statistics program Stata in this research to answer the research question: To

what extent do the board characteristics and board strengths affect the accounting conservatism before and after the financial crisis? Furthermore, the empirical research

model in this study is replicated from the research of Ahmed and Duellman (2007), but the used databases and time period of the sample are different from their research.

3.2 Research measurements and variables

In this subsection the proxies for the board characteristics and their strengths as well as the proxies for two different accounting conservatism measures will be discussed. First, the five independent proxies of the board of directors will be further discussed in details. Thereafter, the two different measures of accounting conservatism will be explained.

3.2.1 Measures for board characteristics and board strengths

The independent test variables are five board of director characteristics that focus on independence and the monitoring incentive strengths of the board of directors. These characteristics are the percentage of insiders on the board, the existence of CEO and chairman duality, the board size, the outside director ownership and the average number of additional directorships held by the board members.

The first measure of board independence is the percentage of insiders on the board of directors. Consistent with previous researches (Ahmed & Duellman, 2007; Klein, 2002), I also define inside directors as members of the board who are currently employed or have been employed by the company for sample period of three years. Additionally, these inside directors have to be linked to the current management, and/or related to the company founder. In this research, the definition of independence of directors is consistent with Klein (2002). He defines that only outsiders, who have no relationship with the board members or the firm as fully independent. However, in the study of Ahmed and Duellman (2007), the affiliated directors, who have significant business transactions with the firm, are considered to be

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22 independent directors as well, which differs in this research. Thus, this variable is calculated as the percentage of total insiders of a board divided by the total board members.

The second measure of board independence refers to the separation between the position as the CEO and as the chairman of the board. This proxy also refers to the strength of outside director monitoring incentives, because when the CEO is also the chairman of the board, it is more likely that he will act in favor to himself during the nominations and elections of new directors and therefore they might be less independent directors. This means when these two functions are separated, the board of directors will be more independent from the management (Jensen, 1993) and that the outside directors have stronger monitoring incentives. Prior researches suggest that the existence of CEO- chairman duality leads to lower firm debt ratings (Ashbaugh, Collins & LaFond, 2006), and also greater likelihood of an SEC enforcement action (Dechow et al., 1996). Thus, in this research I measure the existence of CEO/chairman duality as an indicator variable and which equals one when the functions of CEO and chairman of the board are managed by different directors, zero if otherwise.

The third measure refers to the monitoring strength by focusing on effect of the size of the board. The size of the board is measured as the natural log of the total board members of a board. However, there are conflicting views about this effect. According to Jensen (1993), the greater the magnitude of a group, the more difficult it is to control and to coordinate the group relatively to a smaller group. This means that a large board might be less effective and the functions of the member are less optimal operated than a smaller board. Besides, a larger board might also lead to a free-rider problem in the sense that some members might put less effort to monitor the management, because they are relying on the effort of other members (Ahmed & Duellman, 2007). These free-rider problems are evidenced in the research of Hermalin and Weisbach (2003) and they find a negative relation between the size of the board and the firm value. On the other hand, a larger board might permit specializations of the directors and this will provide a positive effect to monitoring strength of the directors. Klein (2002) supports this view with the evidence that audit committee independence is positively associated with the board size. Therefore, a larger board with more members leads to fewer committee assignments for a director and it enables these directors to focus and specialize in their assigned tasks (Ahmed & Duellman, 2007).

The fourth measure proxies to the strength of monitoring incentives of the outside directorship and therefore I use the percentage of shares held by outside directors. Prior researches find that outside director ownership increases monitoring incentives. Beasley

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23 (1996) shows that outside director ownership is linked to a lower probability of financial statement fraud and Ashbaugh et al. (2006) show that greater outside director ownership is also linked with higher firm debt ratings. Furthermore, Jensen (1993) notes the fact that outside directors are an important factor of the independence of the board, but they must have significant equity stakes in the firm, when it comes to having sufficient incentives to monitor and confront the managers. However, the outside directors must not bear a major part of wealth due to these equity stakes, because this could effects their decisions and monitoring incentives (Fama & Jensen, 1983).

