The Effect of Accounting Conservatism on Corporate Financing Activity:Evidence from JapanSouhei IshidaGraduate School of Commerce and Management, Hitotsubashi Universitycd132001@g.hit-u.ac.jp3 August, 2014AbstractThis study examines how two types of conservatism―unconditional conservatism and conditional conservatism―affect Japanese firms’ financing activity, in particu lar, borrowing money from banks. This study obtained the two main findings. First, firms practicing a higher level of unconditional conservatism borrow more money from banks under the condition of facing a funding shortfall. Second, the degree of their conditional conservatism does not significantly relate with the degree of proceeds from loans. These results are robust to the endogeneity problem between conservatism and firms’ borrowing activity. In addition, I find that firms having a strong relationship with the main bank benefit from unconditional conservatism and conditional conservatism is useful for firms having a weak relationship with the main bank. This paper reveals that the economic consequences of conservatism vary across institutional factors and suggests the possibility that the nature of conservatism has been misjudged by focusing only on the accounting system when considering its economic consequences.Keywords: Accounting Conservatism; Corporate Financing Activity; Loan; Main Bank1.IntroductionThis study examines how two types of conservatism―unconditional conservatism and conditional conservatism―affect Japanese firms’ financing activity, in particular, borrowing money from banks.Conservatism has a long history. For example, conservatism is said to have influenced accounting practice for at least 500 years (Basu 1997). Conservatism became an American accounting principle in 1938 (Sanders et al. 1938), and was described in Japanese accounting principles in 1949 (ESB 1949). However, there has been a global movement for the elimination of conservatism. In 2005, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) published a joint paper discussing conservatism as part of the conceptual framework project, which stated that the common conceptual framework should not include conservatism among the desirable qualitative characteristics of accounting information (FASB 2005). The process of accounting standards convergence, in turn, led their attitudes to influence those of the Accounting Standards Board of Japan (ASBJ) (Yaekura 2007).On the other hand, many researchers have analyzed the economic rationality of conservatism and reported that it improves the efficiency of contracting (Watts 2003). However, these papers suffer from two problems. First, the conservatism examined by previous research is not always the same as that eliminated by the bodies in charge of setting standards. While many previous studies focus on “conditional” conservatism and analyze it’s rationality (García Lara et al. 2014; Iyengar and Zampeli 2010; LaFond and Roychowdhury 2008; Nikoleav 2010; Wittenberg-Moerman 2008), Kanamori (2009) reveals that the conservatism eliminated by standards setting bodies is not conditional conservatism but rather “unconditional” conservatism1. Therefore, academic research cannot contribute to setting standards without drawing a distinction between conditional conservatism and unconditional conservatism and examining the economic consequences of each.The second, problem is the external validity of previous research. As stated above, many studies have focused on conservatism. Many of these argue that unconditional conservatism does not 1Kanamori (2009) examines accounting standards published by FASB from 1973 to 2002 and finds that approximately 40% of published accounting standards exclude unconditional conservatism.improve contracting efficiency, unlike conditional conservatism (Bauwhede 2007; Ball and Shivakumar 2005; Qiang 2007; Zhang 2008). However, because these studies analyze U.S. listed companies, questions can be raised about the validity of generalizing these findings to firms based in other countries. Wysoki (2011) argues that an accounting system is interrelated to other institutional factors and the economic consequences of accounting systems can vary across these institutional factors. This suggests the possibility that the nature of the economic consequences have been misjudged by focusing only on accounting systems.Using a large sample of Japanese listed firms during 2003–2012, I analyze how both unconditional conservatism and conditional conservatism affected corporate borrowing activity from banks. Japanese financial system is centered on banks, which develop a long-term and close relationship with their borrowers (Hiroda 2012). This traditional Japanese system is known as the main bank system, and has possibly lead conservatism to have consequences different from those observed in other countries.This study obtained the two main