Unconditional Conservatism and Subsequent Real Earnings Management

39 Pages Posted: 11 Feb 2020

See all articles by Debarati Basu

Debarati Basu

XLRI - Xavier School of Management

Kaustav Sen

Pace University - Lubin School of Business

Date Written: December 1, 2019

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

Suggested Citation

Basu, Debarati and Sen, Kaustav, Unconditional Conservatism and Subsequent Real Earnings Management (December 1, 2019). Pace University Research Paper, Available at SSRN: https://ssrn.com/abstract=3521161 or http://dx.doi.org/10.2139/ssrn.3521161

Debarati Basu (Contact Author)

XLRI - Xavier School of Management ( email )

C H Area (E), Jamshedpur, Jharkhand
831001
India

HOME PAGE: http://https://acad.xlri.ac.in/facprofile/index.php?701

Kaustav Sen

Pace University - Lubin School of Business ( email )

1 Pace Plaza
New York, NY 10038-1502
United States
212 618 6413 (Phone)
212 618 6410 (Fax)

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