Accounting Conservatism and Accounting I

Academic Journal of Research in Business and Accounting
www.newscienceseries.com

vol. 3, No. 3, June, 2015, 21-30

ISSN: 2311-326x

Accounting Conservatism and Accounting Information Quality

Farrokh Barzideh 1, MohammadAli Izadpanah2, Soroush Lotfi3

Abstract

Abstract

his study aimed to examine the relationship between accounting
conservatism and accounting information quality in 120 firms
listed on Tehran Stock Exchange (TSE) during a 6-year period from
2008 to 2013. Using correlation method and multiple linear regression
technique, the results of this study showed that there is a positive
relationship between accounting conservatism and accounting

information quality. Also, research evidences showed that when the
firm size increases, accounting information quality increases too. Also,
the results of this study showed that when the firm’s auditor is from the
private sector, then accounting information quality is high compared to
other firms. There is also a negative relationship between financial
leverage with accounting information quality. The results of this study
emphasized that profitability and loss reporting have not any
relationship with accounting information quality.
Key Words: accounting conservatism, accounting information quality, private
corporate audi

1

professor, Faculty member of Allameh Tabatabai University, C.P.A, Tehran, Iran
MSc in Accounting, International Pardis University of Guilan, Izadm51@yahoo.com
3
Corresponding author: MSc in Accounting, Allameh Tabatabai University, s.lotfi921@gmail.com

2

Barzideh, Izadpanah and Lotfi

Introduction
Qualitative characteristics of accounting information have an undeniable role in promoting the
quality of financial statements information. One of the qualitative characteristics of accounting
information is accounting conservatism. According to the theoretical foundations of International
Financial Reporting Standards (IFRS), accounting conservatism is one of the characteristics that
promotes the reliability of accounting information (Corporate Audit, 2011). Therefore, it is claimed
that accounting conservatism has a vital role in providing useful information for decision-making as
well as evaluating managerial stewardship behavior. But, with compiling a common conceptual
framework of Financial Accounting Standards Board (FASB), accounting conservatism has been
eliminated from qualitative characteristics of accounting (AFAS 8, 2010). Watts (2003) considers
accounting conservatism as an important characteristic for promoting the accounting information
quality. According to him, non-conservative accounting standards allow managers to predict
commercial units of accounting figures (e.g. profits) for their own advantage in order to get more
rewards. He believes that managers sacrifice the quality of financial statements information for their
personal interests. However, accounting conservatism delays profit identification until its realization
and this promotes the quality of financial statements (Watts, 2003). On the other hand, Chen et al.
(2007) state that accounting conservatism compared to the non-conservative standards and procedures
of accounting has more negative impacts on the accounting information quality (Cheng et al., 2007).

Therefore, the main research question of this study is that to what extend accounting conservatism
affects the quality of financial statements. The increase of non-conservative standards by FASB as
well as the lack of adequate research in this context, have motivated the researchers to investigate the
effect of accounting conservatism on the quality of financial statements.
The main purpose of this study is to investigate the relationship between the quality of financial
statements and accounting conservatism. The second purpose is to inform analysts, users of
accounting information, accounting standards developers, society of CPAs and the stock exchange of
the determinants of the financial statements quality. It is expected that the results of this study can
bring the following achievements and scientific added value.
First of all, it is expected that the results of this study expand the theoretical foundations of studies in
the context of accounting conservatism. Second, the results will show that whether accounting
conservatism and the quality of financial statements are two different subjects in analyzing the
information of financial statements of firms listed on the stock exchange. This, as a scientific
achievement, can provide useful information for financial analysts and users of the financial
statements as well as students and professors of accounting. Third, the results of this study can propose
new ideas for new investigations in the field of accounting conservatism and the accounting
information quality.

