THE RELATIONSHIP BETWEEN CORPORATE GOVERNANCE AND ACCOUNTING CONSERVATISM IN FINANCIAL STATEMENT (Applied Study on Egyptian Securities Market )

Abstract

Abstract : Whilst extensive research has been done on the association between corporate governance and firm performance, the empirical evidence is inconclusive. This paper argues that the failure of past studies to establish a positive association between corporate governance and performance might be caused by the use of conservative accounting in firms. If firms with stronger corporate governance adopt more conservative accounting procedures, then tests of the relationship between corporate governance characteristics and performance will be biased downwards. If market participants fail to recognize a link between conservative accounting and corporate governance, then firms with stronger corporate governance might also be systematically undervalued. Therefore, studying the relationship between selected corporate governance attributes and the extent of conservative accounting does more than just extend our understanding of the link between governance characteristics and accounting quality. It also provides useful insights for interpreting the existing literature on the association between corporate governance and performance. In this paper , detailed investigation is undertaken of the link between several governance characteristics (as well as an aggregate index) and the extent of conservatism evident in Australian firms’ financial reporting. Overall, the results provide only weak evidence that firms with certain governance characteristics report more conservatively. Evidence of any such link is restricted to measures of board composition and leadership, and even then the results are sensitive to the method used to measure the extent of conservatism in financial reporting. There is no systematic evidence of an association for measures of audit committee composition, nor board size. Finally, there is only weak evidence that use of a Big 5 auditor affects the extent of conservatism and the results are sensitive to the period investigated. These results are all robust to explicitly recognizing possible . Conservative accounting has been practiced by firms for centuries and it is an important attribute of earnings. It has also been used to measure earnings quality by prior studies (Penman and Zhang 2002; Beekes, Pope and Young 2004; Ball and Shivakumar 2005). Initially, conservative accounting was generally viewed as an accounting bias that resulted in low book values. However, recent studies distinguish between accounting bias resulting from timelier reporting of economic losses relative to gains (conditional conservatism) and accounting bias associated with a predetermined understatement of book values (unconditional conservatism) and argue that these two factors are not equally important from the contracting perspective. Conservatism Theories of Conservatism There are various hypotheses to explain the demand for conservative accounting (see Watts 2003 for a discussion of some of these hypotheses). The earliest explanation is the contracting hypothesis. Other hypotheses have been proposed more recently, mainly in response to recent events, for example, the increase in shareholder litigation and conservatism in the tax system. The contracting demand for conservatism is associated with the role of accounting in contracting, as conservatism is an important principle in accounting. Contracts have been used to reduce agency problems associated with the separation of ownership and control within a firm and accounting has been used for many centuries by organizations to facilitate contracting (Watts and Zimmerman 1986). The two main contracts within the firms are: debt contracts and managerial compensations contracts. Conservative accounting is required in contracting between shareholders and managers. Since the performance of managers is measured by accounting numbers and since managers’ tenure is limited and they normally have more information than shareholders, they have incentives to artificially inflate short term earnings by choosing aggressive accounting, thereby boosting their performance in the eyes of the shareholders. It is for this reason that shareholders, through their board, demand that the firm adopts conservative accounting to offset managerial optimism. Conservative accounting is also required in contracting between debt-holders and managers. Debt-holders have asymmetric payoffs from their investment in the firm in that they do not share the excess returns when the firm does well but they receive a lower return when the firm fails to meet its obligation. Therefore, debt-holders require the firm to adopt conservative accounting to avoid overstatement of value and to reduce, in turn, the potential excessive dividend payments and payments to other parties (Ball, Robin and Sadka 2006). The contracting theory is discussed in more detail in subsequent sections. Conclusions : In this paper we assess the association between accounting conservatism and corporate governance. Accounting conservatism produces earnings that reflect bad news more quickly than good news. In particular, we investigate whether firms with low antitakeover protection and low CEO involvement in board decisions (strong corporate governance) exhibit a higher degree of accounting conservatism, as defined by Basu (1997), than firms with high antitakeover protection and high CEO involvement in board decisions (weak governance). Our proxy for the level of accounting conservatism is Basu’s asymmetric timeliness of earnings measure. We define the quality of corporate governance using a composite measure that incorporates the level of antitakeover protection and level of CEO involvement in the decisions of the board of directors. This proxy incorporates mechanisms of external and internal governance of the firm. It is important to include both as they have a complementarily effect: external governance reinforces the effectiveness of internal governance, and vice versa. we find that the asymmetric timeliness of earnings to bad news is significantly higher for firms with low antitakeover protection and low CEO involvement in board decisions than for firms with weak governance. This result is robust to controlling for the investment opportunity set, as it has been shown that differences in asymmetric timeliness can be driven by differences in growth opportunities unrelated to conservatism (Roychowdhury and Watts, 2004).