Abstract

We examine the correlation between bank loan approval standards and accounting conservatism. Using the bank loan approval index in the People’s Bank of China as measure of loan standard, we show that accounting conservatism improves when bank loan approval standards are tightened. We then conduct further tests to address the endogeneity and robustness, yielding highly consistent results. Finally, both ownership and the banking connection significantly moderate the relationship between bank loan approval standards and accounting conservatism. Our findings provide policy implications on controlling loan approval standards, which may effectively reduce credit risks and promote accounting conservatism.

Introduction

Credit risk uncertainty for banks has increased since the global financial crisis in 2008 and the 2019 outbreak of the Coronavirus disease 2019 (COVID-19) pandemic. This heightened credit risk uncertainty has led commercial banks to focus more on loan issuance, increasing difficulties for enterprises to secure financing (Goodell, 2020). From the perspective of commercial banks, enterprise solvency is a crucial factor in determining whether to lend, reflected in the disclosure of accounting information. Accounting conservatism, an important indicator of accounting information quality, is often considered to reduce credit risks for commercial banks when approving loans. From the perspective of enterprises, bank loan approval standards indicate the availability of loans and determine the loan interest rate and amount, which directly affect the financing costs of enterprises. Therefore, exploring the influence of bank loan approval standards on enterprises’ accounting conservatism can reduce information asymmetry between commercial banks and enterprises, decrease credit risk for commercial banks, and help high-quality enterprises obtain more credit support.

This study examines the relationship between bank loan approval standards and corporate accounting conservatism to fill the research gap. Previous studies mainly examine the measurement method of accounting conservatism (Basu, 1997), the causes (Watts, 2003), the determinant factors (Shaw et al., 2021), and the economic consequences (Bonetti et al., 2017). Among them, the earnings-stock return measurement method proposed by Basu (1997) is the most widely used, and its measurement results are more accurate than other measurement methods. Other scholars have also adopted the accrual and NI models based on the accrual basis proposed by Ball and Shivakumar (2005). Watts (2003) found that most extant studies focus on contractual relationships, shareholder litigation, accounting control, and government tax, among which debt contract is the most concentrated research.

Conclusions

This paper presents an empirical analysis of the impact of bank loan approval standards on firms’ accounting conservatism. The research findings reveal the following insights.

1. Bank loan approval standards can affect firms’ accounting conservatism, and these two variables have a significant negative correlation. As bank loan approval standards increase in stringency, commercial banks exhibit a declining willingness to lend, consequently reducing the success rate of enterprise loan approvals. To obtain the required loans, enterprises must enhance the quality of accounting information and improve accounting conservatism.

2. State-owned enterprises demonstrate a higher level of accounting conservatism. State-owned enterprises possess unique characteristics and relatively strong creditworthiness, resulting in lower credit risks for banks than non-state-owned enterprises. Given their social responsibilities, capital requirements, and the desire to maintain favorable access to bank loans, state-owned enterprises proactively adopt more robust financial reporting methods to ensure higher-quality accounting information.

3. The background of senior executives in the banking sector can influence the integrity of corporate accounting practices to a certain extent. When corporate executives possess banking experience, their inclination toward accounting conservatism tends to be weaker than executives from other industries. Executives with banking experience foster higher trust between banks and enterprises, leading to relaxed lending requirements and expanded loan availability. As a result, accounting conservatism decreases in these circumstances.

Capital controls as restrictions on capital flows are a tool proposed as a cure to the destabilizing market movements of the 1970s (i.e., Tobin, 1978) despite the criticism that they have received (Edwards, 1999). Capital controls resurfaced during the European Financial Crisis and the restrictions imposed on capital flows in Cyprus and Greece. These were the first instances of capital control implementation in the European Union’s history and had various effects on firms’ financial positions. By using a sample of EU countries and distinguishing between austerity and capital controls periods, we assess the effects of capital controls on the stock liquidity of firms. All of the sample countries have a common financial reporting framework (International Financial Reporting Standards -IFRS), and some of them implemented a range of different measures from less intensive, such as increases in tax rates, to more intensive, such as the enforcement of capital controls, in their effort to stabilize their economies. For the task at hand, we specifically engage two accounting determinants of information asymmetry, namely, conditional conservatism and the level of earnings management. Our results show that financial reporting quality as measured by higher conditional conservatism and lower earnings management is beneficial for liquidity. However, during the capital controls period, the relation between conditional conservatism and liquidity becomes negative, and this negative relation relates to less risky firms. Thus, the negative relation between conditional conservatism and liquidity is likely due to investors keeping more conservative firms in their portfolios as a measure against the crisis.