Theoretical Framework and Review of Literature
Definition of conservatism

Conservatism defines accounting in a way that it needs to have a high degree of approval for the
recognition of good news, such as profits, in the face of bad news, such as losses. This definition
defines conservatism from the viewpoint of profit and loss. However, another definition is the
definition of accounting conservatism from the viewpoint of balance sheet. According to this
viewpoint, in cases where there is doubt in choosing between two or more methods of reporting, the
method that has the least favorable effect on shareholders’ equity should be chosen. The third
definition of conservatism is based on the combined view of balanced sheet and profit and loss. In this
viewpoint, conservatism is an accounting concept that leads to decrease of retained earnings reported
by later recognition of income and faster recognition of the cost, lower assessment of assets and higher
evaluation of debts. In this study, the third definition has been used to calculate conservatism index.
Another category has been presented for the definition of accounting conservatism that consists of
conditional and unconditional conservatism. Conditional conservatism is a kind of conservatism that

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Vol. 3, No. 3, June, 2015
has been required by accounting standards. This means immediate recognition of loss if there are bad

news and lack of recognition in situations where there are good news. For example, the use of least
cost or net sales in evaluating the inventory is considered as a type of conventional conservatism. This
type of conservatism is also called profit and loss conservatism or retrospective conservatism. On the
other hand, unconditional conservatism has not been required by adopted accounting standards. This
type of conservatism is also known as balance sheet conservatism or prospective conservatism
(Banimahd & Baghbani, 2009).

Conventional Interpretation of Accounting Conservatism
Some researchers have filed different interpretations for conservative reporting. All of them have
proposed that conservatism has some advantages for the users of financial statements. Until the
moment that accounting indexes and standards are used for reporting the performance of management,
the problems arising from the opportunistic behavior of managers would be always in financial
reporting. In order to increase personal profits, managers would act self-centered in using accounting
standards that are the basis of information for investors and share accounting information according to
their personal interests. If the limitations that limit this selfish behavior are not available, then
accounting information in financial reports would be biased. But, conservatism by requiring the ability
to demonstrate and confirm the self, can limit opportunistic and biased behavior of managers. In
practice, conservatism neutralizes the biased behavior of managers and delays profit recognition; as a
result, net assets and profits are shown lower. In the contracts, aforementioned effects increase the
value of the firm; since, conservatism limits opportunistic payments of managers to themselves and

other groups such as shareholders. The increased value of the firm divides among all contracting
groups and their welfare increases. In this sense, conservatism is an effective contractual mechanism
(Watts, 2003).

Review of Literature
Dimitropoulis et al. (2013) examined the effect of using international standards of financial reporting
on the accounting information quality in firms listed on the Athens Stock Exchange. They indicated
that using these accounting standards increases the accounting information quality in terms of early
recognition of loss, reduction of earnings management and increase in information content of
accounting figures (Dimitropoulos et al., 2013). Tan (2013) showed that whenever financial reports
are used by lenders or lenders give loans to bankrupted firms and appoint people to firm restructuring
after bankruptcy, then, accounting conservatism increases. The results of his study state that whenever
firm’s financing is through debt, then, the demand for conservative financial reporting increases (Tan,
2013). Lin et al. (2012) studied the accounting information quality among German firms both before
and after implementation of international financial reporting standards. They found that after
implementation of the above mentioned standards, the accounting information quality has been
increased in terms of early recognition of loss, earnings management reduction and relevant
information compared to past (Lin et al., 2012).
Hamdan (2012) conducted several studies in Bahrain and showed that large firms have more
accounting conservatism than smaller firms. He found that there is no significant relationship between

accounting conservatism and the quality of profit among Bahraini firms. Also, those firms which have
more debt, have more conservatism compared to others (Hamdan et al., 2012). Ruch and Taylor
(2011) examined the conducted studies in the field of accounting conservatism and encountered
different data about the benefits of accounting conservatism for promoting the quality of financial
statements. Among them, we can refer to this point that accounting conservatism leads to the
management of profit and this is achieved through creating accounting reserves such as saving
doubtful receivables. On the other hand, they concluded that conservatism leads to the reduction of
information asymmetry and improving the transparency of financial statements information.
According to the results of their study, accounting conservatism can be used as an efficient
conventional mechanism in order to prevent conflicts of interest between managers and shareholders
as well as shareholders and creditors (Ruch & Taylor, 2011). Kravet (2012) showed that accounting
conservatism decreases managers’ incentive for risky investments. He found that those managers who
implement higher accounting conservatism, have less risky investments (Kravet, 2012). Iatridis (2011)

