This paper investigates whether a firm’s life cycle stage affects its reporting conservatism in the cross-section. We use two measures of reporting conservatism used in Givoly and Hayn (2000): the level of non-operating accruals and the market-to-book ratio (unconditional conservatism); and the conservatism measure suggested by Basu (1997) (conditional conservatism). Firms are classified annually into life cycle stages using procedures proposed by Dickinson (2011). We find that unconditional reporting conservatism decreases over life cycle stages, but do not find evidence that conditional reporting conservatism is associated with life cycle stages. Our findings complement Givoly and Hayn (2000) and have implications for financial statement analysis and future research on accounting conservatism.

Introduction

This paper investigates whether a firm’s life cycle stage affects its reporting conservatism in the cross-section.1 Our inquiry is motivated by and closely related to Givoly and Hayn (2000) in which they document that financial reporting in the U.S. has become more conservative in the past four decades based on four sets of empirical measures of accounting conservatism that they develop. We argue that reporting conservatism not only can vary over time as documented in Givoly and Hayn (2000) but it can also vary in the cross-section in any given year. More specifically, we examine the cross-sectional variation in reporting conservatism in this paper from a life cycle perspective, and thus complement Givoly and Hayn’s (2000) time-series evidence on reporting conservatism. The life cycle theory of firms prescribes that firms evolve through several distinct life cycle stages. Firms in different life cycle stages exhibit different financial characteristics and require different management skills, priorities and strategies. In particular, the life cycle theory prescribes that a firm should maximize revenue growth early in its life cycle stages in order to create permanent demand or cost advantages over its competitors, which implies that firms would show different cash flow patterns across their life cycle stages. For example, a firm would have negative cash flows from investing and operating activities in the introduction stage as the firm enters the market. However, as the firm reaches the growth and mature stages, the firm would have a positive cash flow from operating activities. Based on the intuition above, Dickinson (2011) develops a proxy for firm life cycle using a firm’s cash flow patterns from operating, investing and financing activities. Conservatism is a long-standing convention in financial reporting, and a multi-dimensional concept. A variety of definitions and measures of accounting conservatism have been developed. For example, Givoly and Hayn (2000) define conservatism as “a selection criterion between accounting principles that lead to the minimization of cumulative reported earnings by slower revenue recognition, faster expense recognition, lower asset valuation, and higher liability valuation.” Basu (1997), on the other hand, defines conservatism as an asymmetry in reported earnings that respond more quickly and completely to “bad news” than to “good news.” These measures of accounting conservatism can be categorized into two groups: conditional and unconditional conservatism (Beaver & Ryan, 2005). Unconditional conservatism (or news independent) means that at the initial recording of assets and liabilities, the accounting process will lead to expected unrecorded goodwill (e.g. accelerating deprecation of property, plant, and equipment above that of economic depreciation). Conditional conservatism (or news dependent) means that under negative conditions book values are written down, but under favorable conditions the book values are not written up (e.g. the use of lower of cost or market in inventory valuation). Givoly and Hayn (2000) develop four measures of accounting conservatism, and demonstrate that financial reporting in the U.S. has become more conservative in the last four decades.