Corporate Governance and Accounting Conservatism in China

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Corporate Governance and Accounting Conservatism in China*
Donglin Xiaa and Song Zhub,**

School of Economics and Management, Tsinghua University, China School of Economics and Business Administration, Beijing Normal University, China


Abstract A principal-agent relationship exists among creditors, shareholders and management, and information asymmetry among them leads to asymmetric loss functions, which induces conservative accounting. This paper investigates the determinants of accounting conservatism using accrual-based measures and data from 2001 to 2006 in China. We find that a higher degree of leverage, lower level of control of ultimate shareholders and lower level of management ownership lead to more conservative financial reporting. We also find that political concerns and pressures among state-owned enterprises are greater than those among non-state owned enterprises, which leads to more conservative financial reporting among the former. However, a decrease in such concerns leads to a decrease in accounting conservatism. Overall, we find that among the determinants of conservatism in China, debt is the most important, followed by ownership, and that board has little influence. JEL classification: G30; M41 Keywords: Information asymmetry; Agency problem; Accounting conservatism; Political concerns; Corporate governance


We thank George Yang from Chinese University of Hong Kong and participants at CJAR Summer Research Workshop for helpful comments. We express our sincere appreciation to the anonymous referee and the English editor. This paper is sponsored by the National Natural Science Foundation of China (grant number 70772017). ** Corresponding author. Song Zhu: E-mail address: Correspondence address: School of Economics and Business Administration, Beijing Normal University, Beijing, China, 100875. Donglin Xia: E-mail address: School of Economics and Management, Tsinghua University, Beijing, China, 100084.




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1. Introduction
Conservatism is an important and basic principle in financial accounting. It stipulates that possible errors in measurement should be in the direction of understatement rather than overstatement of net income and net assets. If two estimates of earnings or assets to be received or paid in the future are approximately equally likely, then conservatism dictates that the less optimistic one be used (Statement of Financial Accounting Concepts No. 2, FASB).1 Under conservative accounting, the average market value is higher than the book value in the long run (Feltham and Ohlson, 1995; Zhang, 2000; Beaver and Ryan, 2000; Penman and Zhang, 2002). Such accounting recognizes bad news in a more timely way than it does good news, leading to asymmetric timeliness of earnings (Basu, 1997; Ball et al., 2000; Givoly and Hayn, 2000; Holthausen and Watts, 2001; Ball et al., 2003; Watts, 2003a). This type of conservatism is also known as conditional conservatism (Beaver and Ryan, 2005).2 Conservatism is beneficial for creditors,3 minority stockholders,4 the whole firm5 and regulatory authorities6 (Ahmed et al., 2002; Watts, 2003a; Francis et al., 2004; Nikolave, 2006; Ahmed and Duellman, 2007; Zhang, 2008). Watts (2003a) proposes that one factor influencing accounting conservatism is regulations. He argues that standard setting authorities may face political pressure and public criticism. To reduce their political costs and protect the interests of investors, these authorities prefer conservative accounting (Bushman and Piotroski, 2006). However, Ball et al. (2003) contend that management incentives have a greater influence on financial reporting policies than have other factors. In China, managers face pressure from the government. This affects their political future and is thus likely to be






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