Finally, the last measure focusses on the monitoring effectiveness of the directors by examining the additional directorships. This independent variable refers to monitoring expertise and it is measured as the total number of seats hold by directors outside the board which they operate in, divided by the total number of directors who possess these additional seats. Additional directorship is often seen as monitoring expertise or extra board experience. However, there are ambivalent views about the benefits of additional directorships. Fama and Jensen (1983) argue that additional directorships of outside members lead to a greater monitoring expertise. The reason therefore is that these outside directors will learn and adopt monitoring skills from other boards. Moreover, these outside directors have relevant complementary knowledge about certain expertise, because they are often specialized in dealing with decision problems in other complex organizations. Ashbaugh et al. (2006) follow this view and their result shows that the percentage of directors holding an additional directorship is positively associated with firm debt rating. Conversely, the downside of additional directorships is that directors could be distracted from their duty of monitoring the firm when they have to monitor more firms at the same time. Beasley (1996) follows this view and documents that the average number of outside additional directorships held by board members is positively associated with the probability of financial statement fraud.

Special attention must be paid to the last independent variable. The additional directorships of each individual director of each company per year are calculated by matching his/her full name in the obtained data sample with the obtained entire database of all companies in the U.S. of ISS in that same particular year. This means that the additional directorships also include board seats held in non-S&P 502 firms by the directors of the sample group (S&P502 firms). However, the raw data of full names of the directors obtained from database in sample period 2007 – 2013, contains several systematic spelling errors, which cause that their full names did not exactly match (spelling errors, unnecessary commas

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24 and space, inconsequently writing out full names and inconsequently using academic titles) with the data from the entire database of all companies in the U.S.

I restrain these errors, semi-manually with the help of the Levenshtein distance algorithm. The Levenshtein distance algorithm calculates the similarity of two strings (in this case the full names of the directors) by estimating the distance between these strings (Levenshtein, 1966). A lot of researches use this method in their researches (Cohen, Ravikumar & Fienberg, 2003; Soukoreff, & MacKenzie, 2001). This distance is expressed as a number between 0 and 1, which reflects the percentage of similarities of two names. Using Levenshtein distance algorithm I calculated the percentage of similarity of each director’s full name with director’s full names of all other companies for that particular year in the entire database search field. I manually verified and corrected 262 observations of director’s full names and corresponding company for which the Levenshtein distance (similarity percentage) was higher than 85 per cent in the seven year period (2007- 2013). This threshold was chosen after visual inspection of the Levenshtein distances for the first 50 director names. The threshold appeared to be very prudently chosen, because majority of the Levenshtein matches appeared to be no actual matches. Using the sub sample for which the distance was higher than the threshold, it enables me to verify additional directorships without going through the entire database. Furthermore, this enabled me to include more reliable data for the additional directorships variable by not involving the errors, which I would not had observed when I had simply matched names.

3.2.2 Measures for accounting conservatism

In this research the dependent variable conservatism focusses solely on firm-specific measures at the end of each year of the three sample periods (2002-2006 & 2007-2013 & 2002-2013). The two firm-specific proxies that examine for conservatism are a broad constructions of conservatism in the reality. This construction reflects the cumulative effect of managers’ accounting treatments. There is a general notion about conservative accounting examined in this research, which is that the conservative accounting reduces the book value of equity relatively to the market value of equity (market-based measure). Besides that, the conservatism also reduces the income relative to cash flows from operating (accrual-based measure) (Ahmed, Billings, Morton & Stanford-Harris, 2002).

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The market-value based measure

The market-value based measure of conservatism, CON-MKT, is a stock measure and it shows the cumulative influence of conservatism on book value of equity (Ahmed et al., 2002). This measurement derives from Beaver and Ryan (2000) and they argue that changes in book-to-market ratios are a function of two components, which are the biased and lagged accounting recognition. They examine the biases and lags in book value and their effects on the ability of the book-to-market ratio to predict book return on equity. The biased component of book-to-market are suggested as a proxy for conservatism, because the book value is constantly understated and therefore below market value. Their definition of bias is consistent with the definition of conservatism of Feltham and Ohlson’s (1996), which is an asymptotic difference between the firms’ book and market value. In other words, the book value will be continually higher (lower) than the market value and this leads to the fact that book-to-marker ratio will also be continually above (below) one (Beaver & Ryan, 2000).