Barzideh, Izadpanah and Lotfi

examined accounting disclosure, accounting quality and conditional/unconditional conservatism. His
findings indicate that those firms which have higher disclosure quality, have higher profitability and
liquidity as well. Those firms which had change in management or have been supervised by one of the
four biggest accounting institutes, tend to have a higher disclosure quality. Higher disclosure quality

leads to less profit management. Also, these firms show higher conventional conservatism and lower
unconditional conservatism. His findings indicate that conditional conservatism has a negative
relationship with unconditional conservatism, in a way that conditional conservatism tends to increase
efficiency while unconditional conservatism may facilitate opportunistic behavior of managers.
Studies by Iatridis also provide some evidence about asymmetry disclosure of loss in firms with high
financial leverage (Iatridis, 2011). Lee (2010) examined the role of accounting conservatism in firms’
financial decisions. He indicated that firms with higher accounting conservatism, show less flexibility
in leverage management and decisions related to issuance shares. Generally, the results of his study
indicate that although firms benefit from the reduction of related costs through using conservative
financial reporting, their flexibility decreases relating to access to capital and this is effective in
financial decisions (Lee, 2010). Chi et al. (2009) examined the relationship between conservatism and
governance. The results of their study indicate that firms with weak governance tend to be more
conservative. These results are consistent with the view that conservatism can be used as an effective
mechanism in governance (Chi et al., 2009).
Chi and Wang (2008) examined the effect of accounting conservatism on information asymmetry
among minority and majority shareholders. They concluded that conservatism leads to the reduction of
information asymmetry and if conservatism is removed from the qualitative characteristics of
accounting information, shareholders should closely monitor the information asymmetry (Chi &
Wang, 2008). LaFond and Watts (2007) examined the informative role of conservatism. They argued
that information asymmetry between factors within the firm and investors from outside the firm lead

to conservatism in financial statements. Their experimental tests are based on this idea that
conservatism, decreases incentives and capabilities of managers in manipulating accounting figures;
therefore, it can decrease information asymmetry. Their findings are inconsistent with IFRS, based on
this view that conservatism leads to information asymmetry. They believe that if conservatism is
removed from the qualitative characteristics of accounting information, information asymmetry
increases that this is in contradiction with the rules of the stock exchange.
Mashayekhi et al. (2009) in order to measure conservatism, first of all, implemented (symmetrical)
non-operational accruals; then, implemented adjusted ratio of market net assets to their book value and
concluded that with any increase in conservatism, less dividend is distributed. Therefore, conservatism
leads to effectiveness of contracts between interest groups in the business units. Also, using adjusted
ratio standard of net market value of net assets to book value to measure conservatism, they found that
the sustainability of profits decreases by increasing conservatism. Khajavi and Kermani (2010)
examined the effect of conservatism on the stability of firms’ profit listed on the TSE. According to
the results of their study, firms with less conservatism would have more stable profits. It means that
there is a negative relationship between conservatism and the stability of profits. Lotfi and Hajipour
(2010) in a study entitled “the impact of conservatism on management error in anticipation of profit”
found that there is a negative relationship between firms’ conservatism and their profit anticipation
error. In other words, whenever the firm is more conservative, its profit has less tendency toward
optimism. Khoshtinat and Yousefi (2007) examined the relationship between information
symmetry/asymmetry and conservatism. The results of their study indicated that information

asymmetry among aware and unaware investors leads to conservatism changes but conservatism does
not lead to information asymmetry. Kordestani and Haddadi (2009) showed that there is a negative
relationship between capital cost based on firms’ portfolio and conservatism based on profit time
asymmetry. Also, there is a positive and significant relationship between the capital cost and
conservatism based on the ratio of market value to book value of stock. They argued that the reason
for different reactions of capital cost to two conservatism standards is caused by differences in the
structure of these two criteria. Etemadi and Farajzadeh (2012) examined the effect of profit
management and capital structure on profit conservatism. These researchers argue that profit
management, regardless of its increase or decrease, affects profit conservatism and increases
conservatism. Those firms which implement profit decline management, report more conservative