findings. First, firms practicing a higher level of unconditional conservatism borrow more money from banks under the condition of facing a funding shortfall. Second, the degree of their conditional conservatism does not significantly relate with the degree of proceeds from loans. These results are robust to the endogeneity problem between conservatism and firms’ borrowing activity.In addition, I find that firms having a strong relationship with the main bank benefit from unconditional conservatism and conditional conservatism is useful for firms having a weak relationship with the main bank.This paper greatly contributes to the literature. First, this study reveals that firms benefit from unconditional conservatism in Japan. Previous research argues that conditional conservatism benefits firms through improving their debt-contracting efficiency, unlike unconditional conservatism. I provide evidence different from that found by this previous research.Second, this study reveals that the economic consequences of conservatism vary across the degrees of firms’ relationships with the main bank. Wysoki (2011) argues that the accounting system is interrelated to other institutional factors, and therefore the economic consequences of theaccounting system can vary across different institutional factors. This study followed through on this possibility to examine if the economic consequences of the accounting system have been misjudged by focusing only on the accounting system itself. Thus, this study contributes to literature on the new institutional accounting regime.Finally, this study focuses on proceeds from long-term loans payable. Using interest rate and credit rating, previous studies examine the economic rationality of conservatism for debt contracting (Bauwhede 2007; Nakamura 2008; Zhang 2008). However, I cannot directly analyze the relationship between conservatism and debt contracts using these items because I was unable to identify when these items are decided. On the other hand, data on proceeds from long-term loans payable are a readily available form of cash flow statement that permits identification of when firms borrow money from banks. Therefore, this study provides direct evidence for the link between conservatism and debt contracts. In addition, my approach opens the possibility of application to other studies.The remainder of this paper proceeds as follows. Section 2 reviews the literature and presents the hypotheses. Section 3 provides a detailed research design and sampling methodology. Section 4 provides the main results, and Section 5 reports additional results. Section 6 provides the conclusion.2.Literature Review and Hypotheses(1)Unconditional Conservatism and Conditional ConservatismThis section reviews previous research and provides the hypotheses. First, I provide a simple explanation of conservatism and define both unconditional conservatism and conditional conservatism.Conservatism is defined as a downward bias in the accounting of net asset value relative to economic net asset value resulting from the asymmetric recognition of economic value in accounting income (Beaver and Ryan 2005; Ruch and Taylor 2011). Based on this definition, conservatism manifests itself in two approaches. One that recognizes expenses earlier and other that recognizes revenue later. However, many previous studies present only the former as an example of conservatism. Examples of conservatism include (i) lower cost or market for inventory, (ii)impairment for long-lived tangible and intangible assets, (iii) immediate expensing of the cost of internally generated intangible assets, and (iv) accelerated amortization of long-lived assets (Edwards 1989; Ryan 2006; Sanders et al. 1983). Because revenue is generally recognized on a realization basis and conservatism has no room for the recognition of revenue, many previous studies may regard recognizing expenses earlier as an example of conservatism. Based on this view, whether a firm is conservative depends entirely on the timing of recognizing expenses.Recent studies point out two ways in which conservatism can be utilized in terms of recognizing expenses. One is recognizing expenses at the time when the value decreases, whereas the other is recognizing them before the value decreases. Consider, for example, the recognition of goodwill expenses. They can be recognized in two ways: (i) amortization and (ii) impairment2. Although impairment accounting recognizes the expenses when the value of goodwill declines, amortization accounting recognizes expenses before the value of goodwill declines. Given that revenue recognition is based on a realization basis, both these methods underestimate accounting of net asset value. However, because a time lag exists between impairment and amortization in terms of the timing of recognizing expenses, the timings of underestimating accounting of net asset values differs between these two methods. Recent studies focus on these timing differences and call the conservatism of recognizing expenses when the value declines as “conditional conservatism” and the conservatism of recognizing expenses before the value declines as “unconditional conservatism” (Beaver and Ryan 2005).