Conservatism Determinants Hypothesis Development

2398 its expected litigation costs. The third possible explanation is taxation; in profitable firms, conservatism reduces the present value of taxes, thus increasing the value of the firm. The fourth possible explanation of conservatism in financial reporting is standard setters‘ and regulators‘ incentives. Both standard setters and regulators are exposed to asymmetric loss functions because they would be more criticized if they adopt accounting standards that favor overstatement of net assets instead of understatement of net assets. Finally, the fifth reason for conservatism in financial accounting is theoretically introduced and empirically tested recently by La Fond and Watts 2007. T hey argue that conditional conservatism may serve as a corporate governance mechanism to reduce the information asymmetry among the various parties managers, shareholders, investors, stakeholders in general involved in firms‘ contracts, litigation, taxation, and regulation processes. Much of the information asymmetry arises from the firm‘s investment opportunity sets, but it also occurs because of the way the firm‘s management, more informed about events and investment opportunities, formally collects and reports information to 2399 stakeholders. The two common denominator factors in the economic explanation of accounting conditional conservatism are the asymmetry of both the loss functions and information sets that characterize the different categories of stakeholders. 2.3. Positives and Negatives View of Conservatism Positives view of conservatism. Theory and evidence suggests several informational benefits of conservatism, such as reducing benefits of earnings management Chen et al., 2007, improving information quality Fan and Zhang, 2008, and signaling managerial private information Bagnoli and Watts, 2003. The unifying underlying theme of these studies is that conservatism improves information quality and thus should reduce information asymmetry betwee n informed and uninformed investors. La Fond and Watts 2008 and Khan and Watts 2007 examine the associations between conservatism and firm liquidity levels and provide some evidence consistent with the idea that decreases in firm liquidity are followed by increases in firm conservatism. 2400 Negatives view of conservatism. Several studies show the association of higher conservatism levels with lower earnings persistence. It implicate that if conservatism reflects contemporaneous bad news more fully, then t he likelihood of future bad news is lower. Basu 1997 shows that bad news of earnings surprises are less persistent than good news earnings surprises. Roychowdhury and Frankel 2007 show that greater conservatism levels are associated with less persistent special items. Per se, lower persistence of earnings of more conservative firms does not suggest that conservatism negatively affects stock holders because observed lower earnings persistence could be due to more complete revelation of bad news. Paek et al. 2007 show that firms with more conservative reported earnings have lower earnings multiples because conservatism reduces earnings persistence. Their result suggests that conservatism introduces noise in the earnings process and thus makes earnings less value-relevant. However, the implications of this result for usefulness of conservatism are not necessarily clear. More persistent earnings are associated with lower uncertainty about firms‘ future performance, and make it easier for 2401 investors to correctly estimate earnings multiples. At the same time, given well documented results that bad news in general is less persistent, lower earnings multiples are expected for bad news firms. The latter implication suggests that conservatism does not necessarily hurt users of financial information. Hui and Matsunaga 2004 show that more conservative firms issue less management earnings forecasts. One possible consequence of this result is that overall level of firm disclosure of more conservative firms is lower, t hus possibly hurting uninformed shareholders. However, this prediction need not hold true. Recent studies in disclosure literature point out that greater levels of firms‘ voluntary disclosure have a limited positive effect on firms‘ cost of capital Francis et al., 2007, and liquidity Pevzner, 2007. Kim and Pevzner 2008 address a question of whether accounting conservatism is beneficial to the stock market. They examine 1 whether conservatism is associated with lower likelihood of future bad news, a nd 2 whether the stock market reaction to firms‘ earnings surprises varies with firms‘ conservatism levels. The result: First, we show that higher current conservatism 2402 today is associated with lower probability of future bad news. Second, find evidence that the stock market reacts stronger weaker to good bad earnings news of more conservative firms. Thus, this study provides additional evidence that conservatism affects stock prices. The hypothesis is as follows: Hypothesis 1: Higher conservatism levels are associated with lower likelihood of future bad news. 3. Research Design 3.1. Sample Selection We restrict our sample to all non financial firm that listing in Singapore and Pakistan stock exchange with December fiscal year ends over the 2005 -2007 time period, and the data available on OSIRIS database.

3.2. Tests of the Hypothesis

The empirical model of the likelihood of future earnings and dividend decreases, is the following regression model: 1 Earn Decrt+1= β0+ β1CONSt+ β2 ROAt + β3 EARNt + β4 MVEt +et 2 Div Decrt+1= β0+ β1CONSt+ β2 ROAt + β3 EARNt + β4 MVEt +et 2403 Where: Earn Decrt+1 : a dummy variable equal 1 if a firm experienced a reduction in earnings before extraordinary items in year t+1 as compared to year t. Div Decrt+1 : a dummy variable equal 1 if a firm experienced a reduction in dividends per share in year t+1 as compared to year t. CONSt: conservatism that measure according to Ball and Sivakumar 2005 Kim and Pevzner 2008: coefficient βγ from the following regression, multiplied by -1. OIt = αt + β1 D+ ββ OIt-1 + βγ DOIt-1 +et Where: OIt is change in operating income in year t deflated by beginning market value of equity. OIt-1 is change in operating income in year t-1 deflated by