The signalling theory of accounting conservatism developed in this chapter has the following implications for the accounting literature and accounting standards set- ters.
First, the signalling theory of accounting conservatism shows that conservatism may help addresses the problem of information asymmetry in the credit market. This theory shows that accounting conservatism is a signalling mechanism which can reduce, or eliminate, the information asymmetry about the borrower firm’s risk- iness. The model shows that high risk firms tend to adopt a lower degree of conser- vatism, while low risk firms tend to adopt a higher degree of conservatism. Since the lenders can learn about the true risk levels in the borrower firms through observing the borrower firms’ levels of conservatism, credit market rationing problem could be resolved. This underlines the information content contained in a firm’s degree of accounting conservatism.
Second, the signalling theory of conservatism suggests that a higher degree of accounting conservatism isnotalways good, or‘efficient’, if I use the word of Zhang (2008). In contrast, the prior literature tends to hold the view that the higher the de- gree of accounting conservatism, the more efficient the debt contract is. Such a view is evident in Zhang (2008), who interpret ‘efficiency’ as both theex antesaving of interest to the borrower firms and theex postreduction of managerial opportunism. While this notion of efficiency is intuitive, it may lead to undesirable or even illog- ical conclusions. If a higher degree of conservatism were always more desirable, then firms in the real world would have all adopted extreme conservatism, which is not supported by the existing empirical evidence. The fact that the existing empiri- cal evidence shows that there is a systematic cross-sectional variation in the degree of conservatism across firms indicates that there must be some costs to adopting higher degrees of accounting conservatism.
In this regard, the signalling model of conservatism explicitly recognizes that one of the costs of accounting conservatism is the decrease in the value of equity, which is the consequence of increasing the value of the debt. Given such cost, firms trade off the benefits and the costs of conservatism and adopt a degree of conservatism that is optimal for themselves. That results in an equilibriumdegree of accounting conservatism for each firm. The contribution of this model is that it shows that the equilibrium degree of conservatism may depend on the level of operating risk in the firm.
Third, the results of this chapter differ from the results obtained by Gigler et al. (2009), whose analytical study concludes that accounting conservatism is not ex post efficient, in the sense that conservatism triggers too many ‘false alarms’, i.e. early violations of debt-covenants. Gigler et al’s results indicate that accounting conservatism is not beneficial to debt-contracts, in contrast to the most of the em-
pirical literature in this area. In contrast, my model concludes that accounting con- servatism may indeed be beneficial to debt-contracts, although my model does not argue that conservatism is always beneficial. Whether a higher degree of conser- vatism benefits a firm depends very much on the firm’s level of operating risk
The differences between my conclusions and those of Gigler et al. (2009) are mainly due to the different ways in which each model is constructed. First, Gigler et al’s theory is based on a moral hazard model, whereas my theory is based on an adverse-selection/signalling model. Second, Gigler et al.(2009) treat the degree of accounting conservatism as an exogenous variable, whereas I treat it as an endoge- nous variable. Third, to a lesser extent, the concept of conservatism receives some- what different statistical characterizations in these two approaches, which partly contributes to the differences in the results obtained. I believe that the statistical characterization of conservatism in this chapter is more intuitive and more consis- tent with Basu’s (1997) operational definition of accounting conservatism.
Fourth, the signalling theory of conservatism proposed in this chapter identifies a potential area for future empirical research. The existing empirical literature on accounting conservatism primarily tends to emphasise the positive effect of con- servatism on the value of debt, but ignores the corresponding negative effect on the value of equity. Furthermore, the existing empirical work has predominantly focused on the economic demand for conservatism in a moral hazard framework (for example, Ahmed et al., 2002; Zhang, 2008). According to the best of my knowledge, no studies have yet directly examined the role of accounting conser- vatism in a signalling framework. It would thus be particularly interesting to em- pirically test whether firms with low operating risk tend to choose higher degrees of conservatism, and firms with high operating risk tend to choose lower degrees of conservatism.
Fifth, the signalling theory developed here has a direct implication for account- ing standard setters around the world. The signalling theory contends that account- ing standards should not be over-restrictive in terms of the degrees of accounting conservatism that firms can adopt. Instead, firms should have some freedom in choosing their own degree of accounting conservatism, within a certain range, of course. If accounting standards forced all firms to adopt the same uniform degree of conservatism regardless of their levels of risk, the signalling power of conser- vatism, and hence its potential contribution to value, could be lost.
3.6
Conclusions
In this chapter, I have proposed a new theory to explain the existence of, and the demand for, accounting conservatism, which is based on a signalling model of con- servatism in the debt market. This theory shows that the economic demand for accounting conservatism may not only driven by litigation costs and moral haz- ard issues, but also driven by the issue of information asymmetryin the debt mar- ket. The equilibrium of this chapter’s signalling game demonstrates that accounting conservatism, acting as a signalling device, can reduce the information asymmetry between lenders and borrowers. The main findings of this chapter can be divided in two categories, as below.
First, I established four basic properties of accounting conservatism, as stated in the four lemmas. The analytical proofs of these four properties are based on Basu’s (1997) definition of conservatism as the asymmetric timeliness of earnings, and re- quire very few additional assumptions. The definition of risk is based on Rothschild and Stiglitz’s (1970) mean-preserving-spread. The four lemmas together examine the joint impact of accounting conservatism and a firm’s operating risk on the firm’s
earnings, and the values of debts and equity. These lemmas therefore establish a bridge connecting accounting conservatism on one side and the operating risk on the other.
Second, I investigated the signalling role of accounting conservatism in the debt market. In this chapter, there are two levels of risk: Risky and Safe. The firm it- self and its equity-holders know its own level of operating risk, but the lenders in the credit market do not have that information. In the long-run, this information asymmetry problem may lead to adverse-selection in the credit-market, and possi- bly a credit-rationing problem (Stiglitz and Weiss, 1981). The model shows that accounting conservatism can help resolve this problem, by serving as an informa- tion signal about the firm’s true level of risk. In particular, this chapter proves that if the Single-Crossing Property of conservatism holds, then there exists a continuum of separating signalling equilibria. In the separating equilibrium, the risky firms choose a low level of conservatism (usually the zero level), while the safe firms choose a high level of conservatism.
In addition, using Cho and Kreps’s intuitive criterion, I further ruled out the pooling equilibrium from this signalling game, because the pooling equilibrium is unstable. This implies that the separating equilibrium is the only stable solution to the signalling game.
The proposed theory has a range of potential implications for both accounting researchers and accounting standard setters. In Appendix B to this chapter, I provide a preliminary empirical test of the signalling theory. The results are supportive, but opportunities for more rigorous tests remain for future research.