(2)Conservatism and Contracting Efficiency3On the basis of Basu (1997), many studies attempted to reveal the economic rationality of 2Under U.S. general accounting principles (GAAP) and IFRS, goodwill most not be amortized and should be regularly tested for impairment (IFRS 3; Topic 350). On the other hand, goodwill must be amortized within 20 years under Japanese GAAP and be regularly tested for impairment (Corporate Accounting Standards 21).3Because many previous studies do not draw a distinction between unconditional conservatism and conditional conservatism, I categorize these studies into “unconditional conservatism” research and “conditional conservatism” research based on the measurements they use. If these studies use the measurements proposed by Ball and Shivakumar (2005), Basu (1997), Callen et al. (2009), and Khan and Watts (2009), I categorize them as “conditional conservatism” research. On the other hand, if they use the measurements proposed by Ahmed et al. (2002), Beaver and Ryan (2000), Giner and Rees (2001), and Penman and Zhang (2002), I categoriz e them as “unconditional conservatism” research.conditional conservatism. A review of recent papers revealed broad agreement with the opinion that conditional conservatism improves contracting efficiency.Shareholders and creditors often contract with a firm manager on the basis of accounting numbers. However, because information asymmetry exists between the manager and shareholders/creditors, the manager has incentive to bias earnings and equity upward by recognizing losses later to maximize his or her own welfare. This is likely to impair both shareholder and creditor wealth. Watts (2003) argues that (conditional) conservatism improves contracting efficiency to offset this upward bias.Recent empirical research finds that both shareholders and creditors demand conditionally conservative accounting by firms. For example, Qiang (2007) focuses on U.S. firms and shows that higher debt equity ratio induces a greater level of conditional conservatism. In addition, using a sample of U.S. firms, Nikolaev (2010) reports that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition (i.e., conditional conservatism). On the other hand, LaFond and Roychowdhury (2008) examine (conditional) conservatism from the shareholders’ perspective. They use U.S. firms and show that (conditional) conservatism increases in the presence of agency problems between managers and shareholders. Iyengar and Zampeli (2010) also analyze the relationship between (conditional) conservatism and the sensitivity of executive pay to accounting performance. Using a sample of U.S. firms, they find that the sensitivity of executive pay to accounting performance is higher for firms that report (conditionally) conservative accounting earnings.Furthermore, some studies provide evidence that firms share in the shareholder and creditor benefits arising from conditional conservatism. For instance, Bauwhede (2007) examines U.S. firms and finds evidence that the credit ratings of firms in industries with more conditional conservatism are significantly more favorable. Using a sample of U.S. firms, Zhang et al. (2008) also show that (conditionally) conservative borrowers are more likely to violate debt covenants following a negative price shock and that lenders offer lower interest rates to more (conditionally) conservative borrowers. Wittenberg-Moerman (2008) focuses on U.S. firms and reports that timely lossrecognition (i.e., conditional conservatism) reduces the bid–ask spread in the secondary loan market. In addition, García Lara et al. (2014) examine U.S. firms and find that increase in firm-level conditional conservatism leads to a future decrease in the bid–ask spread and in stock returns volatility.In summary, many earlier studies provide evidence that conditional conservatism improves contracting efficiency. At the same time, the economic rationality of unconditional conservatism is questioned. For example, Ball and Shivakumar (2005) argue that unconditional conservatism does not function so as to improve contracting efficiency. Although unconditional conservatism biases both earnings and equity downward, this downward bias occurs independently of any economic value reduction. Thus, unconditional conservatism does not provide fresh insight into contracting, while on the other hand, it introduces noise into decisions based on accounting information and reduces contracting efficiency. Consistent with Ball and Shivakumar (2005), Qiang (2007) shows that a higher debt equity ratio induces a lower unconditional conservatism level. In addition, Bauwhede (2007) finds that the credit ratings of firms in industries with more unconditional conservatism are significantly less favorable. Zhang et al. (2008) also show that more (unconditional) conservative borrowers are less likely to violate debt covenants following a negative price shock and that the degree of (unconditional) conservatism is positively related to interest rates4.