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Vol. 3, No. 3, June, 2015
profit that indicate high conservatism. Firms which resort to increasing profit management through
positive accruals, implement less conservatism in their reporting. Capital structure affects the size of
conservatism. Those firms which used more equity, have implemented more conservatism in

measuring profit. Mehrabani et al. (2011) studied the relationship between conservatism and
unexpected accruals in TSE as the main research question. Since the breakdown of accruals to
unexpected accruals and expected accruals can affect the results of study, they used two models of
adjusted Jones and adjusted Jones with non-linear flows. Their findings show that unexpected accruals
resulted from adjusted Jones model have positive and significant relationship with conservatism. On
the other hand, they did not find any positive and significant relationship between the effects of
unexpected accruals resulted from adjusted Jones model and non-linear flows on conservatism.
Karami et al. (2010) examined the relationship between firm’s governance mechanism and
conservatism. According to the results of this study, they concluded that there is a positive relationship
between the ownership percent of board members and institutional investment with conservatism.
Also, they argued that there was a negative relationship between the ratio of outside members of the
board and conservatism.
Moradzadehfar et al. (2011) examined the relationship between conservatism and firm’s governance.
According to the results of this study, they found that there is a positive relationship between the
institutional ownership percentage of shares and members outside the board. Also, there is a negative
relationship between role separation of Chairman of the board from managing director and
conservatism. The general conclusion of their study approves the complementary view about the
relationship between conservatism and firm’s governance mechanisms. Khodamipour and TorkZade
Mahani (2010) indicated that those firms which their CFO is larger than their taxable income, have
more conservatism compared to other firms, but in the case of firms that their CFO is smaller than
their taxable income, it is not possible to argue that they have less conservatism compared to other
firms. Moreover, the findings of this study indicate that taxes not only does not decrease the relevance
of accounting information firms provide, but increase the relevancy of information. According to a
study by Asadi and Jalalian (2012), the relationships between ownership concentrations, the
percentage of institutional investors, financial leverage and firm size with conservatism are different.
These relationships are with respect to conservatism analysis model. According to the model by Bior
and Ryan as well as Givoly and Hayn, there is a significant and direct relationship between
conservatism and leverage as a representative of capital structure. On the other hand, no significant
relationship was found between conservatism and ownership concentrations. In Bior and Ryan’s
model, there was no significant relationship between institutional investors and conservatism, but in
Givoly and Hayn’s model, a significant and inverse relationship was found. Ebrahimi, Kordlor and
Shahriari (2009) examined the relationship between political costs and conservatism. According to the
results of this study, they concluded that there is a negative relationship between the firm size and
investment intensity with conservatism. Also, a positive relationship was found between the degree of
competition in industry and state ownership with conservatism. Rezazadeh and Azad (2008) in a study
entitled “the relationship between symmetry and conservatism” found that change in information
asymmetry among investors leads to change in conservatism. Following the increase in information
asymmetry among investors, the demand for implementation of conservatism increases. Kordestani
and Khalili (2011) indicated that differential information content of cash flows and accruals are less in
firms with higher conservatism which is compared to firms with lower conservatism. Also, there is a
positive consistency between differential information content and accruals with firms’ conservatism.

Sample population and methodology
The sample population of this study consists of firms listed on TSE. This sample consists of firms that
benefit from the following conditions:
1. Firms that have been listed prior to 2007.
2. Due to consistency, reporting data and removing seasonal effects of the financial period should be
until March 20.
3. Due to the specific activities of investment and financial firms, the intended firm should not be
among these firms.
4. The intended firm should have consistent activity during the study period.

Barzideh, Izadpanah and Lotfi

According to the above mentioned conditions, only 120 firms (including 720 observations) had these
conditions during 2007-2012. Therefore, these firms were considered as the sample population of this
study.
The theoretical foundations are extracted from books, articles and theses. The data are collected from
the financial statements of firms that are listed on TSE. Due to this fact that this study uses the sources
and financial statements of firms listed on TSE, it is considered as library research that the observed
financial statements and intended information are obtained. Also, in terms of research questions and
data collection, it is considered as a correlational descriptive study that the relationship between
variables is examined and the data are quantitative.