Introduction

The European Financial Crisis, which started as a debt crisis and continued as a generalized financial crisis, had a significantly more adverse impact on a number of South-European countries in relation to the rest of the Eurozone countries. The inability of these countries to borrow money through the markets due to escalating interest rates led to a number of measures that were targeted at limiting the negative effects of the crisis. These measures ranged from increases in tax rates or decreases in wages and pensions to restrictions of capital flows (Cyprus in 2013 and Greece in 2015). These circumstances were the first in which an extreme measure such as capital controls was used in the European Union, which certainly had an impact on the capital flows of the firms domiciled in the affected countries. The present study attempts to examine how such regulations on capital flows may help an economy to break free from the crisis downward spiral. To this extent, we emphasize the usefulness of financial reporting quality as a protecting mechanism against the crisis and underline the presence of the “flight to quality” phenomenon. Capital controls were devised as a measure of fiscal policy to limit market turbulence. For example, Tobin (1978) proposed the use of an international uniform tax on foreign exchange transactions (Edwards, 1999). These measures were particularly common until the 70s (Johnson and Mitton, 2003). However, due to the continuous effort by institutions such as the IMF for more liberalized emerging markets, the use of capital controls was reduced until the Asian Crisis (Bhagwati, 1998). Therefore, despite the controversy around the usefulness of capital controls (Edwards, 1999), there is a tendency of using these measures as a final solution during a financial crisis from a macroeconomic perspective (Krugman, 1998). For example, during the Asian Crisis, Malaysia used capital controls as a measure of reducing the effects of the crisis (Johnson and Mitton, 2003). Moreover, in the European Union, the financial crisis that affected the countries of the South and in particular, Cyprus and Greece, also led to the implementation of capital control measures to limit the drain of their banking systems.

This paper analyzes the roles of controlling shareholders as either minority shareholder entrenchers or monitors in the relationship between conservative accounting practices and cash holding value. This issue is especially meaningful in countries such as Taiwan that have large numbers of firms with concentrated shareholdings. Consistent with the findings of Louis et al. (2012), our results indicate that accounting conservatism enhanced the value of cash holdings. In addition, our findings support both hypotheses H2a and H2b depending on the proportion of control-affiliated directors, agency problems, and financial crises. In general, the incentive effect of controlling shareholders, H2b, is supported at a relatively low proportion of control-affiliated directors, whereas the entrenchment effect of controlling shareholders, H2a, is confirmed at a relatively high proportion of control-affiliated directors. Moreover, the entrenchment effect is aggravated when a firm suffers a serious agency problem during a period of financial crisis. This study contributes to the current literature on the influence of accounting conservatism on cash value in the presence or absence of controlling shareholders.

Introduction

This study attempts to clarify the role of controlling shareholders either as an entrenchment of minority shareholders or as a monitor of the relationship between accounting conservatism and the value of a firm’s cash holdings. For reasons related to either higher levels of cash flow volatility or high external financing costs, a growing number of firms are adopting a precautionary approach to cash holdings management (Bernstein, 1994). According to Bates, Kahle, and Stulz (2009), US firms that hold large amounts of cash are increasingly unlikely to invest in projects or distribute them to shareholders, but the greater potential for abuses on the part of CEOs raises questions about the practice of enhancing cash value by holding large amounts of cash. Louis et al. (2012) propose accounting conservatism as a separate and potentially influential factor resulting in increased cash value. According to conservative accounting principles, firms tend to recognize their losses in a timely manner while deferring gains until revenues are verified. This practice, which is known as asymmetric timing, has a conservative effect on earnings. Accounting conservatism in the form of timely loss/delayed gain recognition is one method of mitigating agency problems (Watts, 2003). The practice has the potential effect of preventing managers from hiding losses and evading responsibility by manipulating financial data. As a result, conservative accounting practices are viewed as both helping resolve agency problems and increasing firm value by decreasing the potential for lower cash value tied to overinvestment decisions (Louis et al., 2012).

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.