(3)Shareholder Governance vs. Stakeholder GovernanceWhile many empirical studies focusing on U.S. firms reveal the economic rationality of conditional conservatism in contracting, they suggest that unconditional conservatism has no benefits. However, cross-national studies provide evidence that contrasts with these previous findings.Cross-national studies include Ball et al. (2000) and Giner and Rees (2001). If conditional (unconditional) conservatism homogenously improves (reduces) contracting efficiency between countries, then countries should exhibit homogeneous demand for conservatism. However, Ball et al.4However, their result for unconditional conservatism is not statistically significant.(2000) compare the degrees of (conditional) conservatism among seven countries (Australia, C anada, the UK, the U.S., France, Germany, and Japan), and show that discrepancies exist in the degree of (conditional) conservatism among countries: accounting income in shareholder governance countries (Australia, Canada, the UK, and the U.S.) recognize losses in a more timely manner than stakeholder governance countries (France, Germany, and Japan). Furthermore, Giner and Rees (2001) compare the degrees of (unconditional) conservatism among three counties (France, Germany, and the UK) and find that the degree of (unconditional) conservatism in stakeholder governance countries (France and Germany) is higher than that in shareholder governance country (the UK).These studies suggest that the economic consequences of conservatism are likely to vary across countries―corporate governance types. Under shareholder governance, a firm’s ownership is widely dispersed, and the information asymmetry between managers and shareholder/creditors increases. While managers essentially have incentives to disclose good news, they are apt to hold back bad information to maximize their own welfare. Because managers try to hide bad news as information asymmetry increase, shareholder/creditors demand conditional conservatism by firms to counteract this tendency.In contrast, under stakeholder governance, a firm’s ownership includes founder families, the bank, and employees, and is often highly concentrated. These stakeholders are also actively involved in managing the company. Thus, they can reduce information asymmetry via informal communication with managers. This decreases the demand for conditional conservatism found in the stakeholder governance model. On the other hand, the stakeholder governance model generates different demand for firms from the shareholder governance model. Under stakeholder governance, because firm’s ownership is highly concentrated on sta keholders and they develop long-term relationships with the firm, they cannot easily transfer their ownership to somebody else. Therefore, shareholders are concerned with the firm’s long-term financial viability (Ding et al. 2008; Hiroda 2012).Ding et al. (2008) and Sanders et al. (1938) suggest that (unconditional) conservatism is possible to satisfy their demand. Accounting income is related to payments such as employee compensation,executive compensation, dividends, and tax. Because unconditional conservatism biases accounting income downward, it can reduce payments related to accounting income. Therefore, unconditional conservatism overcomes doubts over firms’long-term financial viability. Biddle et al. (2012) provide evidence supporting this opinion, finding that unconditional conservatism mitigates ex ante bankruptcy risk and reduces incidence of real bankruptcy by enhancing firms’ cash holding s.(4)Role of Conservatism in JapanSome previous studies suggest that the economic rationality of conservatism can vary across corporate governance types. Using a sample of Japanese firms, I examine if unconditional conservatism and conditional conservatism have economic rationality in Japan.Japan’s financial system is centered on banks, which develop long-term and close relationships with borrowers (Hiroda 2012). Hiroda (2012) examines the relationship between the main financing bank and a firm, showing that 97.8% of Japanese firms did not switch their main financing bank during the period of 1995–2000. He also reports that 94.3% of firms did not switch during 2000–2005, and 95.1% did not switch during 2005–2010. This traditional Japanese system is known as the main bank system and is categorized as a stakeholder governance model. Main banks cannot easily transfer funds from clients to others firms because they develop a