We examine the effects of the two major accounting reforms of 2001 and 2007 in China on conservatism in earnings using a variety of measures to ascertain the existence of conservatism and to gauge its degree. Our results provide evidence of different levels of conservatism in financial reporting in China during the period under investigation. We suggest that conservatism has generally existed in financial reporting in China since the 1998 accounting reform. However, the effects of the two accounting reforms on conservatism in earnings vary. Specifically, the 2001 accounting reforms significantly improved conservatism in earnings whereas the 2007 reforms reduced the extent of conservatism in earnings. We also note that conservatism in earnings rebounded following the 2007–۰۹ global financial crisis. Furthermore, the 2001 accounting reforms have a greater positive impact on conservatism in earnings in regions with a lower level of legal protection for investors whereas the negative impact of the 2007 accounting reforms on conservatism in earnings is not affected by the level of legal protection for investors. These results suggest that accounting reforms that restrict managers’ abilities to conduct earnings management and improve conservatism in earnings serve as an important substitute mechanism for institutions of investor protection. Our findings provide useful insights into accounting conservatism and have important theoretical and practical implications for accounting regulators, investors, and researchers.

Introduction

The international accounting literature has seen an increasing amount of research effort devoted to examining the impact of accounting convergence on the quality of financial reporting across the world in the last decade. Some studies attempt to ascertain whether financial statement information derived under international accounting standards and information derived under local generally accepted accounting principles (GAAP) during the same time period differ. For example, Prather-Kinsey and Shelton (2005) utilized US-based companies complying with US GAAP as a benchmark to examine the financial reporting quality of South African and UK companies that adopted international accounting standards. Their results indicated that South African (UK) firms reported significantly greater (lower) absolute values of discretionary accruals than US firms. In contrast, Grossman, Smith, and Tervo (2013) showed that differences in financial statement results between International Financial Reporting Standards (IFRS) and US GAAP were not significant in a sample of firms headquartered in the European Union (EU) and listed on the New York Stock Exchange. Hellman (2011) studied Sweden’s voluntary adoption of IFRS, which allowed deviations from the official IFRS. The results demonstrated that such a soft approach gave managers discretion to conduct earnings management. Other studies have examined whether the adoption of international accounting standards affects accounting quality by comparing earnings between the pre- and post-adoption periods. For example, Zéghal, Chtourou, and Sellami (2011) reported a reduction in earnings management following the mandatory adoption of international accounting standards in France. Zeghal, Chtourou, and Fourati (2012) investigated the adoption of IFRS in 15EU countries and reported some improvement in accounting quality associated with convergence with international accounting standards. Paananen and Lin (2009) examined the characteristics of accounting information of German companies reporting under International Accounting Standards (2000–۲۰۰۲), voluntary adoption of IFRS (2003–۲۰۰۴), and mandatory adoption of IFRS (2005–۲۰۰۶). They found a decrease in accounting quality after the mandatory EU adoption in 2005. Empirical research conducted on the impact of accounting convergence in China is limited. Ball, Robin, and Wu (2000) examined quality of accounting income of Chinese companies reporting under both domestic accounting standards and international accounting standards for the period 1992–۱۹۹۸ and documented a lack of timely reporting of economic losses in accounting earnings under both financial reporting frameworks.