Since the occurrence of the Enron scandal, the U.S. passed the Sarbanes-Oxley Act in 2002 in order to restore confidence in the capital market. The Act imposes new regulations on auditor independence in order to ensure and improve audit quality in response to the offering of the extensive non-audit services by Arthur Andersen to Enron. In 2001, Arthur Andersen charged Enron US$25 million for auditing services and $27 million for non-audit services. The U.S. juridical authorities believe that the offering of non-audit services hampers the independence of auditors. Therefore, the Sarbanes-Oxley Act specifies the scope of non-audit services to clients by auditors, and stipulates the annual disclosure of audit fees and non-audit service fees. Opinions are divided regarding the restrictions that the Sarbanes-Oxley Act place on non-audit fees. Proponents indicate that, if the percentage of non-audit service fees is too high, auditors are likely to yield to clients regarding the loss of concentrated incomes, thus, losing their independence; while opponents argue that the demand for non-audit services naturally increase with the diversified developments of the corporate world. Meanwhile, nonaudit services may cause clients to become even more dependent on auditors; hence, the independence of auditors is augmented. In fact, non-audit services enhance the auditors’ understanding of clients, and their ability to identify issues, which improves audit quality without compromising the independence of auditors. Literature suggests that increased non-audit service offerings enhance the economic dependence of auditors regarding specific clients, while challenging the independence of auditors (Simunic, 1984). However, concern over reputation and litigation costs is a gating factor to the integrity of auditors’ independence (Davis & Simon, 1992). In sum, whether the delivery of non-audit services by auditors affects audit quality is a contentious issue. Empirically, Frankel, Johnson, and Nelson (2002) referred to earnings management as an indicator, and found that increased percentages of nonaudit fees, as well as a rise in the absolute amount of non-audit fees, have negative effects on audit quality. However, Ashbaugh, LaFond, and Mayhew (2003), Chung and Kallapur (2003), Larcker and Richardson (2004), and Ruddock, Taylor and Taylor (2006) did not suggest that the existence of non-audit services affect audit quality and earnings quality. Krishnan, Sami and Zhang (2005), and Francis and Ke (2006), examined the 2001 data, taken before the SarbanesOxley Act, the results suggested that the audit quality of firms is poorer if the percentage of non-audit service fees is high. Lim and Tan (2008) reviewed the same annual data and concluded that the presence of non-audit services is detrimental to audit quality. Criticism of the Sarbanes-Oxley Act holds that the act is overly stringent, detailed, and cumbersome, causing extra governance costs to companies. Article 404 in particular increases listing costs and litigation risks, and damages the competitiveness of U.S. capital markets. Dispute over the causal relation between non-audit services and audit quality centers on whether such a relation changed after the updated regulations of the Sarbanes-Oxley Act in 2002 regarding the independence of auditors and restrictions over the scope of non-audit services.

This paper investigates the effect of corporate governance (CG) mechanisms on the extent of accounting conservatism in Egypt. Separation between a firm’s principals (shareholders) and managers (insiders) can result in managers having greater access to information relating to its operations and management. Meanwhile the primary source of information for shareholders is financial statements published by management. Shareholders are always concerned with how managers implement the principles of accounting conservatism in their financial estimates, as this often results in better protection for shareholders (Cullinan et al., 2012). One reason for the increasing interest in accounting conservatism is that not all areas of accounting are covered by accounting standards (Chung et al., 2003), with some areas requiring a manager’s judgement, which could range from neutral or aggressive, and finally to conservative behaviour and decisions. Therefore, the level of accounting conservatism arguably depends on a manager’s estimates. To control managers’ estimates and maintain conservative reporting, managers should be monitored by instituting a number of CG mechanisms. For instance, the presence of a large number of outsiders on the board can enhance the monitoring process, making managers more conservative in their financial reporting (Garcı´a Lara et al., 2007). Several studies suggest that CG mechanisms can enhance the level of accounting conservatism (Ahmed and Duellman, 2007; Ahmed and Henry, 2012; Elshandidy and Hassanein, 2014; Kukah et al., 2016). Indeed, other studies have demonstrated that CG mechanisms, such as board size and board independence, can reduce accounting conservatism (Chi et al., 2009; Lim, 2011). Meanwhile previous literature emphasises that effective CG mechanisms restrict a manager’s opportunistic behaviour, and thus induce them to be more conservative in their financial reporting. However, the link between CG mechanisms and accounting conservatism varies across different institutional settings. For instance – and using a sample of US firms – Garcı´a Lara et al. (2009) note that there is a positive association between CG mechanisms and the level of accounting conservatism. Similarly, Lim (2011) evinces that CG attributes enhance the level of accounting conservatism in Australian firms. This study, therefore, examines the effect of CG attributes on the level of accounting conservatism in Egypt. As with the CG mechanisms examined in previous literature, the common CG mechanisms that have been used in past studies include board size, board independence, separation between the roles of chairman and chief executive officer (CEO) positions, and auditor type. Noticeably, the decision to focus on Egypt is motivated by a number of reasons. First, most empirical evidence examining the association between CG and accounting conservatism has been conducted in developed countries (Ahmed and Duellman, 2007; Garcı´a Lara et al., 2007; Cullinan et al., 2012) rather than in developing countries, such as Egypt.