long-term relationship with the clients. They demand long-term financial viability for firms via unconditional conservatism. Usui (2004) provides evidence consistent with this viewpoint. Using a sample of Japanese firms, he finds that a higher debt equity ratio induces a higher (unconditional) conservatism level.Furthermore, main banks can share the benefits from unconditional conservatism with their borrower firms. For instance, Nakamura (2008) focuses on Japanese firms and shows that a firm’s degree of unconditional conservatism is negatively related with interest rates. Although this finding is highly suggestive, scrupulous attention is required to interpret them because I am unable to identify when the interest rates listed in the financial statements are determined. Therefore, his study cannot directly analyze whether unconditional conservatism benefits firms. I focus on proceeds from long-term loans payable in order to examine the economic consequences of unconditionalconservatism because it is an easily available form of cash flow statement that allows identification of when firms borrow money from banks. From the above discussions, I develop the first hypothesis: H1: firms with a higher degree of unconditional conservatism borrow more money from banks.As stated above, recent studies suggest that conditional conservatism improves debt contracting and benefits firms via lower debt costs under the shareholder governance model (Bauwhede 2007; Wittenberg-Moerman 2008; Zhang 2008). On the other hand, there is a high possibility that it provides little benefit to firms under the stakeholder governance model such as Japan’s main bank system. Main banks can reduce information asymmetry via informal communication with managers because they are actively involved in firm management. In addition, conditional conservatism is not likely to contribute to a firm’s long-term financial viability in the following respects. First, losses due to conditional conservatism are unlikely to be deductible because such losses are based on unrealized decreases in market value rather than realized losses from transactions (Qiang 2007). Therefore, conditional conservatism cannot reduce payments related to tax. Second, some surveys show that managers do not reduce dividends due to transitory losses as a result of such conditional conservatism (Brav et al. 2005; Hanaeda and Serita 2009). These findings suggest that conditional conservatism does not contribute to a firm’s long-term financial viability. Biddle et al. (2012) also provides evidence that conditional conservatism cannot reduce real bankruptcy rates though it does reduces ex ante bankruptcy risk. From the above discussions, I develop the second hypothesis. In addition, I focus on proceeds from long-term loans payable to compare with the consequences of unconditional conservatism and identify the relationship between conditional conservatism and debt contracting:H2: Degree of conditional conservatism is not related to firm borrowings from banks.3.Research Design(1)Unconditional Conservatism MeasurementFollowing previous studies, I use the measurement developed by Beaver and Ryan (2000) as aproxy for unconditional conservatism. They estimate the following fixed effect model: Book_to_Market i,t= αt+ αi+ Σ2j = 0βｊReturn i,t − j+ εi,t,,(1) where i indexes the firm, and t indexes the year. Book_to_Market i,t is the ratio of the book value of equity to market value of equity at the end of period t. Return i,t − j is the 12-month buy-and-hold return from the beginning of period t − j (j = 0–2). αt is the time effect while αi denotes the firm effect and captures the degree of unconditional conservatism.Because αi is the firm effect, its calculation requires a certain length of estimation period. My study uses an estimation period three years. Specifically, I estimate Eq. (1) using a sample from period t − 2 to t and obtain the unconditional conservatism measurement at the end of period t. Higher αi represents lower unconditional conservatism. I refer to αi multiplied by −1 as UCC i,t. Higher UCC i,t represents higher unconditional conservatism.(2)Conditional Conservatism MeasurementI use the measurement developed by Khan and Watts (2009) as a proxy for conditional conservatism. In contrast, many previous studies use the measurement developed by Basu (1997) as a proxy for conditional conservatism. Basu (1997) estimates the following pooling regression model:X i,t = β1 + β2D i,t + β3R i,t + β4D i,t * R i,t + εi,t,,(2) where X i,t is calculated as net income for period t divided by the market value of equity at the beginning of period t. R i,t denotes 12-month buy-and-hold returns beginning from nine months before the end of period t. D i,t denotes a dummy variable equal to 1 if R i,t < 0, and 0 otherwise. β3 captures the timeliness of gain recognition in earnings. β4 captures the incremental timeliness of loss