Variables
Independent variable
The independent variable in this study is accruals quality index. According to Francis et al. (2005),
this index is as follows:
TCAj,t = α 0 +α1 CFO j,t-1 +α 2 CFO j,t+α 3 CFO j,t+1 + α 4 ∆REVj,t+α 5 PPE j, + ε

TCA: total capital accruals in circulation
CFO: cash flow from operating activities that is obtained from cash flow statements
∆REV: changes in sales revenue
PPE: properties, plant and equipment

ε: the remainder of regression
All variables have been divided by average total assets. The theoretical justifications of the above
model are based on this fact that accruals must explain CFO of previous, present and next periods. The
residual values (εi) from regression accruals represent profit management or profit quality. The lower
the SD of (εi) is, the higher the quality of accruals of accounting quality and vice versa. Therefore, the
SD is multiplied by -1. Accordingly, the SD of the (εi) has been considered as the independent variable
in this study during last four years (Francis et al., 2005).

Dependent variables
Accounting conservatism: in order to measure accounting conservatism index in this study, the model
by Givoly and Hayn (2000) was used. Based on this model, the conservatism index is calculated as
follows:
Accounting conservatism = [operational accruals/total assets in the first period]*(-1)
The operational accruals are obtained from the difference between net income and CFO plus
amortization expense. According to Givoly and Hayn (2000), accruals growth can be an index of
change in accounting conservatism during a long-term period. In other words, if accruals increase,
then conservatism decreases and vice versa. Therefore, in order to determine the change direction of
conservatism, accruals are multiplies by -1.
In this study, after calculating the conservatism index, the average of this index during last four years
has been used. The reason for selecting the above model for measuring accounting conservatism is as
follows:
a) The available models for measuring conservatism such as Basu model that has been used widely,
have high degree of errors. For example, Basu model assumes that whenever the stock returns are
negative, the reason relates to accounting conservatism, while in Iran capital market, negative stock
returns are due to non-accounting information.
b) The information used in this study is based on accounting information and market indexes are not
used in it. Due to the availability and access to financial statements, in order to measure conservatism
in financial statements, this model is more appropriate compared to other models in developing
markets (Banimohammad & Baghbani, 2009).
Firm size: consists of the natural logarithm of each firm’s total assets in each year.
Return on assets: consists of the ratio of total debt to total assets of each firm in each year.
Loss report: is an artificial variable that is shown by 1 and 0. If a firm reports loss in a year, then its
value is 1; otherwise, it is 0.
The type of auditor: an artificial variable is shown by 1 and 0. If the auditor of a firm is Corporate
Audit, then its value is 1; otherwise, it is 0.
Among the above mentioned variables, accounting conservatism index is the main variable and other
variables are the control variables.

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Research Hypothesis
The research hypothesis of this study is as follows:
H1: There is a significant relationship between accounting conservatism and the quality of financial
statements information.

Results:
Descriptive data
The descriptive data of this study are mentioned in Table (1). In this table, the average of quantitative
variables is shown:
Table 1: Descriptive data
leverage

Assets
returns

Total assets

720

720

720

Accounting
conservatis
m index
720

Accruals
quality
index
720

description

Number

of

observations
0/6640

0/13937

2998078/14

- 0/0378

- 0/0587

average

0/6545

0/1127

460611

-0/02185

-0/0436

median

0/3503

0/01752

30635892/54

0/01315

0/00986

SD

0/0619

0/3274

17636

-0/07853

- 0/645

minimum

5/905

2/79

803067528

0/5186

- 0/0029

maximum

The nearness of median and mean values indicates the normality of variables. Also, 41 observations
were related to losing firms and 186 observations had state auditor (Corporate Audit).
Table 2: the number of firms in terms of profit and loss report
total
2013