The book-to-market ratio is generally calculated by the book value of firms’ equity (BVE) divided the market value of firms’ equity (MVE). The BVE equals to the total assets (TA) minus the total liabilities (TL) of the firm each year. Moreover, the MVE equals to the common shares outstanding (CSO) multiplied by the share price (SP) at the end of the fiscal year. For ease of the presentation, after calculated book-to-market ratio, it will be multiplied by negative one, which gives a more clear oversight to the show greater conservatism when this ratio is more positive.

CON-MKT = (𝑇𝐴𝑖,𝑡−𝑇𝐿𝑖,𝑡

𝐶𝑆𝑂𝑖,𝑡 ×𝑆𝑃𝑖,𝑡) × −1 (1)

The accrual-based measure

The accrual-based measure of conservatism, CON-ACC, is a flow measure and it shows the conservatism over the three sample periods. CON-ACC, relies on the view of Givoly and Hayn (2000) and they measure the effects of conservatism on income statement over a large sample period (49 years). In their research they mention that accounting conservatism causes constantly negative accruals, which is conversely with the normal expected pattern of accrual reversals. Therefore, they suggest that the average accrual over examined period forms a firm-specific measurement for conservatism.

Several researches (Ahmed et al., 2002; Ahmed & Duellman, 2007; García Lara et al., 2007) are consistent with Givoly and Hayn (2000) and they use their accrual-based measure for conservatism. Therefore, consistent with these researches, I will also use accruals before

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26 depreciation as the proxy for conservatism (Givoly & Hayn, 2000). Moreover, accrual-based conservatism is calculated by the net income before extraordinary items (NIBEI) plus the accumulated depreciation expense (DEX) minus the cash flow from operations (CFO), deflated by averaged total assets (TA) over that sample period (2002- 2007, five years; 2007- 2013, seven years; 2002- 2013, twelve years). Also for the simplicity, I multiply the measure with negative one, to provide a clear view of conservatism. According to Givoly and Hayn (2000) the more the negative the average accruals over that sample period, the more conservative a firm is, in their provided accounting method. This measured conservatism is reversed when multiplied with negative one. Thus, the more positive values of CON-ACC, the more conservative the accounting is in that period of the firm.

CON-ACC = (𝑁𝐼𝐵𝐸𝐼𝑖,𝑡+𝐷𝐸𝑋𝑖,𝑡−𝐶𝐹𝑂𝑖,𝑡

𝑇𝐴𝑖,𝑡 ) × −1 (2)

3.2.3 Control variables

In this research, seven control variables will be used in order to control the influences of these variables on the dependent variable: conservatism. As already discussed about the agency theory and the agency problems arise from two conditions. The first condition is caused due to the different interests between agents and principals and the second due to the unobservability of the agent’s action (Eisenhardt 1989; Jensen & Meckling, 1976).

Consistent with DeFond (1992) I will use the next three control variables to address the agency problems. The first control variable is inside directors’ ownership and the second variable leverage will proxy for the first condition. The third control variable, firm size, will proxy for the second condition. Ownership given to management will lead to congruence and restrictions of the conflict of interests between managers and shareholders and less agency conflicts (DeFond, 1992; Jensen & Meckling, 1976). Consistent with this theory, LaFond and Roychowdhury (2008)’s results indicate that conservatism as measured by the asymmetric timelines of earnings decreases with the level of managerial ownership. Also Warfield, Wild and Wild (1995), provide evidence that managerial ownership is negatively related with the abnormal accruals. However, the disadvantage of inside director ownership is when these directors have too much ownership, because they could utilize their voting power to get take away the rents from the company. Due to inconsistent theory, therefore I do not have an expectation about the coefficient of this variable.

The second control variable is leverage. According to DeFond (1992) potential agency conflicts will be increased due to higher leverage of the firm. The principals reduce

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