Accounting conservatism is a fundamental principle that has always influenced accounting practices and financial statements. In the accounting literature, this concept has been widely discussed, in terms of its variation over time or across different legal and political regimes (Ball et al, 2008; Ball and Shivacumar 2005; Basu 1997; D’Arcy 2001; Gassen et al. 2006; Lara and Mora 2004; Pope and Walker 1999). Zeghal et al. (2012) introduced conservatism as an attribute of the quality of results and found that it decreased following the mandatory adoption of IFRS. Moreover, these authors found that a decrease in conservatism is more important for the group of countries whose local standards diverge significantly from international standards. In an effort to learn more about the consequences for accounting conservatism of adopting IFRS, it is appropriate to examine the potential impact of culture. Indeed, accounting literature has shown that culture is a key factor in explaining international differences. In their study of the differences in international standards, Ding et al. (2005) found that culture significantly explains divergence between local and international standards. Moreover, the authors underline that the legal system, which was often evoked in the accounting literature to explain accounting differences and international harmonization, turns out to be less explanatory than culture does. In this paper, our aim is to analyze the role of culture in explaining the consequences of IFRS adoption. More specifically, we are interested in analyzing the effect of culture on variation in accounting conservatism following the mandatory adoption of IFRS in the European Union. In fact, the application of these standards did not affect all countries in the same way (Gassen et al. 2006; Hung and Subramanyam 2007; Prather-Kinsey et al. 2008; Soderstrom and Sun 2007; Zeghal et al 2011; Zeghal et al. 2012). In a recent study, Borker (2013) proposed to determine a favorable cultural profile for IFRS. The author raised the issue of applying a set of standards known for their close resemblance to the Anglo-American model in regions with different cultures. The impact of culture on accounting systems and therefore on accounting principles seems important. At this stage, we already expect that culture influences accounting conservatism. In fact, Gray (1988) established a link between the cultural dimensions developed by Hofstede and accounting values. We believe that the results of this study will contribute to a better understanding of the consequences of IFRS application This makes it possible to capture certain biases in the accounting data of countries with different cultures, despite their adoption of IFRS. The remainder of the paper is organized as follows: Section 2 presents a review of the relevant literature the objectives of the study and the research hypotheses. Section 3 describes the methodology. Section 4 reports and discusses the results. Finally, section 5 summarizes the findings and concludes the paper.

Many accounting variables represent estimates of future outcomes. For example, the bad debt expense, pension liabilities, and depreciation expense all reflect managers’ estimates of the future. In fact, many accounting variables are labeled as estimates, such as earnings forecasts and estimated contingent liabilities. Therefore decision-making under conditions of uncertainty is of fundamental importance in accounting. When individuals make predictions they must form beliefs about unknown parameters (Von Neumann and Morgenstern 1967). This entails estimation risk. Estimation risk matters because it alters the behavior of risk-averse individuals (Klein and Bawa 1976). This study shows that estimation risk has a large impact on the degree of conservatism exhibited by risk-averse auditors. We focus on the estimation risk associated with predicting bankruptcy because auditors can incur substantial losses from litigation and reputation impairment when their clients file for bankruptcy (Palmrose 1987; Carcello and Palmrose 1994; Lys and Watts 1994; U.S. House of Representatives 1985, 1990; Firth 1990; Weil 2001; House of Lords 2011). These losses mean that it is important for auditors to form accurate expectations about the likelihood of bankruptcy. Estimation risk arises because the probability that a client will file for bankruptcy is not known. Instead, the probability must be estimated. The level of estimation risk captures the degree of imprecision in the point estimates of bankruptcy. We argue that estimation risk is likely to have a significant impact on auditor behavior because auditors are risk averse. To clarify the distinction between bankruptcy risk and estimation risk, it is helpful to introduce some notation. Let B* represent the risk that a company will file for bankruptcy in the future, where B* is uncertain and therefore must be estimated. Let B^* represent the best point estimate of B* . We measure estimation risk using the standard errors of the point estimates, (SE B^*
), because the standard errors reflect the precision of each point estimate. In particular, B^* is a less precise measure of the company’s bankruptcy risk when SE B^*
is larger, i.e., when there is more uncertainty surrounding the point estimate. When estimation risk (SE B^*
Þ is higher, it is more probable that the point estimate (B^* ) will turn out to be incorrect ex post, which imposes incremental risk upon risk-averse auditors. To illustrate, consider two companies, Y and Z, that have the same point estimates of bankruptcy risk (i.e., B^*y = B^*z), but company Z has higher estimation risk, i.e., SE B^*z
> SE B^*y
. The higher estimation risk implies greater uncertainty in predicting Z’s future bankruptcy status than predicting Y’s future bankruptcy status, even though both companies have the same point estimates of bankruptcy. This uncertainty is expected to be important in explaining auditor behavior because auditors are risk averse. 1 Risk-averse auditors will respond differently to companies Y and Z because Z has greater estimation risk, even though they have the same point estimates of bankruptcy risk. We expect that estimation risk causes risk-averse auditors to behave more conservatively. In particular, we predict that auditors respond to greater estimation risk by a) issuing more going-concern opinions, b) resigning more often from audit engagements, and c) charging higher audit fees. We test these predictions after controlling for the point estimates of bankruptcy (B^* ) to ensure that our estimation risk variable (SE B^*
) captures the incremental effect of estimation risk on auditor behavior.