2012

Year
2011

2010

2009

Report type

679

104

108

117

`118

116

41

19

12

3

2

3

720

123

120

120

120

119

2008
116

profit

2

loss

118

Total

Table 3: the number of firms in terms of audit
total
534
186
720

2013
97
26
123

2012
92
28
120

Year
2011
90
30
120

auditor
2010
90
30
120

2009
85
34
119

2008
85
33
118

Private
sector
public
sector
total

Hypothesis Testing
The results of hypothesis testing are presented in Table (4). According to this table, we can argue that
accounting conservatism has a direct relationship with the quality of financial statements at the 95%
confidence level. Among the control variables, the auditor type, firm size and leverage ratio to the
accounting information quality have a significant relationship at the 95% confidence level. The firm
size has a direct relationship with the quality of accruals. It means that whenever the size of firm is
increased, the quality of accruals increases too. On the other hand, the leverage ratio and auditor type

Barzideh, Izadpanah and Lotfi

have a negative relationship with the quality of accruals. Whenever the debt ratio increases, the quality
of accruals decreases. Also, whenever the auditor is the Corporate Audit, then the quality of accruals
decreases. Other independent variables such as loss reports and profitability do not have any
significant relationship with the accounting information quality. Also, adjusted regression coefficient
of determination (R2) that shows a ratio of explained variance to the total variance, equals to 6/9%
which is according to Table (3). This states that 6/9% of dependent variable changes are according to
the changes of dependent and control variables and the rest is due to the factors that have not been
examined in this research. The Durbin-Watson statistics equals to 1/783. These statistics show that
there is not any consistency among residual values of regression. Also, since the value of variance
inflation factor (VIF) is less than 5, there is not any intense consistency among independent variables.

Significance
level

t-statistics

coefficients

Description

-

0/001

- 3/355

- 0//095

Constant value

1/283

0/041

2/043

0/038

Accounting
conservatism

1/284

0/026

2/231

0/004

Firm size

1/360

0/123

- 1/544

- 0/022

Returns on assets

1/130

0/027

- 2/221

- 0/015

Leverage ratio

1/335

0/198

1/289

0/014

Loss reporting

1/317

0/033

- 2/142

- 0/012

Auditor type

6/9%

Adjusted R2

3/993

f-statistics

1/783

Durbin-Watson

0/000

Has been included

Control variables

VIF

Main
variable

Table 4: hypothesis testing

The effects of year
and industry

Analysis of Findings and Conclusion
The results of this study indicate that accounting conservatism has a direct relationship with the
quality of financial statements information. In other words, with any increase in accounting
conservatism, the quality of accruals increases too. This is consistent with the results of studies by
Watts (2003), Chi and Wang (2008) and Ruch and Taylor (2011). They claim that accounting
conservatism, as qualitative characteristics of information, can increase the accounting information
quality. Among the control variables, the firm size has a direct relationship with the quality of
accruals. It means that the whenever the size of firm is increased, the quality of accruals increases too.
On the other hand, the leverage ratio and auditor type have a negative relationship with the quality of
accruals. Whenever the debt ratio increases, the quality of accruals decreases. Also, whenever the
auditor is the Corporate Audit, then the quality of accruals decreases. This states that privatization of

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Academic Journal of Research in Business and Accounting
Vol. 3, No. 3, June, 2015
the audit profession and its competitiveness can enhance the accounting information quality. Also, the
results indicate that there is not any relationship between assets returns and loss report with the quality
of accruals.

Recommendations
In hypothesis testing, it was shown that there is a significant and direct relationship between
accounting conservatism and the quality of accruals. Therefore, it is recommended to developers of
accounting standards and society of certified public accountants to pay more attention to the
procedures of accounting conservatism and as far as accounting conservation will not distort the
accounting figures, develop the standards of conservative accounting and implement them in a
cautious way. Also, the following recommendations are presented for conducting future studies:
a. Determining the efficient level of accounting conservatism in financial statements in order to
access to beneficial information
b. Comparative comparison of the effect of conditional and unconditional conservatism on the
quality of financial statements
c. Identifying factors affecting the accounting information quality, except the quality of accruals
from the theoretical perspective
d. Classification of private institutes and the quality

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