Academic journal article The International Journal of Business and Finance Research

Operating Risk and Accounting Conservatism: An Empirical Study

Academic journal article The International Journal of Business and Finance Research

Operating Risk and Accounting Conservatism: An Empirical Study

Article excerpt

ABSTRACT

This paper empirically tests the relation between a firm's degree of accounting conservatism and its level of operating risk. This paper constitutes the first empirical study in the accounting literature to test the risk signaling theory of accounting conservatism which is recently proposed by Wang, O hOgartaigh and van Zijl (2010), who argue that a firm optimally selects a degree of accounting conservatism in order to signal its own operating risk to the capital market. Consistent with the signaling theory, this paper reports empirical evidence that US firms with a lower level of operating risk are more likely to adopt a higher level of accounting conservatism than are firms with a higher level of operating risk. This finding indicates that a signaling separating equilibrium indeed exists in the capital market, where firms use accounting conservatism as a signaling device. The findings of this paper highlights the important economic role that accounting conservatism plays in reducing the capital market's information asymmetry with regard to the firm's operating risk.

JEL: G14, M40, M41.

KEYWORDS: Accounting Conservatism, Asymmetric Timeliness of Earnings, Basu Measure, Risk, Asset Volatility.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Accounting conservatism is widely regarded as one of the oldest and most important principles of accounting (Sterling, 1967; Watts 2003a). Traditionally, conservatism in accounting ensures that costs are not understated in the accounts and revenues are not overstated, and it achieves this goal by requiring accountants, when facing uncertainties in economic transactions, or risks, to adopt higher verification criteria for assets and revenues, but lower verification criteria for liabilities and expenses (Basu 1997; Watts 2003a). Due to the pervasive nature of the conservatism principle in accounting, this principle has profound influences on many, if not all, accounting standards in US GAAP and IFRS, as well as on the professional judgments of generations of accountants.

The objective of this paper is to empirically examine the relation between a firm's choice of accounting conservatism and its operating risk. In a recent analytical study, Wang, O hOgartaigh and van Zijl (2010) propose a signaling theory of accounting conservatism in which accounting conservatism serves as a signal by which a borrower firm can convey their private information about their own operating risk to the lenders, prior to the signing of the debt contract. This signaling model of accounting conservatism has a separating equilibrium, in which the low risk firms choose a high degree of accounting conservatism and the high risk firms a low degree of conservatism (Wang et al., 2010). In this paper, I empirically test some of the key predictions of the signaling theory of accounting conservatism.

This study contributes to the accounting literature in the following two areas: First, this study offers the literature's first empirical test of the signaling theory of accounting conservatism proposed by Wang et al. (2010). Second, this study introduces the Vassalou and Xing (2004) iterative algorithm to the accounting literature, which is employed in this paper to quantify firms' operating risk. The Vassalou and Xing (2004) algorithm can be used not only to measure operating risk of a firm, but also to gauge the default risk of the firm, although this feature is not used in this particular study due to the fact that the focus of this study is on operating risk only. The rest of this paper is structured as follows: Section 2 critically reviews the literature on accounting conservatism and Section 3 analyzes the relation between accounting conservatism and the operating risk of the firm based on the signaling framework proposed by Wang et al. (2010). Section 4 discusses the Vassalou and Xing' s (2004) iterative method for measuring asset volatility. Section 5 describes the sample data and their descriptive statistics. …

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