Under conservative accounting, book values should reasonably proxy for liquidation values, thereby allowing lenders to better monitor the borrower‟s ability to repay (Watts, 2003). However, financial reports are generally prepared on a going-concern (GC) basis rather than a liquidation basis. This gives distressed companies considerable leeway to report book values of assets that exceed their liquidation values. We argue that conservative audit reporting helps to compensate for this lack of conservatism in the balance sheet. In particular, auditors are more likely to issue GC opinions when the book values of assets are high compared with their expected liquidation values. This interaction between balance sheet conservatism and GC reporting has not been previously discussed or empirically examined in the literature. Instead, prior studies examine whether auditors‟ GC opinions provide a cautionary warning to investors about the probability of bankruptcy. Our study is different because we focus on the expected outcome of bankruptcy rather than the likelihood of bankruptcy taking place. That is, we focus on the assets‟ liquidation values and the differences between these liquidation values and the assets‟ reported book values under the GC assumption. 1 Our first hypothesis is that auditors issue GC opinions when the liquidation values of assets are expected to be low relative to their book values. In short, if two companies have the same probability of bankruptcy and identical liquidation values, then a GC opinion is more likely to be issued to the company whose assets have higher book values. This first hypothesis takes an auditor perspective in explaining the auditor‟s decision to issue a GC opinion. Our second hypothesis takes the perspective of financial statements users. In particular, we test whether the issuance of a GC opinion has incremental information content for predicting the future realization rate (where the future realization rate is the ratio of future liquidation value to book value). If the GC opinion signals an auditor‟s private information about the lack of balance sheet conservatism, we expect the issuance of a GC opinion to predict lower future realization rates among the companies that file for bankruptcy.

The existing literature documents that Chinese state-owned firms do not have significant levels of conditional accounting conservatism [1] (conditional conservatism hereafter) primarily due to the low demand for conservatism from the debt or bank loan market (see Chen et al., 2010). If other determinants of conditional conservatism such as litigation, regulation or tax (see Watts, 2003; Garcia Lara et al., 2009) are assumed constant, the contracting determinant encompasses more than debt contracting. Little research is conducted on the conditional conservatism in Chinese state-controlled firms with no debt. This study attempts to explore additional dimensions of contracting determinant that could induce conditional conservatism in state-controlled firms, specifically examining the equity demand for conditional conservatism [2]. Along with the debt market demand for conditional conservatism, equity investors can demand accounting conservatism because it allows shareholders to mitigate managerial motivations of opportunistic activities such as expropriation and/or poor project selection (Watts, 2003). Investigating a subsample of US firms with zero leverage, Louis and Urcan (2015) find these firms also exhibit conditional conservatism. They attribute this result to the demand for conditional conservatism from equity investors and suggest that shareholders demand accounting conservatism to mitigate agency conflicts between shareholders and managers. The investor attraction perspective is another dimension of the equity-market demand for conditional conservatism (Hirshleifer and Teoh, 2009). This view argues that individuals process gains and losses differently (Dickhaut et al., 2010), and the relative disappointment from losses exceeds the benefits of gains. Therefore, investors would demand for conditional conservatism because conditional conservatism may reduce the likelihood of future disappointments.