Unconditional Conservatism and Subsequent Real Earnings Management

Abstract

By focusing on the more pervasive unconditional conservatism, we provide fresh insights on how conservatism can be detrimental to financial reporting quality. We examine whether unconditionally conservative (UC) firms engage in more real earnings management (REM) in order to meet or beat earnings benchmarks (MBE). UC firms are expected to be prudent with persistently lower earnings. REM, on the contrary, is an expensive way, with long-term consequences, of manipulating earnings upwards. As expected, we find UC firms display higher discretionary expenses. However, UC firms suspected of engaging in MBE cut back on these expenses (REM) by 0.5 to 2 percent of earnings. Our results reveal differences in manipulation strategies adopted across different organizational forms: group-affiliated UC firms use this strategy opportunistically. Stronger monitoring decreases the level of REM at UC firms. Additionally, accruals manipulation and insider ownership affect an UC firm’s REM choices. Thus, decisions to manage real earnings and choose conservative reporting policies may be intertwined, adding to the debate about conservatism reducing reporting quality. Our findings identify opportunistic behaviour and real costs associated with being conservative which is counter-intuitive and a serious regulatory concern that standard setters and policy makers should consider.

Keywords: Prudence; Financial Reporting Quality; Opportunism; Monitoring; International Financial Reporting Standards (IFRS); Emerging Markets; Business Groups; Insider Ownership; India

JEL Classification: M41, M48, G15, L22, O53