recognition in earnings relative to the gain and degree of conditional conservatism.Although many previous studies estimate Eq. (2) to measure conditional conservatism, it is not sufficient to enable estimation of firm-year measurements. To estimate the timeliness of gain recognition in the earnings measurement and conditional conservatism measurement at the firm-year level, Khan and Watts (2009) specify that both these elements of timeliness are linear functions ofthree firm-specific characteristics (size, market to book, and leverage):G_SCORE i,t = β3 = γ1 + γ2Size i,t + γ3Market_to_Book i,t + γ4Leverage i,t,(3) C_SCORE i,t = β4 = λ1 + λ2Size i,t + λ3Market_to_Book i,t + λ4Leverage i,t,(4) where Size i,t is firm size and the natural log of market value of equity at the end of period t. Market_to_Book i,t is the ratio of the market value of equity to the book value of equity at the end of period t. Leverage i,t is the leverage and ratio of interest-bearing debt to the market value of equity at the end of period t.C_SCORE i,t is the firm-year measurement of conditional conservatism, and G_SCORE i,t is the firm-year measurement of the timeliness of gain recognition in earnings. Coefficients γ and λare constant across firms but vary over time because they are estimated each year. Thus, C_SCORE i,t and G_SCORE i,t vary across firms through a cross-sectional variation in firm-year characteristics and over time through an intertemporal variation in γand λas well as firm-year characteristics. However, Eqs. (3) and (4) are not regression models. To estimate γ and λ, I substitute Eqs. (3) and (4) into Eq. (2) to obtain Eq. (5) , which is then estimated annually:X i,t= β1+ β2D i,t+ β3R i,t(γ1+ γ2Size i,t+ γ3Market_to_Book i,t+ γ4Leverage i,t) + β4D i,t * R i,t(λ1 + λ2Size i,t+ λ3Market_to_Book i,t + λ4Leverage i,t) + (μ1Size i,t+ μ2Market_to_Book i,t+ μ3Leverage i,t + μ4D i,t * Size i,t + μ5D i,t * Market_to_Book i,t + μ6D i,t * Leverage i,t) + εi,t,, (5) Because Eq. (5) includes interaction terms between returns and firm-specific characteristics, firm-specific characteristics must be controlled for separately. Therefore, I include the terms in the last parenthesis of Eq. (5). I substitute γ and λ resulting from the estimation of Eq. (5) and firm-specific characteristics into Eq. (4) each year to obtain the firm-year measurement of conditional conservatism (C_SCORE i,t). I refer to C_SCORE i,t as CC i,t. A higher value of CC i,t represents a firm having a higher conditional conservatism.(3)Standardization of Conservatism MeasurementsI estimate the firm-year measurements of unconditional conservatism and conditionalconservatism as stated above. However, some previous studies point out that these measurements include noise (DeFond et al. 2012; Louis et al. 2012; Zhang 2008). Following these studies, I rank these measurements in ascending order and divide the obtained values by the maximum value of the ranked measurements to reduce this noise. I refer to the unconditional (constitutional) conservatism measurement obtained from this procedure as STUCC i,t (STCC i,t). STUCC i,t (STCC i,t) takes a value between 0 and 1, and the higher value represents higher unconditional (conditional) conservatism. Table1 presents an example of this procedure.(4)Empirical ModelI analyze if unconditional conservatism and conditional conservatism are useful for firms trying to get loans from banks. It is very important for this analysis that the condition where firms intend to collect money with debt is identified. Unless firms achieve the intended aim by conservative accounting, it is not necessarily appropriate to suggest that an accounting system, such as conservatism, provides benefits to firms.Theories explaining corporate financing activity include tradeoff theory and pecking order theory. Some previous studies show that the pecking order model explains considerably more about corporate financing activity than the tradeoff model (Sakai 2009; Shyam-Sunder and Myers 1999). Following these findings, I identify the condition where firms intend to collect money with debt on the basis of pecking order theory. Pecking order theory is modeled as follows:DEBT i,t= α1+ β1GAP i,t+ εi,t= α1+ β1{(DIV i,t + X i,t + ⊿W i,t− C i,t) ÷ A i,t − 1} + εi,t,(6) where DEBT i,t is proceeds from long-term debt and calculated as proceeds from bond issue plus proceeds from long-term loans payable for period t divided by total assets at the end of period t − 15. GAP i,t is the funding gap and is calculated as aggregate investment (DIV i,t + X i,t + ⊿W i,t) minus 5Sakai (2009), and Shyam-Sunder and Myers (1999) incorporate only proceeds from long-term debt into the model as a dependent variable because only long-term financing activity becomes a problem in the context of traditional capital structure theory. However, short-term debt outstanding is adjusted by ⊿W i,t on the right side of Eq. (6).。
